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The changing face of public power: survival of the fittest?

Many municipal utilities and rural electric cooperatives stand on the brink of dramatic structural changes that could sink their credit quality if they fail to transform themselves effectively, according to Standard & Poor's public finance analysts who spoke at a recent Standard & Poor's public power credit seminar in New York.

"As deregulation takes effect throughout the electric utility industry, public power systems need to take lessons from the strategic moves of their investor-owned counter-parts," according to William Cox, director of the Municipal infrastructure rating unit in Standard & Poor's Public Finance Rating department.

"Municipal power systems face significant losses due to stranded costs and revenues," said Marla Fox, an infrastructure group director. A Standard & Poor's study suggests that just retail municipal utilities in California and their wholesale suppliers face more than $1 billion in lost revenue because of stranded costs.

Also, public power entities must confront and navigate past a number of credit shoals born of deregulation, including the need to broaden their investors base, and IRS questions regarding the future of their tax-exempt status if they try to market themselves outside their traditional service areas, and acquisition of risk management and market-hedging expertise.

Public power system executives and market participants need to suspend their traditional assumptions about the status quo and focus on some sobering realties, Cox warned.

"This is a commodity business that is moving to market-based pricing from cost-plus pricing. This is an industry that is demanding rapid response to direct competitive threats. This is an industry requiring its members to gain every possible economy, efficiency, and cost saving. This is an industry that requires aggressive advertising and differentiatation of individual firms from their competitors."

Technological Advances

The public power market is also witnessing uprecedented technological advances and unprecedented growth in market and pricing risks, requiring new and confusing financial tools and risk-management techniques.

Investors must face the reality that public power debt can no longer be analyzed as a mere municipal revenue bond. "It is a government-owned business in a highly competitive market," Cox said.

The changing competitive environment means public utilities must consider sheding the use of debt service reserves, which may be a vestige of the traditional, highly regulated utility market. Systems must decide if the traditional municipal model of level debt service will make sense in in the future.

"Cooperatives and investor-owned utilities will pay down their debt and depreciate their assets," Cox said, "but municipal systems will still accumulated deferred charges" that will have to paid in future years, keeping their fixed costs high.

Despite these impending problems, the majority of Standard & Poor's 175 public utility rating carry a stable outlook, according to Mark Glotfelty, an associate director in the infrastructure group. "The majority of the systems are retail with large residential customers bases that will feel the effects of competitions last," he said. "However, the rapid change in the industry is putting a downward pressure by the negative outlooks on 14 percent of our ratings." Most of these utilities (representing more than $25 billion in debt) are wholesale, and competition is the most fierce at this level.

Public utilities will reexamine every aspect of their businesses. Services that are not profitable or where there is a lack of customer demand will be done away with in order to achieve cost savings. Many utilities win try to fill niches in their local market for nontraditional revenues to augment their core business of power sales and expand market share," Glotfelty predicted.

Utilities might leverage their existing customer base by offering telecommunications services, including local, long-distance, and wireless phone services. The cooperative sector has been in the forefront of providing these types of services compared to many municipal systems because of their obligation to provide economic development initiatives to the rural U.S. "Standard & Poor's believes any utility seeking to provide these types of services should carefully weight the risks and rewards and strike an appropriate balance between the two," Glotfelty said.

Customer Importance

Utilities are beginning to see the importance of the customer to the overall business health of the utility due to the impending deregulation of the industry. Utilities have made dramatic changes in rate structures, such as the Sacramento Municipal Utility District, which this year voted to terminate a heavily subsidized rate class for all-electric, space-heated residences, and Santee Cooper, whose industrial customers are served mostly under contracts calling for market-competitive average rates of 2.5-3.5 cents per kwh.

Another way that electric utilities cut costs and reduce rates is through alliances" Glotfelty added. Some examples are the generation alliance formed between Dairyland Power Cooperative and Cooperative Power Association and the newly formed Alliance for Cooperative Energy Services that was formed by nine G&T's. If the two cooperatives are successful, the improved cost profile will improve their competitive positions.

"While the cooperative sector may have more experience in pulling together to work through trying times," Glotfelty said, "the public-power sector has not experienced the kind of uncertainty over future funding that the cooperative sector is now going through because of the uncertainty over the future of the Rural Utilities Service (RUS).

Standard & Poor's believes that future finding by the RUS with eventually go away. Cooperatives increasingly will need to turn to sources of finding not traditionally used, such as the public capital markets. Cooperatives win need to begin to position themselves before entering the public markets.

Stranded Costs

A key financial consideration that must be factored into any utility's plan is how to deal with stranded costs, the costs associated with utility investments in power generation and transmission assets that win not be recoverable from rate payers when rates are deregulated and based only on market demand.

Standard & Poor's recognizes a parallel concern called stranded revenues, according to Fox. Stranded revenues are a utility's costs that need to be decreased, or revenues increased, to meet the market price for power.

Standard & Poor's conducted a study of the stranded cost and revenue issues among municipal utilities. The preliminary work in the study, in California retail municipal utilities, suggested that the potential annual revenue losses were nearly $700 million per year, and losses for wholesale suppliers, including the Intermountain Power Agency, are nearly 400 million for a total of more than $1 billion for the southern California public power market alone. Most of this is concentrated in the high cost and large Los Angeles Department of Water and Power and Intermountain Power Agency.

"The intent of this study," Fox said, "is to provide a framework for the up-to-now ignored public power and cooperative sectors and to determine, on an individual basis, what they need to do in order to get their houses in order for inevitable competition."

Sector Trends

Municipal utility systems face continuing erosion of credit quality as they struggle to meet competitive threats over the nest several years. `BB' ratings may not be as rare in the municipal and cooperative sectors. Neither will `AA' ratings be as commonplace.

"We're seen that traditional answers to traditional problems will no longer be satisfactory," Fox added. "Utilities have to be agile, responsive and willing to make changes and make hard choices."

"We've seen that traditional answers to traditional problems will no longer be satisfactory," Fox added. "Utilities have to be agile, responsive and willing to make changes and make hard choices."

Among the other trends Standard & Poor's thinks will resist:

* The debt structures lof many generating municipals will continue to plague them until significant inroads are made to pay off their sizable investments and high cost debt;

* The trend to disaggregate utility operations will continue. Rating will bear out the risks inherent in competitive generation market and strengths in transmission service;

* Stranded revenues will challenge many joint action agencies and other high-cost, debt-burdened systems; and

* Many IOUs, as well as some enlightened munis and coops, have responded by beginning to position their utilities for the long haul.

* Standard & Poor's contacts: William Cox, (212) 208-1866; Marla Fox, (212) 208-1863; Mark Glotfelty (212) 208-1352; Steven L. Lubetkin (212) 208-8784.

Pasadena Prepares For

Electricity Deregulation

In a watershed decision that will end its local municipal utility's monopoly of providing electric power, the Pasadena, Calif., city council recently voted to open the city doors to outside competition. As a result, the Pasadena Water and Power Department's 57,800 residential and commercial customers will be able to choose their own electricity providers starting in the year 2000.

Direct access assures our customers that they will receive the benefits of deregulation by having access to electricity at market-based prices,' said city manager Philip Hawkey. The decision, made after a year-long planning and community education campaign that produced nearly 300 recommendations for change within the utility, also clears the way for Pasadena to prepare for activities related to marketing, customer retention, infrastructure improvements, rate design, and building additional market share.

Electric rates in Pasadena already are 40 to 60 percent below those charged by neighboring investor-owned utilities. "We are determined to compete aggressively so our customers will continue to reap the benefits of owning their own utility," said utilities general manager Rufus Hightower.

California state law allows municipal utilities to implement customer choice as late as 2010, but Pasadena determined it was ready to compete and thrive more quickly in the new electric utility marketplace. Investor-owned utilities currently control 70 percent of California's electric business.

Details: Philip Hawkey, (818) 405-4333 or Rufus Hightower, (818) 405-4425.
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Title Annotation:includes related article on electricity deregulation in Pasadena, California; reprint from the January 6, 1997, CreditWeek Municipal
Publication:Nation's Cities Weekly
Date:Jan 20, 1997
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