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Fixed-Income Insights

Not-for-profit retail electric utilities carry strong credit ratings, but we believe there are still critical differences that analysts must weigh to uncover relative value.

(Note: This article is from the forthcoming edition of The Muni Quarterly.)

When most electricity customers in the United States receive their monthly utility bills, they make out their checks payable to large, for-profit, investor-owned utilities overseen by third-party regulatory bodies. These utilities occasionally issue tax-exempt bonds, for certain eligible capital projects, but the majority of power sector tax-exempt issuance actually originates from a smaller, but just as vital, segment of the U.S. electric-generation industry: public power utilities.

Public power utilities are not-for-profit, community-owned entities that serve relatively smaller customer bases. The public power sector can be broken into two subsectors: retail electric utilities, which directly serve end users in their service area, and wholesale electric utilities, which sell generation to retail electric utilities.

Credit rating agencies (such as Standard & Poor’s and Moody’s) tend to rate very highly both retail and wholesale public power utilities. Retail electric utilities, for example, typically receive an ‘AA’ rating, given their essentiality, unregulated rate-setting authority, and monopolistic status in their service area.

 

While public power producers generally carry high credit ratings, differentiation among highly rated utilities is not only possible but also necessary.

 

One might think that given the commonality of upper-tier credit ratings, analysts would find overwhelming similarities among public power utilities when evaluating their bond issues. But, in our view, differentiation among highly rated utilities is not only possible but also necessary, given the sheer abundance of individual issuers: there are 2,011 unique utilities in public power, representing 60% of all unique electric utilities in the United States. Nevertheless, it is interesting to note that, according to the American Public Power Association, public power utilities are relatively small, serving just 49 million people in aggregate (15% of all customers). While there are a number of factors to consider in evaluating the credit profiles of public power entities, we believe there are two key differentiators: a utility’s cost-recovery profile and its generation profile.

Cost-Recovery Profile
Retail electric utilities generally have independent rate-setting authority, but many do not exercise their power to its fullest extent. Keep in mind that retail electric utilities are not-for-profit entities that aim to provide services at the most reasonable price point. What is most preferable for ratepayers (low rates) may not be optimal for the utility’s finance team or bondholders (such as higher rates for a greater financial cushion). Balancing affordability for the customer base with sound financial metrics for the utility is not always easy, especially for those entities that serve economically disadvantaged service areas, where ratepayers may be more sensitive to higher prices. Yet utilities may be willing to raise rates if such increases are less likely to face backlash from ratepayers.

Differentiation in how issuers recover operating costs from ratepayers can also be seen in how effectively, and efficiently, each utility collects revenues. Some utilities minimize fuel price risk by automatically adjusting rates in response to variability in fuel costs, whereas other utilities may adjust rates manually, and in a less timely fashion, in lieu of having in place a price-linked rate-raising mechanism. Some utilities minimize demand risk by automatically increasing rates to achieve revenue targets even if consumption declines. The existence of certain rate-setting mechanisms can help a utility maintain more consistent financial performance.

Generation Profile
In 2017, according to the U.S. Energy Information Administration, approximately 31% of electricity generation in the United States was fueled by coal, followed by natural gas (30%), nuclear (21%), and renewables (17%). The percentage breakdown of fuel used by the utility to provide electricity, known as the fuel mix, is often determined by geographic availability, regulations, and market dynamics. For example, utilities in the Pacific Northwest tend to derive a greater percentage of fuel needs from hydropower, given the abundance of hydroelectric projects built in the area in the mid-twentieth century. On the other hand, utilities in California have little coal dependency, given 1) relatively strict state mandates for cleaner energy and 2) a general preference by utilities for lower-priced natural gas fired plants in the past medium term. Generally, a diverse fuel mix is viewed more positively than a concentrated fuel mix, as an overweighting toward one particular source may leave a utility vulnerable to sudden price increases.

The quality of a utility’s generation assets and fuel mix today often drives tomorrow’s costs. Some fuels are more likely to require greater future capital expenditures. For example, a coal-dependent utility may have relatively higher capital expenditures to ensure compliance with environmental regulations. Or, a coal-dependent utility may have capital improvement plans that call for existing coal generation to be replaced with cleaner sources in the future, which is an expensive undertaking that may weaken credit metrics. A utility with aging and outdated generation capabilities, and relatively high capital expenditure needs, is less preferable from a credit perspective.

Conclusion
We firmly believe that relative value can be found anywhere in the municipal bond market, even in the highest-grade names within a stable sector. In the case of public power utilities, we differentiate among the large number of unique issuers thorough credit analysis of certain factors, which include, but are not limited to, cost recovery and generation. 
 

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