The Next Big Thing: The Fuels Dilemma

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Early Warning Signals
Sharon Bonelli NARUC Accounting/Finance
Conference Salt Lake City, September 21, 2005
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Agenda

• Update on power sector credit rating environment
• Primary focus of credit rating process is cash
  flow
• Early warning signals of power company credit
  deterioration
• Operating
• Investing
• Funding

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Median Senior Unsecured Ratings by Sub-sector

• 08/31/2005
• Utility parent companies BBB
• Integrated utilities BBB
• Distribution companies A-
• Pipelines BBB
• Diversified/unregulated BBB-

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Summary of Ratings Actions
Source FitchRatings. As of August 31, 2005.
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Rating Outlook Distribution
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Anatomy of a Credit Crisis
Limited Financial Flexibility
Flaw in Strategy or Business Plan
Negative Cash Flow
Precursors
Adverse Market Event Loss of Market Confidence
Trigger Event
LIQUIDITY CRISIS!
Asset sales emergency bank credit negotiations
with creditors sale of company
Potential Remedies
Solvency
Insolvency bankruptcy
Outcome
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Whats Happening to Utility Cash Flow?
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Whats Happening to Cash Flow?

• Rising unit costs
• Fuel, Fuel, Fuel!
• Purchased power
• Operating and maintenance expenses
• Pension and OPEB funding requirements
• Growing deferrals for under-recovered costs
• Rising liquidity needs for working capital
• Rate filings - lead to regulatory fatigue?

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Operating Warning Signals
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OperatingWarningSignals

• Customer rates above those of neighboring
  utilities
• Unfavorable outlook for primary industries
  located in the service territory
• Concentration of suppliers with speculative
  credit quality
• Pepco/Mirant
• West Penn Power, Potomac Edison/AE Supply
• Decreasing operating and net margins
• Weakening operating performance metrics
• Increasing EFOR, SAIDI, customer complaints
• Declining availability of base-load units

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Operating Warning Signals

• Risk of outages at key plants during rate cap or
  rate freeze periods
• Monongahela Power
• Risks associated with capped or frozen tariffs
  and rising costs
• Historically, the California utilities
• Ameren UE
• Cleveland Electric Illuminating
• Virginia Electric Power Co.
• Florida Power Company
• First Energy (PA)

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Operating Warning Signals

• Lack of automatic rate adjustment mechanisms for
  fuel
• Central Illinois Light
• Dayton Power Light
• Kansas Gas Electric
• MidAmerican Energy Iowa
• Pacificorp
• Tuscon Electric Power
• Westar Energy
• Lack of automatic rate adjustment mechanism for
  environmental capital spending, power purchases,
  etc.
• Adverse outcome of rate filing
• Central Vermont Public Service
• Florida Power Light

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Operating Warning Signals

• Inadequate reserves, hedging or insurance for
  acts of God
• Low hydro conditions
• Portland General
• Pacificorp
• Idaho Power
• Avista
• Natural disasters

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Investing Warning Signals
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Investing Warning Signals

• Debt funded acquisitions
• Repeal of PUHCA may accelerate MA leading to
  rising event risk and parent level debt
• Investments by utility affiliates in non-core
  activities with uncertain cash flow prospects
• Merchant energy (Duke, Aquila, Xcel, Teco,
  Northeast Utilities, etc.)
• Telecom (Northwestern)
• Home alarms (Westar)
• Whats next?

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Investing Warning Signals

• Significant capital expenditures with no
  assurance of timely recovery or associated cash
  flow
• PSNH (Seabrook)
• LILCO (Shoreham)
• Merchant peaking plants

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Funding Warning Signals
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Funding Warning Signals

• Weakening ratios of FFO to interest and Debt to
  EBITDA
• Persistently negative cash flow during a low or
  negative growth environment
• Cash Flow From Operations less (capital
  expenditures plus dividends)
• Poor earnings quality (high AFUDC, asset sale
  proceeds)
• High sensitivity to market confidence
• Un-hedged commodity price exposure

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FundingWarning Signals

• Securities prices dropping (loan, bond, common
  stock, credit default swaps)
• Use of highly structured, overly complex
  securities
• Enron
• Calpine
• Presence of guarantees, triggers tied to
  affiliates ratings or financial ratios
• Reduced access to capital markets
• Commercial paper market closed
• Planned equity and debt offerings less
  over-subscribed or down-sized
• Debt spreads higher than peers
• Shift to unconventional buyers of securities,
  e.g. hedge funds, distressed debt investors

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Funding Warning Signals

• Bank credit facilities
• Presence of cross defaults to affiliates
  (XEL/NRG), or broad material adverse change
  language that limits requirements to fund
• Pattern of frequent amendments and waivers to
  cure technical defaults
• Increasing bank facility commitments because
  existing lines are fully drawn
• More restrictive terms in bank credit facilities
• Move to secured from unsecured
• Introduction of more onerous and numerous
  covenant reporting requirements
• Shorter covenant reporting cycle

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Funding Warning Signals

• Potential sources of liquidity problems
• Participation in a money pool or has business
  linkages with weaker affiliate
• Litigation that could result in an materially
  adverse legal judgment or settlement
• Lumpy debt maturity schedule
• Delays in financial statement filing or
  certification (DPL, El Paso)
• Disclosure of material weaknesses in reporting or
  controls
• Introduction of shareholder friendly initiatives
  (TXU)

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Other Early Warning Signals

• Over-valued assets relative to recent
  transactions and competitors asset valuations
• Management communication becomes much less (or
  more) frequent
• CFO or other senior officers resign or there is a
  lot of management turnover

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Related Research available at fitchratings.com

• Evaluating Liquidity in the U.S. Power and Gas
  Industry dated as of Sept. 12, 2005
• Wholesale Power Market Update dated as of August
  26, 2005
• Energy Policy Act of 2005 dated as of August 2,
  2005
• Hydro Update dated as of June 2, 2005

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