Recognizing climate change and in the wake of damaging storms and wildfires, regulators and utility executives have focused on building resilient infrastructure. COVID-19 reveals the importance of building a resilient utility business model.
At this writing, confirmed coronavirus cases in the U.S. have surpassed 1.8 million according to Johns Hopkins University. Stay-at-home orders have shuttered commercial and industrial facilities, which has led to steep declines in sales and revenues for some utilities. The unemployment rate in April 2020 approached 15% according to the Bureau of Labor Statistics and many economists expect it to rise further, perhaps to 20-25% by mid-summer. Public utilities in many jurisdictions have been ordered to postpone shut-offs and disconnections and invoice arrearages are growing at the same time as sales (and associated revenues) in the commercial and industrial sectors are coming in well under forecast levels. For example, one of our utility clients, who serves a region whose economy depends heavily on tourism, has seen a 15-20% decline in sales in recent months.
Credit rating agencies are watching carefully, and at least one – Standard & Poor’s – put the entire sector on negative watch over a month ago. For any utility that was already struggling with declining revenues, heavy debt burdens, or the need to recover costs driven by other natural disasters like hurricanes or wildfires, this latest COVID-19-induced revenue loss may be crippling. However, rate increases or decoupling mechanisms may not be the best way to address revenue shortfalls while utility customers themselves are experiencing unprecedented financial strain.
What are utilities’ options?
File for a rate increase
Given the magnitude of revenue shortfalls, one might expect utilities to be lining up for rate increases. However, Regulatory Research Associates (RRA), a division of Standard & Poor’s, noted that in the March - April 2020 period, only 13 filings were made, requesting about $260 million in additional revenue. This is a fraction of the 38 filings made for rate increases of $2.3 billion during the comparable period in 2019.
A rate increase filing is expensive, not only in terms of the cost of preparing and defending the filing, but also in terms of the public relations impact to both the utility and its regulator. Many utilities probably find a rate filing counter-productive at this time, observing the rising unemployment rate, the sharp contraction in household income, and given their desire to foster a positive relationship with their regulators.
Invoke or file for rate decoupling
Rate decoupling mechanisms ensure recovery of an approved revenue requirement, even if sales are above or below expectations. Rate decoupling plans help to protect a utility’s financial health when sales decline in response to energy efficiency measures, for example.
Decoupling mechanisms are less well-suited to the current situation, primarily because they are structured to recover rate deficiencies in the near term (the following year). For residential and C&I customers that are likely to be recovering slowly from the economic devastation following COVID-19, this might prove an intolerable burden—and one that could undermine public support for decoupling itself.
Defer recovery via a regulatory asset
Deferred recovery involves the creation of a regulatory asset. Regulatory assets result when costs are allowed, for ratemaking purposes, to be capitalized and amortized for recovery.
Regulatory assets are typically collected over many years, spreading out collection of high, one-time costs. This approach has been used to deal with cost recovery ranging from stranded assets to natural disasters (e.g., hurricane).
There is considerable interest in using this approach as a response to the current crisis. As recently reported by RRA, regulators in over a dozen states have opened proceedings to address approaches to dealing with the financial headwinds of the pandemic and another 20 commissions have already authorized deferrals.
Deferral may be better tolerated by the public than immediate rate increases. However, for some utilities experiencing an immediate cash shortage, deferred revenue collection via a regulatory asset may not be sufficient.
Securitization or bonding
What if a utility was already financially compromised before the pandemic hit because it was addressing the costs of storm damage, wildfires, or key assets that were stranded and underwater? When the electric industry restructured in the late 1990s and early 2000s, securitization was used to bridge the cash crunch caused by above-market generating assets and purchase power agreements, canceled capital projects, and other burdens created when power supply was dislocated from utility operations and moved to competitive wholesale markets.
To soften the impact to utilities and their customers, utilities ringfenced the required revenue stream established to pay these costs, assigned them to a special purpose entity (SPE), and then issued collateralized debt securities. This is not unlike a governmental “revenue bond” used to finance capital expenditures that produce income like a toll road or commuter rail system.
With legislation enabling securitization rather than a commission order, bonds were often higher rated than a utility’s existing debt. Once placed, the cash provided by the bond was used to defray lost revenues, retire higher-cost debt, or repurchase common stock. As such, this approach not only infused needed cash into utility operations, but also had the effect of lowering the utility’s weighted average cost of capital.
With interest rates at or near historic lows, and with massive federal aid propping up the economy, the current environment for securitization seems compelling as a means to protect utilities and their customers from the burdens of COVID-19-induced lost sales.
Ultimately, regulators and utility executives should seek an approach that maximizes the resilience of the utility business model, taking advantage of learnings from the current crisis to put regulatory and business processes in place that will allow utilities to better manage their finances through similar downturns and disruptions in the future.
We are looking forward to continuing the conversation,
Shawn Kelly | Senior Consultant