Utility debt risk

Katie Bradshaw (MBA/MEM '15)

Katie Bradshaw (MBA/MEM ’15)

Debt risk – in addition to revenue risk – were significant contributing factors in the Energy Future Holdings bankruptcy, the largest bankruptcy of a leveraged buyout on record. While it is relatively rare for utilities to declare bankruptcy, it is not unusual for utilities to carry high levels of debt. In fact, utilities often have capital structures with high amounts of debt combined with highly rated credit quality, signaling that they have a strong ability to repay that large debt.

Typically as debt levels increase, the risk and cost of bankruptcy increases and credit quality decreases. The degree to which bankruptcy risk increases as debt increases varies between companies and industries. For most companies, there is a certain optimum level of debt where the company balances out the benefit of a tax shield and the risk/cost of bankruptcy. Determining this optimal capital structure is difficult for all companies, not just utilities.

Energy Future Holdings and Jefferson County Sewer Authority – which went bankrupt in 2008 – provide excellent examples of the risks associated with utility debt.

What makes utility debt unique?

Utility debt is unique in that utilities have the ability to carry highly levered capital structures while still maintaining a high credit rating. Factors that contribute to these unique debt characteristics include:

Importance of the asset. The majority of utilities have long-term importance and relevance because they provide a product or service that is relied upon in every day life. As a result of this importance, utilities often have a relationship with a government entity. Some utilities are operated independently but are regulated by the government as regulated monopolies, while other utilities have a more direct relationship with government entities such as towns, cities, counties or municipalities.

Because of the governmental relationships, most creditors believe that if the utility for some reason could not meet their debt service payments, the governmental entity would step up and make the payment. As a result, the utility’s credit quality is enhanced by the support of the government entity.

Capital intensive nature. Utilities have high fixed costs, and the associated infrastructure is highly capital intensive. For power and energy utilities this comes in the form of power plants and electric transmission lines, while for water utilities this is in the form of water treatment facilities and water lines. As a result of these infrastructure requirements, utilities must often take out large amounts of debt to fund these large capital expenditures.

Utility debt risk factors

With utility debt there are several associated risk factors. Utility debt risk levels can often be obscured by their credit rating. In addition, while it may seem as if utilities are not subject to broader economic factors because of their importance and governmental association, in reality, utilities still face the same economic risk factors that affect other types of companies.

Obscured risk. On average, the majority of utilities have investment grade credit ratings, with 76% of all US utilities since 1983 falling in the Aa and single-A ratings.1 These high credit ratings imply a low risk of default, but for utilities this can be a misleading representation of credit worthiness. Utilities tend to have high credit ratings at all times – even when leading up to a bankruptcy – making the risk of a utility bankruptcy appear lower than the actual risk levels.

For example, one year in advance of the Jefferson County Sewer Enterprise bankruptcy, the utility’s credit rating was investment grade at single-A, and declined to Caa only right before default.2 The Energy Future Holdings bankruptcy was an exception, in that it was well known that the utility was in trouble and it was only a matter of time before they would be forced to file for bankruptcy. Energy Future Holdings had a speculative grade credit rating at B2 in 2007 before falling to Caa3 in 2012, and they maintained that low rating up until the April 2014 bankruptcy filing.

Economic factors. Despite the fact that utilities provide an important and irreplaceable product, they still face the effects of economic downturns. The Jefferson County Sewer Enterprise fell victim to some of the same debt problems that other companies and individuals faced during the most recent recession. After EPA pursued enforcement action, Jefferson County Sewer Enterprise needed significant capital to upgrade their water and sewer systems. As a result of these needed capital expenditures, the utility assumed a significant amount of debt. The debt included a variety of rate instruments intended to keep debt service at an affordable level. Unfortunately, these rate instruments led to a liquidity problem and made the debt service payments no longer affordable in the period leading up to the recession. As a result of these unaffordable debt service payments, the utility was forced to declare bankruptcy at the start of the recession in 2008.3

As a leveraged private equity buyout, the Energy Future Holdings bankruptcy was also impacted by the most recent recession. The cheap and easily available debt allowed private equity investors to execute a large leveraged buyout. Furthermore, deal valuations were high, forcing private equity investors to take out large amounts of debt to complete the buyout.

Similar to the Jefferson County Sewer Enterprise, Energy Future Holdings simply had debt levels that were well beyond their ability to repay. Economic activity is highly cyclical and it is likely that in the future, other utilities may be in similar situations to Energy Future Holdings and Jefferson County Sewer Enterprise.

Lessons learned

Utilities are in the unique position where they can acquire large amounts of debt because of their important and capital intensive nature, but these same factors make determining the real debt risk difficult.

Although utility bankruptcies are rare, they are not immune to some of the same risks that other companies face, including economic factors. Like other companies, utilities should be careful not to over-lever simply because they have the ability to obtain large amounts of relatively cheap debt. Investors should be careful to evaluate both the revenue risk and the debt risk that a utility faces before moving forward with investments.

By Katie Bradshaw (MBA/MEM ’15)

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Republished with permission from the UNC Environmental Finance Center blog.

[1] Agarwal, Varun, Erica Gauto Flesch, William Hunter, and Merxe Tudela. “Infrastructure Default and Recovery Rates, 1983-2013.” Moody’s Investors Service. May 12, 2014. [2] Ibid. [3] Ibid. [4] Creswell, Julie and Michael J. De La Merced. “Settling the Bets of the Private-Equity Megadeal’s Golden Age.” The New York Times. April 29, 2014.