Expansion and environmental protection: The financial dilemma facing electric utilities

EXPANSION AND ENVIRONMENTAL PROTECTION: THE FINANCIAL DILEMMA FACING ELECTRIC UTILITIES Jerry

Sherman

The electric utility polluting the environment. Edison Utilities

and Fred Luthans'

industry is a very visable For example, in New York

is generally recognized as the single have depended primarily upon oil,

to generate is tons of

electricity; pollutants

and the by-product hurled into the air.

offender of City, Consolidated

largest polluter. coal, and natural

gas

of this generating effort With increased nuclear

power plants some of the air pollution problems are lessened, but thermal water pollution then becomes a problem. In fact, some experts are predicting that by 1980 one-sixth of all the nation's bodies of water will electrical utilities. utilities

be suffering

from

thermal

pollution

A practical solution to the environmental problems is needed. One obvious solution which modern

society a very

caused

caused by American

always turns to for solving its ills is more capital. high cost, the air and thermal pollution of utilities

greatly reduced. For example, Commonwealth Edison approximately $120 million in order to comply with

by

At can be

will have to pay an order to reduce

the thermal pollution of two of its nuclear stations. The problem for utilities, of course, is the lack of capital to pay the excessive price of environmental protection. Besides the outcry for utilities to reduce

their

the current

1 Jerry of Nebraska of Nebraska.

pollution,

energy

crisis.

the public is looking to them to help solve Thus, today the utility industry iS facing

Sherman is an Assistant Professor of Finance, University and Fred Luthans is a Professor of Management, University

30 a very precarious for more electrical

dilemma. energy

On the one hand is the increasing demand and on the other is the extremely high The financial crunch of this dilenmia protection.

cost of environmental has left the electric and challenges for explore how utilities what, if pollution feas

utility the

industry

future. got into

with

The purpose their current

some very

serious

problems

of this article is to financial position and

any, are some possibilities of solving the dilemma of decreased and increased supply of electrical energy in a financially

ble manner. THE CURRENT FINANCIAL Enormous

PROBLEMS FACING UTILITIES

demands are currently

util i ty industry. Few would to assume a much bigger role

being

placed

energy self-sufficiency in the years ahead. of the century the Federal Power Comnission half of all of electricity. is electrical. ment will

on the electrical

argue that electrical if the United States

energy will is to achieve

In fact, predicts

have

by the turn that more than

the energy consumed by the end users will be in the form Currently only one-fourth of the energy consumed The capital expenditures for expanded plants and equipexceed

$20 billion

in a few years.

In addition,

dously high expenditures for non-revenue producing leave utilities with a staggering financial burden.

the

pollution Because

tremen-

controls of social

and legislative pressures, many utilities have sacrificed new construction for financing pollution control. Planned generating additions have been postponed for one or two years, and in a few cases canceled

altogether.

Nuclear

plants,

operate but the most costly to construct, setbacks. There is currently some discussion acts

to allow

utilities

which

are the

cheapest

have been dealt of relaxing

the

to

the biggest clean

air

to convert from oil or natural gas back to From an environmental viewpoint, this is certainly high-sulfur coal. Yet, utilities contend that the pollutionan undesirable alternative.

31 control itures;

equipment produces

emission

controls,

utilities First

is too costly, up to 15 percent of capital expendno revenue; and, similar to the case of automobile tends to reduce operating efficiency. What can

do? Are they merely unfortunate of all is should be pointed out

not get into of aggregate

financial difficulty income statements

overnight. and balance

victims of circumstance? that the utilities did A longitudinal analysis sheets gives some interest-

ing insights into their financial deterioration. Table 1 shows that operating expenses have risen faster than operating revenue by approximately 10 percent since 1965. This in the price of fuel during the past increases

have not been absorbed

has been due mainly to increases three years. These fuel cost totally by increases in the rate

structure. All other operating expenses have remained relatively consistant with revenues. Interest costs also have had a marked effect upon utilities because of the high degree of leverage employed. Since 1965 the economy has witnessed historically higher interest rates on long-term bonds. As a result of these increasing rates, interest costs have increased 67 percent more than revenues The increase of operating tax income from 26.5 percent upon 1973 revenues of $31.8 have produced $3.6 billion note is that the effective 39 percent decline percent' earnings

to 27 percent,

during the 1965-73 period. and interest expenses has reduced in 1965 to 15.1 percent billion, a 1965 pre-tax

pre-

in 1973. Based profit margin would

more in pre-tax profits. One positive federal tax rate has been reduced from and therefore

slightly

reduced

the large

in the after-tax profit margins (16 percent in 1965 to 11 The reduced after-tax margins reduced 1973 retained in 1973). More importantly, this reduced retained by $1.59 billion.

earnings would have been able to finance 10.6 construction budget for the utility industry.

percent

of the

1973

The decrease of profit margins has had an effect on the balance and financing of capital expenditures for construction. Table 2 Internal cash generation (retained earnings shows the pertinent data. sheet

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charge

coverage

federal

tax

rate

SOURCE:

NOTE:

Edison

Discrepancies

Electric

due

Allowance for construction funds as percentage of earnings after preferred dividends

Fixed

Effective

After-tax income After-tax margins Allow. for construction Net income Preferred dividend Balance to comnon 1

for

4%

39% 5.1

2.6

rounding

Institute

to

funds

1::;

1965 ---------

1

1965-73.

margins

4%

39% 4.9

2.7

1::;

1966

Table

and

11%

4.0

41%

ratios--derived

7%

39% 4.4

2.9

2.7 14.4 4

2.7 15.5 2

1968

1967

1 (cont'd)

14%

3.5

38%

2.7 13.3 - 3:;

1969

from

data.

20%

2.8

35%

2.7 12.1 - 3::

1970

.8

24%

2.6

31%

-7-7

1:::

1971

30%

2.6

31%

1:-i! l-1 -33

1972

32%

2.3

27%

1:-z 1'3 -33

1973

iI

Data rates.

Institute--Raw SOURCE: Edison Electric 1974E--Based upon statistical growth

allowance

$58.0

short-term

an estimated

$53.5

$50.0

$31.3 2:*:

52%

$ 6.1

1967

$63.5

$35.1 2i.40

57%

$ 7.2

--1968

$69.8

$39.4 2i.40

60%

$ 8.3

1969

debt.

52.2% 52.9% 54.0% 55.2% 56.6% 9.4 9.4 9.5 9.4 9.1 38.4 37.7 36.5 35.4 34.3 loo.o% 100.0% 100.0% loo.o% 100.0%

$28.4 20.1 5.0

44%

$ 5.0

1966

$26.1 1:*:

35%

$ 4.0

1965 ---

for

*Includes

% of Capitalization Debt* Preferred stock Comnon equity

Capitalization Oebt# Preferred stock Comnon equity

financing

Financing Needs Construction Internal cash generation External financing

% External

2

56.6% 3i.Z . 100.0%

$78.4

$44.3 276.;

66%

$10.2

-1970

$99.0

$54.1 11.3 33.6

64%

$13.4

1972 ___

$107.6

$57.0 37'7 12 9

64%

$15.0

-1973

55.8% 54.7% 53.0% 10.4 11.4 12.0 33.8 33.9 35.0 -100.0% 100.0% 100.0%

$49.2 9.2 29.8 $88.2

66%

$11.9

1971 __

ELECTRIC COMPANIES COMPOSITE (PUBLICLY HELD) Construction, Financing, and Capitalization for 19651974E

Table

53.5% 12.0 34.5 100.0%

863.3 40.9 14.2 $118.4

66%

$17.4

1974E __

35 and depreciation) has increased 231 percent while construction expenditures have gone up 424 percent. For this reason the utilities had to depend construction 35 percent

upon external

outlay, from the

The capitalization through preferred

financing

whereas outside.

in 1974 for

in 1965 the utilities

of utilities

has remained

66 percent relied relatively

constant

the past decade though there has been an increased stock (9.4 percent to 12 percent) and a decrease

amount of equity question facing

(38.4 utilities

percent to 34.5 percent). is whether the capital

the necessary funds for billion if the industry

of the

on only

use of in the

The unsettled

markets will

supply

construction expenditures of more than $20 can only raise a third of the funds internally.

Two very significant ratios conditions for future financing

from Table 2 illustrate even worsening plans of utilities. The fixed charge

coverage has decreased for the industry from 5.1 times to 2.5 times. This deterioration of fixed charges has caused numerous reductions in credit ratings by such services The second alarming ratio in Table allowance preferred actually

for

construction This

dividends. paid during

expensed in future ating equipment. 9 years has grown the

earnings

as Standard & Poor's and Moody's. 2 is the tremendous rise in the

funds as a percentage of earnings after allowance is an interest cost that is

the year,

but

it

is capitalized

attributed

be

to cormnon stock comes from the allowance This fact jeopardizes the dividend payments

construction funds. common stock since the payout ratio averages earnings. Therefore, there would be no real for financing equipment.

and will

years against revenues produced by the new generIn 1965 this ratio was 4 percent and in the following to 32 percent. This means that almost a third of

new generating

equipment

two-thirds retained

and environmental

for on

of reported earnings left control

36 ALTERNATE METHODS OF FINANCING

energy

Meeting and

the duel protecting

demands of increasing the environment is

fortunately, as the discussion already under a severe financial expansion suggests

so far has pointed out, strain. How are they

and environmental protection some possible alternatives.

There finance general

the supply of electrical going to be costly. Un-

at the

utilities are going to finance

same time?

This

section

are several

pollution approaches

possible methods which utilities could use to Luthans and Hodgetts summarize these control. as follows:

One of the most obvious ways would be to use profits after taxes and dividends. A second traditional approach is to employ bank financing. Still a third way is to sell stock or long term bonds. A fourth is to buy the equipment and recoup the investment through rapid depreciation. This fourth alternative was made possible by the Tax Reform Act of 1969. A fifth method is to obtain a subsidy loan, guarantee or grant from the federal government. Since 1970 the government has made available billions of dollars in subsidy payments for antipollution equipment. A sixth approach is to get someone else to buy the equipment and lease it to the company. (1) Most of the alternatives for upon externally generated funds. pointed sheets

financing However,

out, both the aggregate income of the utilities have deteriorated

a point where it raise externally

statements and the during.the past

has become exceedingly generated funds. Yet,

more than $20 billion be problems raising If traditional

then

capital

over the externally externally

balance decade

to

difficult for utilities to if pollution is to be reduced

and at the same time electric generation 50 percent of the nation's energy source, capital must be raised. For example, if is to be electric,

pollution control depend as the previous discussion

expenditures

is to be increased to an enormous amount of external half of total use of energy will

have to average

next decade. There will definitely generated funds in traditional ways. generated funds are going to be a problem,

37 then how will the utilities raise the estimated $12-913 billion annually? Retained earnings will contribute little in the foreseeable future because dividend payout ratios equal two-thirds of the earnings and the

allowance

for

construction

funds

equals

the

rest.

This means equity financing will also have to be external and in the form of connnon stock. In 1974 many utility companies came to the equity markets with issuance of new stock, but it is becoming exceedingly more difficult electric utility

and it is very costly stocks are currently

in terms selling

of dilution. at less than

Many book value.

This means that when more stock is sold to the public, there automatic reduction in book value for the present stockholders. yields

is an

As short term interest rates started to decline, the current of more than 11.5 percent on the average electric utility

started to attract some investors at the beginning However, in the first five weeks of 1975 the utility

of this index

year. increased

22 percent to reduce current yields to about a 9.5 rate. But there still exists very serious questions about the quality of earnings and whether the utilities will be able to continue the dividend The case of Consolidated Edison is still vivid in the memories payments. Consolidated Edison reported earnings of 48 cents per of many investors. share in the first quarter of 1974 but was short of cash required to meet the regular 45 cents quarterly dividend. Also, no dividend was The company did restore a 20 cent dividend paid in the second quarter. in the third

quarter,

but

this

has not

restored

in the comnon stock of Consolidated Edison. conditions, the annual amount of financing (about.84 billion annually) in the quality of earnings The use of preferred

invester Therefore,

through

confidence under present

comTlOn stock

will be difficult because of the reduction and the potential omission of dividends. stock in the capital structures of electric

utilities during the past decade rose from 9 to 12 percent. The problem with preferred stock is that current yields are correlated to long term rates on bonds; and since preferred dividends are not tax deductable,

38 this

substantially

Although preferred

increases

the

cost

of capital

to the utilities.

there are currently suggestions around Washington dividends be tax deductable, this would probably

the largest cause they

to let eliminate

buyers (property and casualty insurance companies) bewould no longer receive the favored tax treatment of

85 percent of the dividends being tax free. The problem of future financing is really not troubled by changing tax laws with respect to preferred stock because preferred stock represents only 12 percent of the capital Attracting difficult crisis

structure. debt financing

and costly proporations.

from 5.1 times have increased

in recent Coverage

for

all

industries

has been increasing

lY

years, and it is becoming a problem of of interest charges has been reduced

in 1965 to 2.5 times in 1973. Debt to equity ratios from 1.36 to 1.55 during the same period. Both of these

facts have caused a number of reductions in credit services. The bond market has become unreceptive

ratings by the rating in general to long

term issues because of the uncertainty of inflation result, many utilities have had to sell bonds with as five years, instead of the traditional thirty.

rates. As a maturities as short This could cause

liquidity assets ities debt.

problems in the and length of their are faced

with

future because of the nature of the utilities construction programs. Lastly, some utilindenture limitations on the sale of additional

SOME POSSIBLE SOLUTIONS TO THE FINANCIAL PROBLEMS

their

Various suggestions very real financial

economic consequences government. The best

have been made as to how utilities can solve woes. All of these potential answers have for both solution

the individual consumer and the from the standpoint of the industry

would be prompter and more adequate rate increases consnissions. There seems little doubt that state

by the state commissions must

39

seek as

to

modernize

forward

cost

test

(e.g.

would

years,

fuel),

produce

The

more

political deal

party

with

the

public

price

hikes

the

government

of

for

utilities

would

and

airlines)

wanting

for

would

certainly

funds.

In

of

less

same

but

the

investment

extremely

of

preferred

million

line

other

is

would or

that when

tax

(e.g.

far

railroads

even

the versus

7 percent of

a net

capital

relief

hand,

short

a

treatment

4 percent

to

provided

be

tax

other

only

fall

credit with

is a time

special

increase

still

compared

pragmatic

inflation,

stock

On the

An

tax

on

industries

utilities

would

at

utilities

However,

of

commissions and

unpopular. for

for

it

the

must

increases and

solution

industries.

help,

The

rate

hold

treatment.

credit

other

$200

sizeable

credits.

a rash

the tax

all

1973

than

tax

cause

investment

7 percent

be

dividends

investment

for

current

would

they

groups

inflationary, to

that

expenditures.

that

considerations.

with

want

return

capital is

consumer-interest

financial

treatment

form

of

for

such

operating

rates

funds

definitely

utilities

higher

higher

economic

problem

possible

tax

the

as

are

for

A second

for

measures

commissions

well-organized

prices and

special

as well

adopting

relief for

generated rate-making

Another

energy

by

rate

allowance

many

many

politics.

higher

the

internally

with

consider

procedures

interim

and

difficulty

must

in

rate-making

the

necessary

cash

flow

expenditures

of

$15

billion. A third to

have

possible

federal

through this

proposal increased

debt,

ratios indenture even

government.

the

of

adds

of

to

limitations though

secured

debt

danger

to

make

earnings

the

problem

of

increase

the

fixed

would

a way

to

stock

high

of

more payments.

debt For

sale

payment

funds

stockholder.

coverage. the

be

with

dividend

already

permit

increase

common

continued

would

difficulty

comnon for

the

promise

help,

The

the

charge not

the

as

costs.

would

by

government's

interest

would reduce

the

utility

potential

financing and

with

reducing

leverage This

type

equity the

and is

unstable. This

guarantees

borrowing

The

solution,

to

many

of

additional

by

the

utilities,

federal

40 The final

possible

solution

is to use industrial

development

bonds

to finance expansion up to $5 million and industrial revenue (sometimes called pollution control revenue bonds) for environmental protection. The latter is authorized from the Revenue and Expenditure Control Act of 1968. There can be unlimited use of tax-exempt bonds to finance pollution control equipment. These bonds have the advantages of having utility

a lower interest rate because could acquire legal ownership

they are tax-exempt of the anti-pollution

By owning the equipment the utility can depreciate it vantage of the investment tax credit. Tampa Electric of one utility who took advantage $27 million worth of the bonds. versus the traditional for Tampa Electric.

and the equipment. and take adis an example

of this approach by selling about The estimated savings of this approach

bond financing

amounted

to about

$17 million

CONCLUDING COMMENTS The electric utility industry, the most capital of American industry, is facing a financial dilemma. is the demand for reduce pollution.

intensive sector On the one hand

more electrical energy and on the other Both demands are costly and are putting

is demand to a severe

financial burden on the already shakey utility industry. If the United States is to be energy self-sufficient by 1985 and if the electric utilities increases their role in producing more energy,

then

financing capital expenditures by the utilities becomes a severe problem. The added burden of conforming to social and legislated environmental protection makes the problem seem almost insurmountable. However, the solutions suggested in the above discussion can help utilities meet the challenge. In the final analysis, the public will have to decide where the fine line is to be drawn between expanded energy

supply

and environmental

protection.

In the meantime,

nological and financial innovations need to be developed can have sufficient energy and a safe, clean environment.

tech-

so that

society

41

REFERENCES

1.

Luthans, 2nd

Fred, Edition.

and

Hodgetts, New York:

Richard M. Macmillan,

So&z2 (in

Issues

press).

in Business,