IV. Capital Structure
Capital structure consists of long-term debt, preferred stock, and common equity.4 Because the level of financial risk that the utilities face is determined in part by the proportion of their debt to permanent capital, or leverage, we must ensure that the utilities' adopted equity ratios are sufficient to maintain reasonable credit ratings and to attract capital.
A. PG&E
PG&E seeks a test year 2006 ratemaking capital structure of 46.00% long-term debt, 2.00% preferred stock, and 52.00% common equity. This capital structure reflects a 50 basis point increase in its currently authorized 45.50% long-term debt ratio and a 50 basis point decrease in its currently authorized 2.50% preferred stock ratio. PG&E proposes no change in its currently authorized 52.00% common stock ratio.
The minor change in PG&E's long-term debt and preferred stock ratios is consistent with the approved Modified Settlement Agreement and PG&E's bankruptcy court approved Plan of Reorganization. The proposed ratemaking capital structure is also nearly identical to its 2006 projected financial reporting capital structure.5 There is no opposition to PG&E's requested test year 2006 capital structure.
B. SCE
SCE seeks a test year 2006 ratemaking capital structure of 43.00% long-term debt, 9.00% preferred stock, and 48.00% common equity. This is the same capital structure that it is currently authorized. It is also consistent with its 2006 simple average projected financial reporting capital structure of 44.00% long-term debt, 9.00% preferred stock, and 47.00% common equity.6 There is no opposition to SCE's requested test year 2006 capital structure.
C. SDG&E
SDG&E seeks a test year 2006 ratemaking capital structure consisting of 43.25% long-term debt, 5.75% preferred stock, and 51.00% common equity. This is a 200 basis points change from its currently authorized 45.25% long-term debt and 49.00% common equity ratios. SDG&E proposes no change in its currently authorized 5.75% preferred stock ratio.
SDG&E seeks a change in its authorized capital structure to mitigate the negative effects of debt equivalence imputed by rating agencies into SDG&E's financial coverage for credit rating purposes.7 This proposed change resulted from SDG&E conducting studies to evaluate the financial impact and cost to customers to bring its ratio of funds from operations (cash flow) to debt8 back to the range of an Standard & Poor's (S&P) "A" rating and to mitigate the increase in its debt to capitalization ratio.9 These ratios are two of the three primary financial factors used by S&P to assess the impact of debt equivalence. 10 The remaining financial factor is cash flow to interest coverage, a measurement of the headroom a company has to fulfill its current interest payments.
This requested change in capital structure is opposed by the Office of Ratepayer Advocates (ORA), Federal Executive Agencies (FEA), and ATU.
ORA opposes the capital structure change on the basis that the appropriate means of resolving the potential impact of debt equivalence is through SDG&E's Market Indexed Capital Adjustment Mechanism (MICAM).11 The MICAM was implemented in D.96-06-055, as modified by the adoption of an all-party settlement with SDG&E, ORA, UCAN, and FEA in D.03-09-008. This is because such a deviation from the MICAM would contravene Commission policy in favor of settlement as a means of conserving the resources of parties and the Commission for contested matters that cannot otherwise be resolved.12
FEA opposes the change on the basis that the change would not further strengthen SDG&E's "A" credit rating from S&P. This is because SDG&E's currently authorized capital structure, actual capital structure at year end 2004, and cash flow coverage of debt interest expense already support a strong A bond rating from S&P.13
ATU opposes the change on the basis that SDG&E has not been placed on credit watch by either S&P or Moody's and has received a stable outlook from both rating agencies. 14 ATU concludes that the capital structure incorporated into the MICAM is sufficient for SDG&E to maintain its current credit quality. However, if the Commission finds it necessary to mitigate SDG&E's debt equivalence through a change in capital structure, ATU recommends that the percentage of debt be decreased by 285 basis points to 42.40% with a corresponding increase in preferred stock to 8.60% and no change in the common equity ratio. ATU contends that this alternative capital structure would achieve approximately the same improvement in the funds from operation to debt ratio as shifting the capital structure from debt to common equity. More importantly, it would be less costly to SDG&E's ratepayers.
Debt equivalence is not a new issue. As recognized in D.04-12-047, debt equivalence has been reflected in the utilities' credit rating since at least 1990. We specifically recognized in last year's ROE proceeding, in which SDG&E along with PG&E and SCE participated, that debt equivalence associated with purchased power agreements (PPA) can affect utility credit ratios, credit ratings, and capital structure.
We declined to adopt a formal debt equivalence policy in that proceeding. However, we affirmed that debt equivalence impacts would be assessed on a case-by-case basis along with other financial, regulatory, and operational risks in setting a balanced capital structure and fair ROE. Our goal in so doing was and continues to be to provide reasonable confidence in the utilities' financial soundness, maintain and support investment-grade credit ratings, and provide utilities the ability to raise money necessary for the proper discharge of their public duty.15 We have no reason to change, and no utility has requested that we change this method of considering debt equivalence.
SDG&E is the only utility seeking to mitigate debt equivalence through its capital structure. Normally, we would assess the debt equivalence impact on its current investment grade "A" credit rating from S&P and A2 credit rating from Moody's. However, SDG&E used only the three primary financial factors of S&P to support its capital structure change. Appendix A to this order sets forth a comparison of that result.16
Although power contracts with the California Department of Water Resources (CDWR) are not considered obligations of SDG&E and do not impact its operating leverage or debt equivalence, SDG&E included in its calculations a portion of its CDWR contracts expiring in the 2008 through 2010 time frame which SDG&E may replace with PPAs.17
While Appendix A show that the inclusion of SDG&E's PPA debt equivalence would lower its A rating coverage under each of S&P's primary financial factors, its cash flow interest coverage would remain near the mid-A range irrespective of which scenario is used. These scenarios are no change in the equity ratio and ROE, a change in only the equity ratio, and a change in the equity ratio and ROE.18 These cash flow interest coverage changes do not support a need to change the authorized capital structure.
Although SDG&E's debt to capital coverage would improve under each of the scenarios, its coverage would remain around the bottom BBB rating range and substantially below an S&P A rating range. This coverage would not materially change under either of the scenarios.
The cash flow to debt coverage under either a change in ROE or a change in common equity and ROE scenario would bring this coverage up to the bottom of an S&P A rating range. Under the no change scenario, SDG&E's coverage would barely drop outside of the bottom of an S&P A rating range. The cash flow to debt coverage would not materially differ under either of the scenarios.
As addressed in last year's cost of capital proceeding, those financial factors are used as part of an S&P formula in assessing the viability of future power procurement contracts, and are not the sole criteria in establishing an overall credit rating.19 The above comparison of SDG&E's information demonstrates that its financial coverage under S&P's primary financial factors would improve, although not materially, with an increase in its ROE and further improve with an increase in its common equity ratio. However, this capital structure change, in SDG&E's assessment, would require a 90 basis point increase in its ROE to compensate its shareholders for a more highly-leveraged capital structure. This requirement equates to a $17.64 million increase in its revenue requirement, almost half of its requested $39.10 million revenue requirement.20
This information, in itself, does not justify a change in capital structure. This is particularly so, given that the increased revenue requirement needed to compensate shareholders for added risk would not materially improve the financial factors S&P considers in setting credit ratings or result in an improved credit rating of its investment grade credit rating of A from S&P or A2 from Moody's.21 Further, SDG&E has received a stable outlook from S&P and Moody's and is not on credit watch by either of the rating agencies. SDG&E's information, credit status, and credit ratings do not substantiate a need to mitigate debt equivalence through a change in its authorized capital structure at this time.
D. Conclusion
The capital structures proposed by PG&E and SCE are balanced, attainable, and are intended to maintain an investment grade rating, and to attract capital. For these reasons, we find that the proposed capital structures of PG&E and SCE are fair, consistent with law, in the public interest and should be adopted. SDG&E's currently authorized capital structure is also balanced, intended to maintain an investment grade rating, to attract capital, consistent with the law, in the public interest and should be adopted. The adopted capital structures are detailed in the following tabulation.
CAPITAL RATIO |
PG&E |
SCE |
SDG&E |
Long-Term Debt |
46.00% |
43.00% |
45.25% |
Preferred Stock |
2.00 |
9.00 |
5.75 |
Common Equity |
52.00 |
48.00 |
49.00 |
Total |
100.00% |
100.00% |
100.00% |
The next step in determining a fair ROE is to establish reasonable long-term debt and preferred stock costs.
4 Debt due within one year, short-term debt, is excluded.
5 Exhibit 25, p. 3.
6 Exhibit 4, p. 2.
7 Debt equivalence is a term used by credit analysts for treating long-term non-debt obligations, such as purchased power agreements, leases, or other contracts, as if they were debt in assessing an entity's credit rating.
8 Cash flow to debt is a measurement of how many years it takes for a company to repay all its debt with internally generated cash flows.
9 Debt to capitalization is a financial leverage indicator.
10 Although other rating agencies such as Moody's also consider the impact of debt equivalency, S&P is the only rating agency that utilizes a formula.
11 The MICAM is a formula that allows SDG&E to automatically adjust its revenue requirement based on utility bond rate changes in each year that SDG&E is not required to file a cost of capital (COC) application. The MICAM does require SDG&E to file COC applications on a five-year cycle.
12 ORA's Opening Brief, p. 31.
13 Exhibit 30, p. 8.
14 Exhibit 32, p. 10.
15 D.04-12-047, mimeo., p. 13.
16 SDG&E first used an S&P 30% risk factor then revised it downward to 20% and again increased it to 30%. This comparison is based on a 30% risk factor assigned to SDG&E by S&P on the basis that this risk factor assigned by S&P is expected by SDG&E to increase to 30% next year.
17 Exhibit 13, p. 12.
18 Both PG&E and SCE considered cash flow interest coverage to be the most important benchmark for their credit rating in last year's ROE proceeding. See D.04-12-047, mimeo., p. 9.
19 D.04-12-047, mimeo., p. 13.
20 A 10 basis point change in the authorized ROE results in a $1.96 million revenue requirement change pursuant to Late-Filed Exhibit 50. Hence, 90 basis points divided by 10 time $1.96 million equals $17.64 million.
21 The S&P credit rating is at the fourth of ten steps above a non investment grade rating and Moody's is at the fifth of ten steps above a non investment grade rating.
