IV. Debt Equivalence
Debt equivalence is a term used by credit analysts for treating long-term non-debt obligations, such as purchase power agreements (PPAs), leases, or other contracts, as if they were debt, in assessing an entity's credit rating.
Debt equivalence became an issue in a rulemaking proceeding (R.01-10-024) on establishing policies and cost recovery mechanisms for generation procurement and renewable resource development. Section 454.5(b)(1)) requires "an assessment of the price risk associated with the electrical corporation's portfolio, including any utility-retained generation, existing power purchase and exchange contracts, and proposed contracts or purchases.
Although debt equivalence was addressed in the discussion portion of an interim decision (D.04-01-050) of the rulemaking proceeding, that issue was deferred to upcoming cost of capital filings where the energy utilities were to present detailed evidence about the treatment of debt equivalence by the rating agencies. In compliance with that decision, SCE and PG&E included the debt equivalence issue in their respective test year 2005 ROE applications. San Diego Gas & Electric Company (SDG&E), the Office of Ratepayer Advocates (ORA), jointly Aglet Consumer Alliance and The Utility Reform Network (Aglet-TURN), Calpine Corporation (Calpine), and the Cogeneration Association of California (CAC) actively participated in this issue. The rating agencies, Fitch, Moody's and Standard & Poors (S&P) did not participate in this proceeding.
According to the utilities, the rating agencies take the view that a utility would either be constructing generation facilities and therefore taking debt onto its balance sheet, or contracting for a purchased-power obligation that is essentially fixed by the nature of the need to provide service, if not by contract terms. Payments on the PPAs are treated as fixed payments. Therefore, those payments are analyzed as if they are interest on a debt obligation by the rating agencies and included in the rating agencies' analysis of interest coverage, cash flow to debt, and balance sheet, debt to capital. However, payments on those PPA contracts having less than three years remaining are excluded from the rating agencies' analyses. The end result of that analysis is a credit rating. The higher the credit rating the more benefit to ratepayers through lower fixed payments and overall costs.
PG&E explained that Moody's and S&P share a philosophy about purchased power but apply different methodologies in assessing debt equivalence to the individual utilities. Moody's determines how to treat PPAs according to the degree that a real transfer of economic risk has occurred from the utility to the power provider. It assesses the risk subjectively, using a sliding scale on what it calls the "risk containment." The more certain it perceives a payment for PPAs to be, the more likely it is that Moody's will include the net present value in its calculations of financial metrics.
The utilities testified that S&P applies a quantitative approach in assessing debt equivalence. Since 1990 S&P capitalized PPAs on a sliding scale it called a risk spectrum, similar to Moody's method. Up to 100% of the net present value of PPAs were included in its calculations of credit metrics. In May 2003, S&P revised its method of debt equivalency risks to a quantitative approach from the subjective approach. S&P now reflects the opinion that there is little difference between a "take-and-pay" PPA and a "take-or-pay" PPA. As a result, S&P's revised method reflects more risk from PPAs than prior to May 2003. S&P now uses a formula to calculate the net present value of the capacity payments of a PPA using a 10% discount rate and a 30% to 50% risk factor. S&P currently assesses a 30% risk factor on the California energy utilities.
The utilities, while acknowledging that debt equivalence has been reflected in the utilities' credit ratings, since at least 1990, are now concerned that the imputation of debt equivalence on their PPAs adversely impacts their PPA evaluations and credit ratings, thereby resulting in a higher level of operating risks and increased costs.
A. Utilities Proposed Solution
SCE, PG&E, and SDG&E recommended that the Commission establish a debt equivalence policy in this proceeding to alleviate their concern that debt equivalence is an added cost that needs to be considered both in determining an appropriate capital structure and in making resource procurement decisions. Policy recommendations proposed, jointly or individually, by the utilities included recognition that debt equivalence adversely impacts credit ratings; use of annual ROE proceedings to update and mitigate debt equivalence impacts on credit ratings; and, adoption of S&P's quantitative debt equivalence formula for use in assessing debt equivalence costs in power procurement decision-making proceedings.
Calpine concurred with the utilities' need to adopt a debt equivalence policy in this proceeding. However, it recommended that any relationship between debt equivalence and power purchase procurement evaluations should be addressed in the long-term procurement rulemaking proceeding, R.04-04-003.
Aglet-TURN, CAC and ORA recommended that debt equivalence adjustments should be considered on only a case-by-case basis and specific to a utility's current credit profile based on quantitative and qualitative evidence. However, Aglet-TURN did propose general guidelines for inclusion of debt equivalence findings of fact and conclusion of law.6
1. Debt Equivalence Impact
What impact does debt equivalence have on SCE and PG&E's test year 2005? We know that SCE's long-term debt currently has investment grade credit ratings of BBB from S&P and A-3 from Moody's, and that its preferred stock has a marginal non-investment grade credit rating of BB+ from S&P and a marginal investment grade credit rating of Baa3 from Moody's. To improve its credit ratings, SCE proposed to increase its preferred stock ratio to 9% from 5% and correspondingly, to reduce its long-term debt ratio to 43% from 47% as a least-cost approach to increase its credit quality. If approved, SCE would maintain its test year 2005 target capital structure on average over time beginning in 2005 as a foundation for its ultimate return to a Single-A credit rating or better.
ORA evaluated SCE's credit profile, rating and capital needs. Based on that evaluation, ORA concluded that SCE's proposal to increase its preferred stock component was a relatively low cost means to enhance SCE's credit profile. Aglet-TURN, acknowledging that the increase in preferred stock and associated reduction in the proportion of long-term debt would improve SCE's credit ratios, but opposed SCE's preferred stock proposal for several reasons. Some of those reasons were that SCE had not shown that improved credit ratios are necessary to maintain adequate service, had not performed any cost-effectiveness study, and that the additional cash flow generated from the additional preferred stock would not be material.
In D.89-11-068, the Commission reasoned that the utilities should be given some discretion to manage their capitalization with a view towards a balance between shareholders' interest, regulatory requirements, and ratepayers' interest.7 Here, we find that SCE has designed its preferred stock proposal to rebalance its capital structure with the goal of obtaining improved credit ratings, thereby benefiting both shareholders and ratepayers. This approach avoids the need to micro-manage the utility's capital structure and also supports the utility's desire to maintain investment grade ratings; therefore, we concur with SCE's preferred stock proposal.
PG&E, with an investment grade credit rating of BBB- from S&P, did not request any adjustment to its authorized capital structure or ROE applicable to debt equivalence in this proceeding.
Using ratio analysis, SCE and PG&E used the major guideline components of debt to capital, interest coverage, and cash flow to debt used by S&P for assigning credit ratings to compare SCE's and PG&E's test year 2005 ratios on a PPA debt equivalence and non-debt equivalence basis. The result of that comparison is set forth in Appendix A. Of those guideline components, SCE considered interest coverage the most important benchmark for credit ratings.8 PG&E also considered interest coverage the most important, placing next in very close importance cash flow to total debt, and least importance debt to capital.9
While Appendix A showed that the inclusion of PPAs would lower SCE and PG&E's interest coverage and cash flow to debt coverage, the utilities' interest coverage would remain within S&P's A credit ratio range and their cash flow to debt ratio would remain within S&P's BBB credit ratio range. Those results would not change under either SCE's requested 11.60% ROE or Aglet-TURN's recommended 10.20% ROE or under PG&E's authorized 11.22% ROE. From that comparison of utility information we can only conclude that debt equivalence would not have a material impact on either SCE's or PG&E's credit ratios or capital structure at this time. Although SDG&E provided information on the impact of debt equivalence on its Otay Mesa PPA, it did not provide any information on what impact, if any, that contract had on its total company credit ratings, total company financial ratios considered by rating agencies, total company capital structure, or total company ROE.
2. Annual ROE Proceeding
Given the changing energy market and utilities' increased dependency on long-term procurement contracts, the utilities' proposal to update debt equivalence impacts on credit ratings and capital structure has merit and should be adopted. The utilities, as part of their annual ROE applications, should include testimony on credit rating and capital structure impacts, including mitigation recommendations, of debt equivalence on their PPAs. Information to be provided in that regard should include current credit ratings from Moody's and S&P; expected impact of its ratings due to debt equivalence; capital structure and ROE with and without debt equivalence; debt to capital, interest coverage, and cash flow to debt financial ratios with and without debt equivalence; and, pre and post-tax financial ratios.
Should a utility find a need for expedited resolution of debt equivalence outside of the annual ROE proceeding due to the lowering of its credit ratings to a non-investment grade level, it should consider filing an application to demonstrate financial need.
SDG&E is in a different situation than SCE and PG&E because it is not required to file an annual ROE application. That is because an all-party settlement agreement to modify SDG&E's Market Indexed Capital Adjustment Mechanism (MICAM) approved by D.03-09-008 included a provision that unless certain off-ramps require otherwise, SDG&E would only file a full ROE application every fifth year. Therefore, absent any unusual circumstances triggering the filing of a ROE application, and absent the Commission's specific order requiring SDG&E to participate in a ROE proceeding, SDG&E's next regularly scheduled ROE application is not due to be filed until May of 2007.
SDG&E intervened in this consolidated ROE proceeding as an interested party on the basis that the general procurement and renewable resource development rulemaking proceeding (R.01-10-024) found in Finding of Fact 46 of D.04-01-050 that the appropriate forum to address debt equivalence is in the ROE proceeding for each utility and that Footnote 26 of D.04-06-011 "required" SDG&E to participate in debt equivalence issues likely to be addressed in this consolidated proceeding to the extent that SDG&E seeks resolution of such issues deferred in the generation procurement and renewable resource development rulemaking (R.01-10-024) proceeding. That footnote actually encouraged, but did not require, SDG&E to participate in this proceeding.
SDG&E, recognizing that the implementation of debt equivalence mitigation can be addressed in annual ROE proceedings,10 asserted that debt equivalence policy developed in this consolidated ROE proceeding must pertain to SDG&E as well as to SCE and PG&E on the basis that requiring SDG&E to wait until its next ROE proceeding to develop such policy for SDG&E could have a deleterious affect on its creditworthiness evaluation by the credit agencies.
To mitigate negative credit impacts of its long-term PPAs, SDG&E recommended that SDG&E should be authorized to increase its equity with a simultaneous reduction of debt equal to 65% of the debt equivalence for each individual PPA contract approved by the Commission with the cost associated with that capital structure adjustment rolled into the costs of each PPA. The impact of SDG&E's debt equivalence mitigation recommendation on its recently approved Otay Mesa PPA would be $40 million at a net present value impact for the nine year period January 1, 2006 through December 31, 2014 and based on equity equal to 65% of the debt equivalence added to SDG&E's ratemaking capital structure.11
Again, SDG&E provided no information on its current credit ratings and insufficient information to enable us to assess the debt equivalence impact on its overall credit ratings and capital structure. Therefore, we decline to adopt SDG&E's proposal. SDG&E should file a test year 2006 ROE application by May 9, 2005, along with SCE and PG&E, so that we may properly assess what impact, if any, that debt equivalence has on its credit ratings and capital structure, including mitigation recommendations. To the extent that SDG&E believes that debt equivalence may have a material impact and recurring drain on its credit ratios or ratings, SDG&E should consider modifying its MICAM settlement agreement so that it may resolve that concern through yearly ROE applications.
3. S&P's Debt Equivalence Formula
Although the utilities recommended adoption of the S&P debt equivalence formula, ORA and Aglet-TURN opposed the use of S&P's debt equivalence formula and any other specific quantitative financial metric method. ORA contended that sole reliance on such a financial method would ignore other measurable mitigating factors such as future utility outlook, changing regulatory environment, and legislative actions.12 Aglet-TURN argued that debt equivalence risks are not new; substantive increases in debt equivalence risks will come only if new long-term contracts replace electricity production from utility-owned generation stations or existing contracts with lower levels of debt equivalence; adoption of a specific formula method foregoes flexibility in long-term contract provisions; rating agency methods and risk factors are subject to change; and lack of testimony from the rating agencies, academic and industry evaluation of S&P's calculation method did not allow for a thorough analysis of this method.
We concur with ORA and Aglet-TURN. The evidence presented in this proceeding did not substantiate a need to consider the debt equivalence issue outside of our traditional ROE assessment of risks. We will continue to assess debt equivalence risks along with other financial, regulatory, and operational risks in setting a ROE and balanced capital structure reasonably sufficient to assure confidence in the financial soundness of the utility to maintain and support investment-grade credit ratings and to enable it to raise money necessary for the proper discharge of its public duties. S&P's debt equivalence formula should not be adopted at this time.
4. Debt Equivalence Policy
We decline to adopt a formal debt equivalence policy. However, we do recognize that debt equivalence associated with PPAs can affect utility credit ratios, credit ratings, and capital structure. Credit rating agencies have long recognized debt equivalence as a risk factor and we have and will continue to reflect the impact of such risk in establishing a fair and reasonable ROE and in approving a balanced ratemaking capital structure. In that regard, we have identified information that the utilities should provide in their annual cost of capital applications to enable us to better assess debt equivalence risks. Our goal is to provide the utilities with a fair and reasonable ROE and ratemaking capital structure that, among other matters, support investment-grade credit ratings.
