quirements, as is pointed out in recent work at the Electric Power Research Institute (83). On the other hand, a low replacement requirement combined with only 1.5 percent demand growth per year would require almost no new capacity. This then is the dilemma for utility strategists. A shift of only 2 percentage points in demand growth combined with a more stretched out retirement schedule can reduce the requirement for new powerplants from hundreds of gigawatts (a number requiring a capital outlay of $0.5 trillion to $1 trillion 1982 dollars) to almost nothing. Some of the factors affecting utility choice of strategy, given this situation, are discussed in the next sections. RATE REGULATION AND POWERPLANT FINANCE Although the national average reserve margin will not dip below safe limits until well into the next decade, individual utilities may consider ordering powerplants before 1990 for any of three reasons: to replace expensive oil or natural gas generating capacity, to anticipate growth in their region, or to start a long leadtime plant well before it may be needed in the 1990's. This section describes the framework of rate regulation within which such a decision is made. The next section explores the broader strategic options for utilities. Utilities' Current Financial Situation Although the financial situation of utilities is improving slowly, they are still in a greatly weakened financial condition compared to their situation in 1970. The series of figures 9 through 14 prepared for the Department of Energy shows the origins of the financial difficulties of the 1970's until the relative improvement of 1982 (described below). Utilities raised enormous amounts of capital in external financing in the 8 years from 1973-81, more than double the requirements of the telephone industry-the next most capital-intensive industry (fig. 9). In the process, more and more of utility assets became tied up in construction of new generating capacity (fig. 10), which equaled a quarter of all utility assets as of 1981. At the same time, even with high rates of inflation the nominal return on equity was kept constant. Thus the real value of utilities' return on equity declined sharply (fig. 11). As a consequence of high inflation, enormous amounts of investment and large fractions of assets under construction, there was weakening of many indicators of financial health that are watched closely by investors. The amount of earnings paid out as dividends increased, leaving less for retained earnings to finance future projects. The ratio of operating income to interest on debt-pretax interest coverage-fell to disturbingly low levels. The cost of capital from issues of new stock and bond sales rose accordingly. After 1973, far more utility bonds were downgraded than upgraded; the number of utility bonds rated only "medium grade" BBB, increased from 10 to 43 (fig. 12). A lower rating usually means that investors require a higher yield in order to purchase the bond, and institutional investors may not be willing to purchase the bond at all (45). Similarly, the average market value of utility stock fell steadily from its high of about 21⁄2 times book value in 1965, to a level equal to book value in 1970 to less than book value in 1974 (fig. 13). When stock sells below book value, there are two consequences. The utility must issue more stock, (and pay out more dividends) to raise each new unit of capital than the value of each existing unit of capital, and the value of stock for the existing stockholders is diluted. (See box A for a discussion of market-to-book ratio and stock dilution.) One of the most serious problems for utilities has been a steady squeeze on cash flow. As shown in fig. 14, almost 50 percent of utilities' nominal return on equity was paper earnings in the form of allowance for funds used during con struction (AFUDC). (See box B.) One result is that utilities have retained less and less of their earnings. The share of earnings paid to stockholders as dividends-the dividend payout ratioincreased from 68 percent in 1970 to 77 percent in 1981. For some companies it was above 100 percent, which means they paid out more than they earned (45). In 1982 and 1983, there was some improvement in utility financial health. As of December 1983, market-to-book ratios were up to an average 0.98, and 51 out of 103 utilities had marketto-book ratios of more than 1.0 (59). Although more bonds are being downgraded than up Box A.-Market-To-Book Ratio and Dilution of Stock Value When the stock of a utility is selling below its original selling price, the market-to-book ratio of the stock is below 1.0. This situation means that any sale of new stock at this lower-than-book price will dilute the value of the existing stock. This will be true even after the new asset begins earning at a full rate. The example that follows illustrates what happens when a utility's stock sells at half of book value, at book value, and at twice book value. A utility goes into business by selling 1,000 shares at $10 each. The State regulatory agency allows the company to earn a 10 percent return. Ten percent on $10,000 is a $1,000 profit, which equals $1 a share. Now, let us say that the company has to raise $10,000 to build another powerplant and that the regulatory agency will let the utility earn another $1,000 (10 percent of $10,000) as soon as the plant is completed. Depending on the price at which the company sells new stock, the new financing reduces (dilutes), leaves unchanged, or increases earning per share. In the following table, we show what happens when new stock is sold at $5, $10, or $20. Note that when the stock has to be sold at a low price ($5), earnings per share fall from $1.00 to $0.67 after the offering, despite the rise from $1,000 to $2,000 in the utility's income after the new plant goes into service. In the second example, earnings per share are not diluted by the offering. In the third, they are actually improved. Electric utility companies often need to sell stock to finance their capital expenditures. When shares are to be sold at low prices, such as those that currently prevail, financing is diluting. Thus, large capital expenditures at a time of low stock prices may be detrimental to current shareholders. That is one reason why many financial experts view a slowdown in utility spending as favorable for shareholders. SOURCE: Adapted from a description in Hyman and Kelley, The Financial Aspects of Nuclear Power: Capital, Credit, Demand and Risk, American Nuclear Society, Dec. 3, 1981 (47). The History of the Deterioration in the Financial Health of Electric Utilities, 1960-82 Figure 9.-The Electric Utility Industry is Dependent on Externally Generated Funds 173 aNet of debt retirements. fConstruction work in progress (CWIP) refers to plant being built, but not yet in service. Figure 11.-Beginning in 1972, the Utilities' Real Return on Equity Has Been Eroded by Inflation (utility industry annual average return on common equity (end of year)) Coal mining 34 Figure 12.-Since 1973, the Average Utility Stock has Sold Below its Book Value 99 66 12 72 74 80 32 82 Figure 13.-In 1970, A Majority of Utilities Were Rated AA or Better, in 1982, a Majority Are Rated A or Worse Figure 14.-Over Time, the Share of AFUDC in Total Earnings Has Increased and the Share of Cash Has Fallen SOURCE: Booz-Allen & Hamilton Inc., The Financial Health of the Electric Utility Industry, prepared for the Department of Energy October 1982, using data from Utility Compustat; U.S. Department of Commerce, Survey of Current Business; Edison Electric Institute, Statistical Yearbook of the Utility Industry; Standard and Poor's Bond Guide; Energy Information Administration, Statistics of Privately Owned Utilities. 1981 Box B.-Accounting for the Capital Costs of Powerplants Under Construction: “CWIP" and "'AFUDC'' PUCs differ widely in their treatment of the capital costs of powerplants under construction; i.e., the costs of interest, preferred dividends and return on equity. There are two different methods for treating these costs in the rate base. Many PUC's use a mixture of the two. Construction Work in Progress (CWIP). Using this method, PUCs include the costs of capital for construction work in progress in the rate base and thus provide for current recognition of the cost of financing construction. Electricity rates are set high enough to provide revenues to pay the capital costs of both the used and useful assets and those under construction. Allowance for Funds Used During Construction (AFUDC). Using this method, PUCs defer the recognition of capital costs until the asset being constructed actually enters the rate base as a "used and useful" asset. Construction expenditures for plants not yet in service are set aside in a special account labeled CWIP which is listed as an asset on the balance sheet. This "asset" earns a paper return until the plant is placed in service. The return is generally equal to the utility's embedded cost of capital (rather than the construction project finance cost) and generally is not compounded. The return is reported as income on the utility's income statement in an account labeled AFUDC, even though the utility receives no cash income. When the plant eventually is placed in service, the accumulated AFUDC account is added to the book value of the plant, based on actual construction expenditures, and the full sumplant cost plus AFUDC-is placed in the rate base. The full sum earns a return and is depreciated over the accounting life of the plant. In current dollars, AFUDC can double or triple the cost of a plant. After the impact of inflation has been deducted, however, AFUDC adds modest amounts of real cost, depending on construction time and the real interest rate that is paid (see table 9 in the next section): 12 percent for an 8-year leadtime and real interest of 3 percent, and 33 percent for a 12-year leadtime and 5-percent real interest rate. State Policy on CWIP and AFUDC. Most States combine CWIP and AFUDC. More than half the States allow some CWIP on some or all utility construction expenditures. In some states it is restricted to utility purchases of pollution control equipment. Whatever construction expenses are not allowed as CWIP are then accumulated as AFUDC. graded, the number of net downgradings has been reduced sharply. By late 1983, the average earned return on common equity for the 100 largest electric utilities was up to 14.1 percent, more than 200 basis points higher than the earned return in 1980 (59). Implications of Utilities' Financial Situation There are two ways of looking at the current financial situation of the utilities and the incentives to build more plants. From one perspective the electric utilities have shared in general economic problems and have not fared as badly as some industries. The market-to-book ratios of all industrial stocks fell over the 1970's, although on average the industrial stocks stayed well above a market-to-book ratio of 1.0. For the first part of 1982, the return on investment of the electric utilities ranked 14th out of 39 industries, well above the average for such industries as chemicals, appliances and paper (41). From this point of view, there is no need for further concern about near-term utility solvency. The worst of the utilities' problems are coming to an end, and their financial situation should improve gradually. Public utility commissions (PUCs) have responded by increasing the allowed rate of return to utilities, and the Federal Government has provided additional relief from cash flow shortages in the 1981 Economic Recovery Tax Act through liberalized depreciation allowances. The tax law further mandates that these must be "normalized" (retained by the utility) rather than "flowed through" to the consumer |