S&P - Public Finance Criteria (2007). - The Global Clearinghouse

Electric Utility Ratingsfor systems that have high debt due to their investmentsin high-cost generating assets and the extendeduse of capitalized interest to fund them. Popularoptions that are being pursued by public powerinclude the restructuring of debt, extending the usefullives of plants, writing off uneconomicresources, accelerating the amortization of high-costdebt, and increasing the use of variable rate debt,interest rate swaps and other debt derivatives. It isquite likely that still other financial tools will beintroduced in response to the pressure to bringdown rates.The use of each of these tools is evaluated relativeto its appropriateness to the specific situationof a given utility. Generally, these mechanisms canbe said to produce positive results to the extentthat they reduce the upward pressure on rates.Utilities that maintain adequate cash balances todeal with the opportunities and challenges posedby a restructuring industry maintain importantflexibility. For instance, ample funds will allowthem to pay off high-cost debt, thereby improvingtheir cost of capital and equity ratio. Some systemswith strong business fundamentals could reducetheir cash balances without impacting their creditratings. This is particularly true for distributionsystems that do not have the same pressures anddemands on liquidity as the more generationdependentsystems. The movement of the industryin this direction is evidenced by the revised bondresolutions and indentures that are designed to freeup reserves that have been maintained under traditionalfinancing documents.Standard & Poor’s monitors the use of syntheticfinancial instruments. These instruments presentbenefits, but also can increase risk, particularly asoperating margins and reserves are trimmed toachieve competitiveness. Because risks associatedwith financial derivatives are borne by ratepayersand are not shared with owners, as is the case withinvestor owned utilities, it is imperative that a veryhigh degree of oversight and control be employed.Legal Provisions Of Retail Electric SystemsStandard & Poor’s views an electric revenue bondtransaction’s legal provisions in conjunction withthe system’s overall financial profile. For electricutilities that are able to generate system surpluswell above minimum levels required by bondcovenants, legal provisions will be of less importancein the rating analysis. For electric utilities thatdemonstrate relatively weaker financial profiles, theanalysis of legal provisions remains a critical factor.As defined in a bond indenture or resolution, thelegal provisions make clear the issuer’s capabilities,responsibilities, and the bondholder’s recourse inthe event of the issuer’s noncompliance.For an electric utility with a strong financial profile,strong or weak legal covenants will not correlatewith a higher or lower rating. For a weakerelectric utility, liberal legal covenants will continueto be viewed as a weakness and could serve as thebasis for the assignment of a lower rating to systemswith modest credit quality.The most important legal provisions reviewed arethe security pledge, rate covenant, flow of funds,additional bonds test, and debt service reserve.Also, a growing number of issuers are incorporatingswaps or other derivatives into bond transactions,to supplement the traditional legal structure.Please refer to the Debt Derivative Profile sectionfor additional information.SecurityThe most common form of bond security for utilitybonds is system net revenue. Some issuers elect tosecure bonds on a gross revenue basis. However,Standard & Poor’s believes that pledged system revenuesshould always be sufficient to cover debtservice and operating expenses and, therefore, doesnot differentiate between net and gross revenuepledges. Similarly, off-balance sheet debt obligationsof retail utilities that are usually secured by systemoperating expenses are treated as senior lien debt.Typically, these payments are take-or-pay obligationswith wholesale agencies.Rate CovenantThe rate covenant establishes the minimum level ofdebt service coverage that a system must provideon a fiscal-year basis. Standard & Poor’s analyzesthe rate covenant in relation to the overall operationaland financial performance of the individualsystem. Generally, a mature system with stableoperational and financial performance will notneed as strong a covenant as a system that can besubject to volatile financial margins or anticipatesa large capital program.A rate covenant addresses all obligations—seniorand subordinate debt, as well as other system fundrequirements. Typically, rate covenants for retailsystems range from 1.10x-1.25x the annual principaland interest requirements of senior lien debt.This extra margin provides bondholders with financialprotection. Sufficiency-only rate covenants ofsenior lien debt are of less concern for issuer’s thatconsistently set and achieve internal coverage policieswell in excess of coverage levels required by therate covenants.For issuers that operate at less substantial margins,weak or sufficiency-only rate covenants willplay a greater role in determining the rating. Forthese issuers, a covenant that allows the issuer touse existing cash reserves, otherwise known aswww.standardandpoors.com125