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Relative economics between coal and renewables have irreversibly shifted toward clean energy, leading a wave of states including Colorado, Missouri, and New Mexico to consider how they can quickly move beyond coal without unduly burdening consumers.
Fortunately, several policy solutions can protect consumers and investors through this utility financial transition, and refinancing these soon-to-be stranded assets with low-cost capital can expedite the process.
By swapping coal debt for clean energy equity, utilities can address unrecovered investment balances and retire coal plants early, cutting consumer costs while benefiting impacted communities and utility shareholders.
Financial tools to swap coal debt for clean energy equity
In the power sector’s coal-to-clean transition, early-retired plants leave utilities with unrecovered investment balances – a problem that must be addressed. While early fossil plant retirements can cut consumer costs by avoiding volatile fuel purchases and reducing operating costs, paying down the remaining value of investments tends to increase consumers’ rates. Accelerated depreciation schedules, which speed up investment collection and match recovery to earlier retirement dates, are particularly challenging because they often offset savings from early retirement by raising consumers’ short term rates.
But accelerating depreciation and paying utilities a rate of return on their remaining value of investments for retiring power plants is not the only solution to this problem. Financial mechanisms similar to home mortgage refinancing can reduce costs of paying off remaining coal plant values, balancing financial interests of consumers, impacted communities and workers, and utility shareholders. Accommodating these diverse interests improves probabilities of regulators approving early fossil fuel plant retirements.
Refinancing unrecovered plant value of investments to take advantage of lower cost capital through securitized bonds can reduce consumers’ rates. Replacing “regulatory assets” (equity portions of unrecovered early-retired plant investments) with utility corporate debt can also rebalance financial impacts – particularly where securitization legislation is not in place. In both cases, swapping higher-cost equity investment with lower-cost debt creates lower utility costs for carrying these assets.
Utility capital structure – equity and debt
Utility financing includes equity where investors buy shares of ownership, and debt where investors make loans by purchasing corporate bonds. Equity investors require higher returns, because equity owners share risks of business ownership and operations. In exchange for bearing these risks, equity owners expect to be proportionally rewarded through share price growth or with dividends awarded on a per share basis.
Utility financial debt structures are comprised of corporate or commercial bonds that investors buy with the promise their loans will be repaid in a fixed amount of time, with interest determined when bonds are issued. Because bonds carry repayment promises secured with pledges that assets will be available to back them, debt investors require returns associated with lower investment risks than equity, so debt costs less than equity.
If the utility were to enter bankruptcy, debt holders are more likely to be repaid, while equity holders could face little to no repayment. Equity investors’ last-place in line helps to explain why Pacific Gas and Electric’s bankruptcy announcement cratered its stock value by 50% overnight, down 90% from the company’s market valuation before wildfire liability concerns began in late 2017.
Other financing tools, like ratepayer-backed bond securitization, can be even cheaper than corporate debt. Securitization creates a non-utility entity that collects revenue from customers and issues bonds backed by this revenue stream. By isolating this very consistent and low-risk revenue stream (we won’t stop buying electricity any time soon), these bonds can achieve interest rates on par with the lowest-risk securities, like U.S. treasury bills.
Should swapping debt for equity concern investors?
By itself, raising utility debt margins might concern equity investors, but it is less important when considered with other factors, including magnitude. Too much debt increases bankruptcy risks, since debt holders have contract rights to their investment repayment and interest which allow creditors to force repayments through bankruptcy in case of default. No such guarantees accompany equity ownership, so too much debt carries severe risks to equity investors.
More equity than debt also tends to dilute shareholder ownership and spread ownership risks, so equity owners’ profit potential is reduced if equity capital expands at the expense of debt. As such, there is no “correct” debt to equity ratio for regulated utilities, though a 50/50 split is preferred by utility managers.
Regulators typically set electricity rates after utilities have established their capital structure and investors have made their choices in financial markets. Regulatory interventions in utility managers’ capital structure choices are rare, but they do arise. Regulators might insist on adjustments as part of the coal-to-clean financial transition, or utility management might exercise its discretion and propose financial structure adjustments to rebalance risk in light of ongoing risks of owning costly, outdated, environmentally risky coal generation.
From the utility perspective, debt carries no earnings for shareholders, because regulators only allow utility profits on equity investment. With earnings only allowed on equity investment, utility managers are incentivized to sell shares and raise investment capital, or allocate profits toward investment capital to increase their business value. ”
Debt leverage impacts - "all else equal"
Proposals to replace equity with debt still might concern investors. Equity holders might object to replacing equity on which their share earnings depend with debt, as it represents lost earnings opportunities. Debt holders might question whether additional debt issued to replace equity in utility financial structure would create more competition for dollars to cover their debt payments, thereby reducing the likelihood they would receive their interest payments on time and in full.
While these investor concerns make general sense, the only way to properly judge them is in context of the larger financial setting in which utilities might replace some equity with more debt. Many factors other than debt to equity ratios play into utility financial analysis, which must be kept in mind when more debt leverage is undertaken.
Regulators facing the growing coal-to-clean challenge should ask themselves three questions in order to create the right debt for equity policy:
- Can securitized or “ratepayer backed” bonds refinance regulatory assets at lower investment costs than corporate debt, if state legislation allows this option?
- Can utility investment in new clean energy resources replace part or all of earnings opportunities foregone in refinancing equity with debt?
- Will changes in debt-to-equity ratios present undue levels of risk, compared to debt and equity relationships in other utilities in similar circumstances?
Low-cost capital will be essential to quickly scaling the clean energy transition needed to avoid locking in dangerous climate change. Within large investor-owned utilities, refinancing a modest portion of assets with debt may ultimately be easy for shareholders to absorb, making this an attractive option to expedite the coal-to-clean transition. For smaller, less-diverse utilities, or public entities like municipal or cooperative utilities, the financial calculus and tools available will differ.
Either way, low-cost financing can help utilities retire coal generation early to save consumers money and reduce emissions without undue burdens on investors.
