1. The Changing Economic Environment An Industry Perspective Society of Utility and Regulatory Financial Analysts 42 nd Financial Forum April 29, 2010

2. 2 Characteristics of US Capital Markets Large Liquid Sophisticated Backed by largest and most flexible economy Top-quality legal infrastructure –Corporate law –Bankruptcy law Ownership is widely held

3. 3 Characteristics of US Electric Utilities Seasoned companies and regulatory environments Transparent business organizations Large number of comparators Many utilities have: –Scale businesses –Ample research coverage –Liquid securities

4. 4 Did Something Happen in the Last Two Years to Change These Conclusions? Volatility in the US and global economies Volatility in the US and global financial markets But utilities did fairly well on the whole –No bankruptcy filings –Capital mostly preserved –New capital available most of the time

5. 5 Lehman Bankruptcy Utility Bond Performance Source: Bloomberg

6. 6 Utility Stock Performance Lehman Bankruptcy Source: Bloomberg

7. 7 So what is the problem?

8. 8 The crisis itself is not the problem

9. 9 The Problem is Investors have begun to realize that long-term returns for utilities are poor –Equity: returns to equity are not fair and equitable –Debt: credit quality has deteriorated and will continue deteriorating

10. 10 Utility Equity Returns Are Not Fair and Equitable Supreme Court standards Bluefield Water Works v. PSC, 262 U.S. 679 (1923) a return equal to that generally made at the same time and in the same general part of the country on investments in other business undertakings which are attended by corresponding risks and uncertainties…. FPC v Hope Nat. Gas, 320 U.S. 591 (1944) It is not the theory, but the impact of the rate order, which counts. By that standard, the return to the equity owner should be commensurate with returns on investments in other enterprises having corresponding risk

11. 11 Utility Equity Returns Are Not Fair and Equitable How has US regulation performed relative to that standard? –Returns are set on tangible book value, so therefore fairness and equity must be measured using earned returns on tangible book equity –Five-year (2005-2009) average earned ROEs S&P500 Utilities = 12.28% S&P500 Industrials = 19.59% and S&P500 average= 16.03%

12. 12 But Lower Returns Are Fair Because Risk Is Lower The risk is the regulatory outcome (i.e, the taking without just compensation)

13. 13 But Even if Results Are Bad, Investors Havent Gone Away They wont, they simply re-price Source: Bloomberg

14. 14

15. 15 No Basis for Applying Market Returns to Book Values Formulas are market-based –CAPM –Dividend discount model –Conclusions of other utility regulators As applied, current regulatory model drives the market value of utility equity to equal book value –No other common equity in the economy works this way –No basis in statute or precedent for this result –No known theoretical justification for this treatment Fair and equitable Market RateXMarket Value=Market Return Book RateXBook Value=Book Return Current U.S. practice Market RateXBook Value=Taking Book RateXMarket Value=Excessive Profit

16. 16 Forcing Market to Equal Book Is Not Just Unfair and Unreasonable The brinksmanship of this regulatory model –Raises costs of capital in the long-term –Instills inflexibility –Encourages conservatism –Is difficult to reverse

17. 17 Possible solutions 1.Market rate x Market value a.UK model for utility returns b.(Marginal return) x (rate base increased by inflator) 2.Book rate x Book value a.(ROE from competitive businesses) x (book value of rate base) b.(Use book values in dividend discount model) x (book value of rate base)

18. 18 Other Sources of Investor Discomfort with Returns Regulatory lag –Many jurisdictions dont fully reflect cost of operations in the year for which rates are set –Fixes: forward test year, trackers or true-ups Penalty-orientation –Many jurisdictions prefer the optics of punishment to those of rewards –Fix: balance in incentives and penalties Mixed messages –Reduced equity returns for higher credit ratings –Merger economics taken as customer benefit –Reduce cash flow, then describe business as low risk

19. 19 Debt: Average Credit Quality Has Deteriorated Source: Utility operating company ratings as determined by S&P

20. 20 Why should we care?

21. 21 What Is the Problem That Returns Need to Address? 1.Utility financing needs continue 2.Investors have other investment choices 3.Smaller utilities are already under pressure 4.Utilities face risk from increases in interest rates and inflation 5.Cost of litigation?

22. 22 1. Utility Financing Needs Continue Utilities have always been capital intensive –Spend twice as much on capital as they recover in depreciation, twice what industrials spend Potential for significant new needs –Customer demand –New technologies (e.g., smart grid) –Government mandates (e.g., climate objectives) Revenue requirement for replacement plant far exceeds the revenue requirement of what it replaces

23. 23 Utility Free Cash Flow Forecast to be Negative Source: Barclays Capital, June 2009 Note: Free cash flow defined as operating cash flow less cap ex.

24. 24 2. Investors Have Other Investment Choices Investors dont have to own utilities on current terms: they can hold out for more Utilities are a small factor in capital markets –8% of corporate debt issuance –3% of equity Investors have demonstrated a willingness to stop funding other industries: e.g., autos, banks

25. 25 3. Smaller Utilities Already Under Pressure Implication: underspend Implication: risk averse, community averse Implication: sell out, see 1995-2010 consolidation

26. 26 4. Utilities Face Risk from Inflation and Rising Interest Rates Change in direction of interest rates and inflation driven by government deficits Utility earned vs. allowed return has suffered in inflationary times Utility valuations generally lower in high inflation environments due to regulatory lag, structural underestimation of capital costs, and an aversion to sizable increases.

27. 27 Inflation Leads to Utility Earnings Shortfalls Source: Barclays research, June 2009

28. 28 In Turn, Utility Market-to-Book Faces an Inflation Threat Source: Barclays research, June 2009