for systems that have high debt due to their invest-
ments in high-cost generating assets and the extend-
ed use of capitalized interest to fund them. Popular
options that are being pursued by public power
include the restructuring of debt, extending the use-
ful lives of plants, writing off uneconomic
resources, accelerating the amortization of high-cost
debt, and increasing the use of variable rate debt,
interest rate swaps and other debt derivatives. It is
quite likely that still other financial tools will be
introduced in response to the pressure to bring
down rates.
The use of each of these tools is evaluated rela-
tive to its appropriateness to the specific situation
of a given utility. Generally, these mechanisms can
be said to produce positive results to the extent
that they reduce the upward pressure on rates.
Utilities that maintain adequate cash balances to
deal with the opportunities and challenges posed
by a restructuring industry maintain important
flexibility. For instance, ample funds will allow
them to pay off high-cost debt, thereby improving
their cost of capital and equity ratio. Some systems
with strong business fundamentals could reduce
their cash balances without impacting their credit
ratings. This is particularly true for distribution
systems that do not have the same pressures and
demands on liquidity as the more generation-
dependent systems. The movement of the industry
in this direction is evidenced by the revised bond
resolutions and indentures that are designed to free
up reserves that have been maintained under tradi-
tional financing documents.
Standard & Poor’s monitors the use of synthetic
financial instruments. These instruments present
benefits, but also can increase risk, particularly as
operating margins and reserves are trimmed to
achieve competitiveness. Because risks associated
with financial derivatives are borne by ratepayers
and are not shared with owners, as is the case with
investor owned utilities, it is imperative that a very
high degree of oversight and control be employed.
Legal Provisions Of Retail Electric Systems
Standard & Poor’s views an electric revenue bond
transaction’s legal provisions in conjunction with
the system’s overall financial profile. For electric
utilities that are able to generate system surplus
well above minimum levels required by bond
covenants, legal provisions will be of less impor-
tance in the rating analysis. For electric utilities that
demonstrate relatively weaker financial profiles, the
analysis of legal provisions remains a critical factor.
As defined in a bond indenture or resolution, the
legal provisions make clear the issuer’s capabilities,
responsibilities, and the bondholder’s recourse in
the event of the issuer’s noncompliance.
For an electric utility with a strong financial pro-
file, strong or weak legal covenants will not corre-
late with a higher or lower rating. For a weaker
electric utility, liberal legal covenants will continue
to be viewed as a weakness and could serve as the
basis for the assignment of a lower rating to sys-
tems with modest credit quality.
The most important legal provisions reviewed are
the security pledge, rate covenant, flow of funds,
additional bonds test, and debt service reserve.
Also, a growing number of issuers are incorporat-
ing swaps or other derivatives into bond transac-
tions, to supplement the traditional legal structure.
Please refer to the Debt Derivative Profile section
for additional information.Security
The most common form of bond security for utility
bonds is system net revenue. Some issuers elect to
secure bonds on a gross revenue basis. However,
Standard & Poor’s believes that pledged system rev-
enues should always be sufficient to cover debt
service and operating expenses and, therefore, does
not differentiate between net and gross revenue
pledges. Similarly, off-balance sheet debt obligations
of retail utilities that are usually secured by system
operating expenses are treated as senior lien debt.
Typically, these payments are take-or-pay obliga-
tions with wholesale agencies.Rate Covenant
The rate covenant establishes the minimum level of
debt service coverage that a system must provide
on a fiscal-year basis. Standard & Poor’s analyzes
the rate covenant in relation to the overall opera-
tional and financial performance of the individual
system. Generally, a mature system with stable
operational and financial performance will not
need as strong a covenant as a system that can be
subject to volatile financial margins or anticipates
a large capital program.
A rate covenant addresses all obligations—senior
and subordinate debt, as well as other system fund
requirements. Typically, rate covenants for retail
systems range from 1.10x-1.25x the annual princi-
pal and interest requirements of senior lien debt.
This extra margin provides bondholders with finan-
cial protection. Sufficiency-only rate covenants of
senior lien debt are of less concern for issuer’s that
consistently set and achieve internal coverage poli-
cies well in excess of coverage levels required by the
rate covenants.
For issuers that operate at less substantial mar-
gins, weak or sufficiency-only rate covenants will
play a greater role in determining the rating. For
these issuers, a covenant that allows the issuer to
use existing cash reserves, otherwise known asElectric Utility Ratingshttp://www.standardandpoors.com 125