Fitch Comment: 2005 Energy Policy Act To Have Slightly Positive Credit Implications

Business Wire, August 1, 2005

NEW YORK -- The omnibus Energy Policy Act of 2005 (EPACT), passed by the United States Congress on July 29, 2005 and expected to be signed into law by President Bush next week, will result in changes to the electric power and gas utility industries. Fitch anticipates that the act is unlikely to have any negative credit effects and will have mostly positive implications for creditors to the sector. Few consequences of the act will be felt in the near term, with the exception of the elimination of the venerable Public Utilities Holding Company Act of 1935 (PUHCA) in six months after enactment. While the overall effects of the EPACT are either neutral or positive for ratings of utilities and energy companies, the new law also presents pockets of future risk for certain industry participants, such as rising risk associated with mergers and acquisitions and rising capital spending programs.

The Electricity Title of the EPACT (Title XII) is the first major overhaul of U.S. electricity policy since 1992. Among other things, the act imposes mandatory transmission reliability standards, repeals the Public Utilities Holding Company Act of 1935 (PUHCA), provides some expanded authorities to the Federal Energy Regulatory Commission (FERC) while clarifying FERC's authority in formerly gray areas, criminalizes manipulative trading practices in power markets and increases criminal penalties for such practices in natural gas markets, and amends the Public Utilities Regulatory Policy Act of 1978 (PURPA).

Fitch expects that the demise of PUHCA will likely accelerate the recent trend of utility consolidation. Repeal paves the way for mergers of utilities that do not operate as a single, integrated system as well as for acquisitions of utilities by companies from outside the industry. Existing utility groups, perhaps from geographically disparate regions, may begin to consolidate with the potential for operational and administrative efficiencies, and more gas/electric multi-utilities are expected to form. Mergers may offer a way to achieve earnings growth from core competency utility operations. However, the emergence of larger groups could also result in more rating degradation, if merger frenzy results in higher merger premia and more debt-financed merger transactions, and will carry the consequence of more companies exposed to group rating linkage. Fitch notes that heightened merger and acquisition activity and the attendant increase in event risk for utilities will be mitigated by the continuing need for state regulatory approvals and states' tariff-setting authority. More active regulation by state public service commissions and the FERC in areas formerly regulated under PUHCA is likely to follow PUHCA repeal.

FERC authority with regard to the gas sector is expanded by granting FERC sole authority to regulate and approve facilities for the import of liquefied natural gas (LNG). A host of provisions of the bill are oriented toward increasing domestic sources of natural gas, including such measures as: streamlining permitting for drilling on and leasing of federal lands; providing royalty incentives for deepwater production and drilling; and permitting producers to amortize geological costs over two years for tax purposes. Other provisions will benefit development of new gas storage facilities and accelerate depreciation of distribution and transmission pipelines. A controversial provision opposed by some coastal states directs the Department of the Interior to conduct an inventory of natural gas and oil reserves on the Outer Continental Shelf; to carry out the survey, the act permits seismic studies but no drilling, a baby step on the way to potential future offshore development. Congress did not take action on more active provisions to authorize drilling in the Arctic Natural Wildlife Refuge or other frontier areas. On balance, Fitch expects that EPACT will have favorable credit implications for gas distribution and pipeline companies.

The EPACT contains an abundance of tax credits, opportunities for accelerated depreciation, outright grants, and other financial incentives that Fitch expects will be an incentive to increased capital investment in nuclear plant development, such as clean coal technologies, gas storage and pipeline facilities, power transmission, and alternative electricity sources, while reducing the potential adverse effect on credit quality of affected companies. As electric and gas companies formulate related investment plans, Fitch will incorporate the associated economic costs and benefits into individual companies' rating analyses. The incentives provided in the act will serve to lower investment requirements or improve investment returns, helping to offset the risk of investment in new technologies, stimulate development of new base-load generation capacity, and ultimately could moderate the rate of increase in power and gas costs to consumers.

If the act succeeds in stimulating the addition of significant coal and nuclear base-load generating capacity, that may have adverse long term credit implications for owners of nearby gas-fired merchant capacity, since existing gas-fired capacity may be displaced in the economic dispatch queue by the lower variable costs of incremental coal and uranium-fueled power plants. This possibility is mitigated by the long lead-time before such new power plants enter operations, 2010 to 2015 for new commitments to advanced technology coal plants and at least a decade for the next generation of nuclear plants.