Large Capital Projects: What are the Risks and Who Should Bear Them?

Mark Agnew, Edison Electric Institute

NARUC Accounting/Finance MeetingLexington, KY October 13, 2008

Table of Contents

Regulatory Compact – The Key Players Industry’s Soaring Capital Expenditures Risks Facing the Industry

Demand Financing, Credit Regulatory Execution, Inflation Specific businesses (Transmission, Generation)

EEI’s Outreach Activities

Who Shares the Risks? Management

Duty to manage utility/projects prudently Shareholders

Receive an adequate return on investment for risks taken on behalf of ratepayers

Ratepayers Receive reliable service at just and reasonable rates Not responsible for mismanagement by utilities

Good regulation tries to achieve a fair balance of all interests

Soaring Capital Expenditures

Increasing Electricity Demand

Industry Capex Continues to Rise

43.041.840.740.2 41.142.0

43.645.3

48.451.9

55.1

58.5 59.962.4

64.366.2

69.171.4

74.5

35.0

40.0

45.0

50.0

55.0

60.0

65.0

70.0

75.0

80.0

2003 Q4

2004 Q1

2004 Q2

2004 Q3

2004 Q4

2005 Q1

2005 Q2

2005 Q3

2005 Q4

2006 Q1

2006 Q2

2006 Q3

2006 Q4

2007 Q1

2007 Q2

2007 Q3

2007 Q4

2008 Q1

2008 Q2

Capital Spending-Trailing 12 MonthsU.S. Shareholder-Owned Electric Utilities (in $ Billions)

Capex Projected to Top $86 Billion in 2008

P = projected

Industry Capital ExpendituresIndustry Capital Expenditures Industry committed to reliability

and making needed investments in generation, transmission, distribution and the environment Capex

2006 totaled $59.9 billion (+24%) 2007 totaled $69.1 billion (+16%) 2008 projected $86.5 billion (+25%)

Dollar growth in all categories from last year

2008 (+16%) and 2009 (+12%) projections revised sharply upward from last year’s study

Increased spending expected to continue Total capex for 2010-2030 ~ $1.5 trillion*

U.S. Shareholder-Owned Electric Utilities

* The Brattle Group, preliminary findings from The Edison Foundation presentation titled Transforming America’s Power Industry. Represents the entire Power sector.

Overall Infrastructure Investment Needs $1.5 trillion will be required over the 2010 – 2030

period doubling existing net plant in service Distribution - $675 billion Transmission - $233 billion Generation - $560 billion

Represents the entire power industry IOUs, Cooperatives, Municipals, IPPs

Carbon Legislation would enhance overall projection

Source: Transforming America’s Power Industry: The Investment Challenge (Preliminary Findings), The Brattle Group, April 2008

About 2/3 of Industry is State Regulated

Demand Risk

Demand Risk Energy Efficiency

Decoupling and other EE measures How much will this impact future revenues?

Brattle’s latest projections on this impact Required generation could fall by 17% from 2010-2030,

under a reasonable EE scenario Price Elasticity

Consumer reaction to rising gas prices (‘08 v ‘07) Risk – Management/SH – EE & price elas.

Ratepayers - energy efficiency

Financing and Credit Risks

Financing Risk Financing decisions that don’t impair:

Financial strength, Credit Rating Tighter Credit Markets

Overall trend, magnified by recent financial crisis Eventual Rise in Interest Rates?

Rates still at historical lows Strong correlation to awarded ROEs

Dividends – frozen or cut? borrowing to pay? Risk – Ratepayers - Int rates & gen cap trends

Management/SH – all the above

Credit Ratings Risk Taking on too much debt without timely cost

recovery impairs credit metrics may lead to downgrades Increases financing costs Capex plans & related debt mentioned in most

ratings actions/outlooks in 2007-08.

Risk – Management/Shareholders

Industry Leverage Beginning to Rise

Credit Quality Starting to Slide in ‘08

Downgrades outpacing upgrades in 2008 First time since 2004

Average Credit Rating Has DeclinedS&P Bond Ranking for Regulated and Mostly Regulated Electric Utilities

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Year

Below BBB- BBB- BBB BBB+ A- or Higher

Regulatory Risk

Regulatory Risk Timely recovery of large capex is crucial

CWIP Large capex cycles tend to put downward

pressure on realized ROEs Regulatory lag

Risk – Management/Shareholders

Ratepayers Quality of cost recovery affects all.

Regulatory Lag is Returning

($7,500)

($2,500)

$2,500

$7,500

$12,500

$17,500

$22,5001973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

-4.0%

-3.5%

-3.0%

-2.5%

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

Pre-Div FCF Actual less Allowed ROE

Note: Figures reflect Lehman Brothers utility coverage scaled up by a factor of 1.11x to reflect companies not in the Lehman Brothers coverage universe

Source: FactSet and Lehman Brothers estimates

10

Rate Cases on the Rise

Execution and Inflation Risks

Execution Risk

Delays in completing the project Cost overruns Other delays (licensing, environmental

opposition, etc.)

Risk – Management/Shareholders

Construction material costs have soared in recent years.

Labor also on the rise Inflation clauses required by builders

Risk – Ratepayers, Management/Shareholders

Cost Inflation Risk

Raw Materials Price Indexes

Risks by Business Activity

Transmission - Risk Largely regulated, less financing risk Political (siting) challenges

Communities, landowners, environmentalists Enormous long-term planning

Generation Planning risk – when will transmission be in place?

Risk – Management/Shareholders

Generation - Risk General Risks

Project management, fuel choice

Regulated Cost Risk - Management/Shareholders

Ratepayers Overruns (retroactive disallowance) – Mgmt/SH

Merchant Risk – Management/Shareholders

31

Margins Projected to Fall Below Minimum Target Levels

TRE (ERCOT)2009/2016+

New England 2009/2009

RFC (MISO)*2008/2008

AZ/NM/SNV2009/2011

California2009/2012

Rocky Mtn2008/2011

SPP2015/2016+

MRO2009/2009

(US)

New York2011/2016+

RFC (PJM)2012/2014

*Excludes MISO resources outside the RFC boundary

Source: NERC 2007 Long Term Reliability Assessment

Coal-Fired Generation - Risk

Most companies delaying construction starts Proposed capacity fell 11% from Feb to Aug ’08 Large capital outlays, long build time

Carbon regulation How expensive will coal generation be? What model used?......Price of CO2 allowances?

Environmental opposition

Natural Gas-Fired Generation – Risk

Lower capital costs - less financing risk Shorter construction time - less project

management risk. “Bridge” fuel pending nuclear and clean coal

Proposed capacity rose 20% from Feb to Aug ’08

Least risky for continuous power

Nuclear Generation - Risk Financing risk is largest risk

Capturing financing cost in rates is key Considerable project management risks

No nuclear built in decades Majority of in-service dates targeting 2015-2020 Proposed capacity rose 70% from Feb to Aug ’08

Fuel disposal? Risk – Management/Shareholders

Ratepayers (built in rate base)

Renewables - Risk Financing risks are less

Government incentives ….but higher KW hour costs than fossil fuels

Intermittent, RPS driven Low political risk

Political and cultural popularity “Transmission access” risk associated with prime

wind and solar areas Proposed Wind capacity +69% from Feb to Aug ’08 Majority of proposed build by IPPs and foreign utils.

EEI’s Outreach Activities

Opinion Leader Outreach

“Get Energy Smart – Get Energy Active” Internet campaign to help educate consumers about the key issues facing the electric power industry today

1.8 million visits to Web site since launch

Keeping the Lights On—Our National Challenge: Conference in New York focused on industry’s infrastructure needs and the role of energy efficiency

State Capital Road Shows

38

April 16-17, 2008 Fargo and Bismarck, ND

October 22, 2007 Santa Fe, NM March 17-18, 2008 Topeka, KS

June 11, 2008 Albany, NYMay 13-14, 2008 Sioux Falls-Rapid City, SD

Wall Street Outreach EEI’s State-of-the-Industry address to Wall Street EEI Leadership Wall Street Visit Wall Street-Regulator Dialogues

Nearly 20 dialogues to date Wall Street-Utility Leadership Forums

2 forums on climate issues Pre-NARUC Convention Discussion of Market

Conditions (November ‘08) Energy Policy Leadership Forum (Dec. '08)

EEI Financial Publications

Contact Information

Mark Agnew

Manager, Financial Analysis

Edison Electric Institute

(202)508-5049

magnew@eei.org