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Study: Declining ROEs a Threat to LDC Facility Investment

Precarious financial and credit conditions, combined with a continuing downward trend in allowed return on equity (ROE), have raised concerns among local distribution company (LDC) executives and financial analysts about the ability of the industry to attract the necessary investment for utility infrastructure in the future, according to a study commissioned by the American Gas Foundation.

"Equity analysts expressed concern that when allowed returns drift below 10%, financial markets see that as a 'red flag' that could turn substantial investment away from the industry," said the study conducted by Navigant Consulting's energy practice, which examines the process used by state regulators to determine allowed ROEs for natural gas utilities.

"This risk is particularly valid now, according to the analysts, since changes in the population of large investors toward a greater weight of hedge funds and private equity firms allows large blocks of money to move much faster than in the past in departing from an industry."

But while "low returns have created a negative pressure on investment in LDC infrastructure, little impact has been seen to date," said the study, which was released last Tuesday. "Public markets for capital have still been accessible for LDCs in the opinion of the analysts and senior executives because of two factors: 1) the faith in the regulatory system...; and 2) the currently favorable tax treatment for dividends." However, the continuing downward trend for allowed ROEs and political uncertainty could undermine this, it noted.

The threat to the LDC infrastructure is a "looming threat," which is being exacerbated by low returns.

"It is fair to say that there is a widespread concern over the industry's ongoing ability to raise and retain capital. Generally senior executives feel that in the current market, returns below 10% are very problematic, that returns in the mid-10s are adequate to keep the businesses on an even keel, but not to win contested capital in competition with investments in other businesses with similar risk, and that returns in the low 11s...can generally reach risk-adjusted parity with the investments with which LDCs must compete for capital," the study said.

"Clearly the concerns raised by both financial analysts and senior executives in the industry have grown a great deal in importance in the current credit and financial turmoil. The rapidly evolving difficulties in raising all types of capital, both debt and equity, would suggest that any negatively perceived factor, such as inadequate or declining allowed rates of return, could exacerbate an already problematic situation in funding new infrastructure."

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