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S&P: Hedging, Regulatory Support Key to Good LDC Credit

Winter temperatures and high gas prices can put a credit squeeze on local distribution companies (LDC) that don't win in the gas market or win the favor of their regulators. Of 14 LDCs followed by Standard & Poor's (S&P), all have a purchased-gas adjustment clause and all have some form of hedging policy, both positives for credit. But S&P also looks at business profile, supply position, and storage capacity when evaluating LDC credit ratings.

The majority of LDCs in S&P's universe have business profiles that are "well above average" or "above average." LDCs with less desirable business profiles generally suffer from involvement in higher risk deregulated activities and/or they have weak support from their regulators. Supply position refers to the ability to access multiple gas supplies through multiple pipelines; the more the better, and some LDCs fare far better than others in this regard. Also with storage, the more the better. "Some LDCs can meet more than 50% to 60% of peak demand with company-owned storage," S&P says in a research note on high gas prices and LDC credit risk.

When it comes to purchased-gas adjustment clauses, how quickly true-up occurs can have a bearing on LDC credit quality. "Slow recovery could impinge on the firm's liquidity as short-term funds are consumed to finance high-cost gas purchases. In turn, this may necessitate a larger bank line that increases borrowing costs.

"Moreover, in a high-price environment, those firms that use hedging of storage to mitigate risk to end-users need greater short-term liquidity to pay for the commodity. Given today's high and volatile natural gas prices, maintaining strong credit quality depends on ratepayers bearing the responsibility for commodity costs."

S&P says that automatic pass-through mechanisms linked to gas price indices provide the strongest level of credit quality support. Other clauses that allow for the potential disallowance of costs are not as supportive of credit quality. "In such circumstances, history provides us with the best guide to regulators' willingness to accommodate LDCs in their jurisdiction."

S&P has noticed that high gas prices have shook loose more cooperation among LDCs, regulators and legislators in the area of energy efficiency and conservation. Up for discussion is rate restructuring to encourage conservation and energy efficiency without harming an LDC's bottom line. "In essence, 'conservation tariffs' would aim to decouple earnings and rate of return from delivered volumes and should eliminate a current major disincentive for utilities to develop such conservation programs," S&P says. "This would also better align the interest of consumers with utility shareholders by implementing innovative rate designs that would encourage energy conservation and energy efficiency."

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