As downgrades of energy companies by credit ratings agencies such as Standard & Poor’s and Moody’s have increased with the speed of a runaway freight train, the companies have evolved different strategies to keep their businesses running, one of which is to remove or omit ratings triggers in much of their business.

Mike McNally, CFO of TXU Corp., pointed to his company’s problems when the market situation changed in the United Kingdom and ratings triggers kicked in, serving as a “catalyst” for the U.K. business failure, which spilled over to create financial problems for the U.S. parent. TXU reacted quickly to meet the ratings agencies’ standards, cutting its dividend and capital spending and focusing on liquidity. “Cash became king in every part of our business,” McNally told an audience at the UBS Warburg Natural Gas and Electric Utilities Conference in New York City last week. “It was a very difficult year and we’ve put that year behind us.”

Collateral triggers based on agency ratings have been “one of the biggest challenges we’ve had in the industry. The thing that will fix that over time is to quit using rating agency triggers as a sign of adverse change or a sign there’s a need for a collateral requirement, but rather use specific financial ratios from your own financial reports,” McNally said.

UBS Warburg utility analyst Terry Miller noted that over the past 15 months there have been 373 downgrades of energy companies, with one-third of them dropping company ratings by more than one notch. The total downgrades equal the number accumulated by the industry over the previous eight years, and multiple level downgrades used to be extremely rare. Also, he noted the ratings agencies have begun to cite downgrades by other ratings agencies as part of their own evaluation — a practice that never used to happen.

“The interconnected nature of ratings is very disturbing,” said Miller, who focuses on fixed income credit research. He also questioned some other current practices of ratings agencies such as including non-cash writedowns as a basis for downgrades. “Non-cash writedowns should not change ratings.”

“Everyone is confused and puzzled as to what is at work in the energy sector at this point,” said Susan Tomasky, a former FERC general counsel who is now executive vice president and CFO for AEP Corp. The “same shifting sands are affecting the ratings agencies as well; everyone’s standards are changing.” She described AEP’s “extraordinary focus on fundamental issues,” since it became apparent that Enron’s crash would have widespread ramifications.

The company focused on a liquidity plan, bank lines and revolvers, and had a strong commercial paper program until it was recently cut off by a Moody’s downgrade to Baa3. Tomasky said she could — but wouldn’t — wax eloquent “on why AEP should not be a Baa3. But what is most important to me is the issue of stability and the ability to get on with what one needs to do to correct issues around the balance sheet.” Her advice to the ratings agencies is to “focus on stability to give investors confidence, so people can begin to see what’s underlying these companies; the ratings agencies can play a very important role in some return to sanity if that is their focus of attention.”

Tomasky believes companies and investment analysts are going to have to set up their own independent basis for maintaining and evaluating financial strength and risks instead of “being driven by what the ratings agencies tell you.” Analysts should look a lot more closely at what goes into the ratings evaluations.

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