Richard Klein is associate professor

of finance at Clemson University. He

received a B.A. in economics from

City College of New York, an M.B.A. from the Amos Tuck School at

Dartmouth College, and a Ph.D. in

business administration from the University of Texas at Austin. Dr.

Klein has published extensively in business and public utility journals.

34

Electric Utility Preferred Stock Financing - Twilight or New Dawn? The tax laws have greatly diminished the importance of utility preferred stock. But with utility construction programs expected to rise, it’s an opportune time to see if preferreds can be an attractive option again.

Richard Klein

A s recently as 1980, preferred

stock financing by electric

utilities comprised 55% of all U.S.

corporate preferred stock issued.

By 1989, this percentage had

declined to under 12%! In dollar

amounts, electric utility preferred

stock financing had decreased by

two-thirds over the same time

period. Below I analyze just why

this decline occurred and what it

portends for the future.

I. Background: Types of Preferred

Historically, electric utilities

have financed their construction

programs with a mix of about

50% debt, 15% preferred stock

and 35% common equity

During the 197Os, utilities’ com-

mon stock typically sold below

book value. To avoid common

equity dilution and higher debt-

to-equity ratios and at the same

time finance a huge expansion in

generating capacity, utilities

turned to preferred stock issuance

for help. With a decline in con-

struction in the 198Os, utilities did

not feel the need to engage in pre-

ferred stock financing to the de-

gree previously used. Yet 1988

Compustat data showed that elec-

tric utilities still paid $2.154 billion

of preferred dividends, which ac-

counted for 26.2% of the total

amount of preferred dividends

paid.

The Electricitu Toumal

Preferred stock is a hybrid secu-

rity, having some of the elements

of subordinated debt and others

similar to common stock. Per-

haps the most important aspects

of preferred stock are that omis-

sion of a dividend does not place

the issuer into bankruptcy, and

that accountants classify it as

equity

P

referred stock provides a

significant tax advantage

over debt to corporate investors

because they are allowed to

deduct 70% of the dividends they

receive as a Dividends Received

Deduction (DRD) from unaf-

filiated corporations (those in

which they have less than 20%

ownership). Thus, corporations

have a tax incentive to buy prefer-

red stock in lieu of comparable

maturity debt securities because

the interest earned on these secu-

rities is fully taxable. The cor-

porate money manager must hold

the stock for at least 46 days in

order to be eligible for the 70%

DRD. Preferred stock is a highly

desirable financing vehicle for

many utilities.

Currently, most utility preferred

stock is sold “off the shelf” in is-

sues typically from $50 to $75 mil-

lion. That is, the Securities and

Exchange Commission permits

many utility companies to register

all the securities they plan to sell

over the next two years and then

sell some or all of them whenever

they choose to do so.

In the last decade, public

utilities have used three basic

types of preferred stock. They

are: (1) fixed rate preferred, (2)

Dutch Auction Preferred Stock

(DAIS), and (3) adjustable rate

preferred stock (ARPS).

Traditionally, electric utilities

issued fixed rate perpetual prefer-

red stock. But in 1979, the Nation-

al Association of Insurance Com-

missioners (NAIC) ruled that all

new preferred stock purchased by

property and casualty insurance

companies must contain pro-

visions for a sinking fund in order

for the company to carry it on the

books at cost instead of having it

be “marked to market.” The sink-

ing fund must (1) begin no more

than ten years from the date of

issue, (2) retire the preferred stock

at a rate of at least 2l/2% per year,

and (3) have the total retirement

Preferred stock is a highly desirable financing vehicle for many utilities.

of the issue be accomplished

within 40 years from the date of

issue.’

A. Fixed Rate Preferred

Fixed-rate perpetual preferred

is no longer the dominant type of

issue because insurance com-

panies, the largest corporate pur-

chaser of preferred stock, do not

want to carry securities which are

“marked to market” - that is car-

ried at the lower of cost or market

on their books. Also, corporate in-

vestors have been seeking shorter

maturities. Most utilities use

“sinkers” (sinking fund preferred

stock), with a lo-year maturity

currently being the most popular.

The average duration of these lo-

year “sinkers” is eight years. The

sinking fund redemptions are nor-

mally cumulative and take place

annually The “sinkers” permit

the utility either to enter the open

market to purchase that part of

the issue to be retired or to re-

deem the required percentage

from the investor directly at par.

Additionally, many “sinkers”

permit the utility to retire an addi-

tional 100% of the minimum re-

quirement each year on an non-

cumulative basis.

A lternatively a firm may

offer a five or seven year

‘bullet” preferred, which is paid

off at the end of its term. These

developments have tended to

blur the distinction between inter-

mediate term debt and equity.

Sinking fund issues (“sinkers”)

typically sell at lower yields than

comparable non-sinking fund is-

sues because the retirement

process engenders upward pres-

sure on the market price of the

remainder of the issue.

B. Dutch Auction Preferred

The second major type of prefer-

red offered by some utilities -

Dutch Auction Preferred Stock

(DAPS) - is designed to sell at

par, with the dividend rate set by

a Dutch auction every 49 days.

The Dutch auction is held in the

secondary market. Prospective

buyers indicate the interest rate

they will accept; the highest rate

needed to sell all of the DAPS

October 2 992 45

issue offered for resale becomes

the effective rate for all the suc-

cessful bidders. Thus, the bid of

the marginal investor ultimately

determines the yield on the entire

issue.

Existing DAES holders can

place the following orders in a

Dutch Auction: “Hold” -that

just “rolls over” the holdings on a

noncompetitive basis; “Sell” -

sell the DAES holdings at par;

and “Bid” - an order to buy at a

particular rate.

New investors utilize the “Bid”

option. Because the DAPS issues

are sold on a 49day auction cycle,

they fulfill the requirement of the

70% DRD for a 46 day holding

period.

DAPS securities are typically is-

sued in multiples of $100,000, but

can range as high as $500,000 or

$l,OOO,OOO a share. Corporate in-

vestors favor DAPS because of

their liquidity, price stability, and

DRD exclusion.

T he difference in after-tax

yields of DAES versus Com-

mercial Paper or other debt is the

reason why corporate investors

find DAPS attractive. Typically,

the difference ranges from 30 to

100 basis points (or 0.3 to 1.0%). A

tax-paying corporation in the 34%

marginal tax bracket and eligible

to take the 70% DRD would have

an effective 10.2% tax rate on

dividend income (34% x (1.0 -

0.7)). Therefore, a firm’s after-tax

yield would be 89.8% (100% -

10.2%) of the before-tax yield.

This figure contrasts with an

after-tax yield of 66% (100% -

34%) of the before-tax yield for

fully taxable investments such as

Commercial Paper. There is a li- bill rate, the ten-year Treasury

quidity risk if the auction fails bond rate or the 20-year Treasury

and the DAPS shareholders are bond rate. For instance, Duke

subordinate to debtholders in Power’s ARES is 77% of the

cases of reorganization and highest of the three month

bankruptcy. Nevertheless, DAIS Treasury bill rate, the ten year-

normally trades at par value, and Treasury bond constant maturity

investors are not greatly affected rate or the 30-year Treasury bond

by changes in interest rates, tax constant maturity rate as deter-

rates, credit market conditions mined by the Federal Reserve Sys-

nor declining credit quality of the tern. The dividend rate on an

issuer because it is the issuer who ARES issue is restricted to its

absorbs the risks. upper and lower limits, such as

However, while Dutch auction 10.5% and 5.5%.

preferred may be attractive to in- A RI?3 were attractive to

vestors, utilities that issue DAPS utilities because, in infla-

are at the mercy of the market tionary times, the higher prefer-

every 49 days. The question is red dividend costs can be passed

often asked if these securities, on to ratepayers. After banks,

utilities were the largest issuer of

ARES.

ARES were originally (and mis-

Utilities that issue takenly) designed for use as cor-

DA-Z’S are at the porate short-term investments.

But while many investment

mercy of the market bankers thought the ARES issue

every 49 days. would not fluctuate in value, in

fact they became volatile and

declined in value.

New ARES issues are virtually

which are designed to trade at

par, are really equity, but rating

agencies consider DAPS as per-

manent equity capital.

C. Adjustable Rate Preferred

Adjustable Rate Preferred Stock

(ARES) securities were issued for

several years before the first

DAPS issue. Normally, the

dividend on an ARES issue is ad-

justed quarterly The dividend

rate typically is set equal to a

spread from the highest of three

rates, such as the 90-day Treasury

nonexistent today, for a variety of

reasons.2

D. Other Types of Preferred

Some electric public utilities use

still other types of preferred

stocks, including Remarketed Pre-

ferred and Convertible Preferred.

Remarketed Preferred is similar

to DAPS in that the objective is to

maintain the preferred stock at

par and to provide a money

market instrument for corporate

investors.

Remarketed Preferred has a

dividend rate that is reset at the

_

46 The Electricity Journal

end of each dividend period to a

rate that a specified remarketing

agent, such as Smith Barney or

Merrill Lynch, determines will

make the preferred stock worth

par.3 The issuer has considerable

flexibility in choosing the length

of the dividend period, which can

be of any length, even one day

Usually, the issuers vary the

dividend reset period either by 7

days or 49 days. Remarketed Pre-

ferred offers greater flexibility in

selecting the other terms of the

issue so that each share could

theoretically have a different

maturity, dividend rate or other

terms provided that the issuer

and the holders so agree.

Several utilities have issued

Preference Stock, a more junior

version of preferred, because the

covenants and other restrictions

in the utility’s articles of incor-

poration are less stringent for

Preference Stock than for Prefer-

red Stock issues.4

II. Why Issue Preferred?

Electric utilities gain significant

benefits by issuing preferred

stock. These advantages include:

(1) raising funds which might be

unavailable from other sources;

(2) maintaining a given propor-

tion of debt, preferred and com-

mon, (3) complying with state reg-

ulatory requirements; (4) gaining

secondary leverage for common

stockholders which might in-

crease their earnings per share be-

cause the return on new preferred

stock is typically cheaper than

new common by as much as 500

basis points; (5) avoiding issuing

more debt because of rating agen-

cy concerns; (6) maintaining

financing flexibility and access to

capital markets on reasonable

terms; (7) avoiding possible loss

of control (preferred stock normal-

ly does not have voting rights); (8)

taking advantage of a low (or

zero) marginal tax rate which

makes preferred stock financing a

low-cost alternative? and (9)

avoiding default risk (preferred

stockholders cannot have the com-

pany declared insolvent for

failure to pay dividends).

Some observers believe prefer-

red stock financing strengthens

the utility’s balance sheet, espe-

Some observers believe prefuued stock strengthens the utility’s balance sheet, especially from the debtholder’s view.

cially from the debtholder’s point

of view, though most utilities treat

their preferred stock dividend

payments like fixed obligations.

But even with all its supposed

benefits, issuance of preferred

stock by public utilities has fallen

in recent years.

III. Statistical Analyses: Reasons for Declining Use of Preferred

The following tables show the

declining use of preferred stock

financing by electric utilities.

Table 1 shows that the ratio of pre-

ferred stock financing to all capi-

tal financing by electric public

utilities has fallen from 14.0% in

1980 to just 5.8% in 1989. The

amount of new electric utility pre-

ferred stock declined by 64.2% in

that period.

T he Edison Electric Institute

disclosed that the total pre-

ferred stock on electric utilities’

balance sheets dropped from

$26,834 million in 1988 to $25,948

million in 1989, a decrease of 3.3%

in absolute terms6 By contrast,

total capitalization for electric

utilities increased by 1.8% -

$337,910 million in 1988 and

$343,881 million in 1989.7 Thus,

preferred stock financing repre-

sented 7.5% of total capitalization

in 1989 as compared to 7.9% in

1988. This decrease was due in

large part to a number of firms

redeeming their high cost prefer-

red and preference issues in order

to reduce financing costs.

New preferred stock financing

of all U.S. corporations had a less

precipitous drop - from 4.9% in

1980 to 2.7% in 1989. It had

reached a high of 6.0% in both

1982 and 1983.

Only since 1986 has the Federal

Reserve system provided data on

private placements. However,

utilities have generally stayed

away from the private placement

market because of onerous

provisions such as protection

from a change in the DRD and

downgrade protection where the

dividend rate is “grossed up” if

the credit rating deteriorates.

Table 2 reveals that electric util-

ity preferred comprised 55.4% of

A7

all U.S. corporate preferred issued

in 1980, reached a high of 65.3%

in 1981, and fell to just 11.6% in

1989.

Causes for the decrease in the

use of preferred stock by electric

utilities can be attributed to six

developments: (1) its high cost,

(2) adequate utility funding, (3)

the changing nature of the utility

industry, (4) adverse tax effects,

(5) lack of investor interest, and

(6) competition from British firms.

A. High Costs

The most important reason for

reduced use of preferred stock

financing by electric public

utilities is that it is an expensive

source of funds. Dividends on

preferred stock are paid after taxes.

Also, fixed-rate preferred stock re-

quires substantial yield spreads

over DAIS because (1) fixed-rate

preferred stock can be very sensi-

tive to interest rate fluctuations,

and (2) changes in the tax laws -

in particular the DRD - have

made corporate investors wary.

A particularly high-cost utility

preferred currently in use is per-

petual fixed-rate preferred, typi-

cally with a par value of $25. It is

designed to meet the need of the

retail purchaser (the general

public) rather than the corporate

investor. The sale of preferred

stock to the general public is ex-

pensive to the utility because of

the commissions involved and be-

cause the individual investor re-

quires a higher dividend yield,

since he cannot use tax ad-

vantages such as the DRD. Ap-

proximately 20% of the preferred

stock market is “retail.“’

B. Adequate Funding

A number of electric utilities

have not needed to issue new pre-

ferred stock because their internal

cash generation has been more

than sufficient to meet their equi-

ty requirements. In fact, in recent

years several utilities have

generated substantial amounts of

excess funds and, in turn, have

diversified to form independent

power firms and - further afield

- real estate, banking, transporta-

tion, agricultural, and mining

firms.

Having capital sufficient to per-

mit these investments, utilities

may not have felt the need to

issue new preferred stock as a

way to achieve secondary

leverage for their common stock-

holders. A recent study disclosed

that common stockholders of over

70% of all major electric and

telecommunication utilities

earned a higher rate of return on

their investment than did stock-

holders of major non-regulated

U.S. industrial corporations over

the 17-year period 1972 - 1988.9

Perhaps as another result, some

utility commissions have

decreased the allowed returns for

some utility common stock.

C. Utility Industry

Characteristics

The use of preferred stock is

driven by electric generation ex-

pansion. Utilities were engaged

YM

1980

1981

1982

1983

1984

1985

1986

1987

1988

Table 1. Electric Utility Offerings by Type of Security, 1980 - 1989 ($ millions)

Total Capital F;;entof Long-Term Percent of Preferred Percent of Financing Debt Total Stock Total :slon

$14,382 100% $8,308 57.8% $2,010 14.0% $4,063

$14,192 100% $8,929 62.9% $1,174 8.3% $4,090

$16,386 100% $9,225 56.3% $2,137 13.0% $5,025

$12,568 100% $7,583 60.3% $1,903 15.1% $3,083

$11,992 100% $10,173 84.8% $888 7.4% $930

$14,822 100% $12,517 84.4% $655 4.4% $1,650

$23,711 100% $21,391 90.2% $1,681 7.1% $640

$16,130 100% $13,926 86.3% $1,958 12.1% $246

$11,151 100% $9,901 88.8% $748 6.7% $503

Percent of Total

28.3%

28.3%

30.7%

24.5%

7.8%

11.1%

2.7%

1.5%

4.5%

1989 $12,486 100% $10,994 88.1% $720 5.8% $772 6.2%

Source: EBASCO Services Inc.

48 The Electricity Journal

Table 2. Preferred Stock, Electric Utilities vs. All U.S. Corporations 1980 - 1989 ($ millions)

Year Electric Utility All U.S. Corporate Percent of Preferred Preferred Total

1980 $2,010 $3,631 55.4%

1981 $1,174 $1,797 65.3%

1982 $2,137 $5,113 41.8%

1983 $1,903 $7,213 26.4%

1984 $888 $4,118 21.6%

1985 $655 $6,505 10.1%

1986 $1,681 $11,514 14.6%

1987 $1,958 $10,123 19.3%

1988 $748 $6,544 11.4%

1989 $720 $6,194 11.6%

Sources: EBASCO Services, Inc., and Federal Reserve Bulletins

__

in a major capacity expansion

during the 1970s and early 1980s.

For most utilities today the last

construction cycle has ended and

the need for huge sums of capital

has decreased. So, with it, has the

need for preferred stock financ-

ing. Many state regulatory com-

missions are now encouraging

development of conservation

rather than building new generat-

ing capacity.”

E lectric utilities have been

making large expenditures

for transmission and distribution

facilities. Though T&D costs are

not large compared to the cost of

generating facilities, expenditures

for these facilities exceeded the ex-

penditures for new generating

plant in 1989 ($11.2 billion versus

$9.4 billion) for the first time since

1969.i2 Partly because their costs

are smaller, transmission and dis-

tribution expenditures can more

easily be passed on to ratepayers.

Increasingly, utilities are looking

to sources other than their own

October 1991

generation to meet rising elec-

tricity usage. Playing a key role in

that strategy are independent or

utility-affiliated power supply

firms which may supply power to

the franchised utility in a par-

ticular area. Such firms already

provide about 5% of the elec-

tricity generated nationwide.i2

The North American Electric

Reliability Council predicts that

25% of the additional 72,000

megawatts needed over the next

decade will be supplied by non-

utility generators.13 To the extent

this occurs, it will reduce the need

for public utility financing, includ-

ing preferred stock.

D. Changed Tax Laws

Because the purchase of prefer-

red stock is tax-driven, changes in

tax laws have had an extremely

important effect on its issuance.

Two such changes that have been

detrimental to the preferred stock

market are the Dividends

_

Received Deduction and the Alter-

native Minimum Tax (AMT) .

Typically, the corporate

treasurer invests in preferred

stock primarily for the tax

benefits. For 50 years the

dividends received deduction

was 85%, but it was reduced to

80% under the Tax Reform Act of

1986. The DRD was further

reduced to 70% in 1987, when

some members of Congress

wanted to reduce it to 50%. The

1987 Tax Act provides that if the

recipient corporation owns less

than 20% of the issuing corpora-

tion, only 70% of the dividends

are tax deductible.

The 80% DRD applies to cor-

porations owning more than 20%

but less than 80% of the issuing

company For corporations

owning 80% or more of the dis-

tributing corporation, the DRD is

100%. The vast majority of elec-

tric utility preferred stock falls

into the 70% DRD category, which

became effective on January 1,

1988.

T here has also been a sort of

“tax compression.” The top

corporate marginal tax rate has

declined from 46% to 34%, while

the effective taxes on preferred

stock dividends received by cor-

porations rose. With the pre-1987

85% DRD, corporations paid only

6.9% in taxes on dividends

received ((100% - 85%) x 46%).

With the current 70% DRD, firms

pay now 10.2% in taxes ((100% -

70%) x 34%). No clear rationale

has been given for reducing the

marginal tax rate on regular cor-

porate income while increasing

the effective rate on intercor-

49

porate dividends other than to

raise additional revenues.

The implications of the recent

changes in the DRD have been

crucial and damaging for prefer-

red stock issuance. Reducing the

DRD has led to increases in cor-

porate taxes, increases in the cost

of capital, decreases in funds

available for corporate invest-

ment, and higher electricity rates

-because the higher cost of capi-

tal is passed on to ratepayers. The

lower DRD discourages new pre-

ferred financing. The threat of an

even lower DRD has unsettled the

preferred stock market, causing

required yields on existing fixed-

rate preferred and ARPS to rise

and their prices to fall.

In addition to these changes in

the DRD, the Alternative Mini-

mum Tax (AMT) has had an ad-

verse effect. The AMT was

designed to require minimum in-

come tax payments from profit-

able corporations regardless of

the corporation’s regular taxable

income. because of the AMT, the

current corporate tax rate on pre-

ferred dividends received in a

given year may be as high as

16.5% rather than 10.2%.

Table 3 (see inset box) illus-

trates the effect of the AMT on cor-

porate income taxes.

E. Lack of Investors

Primarily because of the tax ef-

fects discussed above, the market

for preferred stock is considerably

more narrow now than in the

past. Therefore, in order to attract

existing investors, issuers have to

provide an even greater yield on

an after-tax basis for preferred (3) money managers for corpora-

stock than on corporate bonds. tions that can use the DRD, (4) cor-

Large potential purchasers of porations or their subsidiaries

preferred stocks include: (1) stock who invest directly for money

property and casualty insurance market purposes, (5) taxable

companies, (2) finance companies, mutual funds, (6) certain nuclear

r

Alternative Minimum Tax and Corporate Income Taxes

W hen Adjusted Current Earnings (which corporation’s effective tax rate would be typically includes preferred diviiends) 16.5% ($49.50&300). However, the firm is

are greater than taxable income, a tax permitted to carry over its AMT as a Mini- preference item is created by taking 75% of mum Tax Credii. the excess. The factor was 50% from 1987- But, as shown in Table 3, suppose that 1989, based on book income. For example, the firm earns $100 in fully taxable interest assume as in Table 3 that a corporatii for 1992. The Adjusted Current Earnings earns $300 in preferred stock dividends for and the Taxable Income would be the same. 1991. The firm would have Taxable Income The ordinary income tax would be $34, and of $90 ((100% - 70%) x $300). Using the there would be no Tax Preference amount. 70% DRD, the firm would pay income taxes The Tentative Minimum Tax woukf be $20, of $30.60 ($90 x 34%). The tax preference which is $14 less than the ordinary Income would be $157.50, which is the diirence Tax. The corporation then is entitled to use between the Adjusted Current Earnings and the Minimum Tax Credit Available to offset the Taxable Income multiplied by the 75% the difference between the ordinary Income factor. Tax and the Tentative Minimum Tax. Thus

The Tax Preference amount and the Tax- the firm wouki pay only the Tentative Mini- able Income are then added together. The mum Tax of $20 and still retain a Minimum total is multiplied by 20% to obtain the Ten- Tax Carry Over of $4.90 for 1993. Current tative Minimum Tax. lf that figure is greater tax law permits the Minimum Tax Credit to than the calculated income tax, the firm has be carried over to future years, which will to pay an additional AMT. In the hypotheti- reduce corporate taxes in future years if the calsituationfor1991,thefirmwouldhaveto regular tax is greater than the Tentative Min- pay an additiil tax of $18.90. Thus, the imum Tax.

Table3. HypothdcalAl ive Minimum Tax Calculations

1991 1992

Adjusted Current Earnings $300.00 $100.00

Taxable Income 890.00 $100.00

Income Tax (34%) 830.60 834.00

Tax Preference $157.50 $0.00

Taxable Income and Tax Preference $247.50 $100.00

Tentative Minimum Tax (20%) $49.50 $20.00

Income Tax 830.60 834.00

Alternative Minimum Tax $18.90 SO.00

Minimum Tax Credit Available from 1991 $18.90

Tentative Mimimum Tax (20%) $20.00

Mimimum Tax Credit Carry Over for 1993 $4.90

50 The Electricity Journal

decommissioning funds, and (7)

stock universal life insurance com-

panies.

For example, insurance com-

panies are a particularly large pur-

chaser of preferred stock. In the

past, insurance companies

matched the maturity of the pre-

ferred stock issue with the dura-

tion of their product obligations.

But with the advent of the AMT,

they do not know until the end of

the year what their AMT obliga-

tions will be. Furthermore, in-

surance companies’ profitability

varies with their claims. If the

property and casualty companies

are profitable, they can use the

DRD. But there are cyclical

periods, as with Hurricane Hugo

and the San Francisco earthquake,

when they incur large losses and

have to increase their loss reser-

ves. Because of these factors and

concern about reduction in the

DRD, insurance companies are

not such dependable purchasers

of preferred stock as in the past.

While electric utilities may still

favor issuance of fixed-rate prefer-

red stock, buyers have shown lit-

tle demand for this security, favor-

ing DAPS over fixed-rate

preferred.

F. Competition from British Firms

A new dimension in the prefer-

red market has been added in

recent years by corporations from

the United Kingdom, which have

issued a considerable amount of

preferred stock in the U.S. market.

Currently comprising about 4 to

5% of the market, this segment ap-

pears to be increasing. During

1989, U.K. preferred issues total-

ing approximately $1.8 billion

were sold in the U.S.i4 Issuers in-

cluded a cross section of banks

and industrial companies. This

growth may tend to crowd out

U.S. electric utility preferred and

bid up required yields.

Dividends paid on British pre-

ferred stock do not qualify for the

70% DRD. However, U.S. inves-

tors do receive an additional pay-

ment from the issuing firm to

help offset U.S. taxes. This pay-

ment, known as Advance Cor-

porate Tax (ACT), is currently one-

third of the dividend amount,

Corporations from the United Kingdom are now issuing a considerable amount of preferred stock in the U.S. market.

which means that U.S. investors

receive a fully taxable cash flow of

approximately 1.33 of the

nominal U.K. dividend rate.15

The ACT payment may be offset

against the U.K. issuer’s tax

liability so that it is not normally

an incremental cost to the issuer.

Because of the U.S.-U.K. Treaty on

Double Taxation, corporate inves-

tors have an effective U.S. tax rate

of 12%.16

Most British industrial prefer-

red issues have been the DAPS-

type and have been privately

placed, while the British bank is-

sues have been fixed-rate per-

petual preferred sold in the public

market. The tax treatment of

dividends is more lenient abroad

than in the U.S., and U.S. inves-

tors have been able to take ad-

vantage of this fact because of the

tax treaties between the two

countries. The shares are repre-

sented in the U.S. by American

Depository Receipts (ADRs), and

the dividends are paid in dollars.

S everal other advantages ac-

crue to the U.S. investor

through ownership of preferred

shares issued by British firms. Be-

cause the dividends are fully tax-

able, they would not be con-

sidered preference income and

would not impact the AMT. Also,

the shares do not require the 46

day minimum holding period as

stipulated by the DRD. With the

advent of the European common

market in 1992, the issuance of

preferred stock in the U.S. market

by foreign investors may increase

dramatically. U.S. public utilities

must now compete for funds on a

global basis more than ever before.

IV Future Industry Plans and Financing

The expected issuance of new

preferred stock is tied to the fu-

ture financing needs of the electric

utility industry, which is changing

rapidly.

Utilities are experiencing the

gradual loss of their monopoly

franchise and are being forced to

become more competitive. The

Department of Energy has

predicted that by the year 2000,

cogeneration by private firms will

October 1991 51

provide 15% of America’s energy

needs.17 Up to 50% of the new

electric capacity in the U.S. during

the 1990s is expected to be sup-

plied by non-franchised utility

generators.” Utilities themselves

are using their unregulated sub-

sidiaries to build power plants in

other utilities’ franchised ter-

ritories. To become more competi-

tive, some utilities are even think-

ing about separating their

generation facilities from their

transmission and distribution

facilities.

U tility executives must now

take into account the fol-

lowing factors: (1) expansion

programs to ensure that generat-

ing capacity and type of capacity

is not out of control, (2) political

aspects of rate shock and rate in-

creases, (3) utility financial struc-

ture, (4) stockholder wealth maxi-

mization, (5) provision of growth

opportunities for employees, and

(6) impact of service and rates on

the customer.

Other financial pressures on

utilities have come from competi-

tion from lower-cost producers,

including both adjoining electric

and gas utilities, as well as cus-

tomer self-generation and

cogenerators. Pressure has also

been felt from treatment by regu-

lators who may regard some util-

ity capacity as overly expensive

or as excess - i.e., not “used and

useful.” This may cause them to

exclude some investments from

rate base.

W ith electric loads increas-

ing once again, it is likely

that the long period of excess

capacity that began in 1974 will

end in the next few years.” Even

so, the forthcoming construction

cycle will likely be much smaller

than the one during the 1970s and

early 1980s. Total electric utility

plant expenditures for investor-

owned electric utility companies,

including expenditures for al-

lowance for funds used during

construction (AFUDC), are

Utility and investor interest in preferred has tumbled of late.

52

projected to be just $75.4 billion

during the three year period 1990-

1992.2’

Yet for many utilities the need

for increased generating capacity

presages the utilization of some

additional preferred stock financ-

ing.

Compliance with major environ-

mental goals of alleviating acid

rain and CO2 emissions, as well

as nuclear plant decommissioning

and nuclear waste disposal, will

require large expenditures by elec-

tric utilities. While some of these

expenditures may be financed

through the use of tax-exempt pol-

lution control revenue bonds,

there will be a considerable

residual amount to be financed

for which preferred stock is-

suance may be important.

V. Conclusion

Because the issuance of new pre-

ferred stock is primarily tax-

driven, the tax laws determine im-

portantly whether electric utilities

will be able to utilize preferred

stock financing. Past changes in

the tax laws - specifically reduc-

tion of the DRD and initiation of

the AMT - have affected the elec-

tric utility industry’s ability to

issue new preferred stock. The ef-

fect of these changes have been:

(1) increased cost of capital, (2)

higher utility rates, (3) less

favorable debt-to-equity ratios, (4)

reduced investment in new

facilities, and (5) multiple taxation.

A survey of the DRD alone as it

applies to our major trading

partners (i.e. Canada, Japan, Ger-

many, Great Britain, and

Australia) shows that our major

Trle Electricitu lournal

competitors do not tax intercor-

porate dividends, or tax them at a

very low rate.*l

The issuance of preferred stock

is also accountingdriven. Accord-

ingly, future issues of preferred

will be either selling at par

(DAIS) or will be structured to be

carried on the investor’s books at

cost. Few fixed-rate perpetual

preferred issues will be offered be-

cause of their high costs.

B ecause public utilities are

once again entering into a

new construction cycle with exter-

nal financing needs, there could

be substantial preferred stock

financing. Additional rationale

for utilities to issue prefemed

stock include: (1) the availability

of the DRD for corporate inves-

tors who would purchase the

stock, (2) the low cost after taxes

for utilities with large tax loss

carry-forwards and substantial

depreciation write offs, (3) the his-

torical inclusion of preferred stock

as part of a ‘%alanced” capital

structure by the regulatory

authorities, (4) maintaining voting

control in existing owners, since

preferred stockholders typically

do not have voting rights, and (5)

the ability to use preferred stock

financing as a means to gain

secondary leverage for common

stockholders.

In spite of the tax, accounting,

and competitive pressures which

have forced down utility use of

preferred, a new day may be

dawning for large scale issuance

of electric utility preferred

stock. w

Footnotes:

1. M. J. C. Roth, A New Look at Prefer-

red Stock Financing, PUB. UTIL. FORT.,

Mar. 27,1980, at 26.

2. First, the Deficit Recovery Act of

1984 increased risk exposure by in-

creasing the holding period for the

DRD from 16 days to 46 days. Second,

the reset mechanism of 13 weeks (com-

pared to the 46 day holding period for

the DRD) led to interest rate risk ex-

posure and price volatility. Third, the

impact of the reduction of the DRD

from 85% to 80% in 1986 and then to

70% in 1987 affected investors rather

than issuers. Fourth, if the credit

rating of the utility itself deteriorated,

new investors in the firms ARPS

would require a higher risk premium.

The dividend structure of ARPS issues

lacks the ability to hedge changing

credit risks. Fifth, the shape of the

U.S. Government securities’ yield

curve can change the relationships

among short-term and long-term rates

and cause the ARPS prices to fluc-

tuate. Finally, the reset mechanism for

ARPS is tied to treasury securities

which are generally sold in a different

market from ARPS securities.

3. J. D. Finnerty, Financial Engineering in Corporate Finance: An Overview, FIN.

MGMT., Winter 1988, at 27.

4. W. N. Davidson III, Preference Stock -

why Is It Issued?, PUB. UTIL. FORT., July

19,1984, at 30.

5. If the utility has tax loss carry-for-

wards and large depreciation write

offs, preferred stock may be less ex-

pensive than debt and may lower the

overall cost of capital.

6. Edison Elec. Inst., Financial Info,

Apr. 6, 1990, at 5.

7. Id.

8. PRICE WATERHOUSE NATL. TAX

SERV., (Natl. Chamber Found., R. A.

Ragland, ed.), THE TAX TREATMENT OF

INTERCORPORATE DIVIDENDS 21 (1990).

9. M. FOLEY AND M. LEHMAN, ELEC-

TRIC AND TELEPHONE UTILITY STOCK-

HOLDER RETURNS, 1972-l 988 1

(National Association of Regulatory

Utility Commissioners, June 12,1989).

10. R. L. Rundle, “Four California

Utilities Will Profit From Energy

Savings Under New Plan,” Wall Street

Journal, Aug. 31,1990, at 2.

11. Financial Info, supru note 6 at 3.

12. EDISON ELEC. INST., CAPACITY AND

GENERATION OF NON-UTILITY SOURCES

OF ENERGY - 1989 (1991). Given the

age of this data, it is likely that the cur-

rent percentage is somewhat higher.

13. Standard & Poor’s Credit Review,

Electric & Gas Utilities, May 11, 1990,

at 4.

14. Direct Offerings of Preferred Stock

by U.K. Issuers, Morgan Stanley, Mar.

1990, at 1.

15. United Kingdom Preferred Shares,

First Boston, May 1989, at 1.

16. Direct Offerings, supra note 14 at 1.

17. R. R. Bosley, Preferred Stock

Professional, May 23,1990, at 91.

18. M. D. Yorkell, The Decline and Fall

of the Regulated Public Utility, l?JB.

UTIL. FORT., May 24, 1990, at 39.

19. C. M. Studness, Ten-Year Utility

Projections of Excess Demand and Capacity, PUB. UTIL. FORT., July 19,

1990, at 43.

20. Financial Info, supru note 6 at 1.

21. Ragland, supru note 8 at 13.

October 1991 53