..Case Studies
|
NUI
Liberty has just issued its
final report in a groundbreaking study of holding-company structure
and operations involving a financially distressed utility. Liberty
performed this study for the New Jersey Board of Public Utilities,
which regulates utility rates and service in that state. The Board
approved holding company formation in 2001 by NUI, a major gas local
distribution company serving over 350,000 retail customers in four
states (about 250,000 of them in New Jersey). The Board imposed a
number of conditions. They addressed, for example, separation of
utility and non-utility finances and resources, corporate
governance, affiliate transactions, and transparency of utility
financial and operating information.
NUI experienced severe
financial distress from major and unsuccessful non-utility growth
plans and ventures. Both holding-company and utility debt ratings
fell below investment grade as a result. Liberty undertook a major
evaluation of performance under the requirements of the
holding-company order and the standards of good-utility practice and
prudence. Liberty performed the following tasks as part of a
six-month examination for the utility regulators:
-
Assessed the quality of performance in meeting holding-company
conditions
-
Recommended future changes to assure full satisfaction of utility
responsibilities
-
Examined the causes of financial distress
-
Judged the sufficiency of efforts to insulate the utility from
them
-
Investigated improprieties in trading operations by an affiliate
for itself and for utility operations
-
Looked at accounting and controls issues
-
Identified weaknesses and gaps in financial and operations
reporting
-
Reviewed corporate governance structure and performance at the
holding company level
-
Evaluated commitment to utility spending
-
Determined the effects on the utility of the weak capital
structure that resulted from poor non-utility financial
performance.
This work has given Liberty a
broad and deep understanding of the regulatory concerns that apply
in establishing and in later monitoring and enforcing conditions and
requirements affecting utility operations within a holding company
context. During Liberty’s audit, the company also placed itself on
the market for sale, as the only feasible option for resolving its
inability to secure financing at reasonable rates and under
serviceable terms and conditions. Liberty has been asked by the New
Jersey Board of Public Utilities to monitor sale efforts to assure
that the eventual sale and restructuring of the company serves the
public interest. This experience deepened Liberty’s insights into
and knowledge of the involvement of investment and financial
advisors with companies experiencing severe financial distress.
Liberty’s recent experience
involving NUI represents the culmination of many years of growing
experience in examining holding company operations in the utility
industry. That work began some thirteen years ago with Liberty’s
audit for the Pennsylvania Public Utility Commission of the
operations of Allegheny Power System. This interstate holding
company had a subsidiary that provided electricity service to a
major portion of the Commonwealth’s western region. Liberty has
since evaluated (for state utility regulators) holding company or
multi-state energy utility operations in the states of New
Hampshire, Tennessee, Illinois, New Jersey, Delaware, the District
of Columbia, and Maryland. Liberty has also examined the operations
of the country’s largest multi-state telecommunications companies as
well, including Bell Atlantic, NYNEX, Ameritech, and GTE.
Liberty’s work has included
some of the country’s best known holding-company problems. They
include a detailed study of holding-company/utility subsidiary
governance, affiliate, and operations problems for the Virginia
State Corporation Commission. That study came after an open and very
public rift developed between the executive management and the
boards of directors of Dominion Resources and its largest and most
profitable subsidiary, Virginia Power, the state’s largest electric
utility. Liberty also performed one of the country’s first detailed
examinations for state utility regulators of the impacts of poorly
performing non-utility investments on utility operations. That
study, of some twelve years ago, examined holding-company,
affiliate, finance, and other issues involving one of the country’s
largest electricity and gas providers, Public Service Electric & Gas
Company of New Jersey.
Liberty’s investigation for
the New Jersey Board covered many topics areas, including financial
structure, corporate governance, strategic planning, and affiliate
transactions, among others. Liberty provides further insights on
some of these topics below, as well as further details on its work
involving NUI.
Financial Structure and Interaction
As reported by the Wall
Street Journal late in 2002, many energy companies, plagued by
disastrous forays into commodity trading and other non-utility
businesses, are increasingly seeking to pass some of their financial
burden onto their utility units. The utility entities of large
energy holding companies are among the few in the business to have
maintained strong financial health in the wake of highly public
meltdowns in energy sector portfolios. According to the Wall
Street Journal, many parent companies would like to take
advantage of the relative financial health in their utility
operations to prop up other troubled subsidiaries. Utilities are
being pushed to buy assets from affiliates, to make loans to
financially troubled affiliates, or to pass more money onto parent
companies than may be optimum for the utility.
The question of financial risk
and separation of the utility from the finances and risks of
affiliates has become an important one. Current events in the
electric utility industry underscore the importance of financial
relationships among affiliates. The major credit‑rating agencies
during the past few years have changed their position on holding
company financial relationships, producing a stance that all
entities in a holding company structure influence the credit of
others. With the development of this new and more robust method for
judging holding company credit have come the widely known troubles
in the wholesale energy markets across the past several years. Such
troubles include the energy marketers that have been a prime target
of diversification activities by parents who own electric and
natural gas delivery utilities. Some of the financial effects of
these ills on utility companies can be readily identified; others
may prove more subtle and difficult to detect.
As part of its investigation
of NUI for the New Jersey Board, Liberty examined and evaluated NUI
and all affiliates for the following potential financial interaction
issues:
-
Maintenance of appropriate equity levels and capital structure at
the utility entity;
-
Assurance that no utility assets are encumbered by the holding
company or affiliates;
-
Presence of guarantees or support agreements and their impact on
the utility;
-
Money flows and funding within the holding company, including the
presence of money pools from which affiliates may borrow;
-
Presence of troublesome clauses, such as Material Adverse Change
clauses or cross‑defaults in financing documents;
-
Joint negotiation of bank lines of credit for affiliates;
-
Cumulative impact of affiliates on utility credit and cost of
capital.
Corporate Governance
Creating the proper balance
between executive management and the Board of Directors is a
difficult task, especially for corporations moving into new and
challenging business areas, as has been the case at NUI over the
past several years. On the one hand, it is, as recent and
unfortunately widespread experience shows, far too easy to create a
structure and a set of operating principles that fails to provide a
source of effective outside and critical examination of management’s
vision, goals, and plans. On the other hand, as Liberty found in
its extensive examination of corporate governance at DRI/Virginia
Power, it is possible to go too far. As a consequence an
antagonistic, confrontational environment can be produced that makes
it difficult for a corporation to focus on day-to-day requirements,
let alone to take steps to adapt and change to emerging
opportunities and risks in a changing business environment.
Liberty believes that the
tension between producing an effectively functioning Board and
keeping it from becoming an inappropriate intrusion on the need for
effective, fluid, and timely executive action is a matter of
succeeding in meeting a small but critically important set of
standards regarding overall corporate governance. Liberty’s
investigation of corporate governance issues on behalf of the New
Jersey Board included an examination of how NUI has applied each of
these standards in designing and in executing its corporate
governance process:
-
Conducting an effective Board Member selection process that
produces the right skills and attitudes;
-
Creating an effective structure for dividing Board
responsibilities ;
-
Assuring sufficient director time commitments;
-
Establishing effective Board participation in executive
succession;
-
Providing sufficient initial and ongoing training and education
for new and incumbent Board Members;
-
Providing the Board with sufficient and timely information to
exercise its responsibilities;
-
Ensuring that the Board is knowledgeable and conversant with the
kinds of information it needs to know to perform effectively;
-
Giving the Board real control over executive compensation;
-
Providing the Board with sufficient and appropriate compensation;
-
Recognizing the differences in the needs and requirements of
multiple subsidiaries, particularly the public service
responsibilities imposed on regulated public utility affiliates;
-
Assuring auditor independence;
-
Properly structuring the roles and interactions between Board
Chairman and CEO;
-
Measuring Board effectiveness;
-
Complying with public requirements (e.g., Sarbanes-Oxley
Act, New York Stock Exchange).
Strategic Planning and
Resource Allocation
Strategic planning and
resource allocation comprise critical top-level processes that
determine business direction and resource commitments and
allocations for a holding company and its operating subsidiaries.
The setting of a specific mission, goals and objectives for an
organization at the executive level should establish the foundation
on which all planning and operations for an entity and its
affiliates proceed. Liberty’s investigation of NUI included the
following aspects:
-
Examination of how the purpose, mission, goals and objectives of
the NUI holding company are defined and measured;
-
Identification and assessment of the short and long‑term financial
objectives and the drivers for reaching these objectives;
-
Review of holding company processes for establishing and managing
resource levels, access to resources, and the allocation of
resources to the utility and affiliates;
-
Review of NUI's capital planning and operating budget procedures
to determine the impact of planning processes on expenditures at
the utility and affiliates;
-
Assessment of the influence of the business environment, markets,
individual unit results, utility service levels, and changing
business conditions on resource allocation and budgeting;
-
Evaluation of NUI's future expectations and strategic plans and
determine if these plans should be changed.
Affiliate Relationships and
Cost Allocation
Affiliate cost assignment and
allocation is an area of significant risk for utility costs. There
must be sound procedures and practices for determining how costs are
to be assigned and allocated. These procedures and practices must
seek the greatest practicable degree of alignment between causation
of cost and responsibility for cost. The procedures and practices
must also be objective, clearly articulated, easy to administer, and
comprehensive, if cross-subsidization is to be avoided. An effective
program for preventing incorrect assignment and allocation of costs
begins with such proper procedures and practices.
The evaluation criteria that
Liberty uses to judge allocation and accounting procedures and
practices derive from two fundamental principles:
-
Regulated activities should not subsidize non-utility affiliates;
-
Costs should follow the cause of the costs. Stated another way,
assignments and allocations should result in a fair distribution
of costs.
Liberty’s investigation into
NUI affiliate relationships and cost allocation/assignment issues
for the New Jersey Board included:
-
Understanding the nature, scope, and extent of the
activities of each affiliate;
-
Determining what business each affiliate does with
ETG directly and what indirect relationships there are;
-
Determining the role of each affiliate in each type
of transaction, agreement, or project;
-
Determining how ETG is insulated from the business
risks faced by each of the wholesale affiliates (this is different
from financial risks being addressed elsewhere; this inquiry
concerns the specific allocation of risks and benefits of
particular agreements or projects);
-
Determining whether the projects or credit of
non-utility affiliates are being supported explicitly or
implicitly by ETG (again, this examination is more granular,
focusing not on overall credit risks, but on those of specific
agreements or projects);
-
Assessing how costs, operating, risks, and profits
are allocated among the utility and non-utility participants for
activities that are conducted jointly.
|