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NUMBER: R-1627 DATE: April 18, 2001 MAIL LOG No.: 76618 TO: Catherine I. Riley, Chairman Claude M. Ligon, Commissioner Susanne Brogan, Commissioner J. Joseph Curran, III, Commissioner Gail C. McDonald, Commissioner FROM: Anthony Myers, Assistant Executive Director RE: In the matter of Baltimore Gas and Electric Company’s Application to Issue $500 Million Principal Amount of Long Term Debt. Case No. 8884 Description of Application: On March 2, 2001, Baltimore Gas and Electric Company (“BGE” or “the Company”) filed a request for authority to issue up to $500 million of long-term debt. BGE states that this authority will give the Company flexibility to structure its financing plans consistent with market conditions. The Company will determine whether to issue the debt in one or more forms based upon market conditions in effect and anticipated at the time of issuance. Parties which should receive a copy of Staff Recommendations: Case List for Case Nos. 8794/8804 Recommended Action (Including Conditions): Staff recommends that the Commission grant Baltimore Gas and Electric Company’s request for authority to issue up to $500 million in long term debt. __________________ Calvin Timmerman Director, RR&E _________________ Randy M. Allen Director, of Accounting Commission Action on ___________________: Approved __ Disapproved __ Accept for Filing __ ___________________ M. Catherine Dowling Staff Counsel Background: On March 2, 2001, Baltimore Gas and Electric Company (“BGE” or “the Company”) filed with the Commission an Application for authority to issue up to $500 million in long term debt. BGE states that the authority requested in its application will give it more flexibility by enabling the Company to structure its financing plans consistent with changing market conditions. The authorization request is supported by schedules that detail net property expenditures, and debt retirement or redemption totaling $500 million. The Company made its application request pursuant to Section 6-102(b) of the Public Utility Companies Article of the Maryland Annotated Code that requires a public service company to obtain authorization from the Commission before issuing stocks, bonds and other securities payable more than 12 months after the date of issuance. The Company, as part of its application, provided a detailed listing of the physical property and facilities, along with the accompanying expenditures. The property and facilities list, for which $250 million in funds were expensed, includes property and facilities, which are used by the Company in: (1) the provision of electric transmission and distribution services; (2) natural gas production, storage and distribution, and (3) related general and common plant. The Company also provided a listing of six (6) series of Bonds and the accompanying expenditures for each series for the retirement, redemption or repurchase of said debt and redeemable preference stock. The stipulated Bond Notes for which the funds were expensed total $250 million, per the application. The Company notes that the application is a request to issue debt to cover the total expenditures for the physical plant acquired and financial instruments retired by the Company. The moneys are required for the reimbursement of money expended by BGE within the last five years for the (i) the acquisition of property, (ii) the construction, completion, extension and improvements of its facilities, and (iii) the discharge of lawful refunding of its obligations. Furthermore, the Company adds that upon sale of the debt, the proceeds will be used for general corporate purposes relating to BGE’s (regulated) utility business. The Company is requesting that this matter be addressed expeditiously, so that BGE can be positioned to act rapidly, should market conditions warrant. Comments: Staff has reviewed the Company’s Application. In order to ascertain the appropriateness of the Company’s request, Staff also conducted discussions with the Company. During these discussions, Staff inquired about a number of issues including: (a) the eventual recovery of any long-term loan costs through rates; (b) the impact of these loans on future rates; (c) the impact on the Company’s capital structure if the loan authorization request were approved by the Commission, and (d) an explanation of transfers of debt to Constellation Energy Group (CEG) non- regulated affiliates in the amounts of $7.6 million and $269.9 million, as noted in the footnotes on Page No. 4 of BGE’s application (total of about $278 million). The discussions with the Company helped explain why BGE was making the debt Application request. The Company explained that BGE was not expanding its current capital base by seeking the debt authorization. The debt will be used to replace current debt through retirement or redemption, or to replace current shortterm obligations used to finance capital expenditures for facilities and/or equipment used in the provision of regulated services. Debt that is issued replaces other more expensive debt, or is balanced by capital assets acquired to provide regulated services. The issuance of new debt will not impact BGE’s current capital structure. With respect to the transfers of the $278 million debt to CEG affiliates, BGE informed Staff that the debt primarily reflected costs related to the purchase of pollution control facilities and equipment attached as property to the generating plants transferred to CEG affiliates. BGE informed Staff that the affiliates would be responsible for making the required payments on the bond debt that was transferred. BGE informed Staff that since the application was made, the $7.1 million debt has been retired, leaving $269.9 million of this debt outstanding. 1 Staff also conducted an analysis of the application, including financial data and additional supporting material provided by the Company. Staff adds that this type of request (i.e. an application for the issuance of debt) by the utility companies that this Commission regulates is not unusual. Moreover, this activity is normal practice, as these companies retire older more expensive debt, and acquire new replacement debt, particularly when interest rates are decreasing or are expected to decrease further. Technical Analysis: As part of its review, Staff looked at the Company’s financial data for the last three years. Staff used a traditional template employed by the Standard and Poor’s Financial Rating Company (S&P), namely (1) the pretax interest coverage (of fixed charges such as interest payments on debt), and (2) the total debt to capital ratio. 2 These two ratings methods applied to BGE for the years 19982000 are depicted below: 1 Even though the debt has been transferred to the CEG affiliates and these affiliates hold the primary liability, BGE will be the secondarily liable party for these debts, since BGE is the original executor of the loan agreements. In case of default by the primarily liable parties, BGE would assume responsibility for repaying the loans. However, BGE would have a claim against the CEG affiliate, in case of default by any one of the affiliates holding this transferred debt. BGE also informed Staff that a separate amount of shortterm debt (issued as notes on unsecured debt) not a part of this application was also paid. 2 Two other ratings benchmarks are (1) Funds Flow From Operations (to) Interest Coverage, and (2) Funds Flow From operations (to) Total Debt (ratio). Pretax Interest Coverage $ Millions 2000 1999 1998 Income 419.9 Interest Charges 184.0 Pretax Interest Coverage (ratio) 2.28 712.7 205.9 3.46 744.2 238.8 3.12 Total Debt/ Total Capital $ Millions Total Debt Total Capital Debt/Capital (ratio) 2000 1999 1998 1,864.4 2,856.7 0.65 2,206.0 4,751.4 0.49 3,128.1 6,299.6 0.50 As seen above, the calculated Pretax Interest Coverage and the Total Debt to Total Capital ratios for the Company changed dramatically in the year 2000 (one of Staff’s initial concerns). For example, the Pretax Interest Coverage ratios for the years 1998 and 1999 (over 3.0) were good indicators that the Company would be able to cover fixed expense items such as its interest due on Bonds and or preference stock. These ratios were consistent with an ‘A’ rated company such as BGE. The Pretax Interest coverage for the year 2000 (of 2.28) was noticeably lower than for the prior two years. Likewise, the Total Debt to Total Capital ratios of about 0.50 and 0.49 for the years 1998 and 1999, respectively are ratios indicative of an ‘A’ rated company, by S&P’s traditional measures. The debt/capital ratio for the year 2000 (of 0.65) on the other hand, was indicative of a company that may be too heavily leveraged by debt using the traditional S&P standard. BGE’s Pretax Interest Coverage and Total Debt to Total Capital ratios for the year 2000 changed dramatically because the Company as well as the parent company Constellation Energy Group, was undergoing a substantial reorganization due in large part to the restructuring of the electric and gas industry in the State of Maryland. One consequence of the electric and gas industry restructuring is that the traditional technical measures such as the Pretax Interest Coverage and Total Debt to Total Capital ratios are no longer applicable, by themselves, as effective measures for the economic strength and vitality for economic entities (such as BGE). This is especially true while the industry is undergoing substantial change, and particularly if the economic entity is undergoing a major reorganization as is the case with BGE and the parent company CEG. The Company provided a copy of a rating of BGE and CEG performed by S&P as depicted in the S&P publication “Standard and Poor’s Creditwire”. S&P is one of several prominent credit rating companies that perform this type of analysis. S&P reaffirmed BGE’s ratings with [a] “positive implications” [rating] for the current and going forward time period. The credit rating by S&P was developed using a more extensive analysis than the one traditionally used by Staff and by S&P. 3 In response to a Staff inquiry concerning a transfer of financial assets related to the Company’s reorganization, 4 BGE informed the Staff that during the electric restructuring transition period, BGE plans to manage its finances to enable BGE’s financial capital structure at the end of this period to mirror the capital structure that existed prior to the transfer of generation related assets. This will have the net effect of restoring BGE’s debt to total capital ratio to previous levels (i.e. in the 40% to 45% range), consistent with the traditional S&P benchmarks. 5 Moreover, the Company noted that the information that was requested (i.e. the schedule breakdown of the financial transfers), was being prepared for a May 1, 2001, filing that is to be made by BGE in its separations proceeding (Case No. 8883). The Company stated that the requested information needed to be extensively reviewed in order to make the May 1 filing date, and that this information could not be made available any sooner than the May 1 date. In its response, the Company also stated that any issues related to the requested information, could be addressed in Case No. 8883, and that the Company felt that the issues surrounding the debt request application were independent of the issues attendant to Case No. 8883. Staff believes that the issues related to actual asset transfers while indirectly related to the debt request application are not central to the Commission’s disposition of this application. Further, Staff is of the opinion that issues related to the actual asset transfers are best addressed in the separations proceeding (i.e. Case Number 8883). Staff notes that the proposed bond debt issuance will not impact BGE’s current capital structure. In addition, Staff’s own analysis and review of documents provided by the Company, and by S&P, supports the Company’s request. Further, Staff adds that these types of debt request applications by utility companies are normal practice in nature, and are generally related not only to internal financial re-balancing undertaken by these companies, but are also related to the level and/or trend of interest rates. Lastly, while the Company was not able to respond to all the questions raised by Staff (e.g. those related to the schedule breakdown of non-debt asset transfers) at this time, Staff does not believe that this particular information would change Staff’s recommendation, with 3 Staff contacted S&P and we were given additional information and further explanation of the methodology(ies) employed by S&P. S&P’s expanded analysis incorporates additional business characteristics and factors of analysis, which include a “10-point business profiles” analysis. 4 Staff had asked the Company to provide a schedule breakdown of the non-debt financial assets that would become part of the reorganized BGE Corporation after the separation of CEG into two independent companies. 5 As part of a separate case before this Commission BGE will be presenting a comprehensive report with respect to the reorganization (of Constellation Energy Group) into two holding companies. (See Case No. 8883). BGE’s transition period for electric restructuring will end on June 30, 2006. respect to the debt request application. 6 Moreover, we believe that the Commission will have ample opportunity to address any concerns or questions that it may have with regard to debt issues and any nexus with the asset transfer issue(s) during the separations case proceedings (Case No. 8883). Consequently, for all the foregoing reasons, Staff believes that granting BGE’s debt application request is appropriate. 7 Recommendation: Staff recommends that the Commission grant Baltimore Gas and Electric Company’s request for Authority to issue up to $500 million in Long Term Debt. ____________________ Gunter J. Elert Regulatory Economist cc: Susan Stevens Miller, General Counsel Felecia L. Greer, Executive Secretary Andrew P. Mosier, Jr., Chief Hearing Examiner Chrys Wilson, Manager, External Affairs However, regardless of Staff’s comments, we do not presuppose nor foreclose on the types of questions the Commission may raise in an Administration Meeting format. 7 Staff notes that the recent Federal Reserve actions reducing the short-term interest rates by a total of 1.5% (150 basis points) should give BGE, if this application is granted, the ability to position itself for access to better (lower cost) interest terms in any subsequent debt issue. 6