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The business risks of many utilities are increasing, Restructuring uncertainty, fuel price volatility,1 the need for extensive capital expenditures for infrastructure improvement, the incurrence of large deferral amounts during a period of capped rates, potential increases in interest rates,2 the requirement for significant environmental expenditures that raise costs but not output, the threat of terrorist activity, and, in some instances, risky provider-of-last-resort responsibilities all contribute to this heightened risk. The rating agencies, recognizing increased utility risk, have responded with significant bond downratings over the past few years. Standard & Poor's still lists nearly 40 percent of the electric utility industry as having a negative outlook; in sharp contrast, very few electric utilities have a positive outlook.
Business Versus Financial Risk
Financial analysts often dichotomize the risk of a firm into business risk and financial risk. Business risk reflects the operating risk of the firm and, in particular the risk that net operating income will not be as expected. Financial risk reflects the additional risk imparted to the firm by the presence of fixed-payment capital (i.e., debt). A firm can control, to some extent, its overall level of risk by adopting a more conservative capital structure (i.e., using more common equity) if its business risk is increased. Other things being equal, the...