UPPCO’s ratepayers are saddled with some of the highest electricity bills in the country. This week, Spark U.P. is exploring the utility’s history and ownership structure in a multi-part series. Part I recounted the Michigan Public Service Commission case that approved UPPCO’s sale to a London-based private equity firm in 2014.
This article explores some challenging topics related to how UPPCO is financed. If that’s not for you, I recommend skipping down to the last section: “What We Don’t Know Could Surprise Us”
Part II: UPPCO, Its Holding Company, and the Brontosaurus in the Room
If UPPCO’s customers are dissatisfied, a utility industry financial expert argues that its investors are probably not too excited, either. After fielding questions about UPPCO from his colleagues, Robert Benninghoff decided to take a deep dive into the utility’s publicly available financial data.
Based in Green Bay, Wisconsin, Benninghoff has 18 years of experience in the electric utility sector industry, much of that as an MBA with a concentration in finance. He specializes in mergers and acquisitions. Benninghoff worked for UPPCO’s former holding company, WPS Resources, before it was renamed Integrys Energy Group in 2006.
He told me that, as he spoke with industry insiders, it became apparent that nobody had a solid grasp on how UPPCO ended up where it is today. He found that the confusion was consistent across the board, regardless of the inquirer’s ideology, interest, or relationship to the utility.
Benninghoff wrote in an email, “in my experience, especially when you are trying to turn a situation around, that’s a very bad place to start to work towards an effective solution.”
After a lengthy analysis of UPPCO’s earnings, financing, and dividend payment history, he published a 78 page white paper on the website of his consulting company, Incident Energy, LLC in March of 2019. The whitepaper is subtitled, “When Utilitarianism Fails: Why UPPCO Investors, Customers and Regulators are Locked in a Zero Sum Game and Preparing for Cooperative Conversion May Benefit All Stakeholders”
In it, Benninghoff asserts that Basalt has likely engaged in a risky and relatively aggressive financial engineering strategy to maximize their probability of achieving profit from their investment.
“In my experience, especially when you are trying to turn a situation around, that’s a very bad place to start to work towards an effective solution.”
But Benninghoff goes a step further and argues that a small, disadvantaged utility like UPPCO that serves a remote, rural region will inevitably struggle to earn a reliable return on equity for its investors and provide its customers with affordable service. From his perspective, this leaves investors little choice but to push the envelope.
As the title of the paper suggests, Benninghoff outlines a path forward for the utility as a member-owned cooperative, similar to several that serve customers throughout the Upper Peninsula and the State of Michigan.
Benninghoff offered some insights on his work in general terms, saying that he’s sympathetic to all parties in the UP to varying degrees.
He wrote, “The MPSC is faced with a difficult balancing act between the investors’ rights to earn a reasonable return on their investments and UPPCO customer’s ability to tolerate the rate pressures that come with it.”
Additionally, Benninghoff wanted to make it clear that he concluded that UPPCO’s day-to-day operations appear to be functioning as efficiently as possible:
“…although likely not a popular conclusion for many of UPPCO’s customers, my analysis demonstrates that from an operational cost standpoint, there is no evidence to suggest that UPPCO’s current owners and management are not at least on par with previous owner-operators, and this should be somewhat surprising given the utility was ‘de-synergized’ when purchased from Integrys.”
In Benninghoff’s analysis, whatever problems UPPCO has do not lie with the utility's employees on the ground.
This Is Where Things Get Complicated: UPPCO v. UPPHCO
In 2014, the Michigan Public Service Commission approved the sale of UPPCO from Integrys to Balfour Beatty Infrastructure Partners. In Michigan PSC filings, both companies repeatedly described the transaction as a “100 percent capital stock sale” from Integrys to a holding company Balfour Beatty created, the Upper Peninsula Power Holding Company, or UPPHCO.
Holding companies are the norm in the utility industry. DTE and Consumers are both holding companies that own several subsidiaries that provide gas and electric service to customers. But usually, holding companies are publicly traded, and therefore required to file financial data with the Securities and Exchange Commission.
But not so with UPPHCO, UPPCO’s holding company. It is owned by a private equity firm that is not subject to comparable levels of outside oversight. Additionally, UPPHCO, the holding company, only has one subsidiary: UPPCO.
And this is where things get complicated. Because after the Michigan PSC approved the sale agreement, the utility’s new owners did something that outside observers did not expect: for tax purposes, UPPHCO, the holding company, treated the transaction like an asset sale instead of a stock transfer.
To get a handle on what this means, I talked to Douglas Jester of CARE, the consumer watchdog that frequently intervenes on behalf of residential ratepayers in UPPCO cases before the Michigan PSC.
“When they actually did the sale, they did what’s called an asset sale. So instead of selling the whole company as a going concern, with all of its legal paperwork and everything else, Balfour Beatty formed a new company called Upper Peninsula Power Holding Company. And the holding company bought the customers, the wires, the pension obligations — everything from the old UPPCO — and created a new UPPCO.”
This is not what the Michigan PSC approved when it issued its 2014 order, although in subsequent cases, the commissioners accepted the consequences. One of the most significant of those consequences is that it allowed the holding company to make an ADIT election.
ADIT stands for accumulated deferred income taxes. It is an obscure feature of utility industry accounting that allows a company to keep a pool of money in reserve to fulfill federal tax obligations.
Here is Jester again to explain:
“Utility taxation is weird. Federal income taxes, corporate income taxes, apply to investor owned utilities on the profits that they earn from year to year…”
When the Michigan PSC approves customer rates, “it’s assumed that the utilities pay the standard corporate tax rate, and that money is collected from the customers as a part of the rate.”
“The actual tax payments are different than that. Sometimes, they’re less. Sometimes, they’re more. So a special account is created to hold the money that’s been collected from the customers but not yet paid to the federal government.”
As of August 28, 2014, the date the sale of UPPCO was complete, the utility’s ADIT account contained about $70 million.
From the standpoint of CARE, if UPPCO’s sale had truly been a stock transfer, the wholesale transfer of the utility as a going concern, then the $70 million ADIT account should have come as part of the package. But because UPPHCO chose to define the transaction as an asset sale, it did not.
CARE opposed the ADIT election in Michigan PSC proceedings and later in the Michigan Court of Appeals. Under Michigan law, investor-owned utilities are allowed to a 10 percent return on every dollar they invest into the business, which is also worked into customer rates. CARE argued that ratepayers should not be on the hook for this increase, as the Michigan PSC approved a stock sale, not an asset sale, in 2014.
But, according to UPPCO, ratepayers would be held harmless because the sale deal worked in a discount to customer rates to account for the ADIT election. The Court of Appeals ultimately sided with UPPCO in the matter.
To recap: watchdogs thought that Ingegrys was selling UPPHCO, the holding company, an electric utility complete with poles, hydroelectric plants, and $70 million of accumulated deferred income taxes. Instead, UPPHCO, the holding company, did not get the $70 million account as part of the package.
So, in order to cover the utility’s federal income tax obligations, investors had to raise the money to pay UPPCO’s seller, Integrys, to cover their tax liability to pay off the deferred taxes. UPPCO then had to rebalance by adding a regulatory asset account. And the Michigan PSC agreed to this, after the fact.
And that is how, without investing in a single gas plant or wind turbine, UPPCO’s assets increased by nearly $70 million in 2014.
The Brontosaurus in the Room: Double Leverage
Back in 2016 when all of this was being argued between CARE and UPPCO before the Michigan PSC and the Michigan Court of Appeals, the concern was whether UPPCO was putting ratepayers on the hook for paying the company’s earnings to its new investors that had been generated from the asset account.
But according to Benninghoff, nobody was paying attention to the private equity firm’s true motivations. Which, in his mind, were simple: Basalt wanted its investors to make as much of a return as possible on as little equity as possible.
He writes, “So much time was spent in testimony with noses pressed up against what intervenors saw as the elephant in the room in the form of… the ADIT election… that no one seemingly noticed (or possibly cared much about) the brontosaurus sauntering across the stage behind the elephant.”
In his analysis, the brontosaurus was this: in pursuing the ADIT election, Basalt significantly restructured the utility by increasing its debt by approximately $38 million, about 57 percent, and its equity by approximately $81 million, about 81 percent.
The $70 million injected into UPPCO, the utility, to settle the tax implications of the ADIT election was financed by debt at the holding company level.
This is typically called double-leveraging an asset, and it is a technique sometimes used by utility holding companies to maximize their returns on equity. It is perfectly legal. However, in order for this technique to work, it is essential that the leveraged companies have sufficient cash flow to service the debt.
The downside of “levering up” is that it makes a company more fragile and less resilient to cash flow volatility. A large utility like DTE Energy, for instance, would be less vulnerable to a leveraged investment strategy (within reasonable limits) than a small, disadvantaged utility like UPPCO, whose small market is more volatile and whose already-high rates are subject to tough scrutiny by the Michigan PSC.
Regulators like the Michigan PSC do not like public utilities to have lopsided debt-to-equity ratios, and in fact it is one of the things the Commission is allowed to regulate. Equity is more expensive, but it provides stability. The more debt a utility company carries, the bigger its risk of default.
In its 2014 sale order, the Michigan PSC required UPPCO to maintain between a 45 and 60 percent equity stake. However, Michigan law gives the Commission no authority to regulate the debt-to-equity ratio of UPPHCO, the holding company.
UPPCO, the utility, maintained the Michigan PSC mandated debt-to-equity ratio. But by Benninghoff’s estimate, financial engineering may have allowed UPPHCO, the holding company, to invest as little as $34 million of equity and carry $200 million in debt.
As of late, the Michigan PSC also seems concerned. Testimony Commission staff filed in February, 2019 notes that the holding company’s debt has been downgraded to Ba1 by Moody’s Investors Service, a rating that is considered below investor grade.
Moody’s characterizes the Ba1 rating category as “obligations that are judged to have speculative elements and are subject to substantial credit risk.” No other Michigan utility holding company has a debt rating below investor grade.
In an email, Michigan PSC spokesperson Nick Assendelft noted,
“There is continued Staff scrutiny under the [merger and acquisition] statute. As a matter of fact, in UPPCO’s most recent rate case, approved by the Commission on May 23, there is this stipulation as part of the settlement agreement:
To the extent that UPPCO issues additional long-term debt in advance of its next general rate proceeding, UPPCO agrees to provide a benefit-cost analysis of the long-term debt alternatives that the Company evaluated as part of its decision analysis in its next general rate case, including the issuance of long-term debt at UPPCO.
In other words, the Michigan PSC has ordered UPPCO to figure out how it will finance its operations in the most cost-effective and sustainable way possible.
Basalt Managing Partner Rob Gregor did not respond to a written question asking if he could clarify investors’ true equity stake in UPPCO.
What We Don’t Know Could Surprise Us
In its most recent rate case before the Michigan PSC, UPPCO asked for $10 million in annual rate increases. The Michigan Attorney General countered that the utility should only get $3.5 million.
It is natural to wonder why the utility settled for so little, and, given the amount of leverage at the holding company level, whether they will have enough revenue to service their debt. If UPPCO were owned by a publicly traded company, regulators, customers, and the general public would likely have a much better idea of the company’s financial position.
But because UPPCO is owned by a private equity firm, there is little the public can do to discern where the company is headed next. Benninghoff notes that, currently, Basalt is not required to disclose its agreements with investors or key elements of its financing:
- Under what conditions can equity investors can withdraw their capital?
- Are there restrictions limiting Basalt’s ability to sell UPPCO’s parts or the utility as a whole?
- Why, exactly, did Moody’s downgrade Upper Peninsula Power Holding Company’s debt to below investor grade?
- Do we know that the company’s leveraging of its equity stake is sustainable, given Michigan regulators’ new focus on reigning in electricity rates?
Benninghoff concludes, “Most of these questions are unnecessary to ask with the transparencies taken for granted with publicly traded utility holding companies.”
In light of this, Benninghoff argues, “In the interests of the public good, particularly UPPCO customers, Michigan regulators should take a broader view of UPPCO’s regulation and a need for more transparent disclosure related to its financing and holding company activities.”
I sent a list of detailed questions to Gregor in an attempt to get clarity on some of these issues. He did not respond.
Instead, UPPCO spokesperson Brett French wrote back with the following: “UPPCO is well positioned and sufficiently capitalized to make significant investments in its generation, distribution and human resource assets.”
In an email, Michigan PSC spokesperson Nick Assendelft admitted that the Commission does not usually regulate private equity firms. “Private equity firms as majority or full owners is [sic] not common,” he wrote.
“The same private equity firm that owns UPPCO also owns Detroit Renewables, a steam provider that the PSC regulates,” Assendelft said. “Private equity firms do, however, invest in any number of the other utilities the PSC regulates, but their owners of shares does not rise to majority owner or full owner levels.”
The other majority PE-owned company Assendelft cites, Detroit Renewable Energy, is an interesting example. Basalt owns it consortium partner DCO Energy.
In March, 2019, the company shuttered an incinerator in Detroit that had been operating for 30 years. The Detroit News reported that the company purchased the incinerator in 2018 for $200 million and had since invested $24 million to upgrade the facility, which was not compliant with air quality standards.
Detroit Free Press reporter Nancy Kaffer wrote that new leadership in city and state government were no longer willing to accept the incinerator’s habitual emissions violations.
“The Michigan Department of Environmental Quality cited Detroit Renewable Energy 750 times between 2013 and 2018, a Free Press investigation found. That’s once every 2.4 days. But the MDEQ was willing to negotiate with the incinerator operator, fining it just $149,000 for eight of those offenses.”
The Detroit News reported that the facility’s 150 employees were “blindsided.” But in an interview, Detroit Renewable CEO Todd Grzech noted that if the incinerator were upgraded to be fully compliant, it would not be profitable, saying, “There’s just not enough money to do it.”
Community advocates hailed the decision to shutter the incinerator as long overdue, and it was seen as a victory for Detroit residents who have long borne the negative health consequences of the facility’s emissions.
But the fact remains that Basalt and its partner were willing to walk away from a $24 million investment after just two years, seemingly without warning, due to increased regulatory pressure.
Elise Matz is a mommy, Yooper, and energy dork, in that order. A former political staffer, in 2019 she was appointed to the Utility Consumer Participation Board. Find her on Twitter at @michigist or email her at elisematz@gmail.com.
