Regulatory Risk, Market Risk and Capital Structure: Evidence from U.S. Electric Utilities

Abstract

There is a sharp contrast when one compares firm leverage ratios between U.S. and British electric utilities, which have both been deregulated in the past decade. In the U.S., leverage ratios have been declining while in the U.K., they show a marked increase. To better understand the decline in leverage of U.S. investor owned electric utilities, this paper investigates the impact of deregulation on the capital structure decisions of these firms. We find that the heightened uncertainty created by the deregulation process and the associated increase in both regulatory and market risks have resulted in firms reducing their leverage ratios. Specifically, we find that the most important factors that impact capital structure are: 1) the stranded cost recovery and divestiture policies and 2) the potential loss of market share due to competition and fears of downward pressure on prices i.e. market risk. We also find that belonging to a holding company lowers leverage while the possibility of a merger decreases leverage. Identifying the importance of these variables for a firm's financing decisions not only furthers our understanding of capital structure choice but also sheds light on the financial effects of deregulation, which have not been previously documented.