Patronage Capital Explained
Once each year, a capital credit statement will be printed on the back of the electric bill for each active member of Eastern Maine Electric Cooperative (EMEC). The statement will reflect each member’s patronage capital, allocated from the most recent fiscal year.
Patronage capital may be an unfamiliar concept to many. Co-ops are the only electric utilities who issue capital credits, and there is nothing exactly like them. They’re called capital “credits,” but they can’t be applied to a member’s electric bill. They’re recorded in dollar units, but they aren’t cash or debt.
So what are capital credits?
Capital credits are records of each member’s ‘patronage capital’– that is, each member’s contingent equity interest in the Cooperative. Patronage capital itself is a mechanism for managing equity and for lowering member electric costs.
If lender requirements are met, and the financial position of the Co-op permits, EMEC could retire a small percentage of the patronage capital. In this context, “retirement” means converting equity to cash and returning it to Co-op members.
Because patronage capital is closely related to financial equity, it may be helpful to discuss what equity is, as well as how businesses accumulate equity over time.
Equity is the value of a business after both its assets and its liabilities are taken into account. On financial statements, equity is calculated by subtracting liabilities from assets.
Generally speaking, if an organization is successful, its value grows over time. The milestones for this growth come at the end of every fiscal year, assuming that revenues have exceeded expenses. Any revenue in excess of expenses is added to equity. Equity has increased.
It works the same for nonprofit electric cooperatives. As a co-op delivers electricity throughout the year, the co-op earns revenues and incurs expenses. At the end of the fiscal year, if revenues are higher than expenses, that co-op is said to have earned a positive margin. (At a for-profit company, this would be called “profit.”) The value of the positive margin is then added to the cooperative’s equity. Equity has increased.
Patronage capital is the way an electric cooperative records this increase in equity. The Co-op allocates the positive margin to each active Co-op member, based on each member’s contribution to revenue in that year. At that point it becomes patronage capital, recorded as capital credits in the member records. The more electricity the Co-op delivers to a member, the larger will be that member’s allocation of the increase in equity.
It is important to note that while capital credits are recorded in dollar units, they represent an equity interest, not cash or debt.
The positive margin is reinvested in the cooperative, helping to lower the co-op’s debt-related costs. It is applied toward debt service payments and investments in the delivery grid that would otherwise be financed through loans.
At every electric co-op, there can be years in which expenses exceed revenue. In that situation, there is a negative margin, which is essentially a net loss. A net loss decreases equity.
Even when there has been a decrease in equity, cooperatives do not take away capital credits. There are no “negative” capital credits issued. What happens instead is that no capital credits are allocated until a year’s net loss has been offset by positive margins in future years.
An example of a negative margin at EMEC was in 2016, when the Co-op’s expenses exceeded revenues. No capital credit allocations were made in 2016. That year’s negative margin was applied against the positive margin in 2017 before capital credits were allocated for 2017.
The process of margins becoming patronage capital continues year after year at cooperatives across the country. In most years, margins are positive. Over time, a co-op’s value and equity increases. Some co-op’s accumulate equity faster than others, and for a number of reasons, EMEC’s equity has accumulated incrementally.
Equity Management and
Capital Credit Retirements
When cooperatives evaluate their financial readiness to retire patronage capital, the level of accumulated equity is one major consideration.
When we talk about equity level, we usually mean equity as a percentage of assets. Most lenders require the borrower to maintain certain equity percentages, which vary based on the type of lender.
This is similar to what happens when someone purchases a house. Banks often like to see a 20% down-payment from the new homeowner. In equity terms, this means that the new homeowner will start out with 20% equity in their home. Equity levels are a measure of financial strength. Higher equity levels therefore give lenders more confidence that a loan will be repaid. That confidence can result in savings if, for instance, the bank offers a lower interest rate on a home loan.
Lenders to electric cooperatives generally require that co-ops maintain a minimum equity level of 30%. The industry standard for co-ops is an equity level between 30% and 50%, and the majority of co-ops have equity levels of over 40%.
The Co-op’s average equity level from 2005 - 2017 was 33.5%.
Lean Margins Lead to
Slower Growth in Equity
Robust financial ratios are a goal for any healthy company, but higher margins can also mean higher prices. By definition, a not-for-profit tries to operate at the lowest cost it can in keeping with sound management principles.
Co-ops must find a balance between these two opposing goals. Some electric co-ops collect larger amounts than strictly needed in a given year. These co-ops enjoy a healthier margin than would otherwise be the case, resulting in more robust financials. Higher margins can also speed the growth of equity, which increases the capacity for retiring capital credits.
For EMEC and some other cooperatives, it has made more sense in the past to collect less revenue up front and to operate on a thin margin. In addition, EMEC overcame some exceptional financial challenges that began in the mid-1980s, and the impacts of those challenges were felt for many years afterward.
For these reasons and others, it has taken the Cooperative longer to reach a point at which a small general retirement of patronage capital seemed feasible. That time has now come. Eastern Maine Electric plans to retire a small portion of the accumulated patronage capital within the next year (by mid-2019).