"Big Bear and the Policy Wonk"
by Roger Feldman -- Bingham, Dana L.L.P.
Down at the Stock Exchange, the Big Bear was holding court, explaining to the visiting Policy Wonk why he thought the power business was tanked by greed and the arrogance of intellectualized power. "It’s simple," he said. "The banks bought the developers’ line and over-leveraged their future; and the regulators stuck by their market theories to the point where analysts began to think they were going to kill the entire business. You can’t make policies that investors won’t pay for and, anyway, you can’t model power industry futures these days. Nobody bets the economists."
Big Bear worries a lot about the rating agencies. "Drill into S&P’s conclusions that there is an overhanging ledge of $90 million in medium-term utility and project debt coming due between 2003 and 2006," he said. "The problem, according to S&P, is that the industry supply-demand fundamentals won’t support the market projections on which refinancing of mini-perms was predicated. In addition to over-capacity and slow economic growth, S&P also cites "low price elasticity due to considerable generating capacity still owned by regulated utilities" as a cause for long-term projected low wholesale prices. Basically, a good chunk of power supply markets remain regulated (and in the hands of still integrated companies). That means that the dreams of the unregulated players trying to push into others’ markets are harder to realize than was thought – and harder than large lending institutions believed could be anticipated. Re-regulation could only make matters harder for surviving interlopers."
"Think about what is likely to happen as the situation gets tighter. First, the banks will gulp up as much restructured liquidity as they can get their hands on, before the facilities are worked out in Chapter 11 restructurings. Worst case, they may find themselves holding assets that have been repossessed. Let’s assume the banks respond to this situation in the coolest, most rational way possible. What will they or their response teams do, ‘best case’:
• seek to assess and realize through workouts, on the one hand, ‘optionality value’ (e.g., potential future value in likely market scenarios);
• seek to minimize risk exposure by securitizing strips of value in the portfolio (e.g., structured products or different types of products (on-peak vs. off-peak)) or services (energy vs. capacity); and
• continually evaluate the ongoing volatility situation, using value-at-risk analyses."
"Anticipating these possibilities, logically, regulators should be seeking to avoid a power industry Armageddon. They should be seeking to create a scene where there is sufficient clarity that the damage control strategies of individual power providers and their lenders have a chance of working. But that’s not necessarily what is happening. I’m not so sure this push by FERC to introduce Standard Market Design ("SMD") squares with that goal. Certainly if you ask FERC, the response will be a resounding ‘yes,’ even though recently it has been willing to sacrifice its push for blanket control and uniformity to regional demands for autonomy. Essentially, its official position is that by ultimately perfecting the deregulated model and by providing certainty as to market structure, it is instituting the necessary reform package to make deregulation finally work, while optimizing the attraction of capital to the industry."
"But this assumes that the consequences of SMD for utility industry structure will be even-handed enough that the power industry as a whole will be able and will want to march toward the very deregulated trading model, followed by many of the companies currently on the bubble. And it tends to ignore the possibility that in the current economic slowdown environment, the status of the traditional integrated utilities and mixed unregulated regulated utilities – now rapidly retreating from trading – are matters of fundamental concerns to the financial community."
Which is why, Big Bear explained, he reviewed with some alarm, Fitch’s recent conclusion about the way SMD reallocates profits among market participants:
‘In general, wholesale generators and energy marketers are likely beneficiaries and integrated utilities may be at risk, especially those that now derive healthy profits from generating power. Transmission access would be enhanced, but market prices for power would tend to be suppressed.’
"No surprise really," said Big Bear. "SMD was supposed to provide consumers with the benefit of reduced prices resulting from competition."
Big Bear wrapped up: "So, you could take everything I’ve said to mean that the deregulated guys are in trouble, flogging an over-leveraged model in a half-competitive market, and FERC is trying to ‘fix’ things by tilting toward the competitive market, thereby undermining the remaining sound credits in the marketplace. If something is broke right now – and the markets are telling the government that big time – you don’t necessarily fix it by breaking up the remains of what isn’t broke without some definite additional plan. Even if that’s not what FERC is trying to do, if it even looks like that’s what it’s about, the markets will at best be so confused as to offer you less or no new capital and, at worst, make a play of betting against you."
The Policy Wonk was both livid and disdainful in his response to Big Bear. "You’re for re-regulation, looking backwards, choking competition with big government, and bringing back the dinosaurs. The key to this thing is to make markets work by removing the remaining inefficiencies," he said. "You just don’t get it."
Big Bear just shrugged and said, "OK, you propose and I’ll dispose."
ROGER FELDMAN, Co-Chair of Andrews Kurth LLP Climate Change and Carbon Markets Group has practiced law related to the finance of environmental and energy projects and companies for 40 years. In particular, he has analyzed and executed a wide variety and substantial value of project financings. He chairs the American Bar Association’s Committee on Carbon Trading and Finance, serves on the Board of the American Council for Renewable Energy, and has been a senior official in the Federal Energy Administration. He is a graduate of Brown University, Yale Law School and Harvard Business School.