May 2004

Name This Tune

by Roger Feldman  --   Bingham, Dana L.L.P.
(originally published by PMA OnLine Magazine: 2004/06/10)
 

Will the name of this publication, “Merchant Power Monthly” soon join its earlier incarnation, “The Cogeneration Letter” in the dust bin of history? Will its listings of EWGs, QFs and proposed projects give way to a listing of trading indices? Is a league table of leading investors in the works? Or alternatively, something like the major league baseball standings of the country’s 32 utilities, with little reports on their chief acquisitions or major capital investments? Was US power deregulation, along with its vaunted overseas cousin, privatization, the source of a speculative bubble unfounded in the  dynamics of the cyclical business of electric energy production and transmission?

The answer is to be found more in the capital markets than in the policy studies of FERC or even the porkladen proposed energy bills of Congress. And at the moment, it is particularly uncertain because many of the players now idling in the financial corridors of potential utility power are of a different sort than those common in the past. They are funds for the investment of “private equity” or high yield debt, in any case at return levels commensurate with the risk now deemed to be characteristic of this once stolid and solid power industry.

Fact is, we are now dealing with what is now again termed a commodity (someone noticed!) and one whose production costs are the subject of the vagaries of another commodity, now once again said to be in short supply (natural gas) and of the politics of pollution (coal) and security, (nuclear, LNG and perhaps even renewables).

The capital markets are also grappling with the prospects for non-payment of the debt which the developers of energy merchants accumulated in the course of developing a massive overbuild of capacity in many geographic regions. A year ago this was perceived as creating an immediate overarching shelf of risk that might taken down the entire industry. Nine out of the twelve merchants and firms dodged that bullet by selling assets or restructuring debt. In a scathing analysis Peter Rigby of Standard & Poor has suggested that debt levels are still excessive and the problem has not gone away. He assembles a variety of data to support the underlying hypotheses that the fundamentals of companies involved in the industry simply are not attractive; plants are long lived; market entry is not as difficult as was thought; and spark spread margins are thin, declining and subject to risk and market competition forces which merchant power into a price taking position. His conclusions: “By almost every measure, the 12 energy merchants exhibit surprisingly weak credit fundamentals . . . (T)hey will struggle to improve their credit measures by any significant degree.” He anticipates that traditional lenders will back away from the sector.”

All that said, there is both a terrific build up of private equity funds seeking to acquire power assets (generally those with existing contracts) and an increasing amount of high yield debt filling the vacuum previously occupied by traditional providers (possibly with equity swaps in mind). There are also firms taking possession of the restructured shells of IPPs. In short, while much money has been lost and is endangered, a considerable amount has come to the table.

There is one problem: it is money seeking high yields in a short period of time. If not from operations — which seems likely to be the case where lucrative and leverageable long-term contracts are not involved- then from asset flips based on attractive purchase and sale prices. Why, however, this should be the case, given the S&P analysis of the fundamentals, remains to be seen. Who will the buyer of last resort be? Logically, I would suggest only the utilities will be left standing, investing in assets for future use. As of now, FERC’s renewed emphasis on competition has locked them out of their own markets. It remains to be seen if that will continue to be the case in the future. Perhaps, the “Merchant Power Monthly” should consider a fine old name like “Public Utility Reports.”

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.