About The Author:
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.
Storm Clouds Over Olympus
by Roger Feldman -- Bingham, Dana L.L.P.
(originally published by PMA OnLine
One of the risks of dwelling on Olympus, is what we call “opportunity
costs” (hubris in Greek) i.e., being so wrapped up in dealing with the world
as you choose to understand it, that you miss the threat posed by reality as
it is. So it has been on Pennsylvania Avenue. So it is in microcosm at the
FERC. The Commission has been perfect-ing its market power determination
screens, while the financial state of the market has become more and more
perilous for practical, long-term competition.
Case in point: FERC has been doing major tinker-ing with its rules for
determination of whether market based rates (“MBR”) should be available to
the owners of particular generating facilities. The approval of market-based
rates has been at the core of FERC’s system of deregulation for a decade.
Applying what is now acknowl-edged to be an outmodeled “hub and spoke” test,
FERC approved virtually all MBR applications, up until the time a few years
ago when it began to challenge receipt by MBRs for “unregulated” facilities
owned or controlled by a utility within the utilities’ area of effective
market power. Since 2001, FERC has first swung to a very rigorous “supply
margin” test; then retreated somewhat to its just announced “two-screen”
test, and now is designing a broad rulemaking proceeding (RM04-7) to
consider under what circumstances market-based rates should be granted to an
applicant. FERC is no longer exempting from MBR-examination the contract
arrangements arrived at by parties just because they are situated in RTOs.
While one expectation is that as a result more vertically integrated
utilities’ facilities will qualify for market-based rates than under the
prior interim rule, the further more troubling expectation is that, for IPPs,
and should be for power asset acquiring entities, much ink and treasure will
now have to be spent on what was a ministerial act.
Without going into the details on the various tests — which are bound to
change some post-Rulemaking, it would appear that in these efforts, FERC is
seeking to preserve some competitive balance between IPP suppliers and
utilities, and thereby to protect the core system of competitive power it
has labored to put in place. There is some merit in this objective.
Nevertheless it represents an unintended diversion from the most important
task which FERC (or someone in the Federal Energy chain of com-mand) should
be monitoring: the efficient redistribution and absorption of the overbuilt
asset fleet through the operation of orderly capital markets. The real story
of 2004 continues to be uncertain independent supplier financial health and
the reshuffling of the asset ownership deck.
The financial reality which the FERC is facing to-day is that a significant
portion of the nearly 175,000 MW of gas fuel generation built between
1999-2003 falls into the “merchant” (i.e., not firmly contracted) category
(and there remains, in addition other generation capacity that is par-tially
built. As a result of the surge in gas prices, the spark spread on this
capacity has waned to a level where project debt service cannot be met in
many instances. There is a significant ledge of debt outstanding which is
coming due with respect to this market power capacity — payment of some of
which was merely pushed out through refinancing and will come due in the
next five years. There is a significant body of sophisticated capital market
opinion that this ledge of debt will not be rolled over again, partly
because capital markets are not as robust as they have been, partly because
faith in the fundamentals of reserve margin absorption has been eroded away,
and partly because banks have gotten a better fix on temporarily running and
then ridding themselves of power assets.
There have been large pools of capital accumulated to purchase what was
perceived to be a golden opportunity to buy assets and later resell
generating at bargain prices. But the market has already taken down a large
proportion of the assets with supporting power contracts that are available.
It is seemingly disinclined to swallow pure merchant power capacity at
anything near cost on the basis of the hockey stick basis of the same story
which created the untimely generation surplus in the first place (abetted by
speculative issuance of developer debt.) The capital mar-kets have also
taken notice of the fact that in this environ-ment of likely rising gas
prices, it is more economic for generators to extend the life of existing
coal plants and profit from the enlarging spark spread which results from
the fact that at the margin the price paid i n many jurisdic-tions is based
on the price for power produced from natural gas.
While the investment banking community currently is brokering some sale of
merchant fleets through auctions, the market clearance price has been at a
significant discount below initial cost and has also reflected seller or
buyer tax benefits from engaging in the trans-action.
In addition, the asset sales that are occurring are, first of all, to “finan-cial”
rather than operating sponsors and are financed to a significant extent with
B loans, which are decidedly short term, or other high-yielding short-term
debt. There are also strategic financial buyers, for the longer term, that
focus on trading around assets, but most private equity funds and many large
private equity investors, are looking for relatively short term exits. The
successful sale of a restructured com-pany, NRG, highlights that there must
be a significant debt reduction of debt through conversion into equity and
facility operating enhancement through cost cutting if sale of a dis-tressed
restructured firm is to be well received.
The current financial market scene also is characterized by move-ment of
bank debt into fewer bands, abetted by skillful financial intermediaries;
the extension of time for some asset foreclosures and th emergence of
several experts companies in asset management. But it should be recalled
that they are merely acting for the lend-ers to whom the assets have
devolved. Good stewardship does not make a stable market environment by
itself. Restructuring individual companies does not restructure power
What should be the responsi-bility of a prudent regulator, survey-ing the
financial wreckage of the power industry? Market deregulation worked almost
too well: leading too many competitors into the market-place, backed by a
willful lender loos-ening of credit market standards by lenders who endorsed
the potential of merchant power approach in the face of both questionable
market realities and in reliance on a national tidal wave of deregulations.
Under the circum-stances, perhaps it is therefore unwise for regulators to
enhance the uncer-tainties of the market by market fur-ther by raising new
issues as to its pricing regimen and by reducing the governance significance
of such re-gional transmission regulatory bodies as it has painfully put in
place? Per-haps it is unwise to treat its role as perfecting a utopian
model, in which the rating agencies have stated little faith, and into which
traditional long term debt is reluctant to venture. Yet, that is the
direction FERC is going. It has the potential to drive the industry forward
into another perfect storm, based on recurring financial industry response
to the overbuild which has overtaken the industry. The longer run threat to
the industry is far greater than the market power issue proposed to be
addressed by the new Rulemaking.
There are storm clouds over FERC Olympus. The local deities think the cloud
relates to issues of protecting local market competition (or now as they
would have it, the pursuit of the efficiency in the new century.) The
capital markets think the clouds have more to do with the financial worth of
some of the assets that competition has produced and the resultant viability
of the IPP companies’ ability to compete. As they say at FERC: lord what
fools these mortals be.
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.