Peter D. Gaw

The annual ritual in January is to roll out a testimony on events that impacted a sector in 2002 and prospects for 2003. For those of us involved in the power generation business, 2002 is the hangover that has no end in sight. It was a year of tremendous challenges that tested all the participants: developers; sponsors; investors; rating agencies; regulatory bodies and bankers. Figure I depicts the downward spiral of the energy merchant sector and the precipitating events over the past 24 months. The once high flying sector is in search of a new business model.

I recall a gathering last January in New York in which I was a participant. This meeting, sponsored by the Electric Power Supply Association (EPSA), was intended to assemble major power generation constituents to discuss the impact of the Enron bankruptcy. The meeting was designed to reassure the investor community that Enron was an isolated situation. The group included representatives from the rating agencies, major developers and the financial markets. The participants comprehended the gravity of the Enron debacle but clearly underestimated the shock waves which have reconfigured the power industry in the United States. We rationalized events as a bi-product of corporate impropriety, a misguided, asset-light strategy and mismanagement. Unfortunately, the fallout has proven to be far worse than anyone initially anticipated. We have witnessed a severe compression of power prices, the collapse of energy trading, a precipitous drop in credit ratings, the evaporation of liquidity and a loss of investor confidence.

The woes the generation market experienced in 2002 can no longer be blamed solely on the Enron debacle. It is clear that the macroeconomic fundamentals of the power generation sector were changing dramatically and neither developers nor third party constituents reacted fast enough to changing market fundamentals. In reality, companies were taking on greater financial risks to pursue aggressive, commodity-based growth. Easy access to credit and a preference for short-term types of financings proved unsustainable. This was exacerbated by financial reporting which was confusing and lacked transparency.

The growth rates experienced in the US merchant power industry between 1998 - 2001 were unsustainable given the economic fundamentals of supply and demand. During this period, new power generation was planned or in construction at a rate of 15,000 MW per month while demand was dampening. This resulted in cancellation of over 80,000 MW of capacity in 2002 and a decrease of 40% on the forward price curve. In addition to the excess generation capacity, spark spreads have also been squeezed due to the economic slow-down, unfavorable weather conditions, and lack of liquidity. In my view, we all should have done a better job of anticipating the risk of over-capacity, which is prevalent in all commodity based industries.

While the similarities between other boom and bust industries are striking, in many ways the merchant energy market has proven more volatile and more cyclical than other industries. Unfortunately, the fundamental weaknesses that are so apparent today were clouded by inaccurate forward price signals manipulated by energy trading, optimistic demand forecast, plant closures that never materialized and a bullish economic outlook. This was further exacerbated by the fact that 70% of the generation business remains under a regulated framework. As an industry, we based much of our analysis on an open and competitive market that has as yet become neither fully open nor competitive.

The aggressive growth strategy of the merchant energy sector was fueled by an equally aggressive financing strategy. Companies increased financial risk with greater dependence on short-term bank financing, bank financing that included covenants and rating triggers, and non-recourse finance. Overall fixed charge coverage of 56 utilities and independent power companies declined from 2.37x in 1996 to 2.19x in 2001 and pretax interest coverage declined from 3.46x to 2.94x over the same period. The average debt ratio of these companies rose from 51.2% in 1996 to 59.7% at the end of 2001. These figures do not include commercial paper or off balance sheet obligations. As such, actual leverage is well above the reflected numbers. It is clear that financial leverage and use of short-term bank financing has placed severe pressure on these companies.

Cash Flow

It is overly simplistic to suggest that banks were not aware that the cash flows from merchant generation might become more volatile. They armed themselves with several additional tools to gain protection from such volatility: tolling agreements from creditworthy parties; miniperm structures, with strong cash control mechanisms and collateral rights; and sophisticated market studies. They also sought comfort from portfolio diversification in terms of geography and fuel type.

In retrospect, many of the market studies appear to have been overly optimistic and the supply of new power plants has had a greatly depressing effect on the prices of wholesale power throughout most parts of the country. Failure or weakness of many of the energy market traders has undermined the strength of many projects that had been buttressed by tolling agreements. Nonetheless, because of the structural protections built into single-plant financings, lenders to such projects are likely to recover on their loans eventually (so long as the equity in the project was both sufficiently robust and, more importantly, actually funded).

More problematic are likely to be the bridging exposures incurred by commercial lenders at merchant energy holding companies. They generally suffer subordination to lenders at specific projects, and in some cases are even unsecured. The asset valuations supporting such financing may also tend to be a bit more vague. In many cases, they were in effect valuations based on the expectation of completions of future projects. In the most extreme cases, banks committed to revolving credits to fund the purchase of turbines for projects that had not yet been identified, let alone understood. Although turbines usually do have tangible value, they do not unless they are completed, and to the extent they are not placed into an operating, cash generating project, their value is greatly diminished. Moreover, because turbines had historically been sold into government-owned or regulated utilities or projects with long term sales agreements with such operators, one could only expect that with the advent of merchant power, their intrinsic values will become more volatile.

Forward Price Curve

The growth strategy of the merchant energy sector was also premised on an optimistic view of the forward price curve. The price signals in the forward market failed to adequately signal the pending over capacity. Most companies began construction with none or only a portion of a plant's expected output hedged with forward supply agreements. As prices collapsed and beneficial short-term contracts expired, companies experienced a severe compression in earnings. Commodity price risk has also played a large role in the declining profitability of trading operations. This appears to be related to three factors: absolute price of power and gas; volatility of prices; and available liquidity in the energy markets. The first two factors are commodity driven with volatility declining along with the fall in prices, thus limiting arbitrage opportunities. The decline in liquidity appears directly linked to the reduced number of creditworthy counterparties.

The investor community has borne the brunt of this collapse with energy market stocks off 70% - 90%, numerous bank financings in default and bondholder value seriously eroded. The vast majority of the energy merchant transactions were financed in the bank market. The problems experienced in 2002 have drastically reduced the availability of bank capital for the power industry. Eighteen months ago, the banking universe supporting the sector consisted of approximately 70 institutions. Today, this figure is estimated at 25 and falling. Companies are finding it more difficult to attract financing to support ongoing working capital needs. In my view, this is not a short-term capital contraction but a longer-term trend that will impact future growth. Clearly, there is a bifurcation in the power market. Plain vanilla utilities with predictable and stable EBIT, a straightforward business model, and limited exposure to non-regulated power industry are in vogue. Companies that have a merchant energy market model and complex financing structures are finding it difficult to raise capital. This trend will continue in 2003.


So what needs to happen to reassure the investor community and stabilize the market? Unfortunately, the outlook for power prices over the next 2 - 3 years does not bode well for either companies that are long on merchant generation or heavily dependent on trading profits. Reserve margins around the country are rising with supply growth far outstripping demand growth. The downward pressure on prices and profitability is expected to continue over the next 36 months. In order to stabilize the market and repair the financial damage there are a number of fundamental changes that must take place.

* The days of financial forensic are over. Companies, in all industries, not just power, need to provide straightforward, coherent and fully disclosed financial information. Investors need to understand the financial data and comprehend the business model.
* Strategy is important. Companies must have a clear and executable business plan. This plan must generate real earnings and real cash flow.
* Companies need to de-leverage the business. The excess leverage used by energy merchant companies over the past five years was and is unsustainable. A more conservative capital structure needs to be adopted. Creative uses of alternative equity products will need to develop, taking the pressure off the balance sheet.
* Creative off balance sheet financing structures must be the exception rather than the rule. The concept of risk transfer inherent in project finance will continue to be an important tool. However, the use of off-balance sheet financings to manipulate earnings or cash flow are no longer acceptable.
* Management will be critical. The investor community must have confidence in the individuals running companies. Reestablishing investor confidence will continue to be a challenge in 2003.

While the hangover continues into 2003, it is clear that all the constituents have a more realistic view of the challenges ahead. Power generation is a fundamental industry which is critical to the health of the US economy. We all must work together over the next 24 months to repair the damage and limit the pitfalls. I am certain that 2003 will be as challenging as 2002, however, we are all smarter and more alert than we were 18 months ago to tackle these challenges.