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.
Predictions
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.
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