The speakers are Dr. Robert B. Weisenmiller, one of the leading experts on the California electricity market and a founder of MRW Associates, Inc. in Oakland, California, Jan Smutny-Jones, executive director of the Independent Energy Producers, the trade association for California power producers, and chairman of the board — until earlier this year — of the California ISO, Vincent P. Duane, vice president and general counsel of Mirant Americas, Eric McCartney, head of project finance lending in North and South America for KBC Bank, a Belgian lender, Robert J. Munczinski, managing director of French bank BNP Paribas Group, Howard Seife, head of the bankruptcy practice at Chadbourne, Ross D. Ain, a former lawyer at the Federal Energy Regulatory Commission and now a consultant for Caithness Energy, and Lynne H. Church, president of the Electric Power Supply Association, the national trade association for the independent power industry.  The discussion was moderated by Robert F. Shapiro from the Chadbourne Washington office.

MR. SHAPIRO: Let us start with a fundamental question.  Many of you have read that the Bush administration and the chairman of the Federal Energy Regulatory Commission have said that the only solution to the mess in California is to build new power plants.  Yet yesterday, the federal government imposed price controls.  The question is will the price controls discourage developers from building new power plants in California?

MR. SMUTNY-JONES: It is hard to say.  There are currently more than 9,000 megawatts of power plants that have been licensed to be built in California.  A number of these are already under construction, and we have to assume that those plants will be completed.  On the other hand, there is a history of unfinished power plants in California.  I don’t think we are going to know the impact of price caps for some time.  That is the negative side.

On the positive side, there is always the hope that price caps might dampen the rhetoric.  Unfortunately so far, the effect appears to be that the California governor has merely moved from talking about price caps to calling for refunds.  It would be a shame if we move next to a debate about refunds rather than focus on how to fix what everyone agrees is a dysfunctional market.

MR. SHAPIRO: Vince Duane of Mirant, do you have a view about the impact that price controls will have on willingness of generators to add capacity?

MR. DUANE: They are a serious concern.  If the question is whether they will put in jeopardy some of the 9,000 megawatts that are planned, the answer is yes.  Power companies looking at building in California look at a risk-reward equation that has some pretty considerable uncertainties and other unquantifiable political risks.  We operate in a national if not global market in which there are plenty of opportunities.

California is certainly an important market.  It is one that deserves a lot of attention from developers.  But there is a misconception that the decision whether to invest is made in corporate boardrooms based on what is the best allocation of capital, or is made by credit unions and banks about where they are willing to lend.  What gets lost is the perspective of Wall Street.  At Mirant, we are faced regularly with having to answer questions about our California exposure.  Anyone who is paying attention to stock prices will appreciate that that constituency is extremely important to public companies.  It is something that we are not able to ignore.  We may feel internally that we can manage the political risks in California, but that cannot be the entire analysis.  We must also consider whether we can convince Wall Street that taking on additional “California exposure” is the right thing to do.

Continuing Bank Jitters

MR. SHAPIRO: Eric McCartney, speaking as a banker, will lenders be willing to finance new construction?

MR. McCARTNEY: First, it is too early to tell what effect the new price controls will have.  There is no financing currently in the market to test the reaction of banks.  However, in general, the European banks are very concerned about the political risk tied to lending to California projects.  On purely an economic level, everyone should be running to California not only to build power projects, but also to finance them, because that is what you are supposed to do in a boom cycle.  But when you consider the political risks, the environmental concerns, the transmission constraints, the unavailability of gas — these are wrenches in the machine.  They make it increasingly difficult to evaluate the risks of doing business in California.

MR. SHAPIRO: So if a generator came in today with a project that has been fully permitted and is ready to be financed, what would you say?

MR. McCARTNEY: If the proposal is for the bank to take market risk in California, I think that risk is too great.  Speaking just on behalf of KBC Bank versus on behalf of a lot of my colleagues in this room, it would be very difficult for us to get credit approval, and I would feel very uncomfortable taking an underwriting risk with such a transaction.

MR. SHAPIRO: Are there other lenders in the room who feel differently?

MR. MUNCZINSKI: One of the real issues is fundamentally where is the credit? A concern that most lenders have in California is what is the credit quality of the Department of Water Resources? The state is planning another bond issue to raise money to buy electricity.  How much of the cash collected from California consumers for electricity will go to the Department of Water Resources to pay bondholders and how much to the utility? Until that question is answered, it will be difficult for a lender to assess the credit quality of the proposed bond issue.  There is also the issue of what role the court in the PG&E bankruptcy will have in parceling out revenue.

MR. SHAPIRO: Before we get to bankruptcy, which is a very important area, I wonder if Bob Weisenmiller can speak to what the state government wants in terms of playing a power purchase role longer term or getting PG&E and Edison back into that role and what it will take to do so.

DR. WEISENMILLER: I think the state will remain the power purchaser for only a short period of time.  The state legislature wants to get out of this business this year.  PG&E is not in any position to pick up the responsibility.  Edison is not either.  Somehow you have to return them to credible entities, which will require assuring the utilities that they can pass through the cost of purchased power.  They will also need to settle past debts with their creditors.  These debts are on the order of $13 to $14 billion.

MR. SHAPIRO: So there will be no creditworthy entity to which lenders can look as a backstop in the foreseeable future?

DR. WEISENMILLER: Right now the state is in it by default.  At some point, if the bond issue doesn’t go, the state will have to face whether it can continue in that role.  You can certainly paint some pretty scary scenarios.

MR. SHAPIRO: Can you argue that the new price controls will have a dampening effect on electricity prices so that the cost of purchased power will come back into balance with the retail rates the utilities are allowed to charge?

DR. WEISENMILLER: They could.  However, if you base your assessment on where electricity prices are in the futures market, they are not yet close.

Ongoing Bankruptcy Issues

MR. SHAPIRO: Howard Seife, which of the two utilities — PG&E, which filed for bankruptcy, or Edison, which did not — is in a better position?

MR. SEIFE: It’s a good question.  Edison may yet find itself in chapter 11; the situation has not fully played out.  However, if you look at the scorecards and see how the two companies have been faring — one in chapter 11 and one out — you see a lot of similarities.  There is not a huge difference to the situation of the two utilities.  Neither has found a long-term solution yet to its predicament.

MR. SHAPIRO: What about QFs that have contracts with the two utilities? PG&E must make a decision at some point whether to accept or reject the contracts.

MR. SEIFE: In chapter 11, the debtor — in this case PG&E — has the ability either to assume a contract or to reject it.  Any contract that it rejects is in effect terminated, and the QF would have a claim for damages in the bankruptcy.  Its claim is a “prepetition claim” and will be paid in bankruptcy dollars, or whatever is provided in the plan.  That could be 20¢, 50¢ or 80¢ on the dollar — whatever is provided for in the ultimate plan of reorganization.

If PG&E decides instead to assume the contract, then PG&E will have to cure the contract, which means paying all the overdue amounts, even those that accrued before the bankruptcy filing.  It is in PG&E’s interest to defer that decision for as long as possible.

Some QFs have gone into bankruptcy court to impress the judge to force PG&E to make a decision soon.  As a middle ground, the QFs and PG&E could negotiate a different form of long-term contract.  That is always an option.

MR. SMUTNY-JONES: Bob, there is also a cycle of political play here.  There is at least an adult in charge now with rules he follows as opposed to the wide-open situation in our legislature.  A deal has been done between the QFs and Edison.  The odds a very high that the QFs will make a proposal to PG&E.  We are in the process of trying to figure out how best to put something like that together.  Earlier this year, PG&E was very close and willing to negotiate some sort of long-term arrangement with the QFs that makes sense.

QF Contracts

MR. SHAPIRO: Will the price controls the federal government imposed this week make such negotiations more likely since the QFs might earn less money by selling their power into the market?

MR. SMUTNY-JONES: I don’t think so.  It is a mixed bag.  There are some people who think the vast majority of QFs would prefer to shed their contracts to sell into the market.  There are some investors who simply want to be done with the contracts and the uncertainty surrounding them and move on with their lives.  Others want a payment structure that make sense.  The Woods decision was a disaster. [Ed. The Woods decision changed the gas component of short-run avoided cost pricing to the cost of gas at a delivery point in northern California.  This had the effect of reducing contract payments to QFs in southern California, making it difficult, if not impossible, for such QFs to cover their operating costs.] It is that sort of thing that is more of a driver in terms of motivating QFs to get some stability long-term.

DR. WEISENMILLER: One of the nightmares that I think a lot of QFs are trying to deal with is the scenario where there is no assumption or rejection of contracts in the immediate future.  They continue to have to supply PG&E, and they are losing out on the boom cycle of the market.  When ultimately PG&E is forced to make a decision a year or two from now, the market may be very different.  What by then may again be a very valuable contract will be rejected by PG&E.  The QF will be left with a general unsecured claim on which it will get pennies on the dollar, and it will be at the mercy of a very different market.

Volatility in Prices

MR. MUNCZINSKI: One thing that has happened in California is the volatility brings in traders.  People like Mirant or Coral Energy or others come in and assume electricity price risk.  I would like to know what other bankers think about that.  You would think you would lend against a Coral credit, which has a triple A rating, but isn’t the bank still exposed at the back end in case Coral made a bad decision about California risk?

MR. SHAPIRO: Let me ask Vince Duane this question.  Are you less inclined as a generator to enter into a volatile market?

MR. DUANE: The problem with California is there is still the question at the end of the day who foots the bill.  Until we get some more certainty on that, we will be concerned about exposing our credit rating to that sort of open-ended risk.

Many people have looked at selling to the Department of Water Resources.  Many generators and generator-marketing combos have gotten comfortable with the credit, notwithstanding the government’s statements that it wants the Department of Water Resources out of the business in a matter of months.  I am probably in the minority here, but Mirant has felt uncomfortable about the ultimate creditworthiness of the DWR.  Particularly when you look out 10 or 15 years, you must really swallow hard to take that risk.  It is not a market risk.  It is a credit risk and one with a political dimension.

Ten days ago, The Los Angeles Times ran an article chastising the Department of Water Resources for committing to long-term contracts at the top of the electricity price cycle.  The criticism is bound to increase.  Is signing such a contract an unreasonable risk for a generator when you have questions about how long the DWR will remain in this business, and more importantly, if those contracts end up being out of the money for the DWR, there is a risk the state will eventually try to back out of the contract? It strikes us as a no-win situation.

MR. SMUTNY-JONES: We are hearing a lot of people raise questions that normally would be raised about Bangladesh in terms of investing money.  That signal needs to get to the politicians in California — not from the generators because the message is obviously self-serving, but from the others in this room.  Of course, you probably think the situation is stupid now.  You have no idea how much worse it could possibly get.  It doesn’t need to go there.

MR. AIN: One thing the bankers might reflect on in the federal order imposing price caps is it may increase the supply of power.  When the government asked the Los Angeles Department of Water and Power, or other public agencies, or out-of-state public agencies, why can’t you sell at reasonable prices, they answered we can’t be assured we can buy back at reasonable prices.  That was a real disincentive for them to be reasonable.  Well, one should now say with the federal government having put a price cap in place can they now sell at reasonable prices at least knowing for a period of time they can buy back at “reasonable prices”?

The second point is that, in order to effect a political solution, the body politic in California will have ultimately to finance the undercollections that have occurred.  They need to know what the level of that undercollection is ultimately going to be and, while you had no controls or caps on prices, there was a blank check and everybody was terrified in California of what that could be.  With this FERC order on price caps in place, there is the possibility that at least some people can begin to estimate with a lot better specificity what the level of ultimate undercollections will be.  Having a QF settlement in place would also help so that the treasurer of the State of California, the governor of the State of California, and the legislature can begin to come out of their shells and say, “What do we really need to make these utilities creditworthy again,” and this time figure out the answer.  That might be the beneficial effect of the price caps.

Effects Outside California

MS. CHURCH: I have a question for the lenders and investors in the room.  We just heard that the federal order for the first time expanded price controls beyond California to the entire 11-state WSCC area and, until today, investment in those other states — Arizona, Nevada, and the Pacific Northwest — has been moving forward rapidly because that is at least pretty safe territory and you are also within reach of a huge market in California to sell into.  Does this order change anyone’s perception of the risk of investing throughout the rest of the WSCC?

AUDIENCE MEMBER: We are developing a project in Arizona, and we have assets in Nevada.  One thing that troubled us was that Nevada has had about a 30% to 40% rate increase already without having the full disease that California has had.  There have been rate increases throughout the West.  As to the creditworthiness, there are still creditworthy buyers and the FERC order, to the extent it immediately caps the top end of the price spectrum, will put less pressure on the incumbent buyers and keep them more creditworthy.  So a simplistic answer would be, it’s helpful, not hurtful, because you have more credit support than you would have if this conflict figuration spreads to the rest of the WSCC with the same vengeance as in California.