Downward Ratings: Where Does It End? | Norton Rose Fulbright
The speakers are William Chew, vice president of Standard & Poor’s, Charles H. Wilson, director of business unit finance for Duke Energy Corporation, John Cooper, senior vice president-finance for PG&E National Energy Group, Eric McCartney, head of project finance lending in North and South America for KBC Bank, a Belgian lender, Bryan Urban, senior vice president-finance for Panda Energy International, and Robert J. Munczinski, managing director of BNP Paribas. The moderator is Robert Shapiro.
MR. SHAPIRO: The degradation of Enron has led the rating agencies to take a much closer look at the utility business. Most of the publicly-traded power companies have seen their credit ratings questioned or lowered in recent months, and the rating agencies have apparently decided that the utility business as it is commonly practiced is much riskier than they had originally thought. These downward movements in ratings have had a devastating impact on the industry and have contributed to the uncertainty that currently reigns in the business.
The rating agencies have become a pivotal player in the market. People are struggling to figure out what they must do to please them. Bill Chew, give us your view of the ratings landscape and how things have evolved over the last six months since Enron collapsed.
MR. CHEW: There are a couple of basic points that Standard & Poor’s has been making for a while — even before Enron collapsed. We have felt for some time that there has been a misperception in the debt markets about the nature of credit in the electricity business. This applies to both corporate and project credits. I have had many conversations with lenders who would make a statement essentially along the following lines: “Wait a minute. At the end of the day, this is electric power, an essential service, and ultimately that should be”— the key phrase is “should be”— “the basis for a strong credit.”
What Standard & Poor’s has been arguing for some time is, yes indeed, that can be the basis for a strong credit and, since the 1930s, the combination of federal legislation and state commission legislation created a regulated utility base with rate-based credits that was one of the most attractive sectors in the corporate bond market.
Unfortunately, I think that aura continued even while the market pursued deregulation. What was missed in deregulation is that electricity standing alone is not inherently a good credit story. It is not like any other commodity business. It has a particular tension. It is important, and the danger of being important is that if its price increases, sooner or later the government intervenes. But the price is also volatile downward. Electricity companies also have greater capital needs than other types of commodity operations.
Without some type of bolstering in the form of franchise rate bases or contract supports, you are generally looking at something that carries a relatively higher risk than other commodity businesses. That’s the reason why we were saying well before Enron collapsed: “Wait a minute. Deregulation in this industry raises business risk. It is not a good mix with rising leverage.” That has been a theme.
It is the reason that we have been downgrading this industry really for the last four or five years.
Focusing on some of the key issues, what do you need to support credit? You essentially need to keep your eye on the recurring cash flow in relation to full fixed charges. That is the key ratio to which we think everyone needs to return.
What occurred recently is a radical change in the perception of the industry. There have been massive cuts in valuation, massive shifts from greed to fear in the market, and absolute terror breaking out in some cases.
MR. SHAPIRO: Has S&P changed its view on whether a company with a major trading business can sustain an investment grade rating?
MR. CHEW: People need to be aware of the capital requirements both in terms of capital adequacy and liquidity that are required to support trading companies. We have not changed our basic view, but we have updated our approach to address some of the current issues that are arising in the market.
The area where I think you are going to see expanded requirements for capital is to address the problem of compound risk — between the credit risk these firms face and the market risk. Companies sometimes assume incorrectly that they have more diversification in their credit profiles than they really do. The reality is their counterparty credit exposures are highly correlated with the markets in which they are trading. You cannot assume that collateral levels will support those credits. The collateral levels are being driven by the market and that is putting stress on the very credits that the trading companies are trying to collateralize. There is a tremendous correlation effect.
What needs to happen is you have to look at the credits separately. The stronger companies will separate the credit risk from the market risk just as every other trading operation in financial products has done.
The other point, if you are running a trading desk in a commodity such as electricity, is you must recognize that your ability ultimately to continue trading rests on the competence of your counterparties. It is not simply what you state your credit to be. It is what your credit is perceived to be.
It is interesting to note that when these trading operations began, we started with much sounder counterparties — double A, triple A counterparties — some of whom operated as separate entities precisely to break out the credit risk and keep it separate from the market risk. These entities were walled off from the banks and non-bank institutions were doing the trading.
That has yet to happen here. Here we began with low investment grade credits in most cases, leaving little headroom to deal with competence and sensitivity issues.
MR. SHAPIRO: Charlie Wilson, do you think that companies like Duke will end up being the only players in this market because they have such strong credit to begin with and the weaker players will be driven from the market?
The Merchant Model
MR. WILSON: When we first looked at merchant generation — merchant energy we call it — you had to be in the trading and marketing business in order to be successful. Much of the value that you get from being in the business is extracted through trading and marketing. By just owning plants, a company is taking a very long term, unhedged position or a long position. Pursuing that strategy alone cannot be successful in the long run. I won’t name companies, but everyone knows companies that primarily had a generation-first strategy with trading and marketing as an afterthought. They scrambled to get into it too late.
Another conclusion we reached was in order to be successful in trading and marketing, you have to be very large. You need a large trading book in order to transact more efficiently. You can manage risk more efficiently.
The last point is trading is an inherently risky business even if it is large, and you need a strong balance sheet and a lot of liquidity. Many early traders did not understand this.
Bill Chew is exactly right. If you go back to the analysis papers that they have published as far back as two or three years ago, they brought this up, but people did not focus on it. Moody’s position was a little harder to discern — that’s just Moody’s — but it hinted at the same things.
Because our management is inherently conservative — and very ratings-focused since Duke got into trouble in the early 1980s with nuclear plants whose cost overruns nearly brought the company down — the view was that we were not going to follow the pack despite pleadings and advice from the investment bankers that, “You shouldn’t be hanging onto an A rating in a sector. The most efficient place to be is triple B flat or maybe even lower. In some cases the cost of capital is lower. It is a capital-intensive industry, blah, blah, blah.”
I’m not sure we were really that smart. Maybe it was serendipity or maybe it was just the inherent nervousness and conservative instincts of our management. But I think the strategy our management pursued has proven itself as a wise approach.
You need those three things. We think the market is now recognizing that. You can’t be a pure generator. You can’t be a pure marketer. You must have a mixed strategy. The trading and marketing must move to the center of that strategy and the plants serve and feed that business. It’s not a matter of “asset lite” or asset heavy or worrying about looking like Enron by being too focused on trading. It’s really how do we work together, where do we extract the value, and how do we sustain things over the long run.
S&P is now repeating more loudly the things that it said more quietly or that people chose to ignore a few years ago: You must be big. This is not a game for the small player.
MR. SHAPIRO: John Cooper, do you agree with Charlie that only the big will survive?
MR. COOPER: Yes, I agree absolutely with everything he said and with the three prongs of the evaluation.
I want to go back to the initial point: can the merchant energy business be investment grade? If you turn that around and ask, “Can you have a merchant energy business without being investment grade,” I think the answer is no.
Start with the integrated model of which trading is a necessary component. The trading business is driven on credit. You can’t buy pipeline capacity, you can’t buy gas, you can’t sell your output to many other marketers unless you can provide counterparty credit. Unless you have an investment-grade credit — and whether a triple B- or a triple B is good enough time will tell, but it probably isn’t because it is not good enough in any other commodity business — then the only way to do it is based on collateral, and nobody has enough cash or can afford enough credit facilities in a shrinking-margin business to collateralize all of your transactions unless we evolve to a system of multi-counterparty netting arrangements through some sort of a clearing process. With such a system, trading would require a smaller capital base. We are not there yet.
MR. SHAPIRO: Do you also agree with Charlie’s point that trading is an essential component of a merchant energy business.
MR. COOPER: There are models where you build assets and enter into long-term contracts to sell all of your output, but I wouldn’t call that merchant generation.
MR. SHAPIRO: Can that model sustain itself in the current environment?
MR. COOPER:Yes, I think so — as long as the counterparties to whom you are selling your power honor the long-term contracts. We used to think that business was very complicated to put together with lots of documents, but it was dirt simple. You build a power plant. You enter into long-term agreements, and all you had to do was make the power plant work and operate at levels of relative efficiency.
MR. CHEW: There is a counterparty dimension to that, though.
MR. COOPER: Yes. Twenty-year contracts at a fixed price eventually get out of market for one party or the other. That’s not really the way the business is evolving, and there are very few counterparties today who are willing to enter into long-term contracts.
MR. WILSON: There will always be room for a niche player. I think you may see some revival in long-term contracts in regions that experienced a lot of price volatility. There will be a return of bilateral contracting and the old project finance model will be employed on a very small scale.
Duke has decided not to do that. First, it is really small. It can’t meaningfully contribute to the bottom line of a company the size of Duke. We might invest in such projects through our finance affiliate, Duke Capital Partners — and smaller developers can probably earn a nice little return doing that one- and two-off projects — but the merchant energy business is a game for the “big boys.” There is no other way to succeed in it.
MR. SHAPIRO: Eric McCartney, is the S&P analysis correct or is it overcompensating for Enron?
MR. McCARTNEY: No one likes to point the finger at anyone else because I think it is partly all of our faults, to be quite honest with you. S&P and Moody’s have been accused of moving the goal posts. In fact, the goal posts never moved, but the play on the field kept moving closer and closer to the out-of-bounds lines as people took more and more liberties with the rules. Every time we did a new deal, we gave in to one more small point. This became the starting point for the next transaction. Before you knew it, we were out of bounds. Before you knew it, we were in a situation where we had not the same type of quality of credit that we had when this industry got started.
MR. SHAPIRO: Bryan Urban, is project financing as we know it dead because there are no offtakers with whom to make deals?
MR. URBAN:The landscape has changed. It is different from where it was a year ago — liquidity is disappearing from the market because there are few buyers willing to enter into long-term arrangements — but the fundamentals of structured and project finance remain as before. There are always opportunities for players to be creative. There will still be room for medium- and smaller-sized companies to compete in this market through alliances or by other means.
MR. McCARTNEY: Just to add to that, the basic business cycle will prevail. You could view the last cycle in which merchant plants were built as one where greedy developers didn’t want to contract long term because they thought that energy prices would remain robust over time. We have deals that had over two times coverage originally that can barely cover debt service today. One could argue the developers thought there was a lot of upside and they were greedy and didn’t want to lock in the current rates by entering into long-term contracts when they were available.
Now we have the other side of the market where the buy side is greedy. Buyers today say, “Great low prices. Wonderful. Why should we contract long term?” And they don’t.
All it takes is one event like a heat wave and energy prices spike to $1,000 per kilowatt hour for a week to have the buyers thinking, “I guess we should contract for some power.”
The cycle will move that wave forward again. Utilities will eventually conclude that a portion of their portfolios should be contracted for long term — 20 years — and a portion at 15 years, a portion at 10 years. What the balance is will be the question.
The question was asked: is project finance dead? No. There is a downturn in the cycle. It will come back alive and well, but going forward, we are all going to see things in a different light after what we have been through.
MR. SHAPIRO: Are the banks still willing to lend on a long-term basis if the offtaker is a good credit?
MR. McCARTNEY: I think those contracts are still out there.
MR. CHEW: The anecdotal reports we have heard suggest the market is giving much more credit to project structures now than probably it had in the past. We went through a period where, as long as equity markets were hot and debt was readily available, why in the world should you spend all that time documenting a project? Just take your project and send it to corporate, and you will do fine and save yourself a lot of legal costs. I think the cycle is turning. People are saying,”We want the type of due diligence that is required at the asset level even if we are lending at the corporate level.”
MR. MUNCZINSKI: I agree with Bill’s point. Certainly, BNP Paribas has a much greater confidence level in project finance structures than a corporate transaction. We can “ring fence” the transaction. We have many years of experience looking at such deals. There are collateral packages and single-purpose entities. We lenders can take a lot more comfort that we know what is going on within that box compared to the surprises that we have all read about and experienced personally in terms of what is going on in corporate America today.
A couple more points: One reason why project finance is not as popular today is that project finance is not really providing a true benefit to the borrower. Go back to 1999. Capital structures for merchants plants were probably 65% debt and 35% equity. Since then, we have gone from 65% debt to 60% to 55% to 50% to 45% to 40%, and I am not sure 40% is where we will stop. And at that point, a corporate borrower probably can leverage at a much higher level, or at least at that level. We project finance lenders are not really providing a great deal of leverage benefit to the sponsors of transactions.
The second thing of which the lenders stand accused — and we have to ascribe some guilt to the rating agencies — is we are taking the position that, even though it is a non-recourse transaction and the assets in question are “strategically important” to the sponsor — we are consolidating them in terms of how we look at leverage at the corporate level.
MR. CHEW: In the interest of equal time, we will argue not all rating agencies are equal. [Laughter] There is one rating agency — the one I speak for — that actually does try to make a specific assessment of each project with the key question being not whether the project is strategic but the economic question: will the parent support the project in stress?
MR. McCARTNEY: We differ.
MR. CHEW: Oh, absolutely. You have talked with me, and we have had the discussion on both sides. Standard & Poor’s has been adamant about insisting there is no free lunch. You should not have the benefit of a halo of support without some exposure to the corporate balance sheet. There is no free lunch in the credit world. I think that’s where a lot of lenders have come back to. In some quarters, it was, “How big is the type on the front page of the offering statements? That decides what we will support.” I don’t think so. The question you have to answer is, in times of stress, will the sponsor put money in as required to support the project? Is there an economic return seen? In some cases, we think you can make that judgment and in other cases, you can’t.
MR. McCARTNEY: Back to answer your question, Bob, I think long-term contracts can still be found in the market. The identity of the counterparty is important and whether it is investment-grade quality and whether the contract is a toll or a contract to supply output to a load-serving entity who needs the power for its own native load. Tolling and power sales contracts mean two different things to bankers. I think bankers have learned a lot over the past eight months about how things should get done in the future.
No sponsor is going to get 25% equity today, but if you have a good strong offtaker for a long period of time, you are going to qualify for long-term financing. I still believe that can be done with the right deal.
MR. SHAPIRO: Let’s talk about the strength of the offtaker. There are a number of tollers in the market. At least, there were tollers last year. They have now been downgraded or partially downgraded. Would you finance with an offtaker that is not investment grade?
MR. McCARTNEY: I may finance it, but I certainly wouldn’t underwrite it because I don’t think the market is prepared to do it.
The first thing that everyone does in looking at a tolling agreement now is to look at the project on a merchant basis. The question is, “If the toll disappears, does the deal work on a merchant basis?” The only way that happens in a tolling agreement structure is if the sponsor puts in at least 40% equity. Does that make sense? Probably not for many developers given the returns needed on the developer side to have an economic deal.
MR. SHAPIRO: So will lenders today finance on a purely merchant basis?
MR. COOPER: Yes. Project finance is just cash flow financing, and any developer who is making an investment in something presumably expects a return. The lenders are taking the first cash flow. As long as the transaction isn’t too big so that you don’t have to find too many lenders — part of the problem in the industry today is that power plants have become too big and expensive — and as long as you have some degree of coverage — be it two times, three times, four times, whatever it is, or enough collateral based on a liquidation scenario — then some bank will get comfortable enough to lend.
The real question is how do you marry that with the long-term deals that are available today in the market. They are very few and far between. We are on both sides of these transactions. Sure, we may be willing to do a tolling deal with someone, but it is not going to provide the return on capital that a developer needs to justify investing in a plant for a long time. Larger companies like ourselves and, I’m sure, Duke don’t want to contribute to the over-build scenario by lending our scarce credit to support someone else — not in the current market.
It’s a different view than we may have had a year or two ago. Credit is scarce. This isn’t how we want to allocate it. Also, there is the uncertainty about whether these tolling deals are going to have to be reflected eventually on the balance sheet as debt or something else. As Bill Chew said, there isn’t any free lunch. Somehow you are using credit capacity whether you are building an asset yourself or are helping someone else build his or her asset by entering into a long-term agreement.
The load-serving entities should be entering into longer-term contracts to lock in these cheap prices.
MR. SHAPIRO: But there is no regulatory incentive to do so.
MR. COOPER: Right, they have no incentive to do so, and they will lock in at the peak of the market just like what happened in California, and you just perpetuate. It is a dysfunctional regulatory structure.
MR. McCARTNEY:The other big problem with financing merchant power plants today is the market consultants. There is little confidence in the market forecasts because they are all over the board. You can’t trust them. They are one thing when you do a project and, two years later when the project is completed, they are completely different. Unfortunately, the market consultant is too heavily influenced by the developer. The developer sits down with the market consultant — who, by the way is supposed to be independent and working for the banks — and says, “This project is being built, and this project isn’t being built, and this project is on hold and that one is not going forward.” The developers have undue influence.
I can give you a really good example. It was a project in which I was involved person-ally. We had a market consultant do a project analysis for us. The consultant did not include a project on which he was working for another developer. He was clearly aware that it was going to get financing and did not include it in our numbers. Interestingly, we looked at the other deal and — guess what — that deal did not take into account our transaction.
MR. WILSON: It kind of amazed us that the bank market bought that whole mini-perm story. [Laughter] [Ed. A “mini perm” is a short-term loan of approximately five years with principal amortization calculated as if the loan were longer term and with a balloon payment of principal due at year five. Many banks lent in recent year to finance construction and up to the first three years of operations of merchant power plants using mini perms. In effect, they were making bridge loans until the developers could find longer-term permanent financing for the projects in the capital markets.] We took advantage of it to a limited degree, but the principle of matching assets to liabilities was violated. Fortunately, we are not a big player in project finance. We are mostly a corporate finance shop. But the banks that really pushed thought they had the magic because, at the time, the capital markets were not willing to take merchant risk.
You couldn’t finance large portfolio deals. The capital markets were saying, “That doesn’t work for us. We are not going to make a 20- or 30-year bet on a pool of merchant assets without any contract cover.” So the banks came along and said, “We will take the bet. We think the capital markets will be there in three to five years to take us out.” So the mini-perm was born. We talk about the unhedged bet that California made that has come back to haunt it; the banks at the time were making a similar unhedged bet. It was, “We can refinance in three to five years these long-lived assets in an inherently volatile, cyclical commodity industry.” It was a huge bet.
Forty billion dollars of financing is coming due starting next year. Now that the sector’s credit quality is perceived to be dropping, the capital markets are running from this. And the rating agencies are asking, “What are you going to do? These are core assets. This is your business, and how are you really going to walk away from that without tanking the whole company?” So they are putting that debt back on credit.
Every company and every case is different, and the rating agencies need to be open-minded about looking at the specifics of the transaction, but the feedback we are getting is mini perms in this sector should not be afforded much if any off-credit treatment.
It’s going to be a massive workout starting next year. The banks are stuck with this paper. Duke will be there hopefully to start picking up the pieces because there will be some undervalued opportunities. Earlier this morning, I mentioned that maybe people don’t realize just how bad things are going to get. We don’t think the people trying to unload power plants today are realistic yet. We have not been as active in acquisitions as maybe a lot of people expect us to be because we think this is going to get worse going into the next year when people must start grappling with these refinancing issues.