The “End Game” For Merchant Power

By Rohit Chaudhry and Adam Wenner

Many merchant power companies in the United States appeared to be barely hanging on financially early in the year. Three are currently in bankruptcy. However, conditions improved enough by early summer for companies in the sector to be able to resume borrowing and to raise additional equity.

The outlook remains cloudy. The companies are highly leveraged with billions of dollars in loans coming due in the next three years. Almost all regions of the United States have more electric generating capacity than they need. This condition is expected to persist in many parts of the US until as late as 2010 to 2014, according to the latest forecasts from industry experts. Private equity funds are circling the power industry like vultures hoping to pick up projects at fire-sale prices. There have been fewer sales than expected. The banks — in no hurry to write off loans — have been allowing loans coming due this year to be refinanced, but the rollovers are short term and often come at a cost to the merchant power companies of having to put up better security, leaving less room for maneuver the next time. Meanwhile, the US economy as a whole is starting to improve.

Chadbourne hosted a debate in San Diego in June on the question, “What is the ‘end game’ for the merchant power industry?”

The following are excerpts from that debate. There were eight debaters, four to a side. Four spoke for the lending community. They are Leanne Bell, a managing director of GE Structured Finance, Gail Nofsinger, vice president in the capital markets division of CoBank, a cooperative bank based in Denver that has been a lender to many merchant power projects, Larry Kellerman, a managing director with Goldman Sachs & Co., and William Chew, a managing director of Standard & Poor’s.

The four debaters opposite were Tom Kilgore, vice president-structured finance with El Paso Energy Corporation, J. Stuart Ryan, until recently executive vice president and a chief operating officer of The AES Corporation, Donald R. Kendall, a leading investment banker in the 1980s who now manages a portfolio in the power sector for hedge funds at Carlson Capital, and Andrew Schroeder, vice president of the EIF Group, formerly known as the Energy Investors Funds.

The debaters alternated in laying out their views of the future and in prodding the other side. Other speakers include Mark Woodruff, president of the AES business unit with responsibility for the western part of North America, Kenneth Seplow, vice president of United American Energy, Adam Wenner, a regulatory lawyer with Chadbourne in Washington, and Michael Polsky, president of Invenergy, an independent power company in Chicago. The moderator was Rohit Chaudhry, a project finance lawyer in the Chadbourne office in Washington.

MS. BELL: In order to set the stage for my response to the end game, I thought it wise to tell you what we had in mind at GE Capital for the game at large.

GE Capital has an energy portfolio totaling almost $8 billion. We have called on many of you in the room looking for partners who share our view of long-term capacity and energy margins, partners who can manage day-to-day operations including dispatch, and partners who are attracted to our well-priced money. We look to invest equity in plants with long-term tolling agreements with investment-grade counterparties. As a structured equity provider, we rationalize giving away upside for downside protection.

Just as with most QFs we invested in long ago, we knew we were dependent on tollers. Our models suggested way too many plants were being built for the capacity values in the near term. Fortunately, we and many others in the room were aware of the mighty big difference between an integrated utility offtaker and a power marketing company.

You may recall the experts once said that Exxon Mobil was a dinosaur that would cease to exist. Exxon Mobil lives on. However, our view internally is that the dinosaur appears to have been the framework around which we did business over the past few years.

Where do we go from here? With respect to us, we’ve made a business of buying QF equity in the nine to 10% after-tax range from sellers looking for liquidity — terms that we hope work only for us.

With respect to the market at large, I’ve come up with this hypothesis, and many of you may disagree with it, but here goes.

For the next year, most of us would probably agree that many gencos will continue to obtain 30-day default waivers and some will die. In time, those gencos that obtained the waivers will decide it is not worth working for lenders without the prospect of the near-term payoff and effectively turn the assets over to their lenders. Lenders secured by distressed assets will hold out for as long as possible hoping for relief in the capacity markets. Relief won’t come and certainly won’t come quickly. Reserve margins and gas prices will stay high, nukes will stay on, and the weather will stay rainy in New York.

Lenders will be forced by the regulators or managements to write down the assets. Sick of managing the power plants, these discounted assets will be offered for sale to aggregators of distressed assets looking for a 15% return. Money will pour in. More and more aggregators will enter the fray, margins will be driven to dismal levels, driving the aggregators to sell their portfolios to investor-owned utilities. It will be cheaper to buy the assets and put them back into rate base than to remain subject to the volatility of the wholesale market. Reintegration will lead to fewer financially-healthy utilities.  They will have a very highly efficient gas fleet but in all the wrong locations. These utilities will eventually be eliminated and power will become a fungible commodity across the United States.

This statement is somewhat controversial, but I’d be interested in my colleagues’ responses to it.

MR. KILGORE: Thank you, Leanne. It is indeed refreshing to hear such happy optimism.  The merchant model is dead. Long live the merchant model.

Let me address where we are, how we got here and where we’re going to go. This paradigm lasted, what, five years?

Why did the paradigm arise? It arose out of several things. First, we are talking about a business that has a fundamental interaction between politics and the marketplace. And whenever the government enters business in a regulated environment, you find mass inefficiency. That mass inefficiency still characterizes the investor-owned utilities today, which is why the merchant model arose, why it died, and why it will come back again in a slightly reformed framework.

The underlying fuel for all this work on our part was firms from 1980 on engaged in a 20-year bull market propelled to grow at all costs and propelled by lenders desperate to put their capital to work at egregious premiums. These combined to erode the independent power industry.  The non-regulated subsidiary companies and energy merchants all scrambled to grow and to claim a market share.

A whole paradigm developed around iron in the ground and megawatts under your control, a paradigm no less bankrupt than looking at internet companies and page views. We succumbed to that, too. How many of you still have dot com companies in your portfolio wondering when they will come back?

What we see in the future for the merchant energy sector is that we will have a new merchant sector, not in the manner described by my esteemed colleague, but rather because there is an inefficiency, and because the regulated markets and their regulators have, in effect, outsourced to the merchant companies the bundling of services and the management of risk.  That function has been lost from the investor-owned utilities.

As we go forward, as the companies involved today restructure, as we replace our managements and bring in management that understands VAR and how to apply it properly, as we apply proper credit policies and margining factors, and as we become more astute political players, you will see a new energy merchant arise, one that is able to function in this market. It will be a private rather than a public entity. It will be very well connected with the local regulatory system. It will arise on a regional as opposed to a national or global basis.  That is the future of merchant energy.

MS. NOFSINGER: I’m surprised to hear you admit that there were things that you didn’t tell us up front — like politics. Did I hear you say management didn’t know what it was doing?

I think we will still have a merchant market. It is not a market to which the banks are eager to lend, but they will continue lending because they want to be repaid what was lent before.

We relied on everything you told us: your plans for the future, your plans to have the most megawatts in the ground, competitive power for everyone, and electricity prices that will remain high enough to allow you to repay your debts to us. It should probably have been obvious that one consequence of deregulation is prices fall.  Where are all the consultants today whose forecasts suggested otherwise just two and three years ago?

One key assumption made by the banks is that if prices fell, eventually demand for electricity would increase. Plants would be dispatched with greater frequency.  That has not happened, either.

At the end of the day, we remain committed to the merchant market. Painful lessons lead to greater understanding of how not to do things the next time. And we are going to get back the money we have already lent.

MR. RYAN: The merchant power companies will be here for some period of time, notwithstanding the severe liquidity crisis that all these companies faced about a year ago. What we now realize is that it wasn’t a liquidity problem but a solvency problem for the most part.

Many people are predicting that the real crunch will come in 2006 or 2007, and merchant companies that refinanced today will be staring bankruptcy again in the face then. I do not believe the merchant companies will end up in bankruptcy.  They were all tailored to be super-high-growth engines, but the same engines still work in coasting mode. There are plenty of places where the companies can find efficiencies within. In addition, the current interest rate environment is a strong wind at the back of those companies that will allow them to restructure and avoid bankruptcy.

Share prices for many of the companies have recovered to a point where they are again able to raise equity.  The more equity they can raise, the farther the threat of bankruptcy recedes.

What will the future bring? I think we will have something other than a merchant energy business. I say that because “merchant” has become a loaded word.  We will have a competitive power market principally because, at the end of day, it doesn’t make sense to sell electricity to each member of a large varied group of customers at exactly the same price and terms. Each customer is different and deserves different terms.

What will happen to all the debt encumbering the merchant power companies? We will obviously see a lot less debt in the future.  The mistake made was too much leverage. It doesn’t require any sophisticated change in structure to fix — just less of it.

On the equity side, I see today many new entities looking for an opportunity to play. The equity money will be there, but there will be much more sophisticated analyses of commodity price risks, credit risks and regulatory risk.  The hybrid model or partial deregulation is a dangerous cocktail. Regulatory risk is a huge problem when regulators are allowed to second guess capital investment decisions on an hourly basis. I do not see the muddled model or the model where everything goes back into rate base as at all likely given the preference in this country for competitive wholesale markets.

MS. BELL: I think Stu Ryan just called me a muddle. Now I’m feeling a little cranky. I took exception to a lot of what you said, but the question that falls out, given the popularity of this concept of aggregators — these hedge funds and other companies that are forming with the intention of buying up assets at distressed prices over time — is how do you see those companies interacting with the El Pasos and maybe one or two others that might still be around after the year passes? Do you see any conflict between the two types of companies? Or do you see them working together?

MR. RYAN: I don’t see the aggregators establishing a significant presence, to tell the truth, and I am someone who is spending most of his time in that space right now. My theory is that most of these companies — the would-be sellers of these assets — are not going to be major asset sellers.  This leaves little room for aggregators. I do not think you will see the equity selling out like that.

MS. BELL: Think about this added twist to my theory. I was a lender for a very long time. The banks will hang on to these assets for as long as they possibly can. But the regulators will move in at some point and ask, “What the hell happened here? You’re calling this a par investment? Your statements are suggesting that condition might hold for a while.” At some point, the regulators will push the numbers down and the assets will end up with the aggregators or somebody else.

MR. RYAN: Depends on size, right? If it is a big enough lender problem, that may be right. If the problem does not rise to the level of $30 billion or so, then I don’t see the regulators stepping in and forcing the banks’ hands.

MR. KILGORE: A question for Gail Nofsinger: wouldn’t you agree with me that there is demand for a unique service and that there is a need for merchant power companies or someone else performing the same role to provide that unique service? It may be an aggregator who provides the service. It may be a Goldman Sachs. I think you would have to agree there is no better evidence of a new merchant model emerging than seeing Larry Kellerman, the quintessential developer, now working as an investment banker and employing money in the sector. Would you not have to agree with me that that is proof positive that the merchant model survives and that there is an ongoing need for management of electricity?

MS. NOFSINGER: Isn’t the fact that Larry Kellerman is on the money side a sign that the lenders are now the owners and they are merely trying to bring good talent to their side in the hope of getting out of the situation?

MR. KILGORE: But that doesn’t answer the question. You may be owners now, but this is a marriage that is still intact. It may be an ugly and long divorce for so many parties involved, but it is still an intact union. And wouldn’t you say that that union will survive in one form or another?

MS. NOFSINGER: Maybe we will stay together, but the question I have for you is: what will your motivation be when we are getting all the money out of it?

MR. KILGORE: You get to ask me questions later.

MR. RYAN: Would the fine and proper Miss Bell please act out for the group just how she would explain to her credit committee that the assets will end up inevitably back in rate base where the potential returns are limited by regulation?

MS. BELL: We invest against contracted cash flows, so at the end of the day we will be making our —

MR. RYAN:You are supposed to be talking to your credit committee.

MS. BELL: I am talking to my credit committee. We invest against contracted cash flows. In round two, we will be a lot smarter about that counterparty with whom we are dealing. In round one, we bought a whole lot of bunk with respect to risk management procedures, and we bought a whole lot of bunk about limits and controls that will not, I think, stand the test of time.

MR. RYAN: How are you going to get to a contract risk as opposed to a regulatory risk in the market you see developing in the future?

MS. BELL: Let me be very clear about the answer here. We are going to our credit committee and we are saying we know the future — I am the creditor, and you are the credit committee — we know the future. The future is expected to be X, and it is a controlled environment but one in which we can make a return over time. It will not be a high return, but it is a stable return.

MS. NOFSINGER: Mr. Kilgore, before we make a decision about separation, what is it you are planning to bring to the table that will allow the marriage to remain intact?

MR. KILGORE: Well, flowers and chocolate have always worked well for me. [Laughter.]

MS. NOFSINGER: That worked the first time around, but the banks are not buying it.

MR. KILGORE: I’m tempted to think about jewelry, but —

MS. NOFSINGER: You are limited to a $500 gift.

MR. KILGORE: We’ll have to work backwards, then. I think the answer is rather simple.  We will bring to the table, as current developers, enough expertise to be able to try recovering some return of our equity and return on our equity. It is unlikely for any developer to stay with a project once he determines that he cannot get either a return of or return on equity. And he will return the project rightfully to the lenders. That leaves the lenders in the merchant energy business. And a group of lenders that apparently failed in its original due diligence — having made an issue of it with us — now gets not only to repeat the mistake of that due diligence, but now has to operate that facility in the absence of people with historical background and expertise to help.  That’s the foreseeable outcome. It is really a transfer one project at a time or one small project company at a time of the merchant model from the original developers and entrepreneurs to the lending community.

MR. KELLERMAN: On behalf of the lending community, I want to start off by saying mea culpa.  We on the lending side have created an egregious error and a major sin by being too lenient, by being too tolerant of the wayward paths of the developer community.

Thus far in this debate, we have heard much about the destabilizing effects of hubris and benign tolerance for an unsustainable business model that has brought this industry to the precipice of ruin. What we have to do is point out and reconcile ourselves to, perhaps, the role that the parties most culpable had in the creation and perpetuation of this sad state of affairs in our industry. Unfortunately, I have to point to ourselves in the commercial lending community as being the perpetuator of the problem.

In the criminal justice system in this fine country of ours, the purveyors of elicit drugs are meted out much, much harsher punishments than the hapless and wayward drug abusers. I point out to you in the audience, the hapless and wayward drug abusers [Ed. The speaker is pointing at the opposing debaters who are representing project developers] who have been on the side of the street unfortunately being given the crack cocaine of liberally-granted funds by ourselves on the lending community. [Laughter.] That must stop. In the halls of this industry, we should likewise be placing due blame and opprobrium where it belongs on the parties who have lavishly dolled out the funds that have been responsible for this industry’s demise.

Thinly-capitalized developers and larger merchant energy firms have become this sector’s junkies. Junkies motivated and, yes, actually rewarded by weak lenders via the cocaine of liberally-available project financing against assets that have no power contracts and very little chance of ever getting a power contract.

Just listen to these numbers: 45, 44, 41, 40. No, these are not the respective IQs of the poor hapless debaters opposite. [Laughter.] No, these are the projected 2004 summer reserve margins in the SPP, ERCOT, SERC and MAIN respectively. On the hottest day next year, verily, there will be more than 40% more metal in the ground in these regions than could possibly be used. And nationally that figure is a bloated 34%.

The fundamental cause of this great waste of capital and destruction of value in our industry is that somebody gave these misguided souls a weapon of mass economic destruction, and that weapon was cheap, highly available capital without a disciplined diligence process effectively to constrain these poor souls from misapplying that capital.  That is our fault, and it is something that we on the lending side should stop. [Laughter.]

But alas, now it is 2003, the morning after the big party. Drained kegs and empty Dorito bags litter the floor of our collective house. [Laughter.]

The lenders have woken up and discovered that their homes are filled with marginally conscious, blurry-eyed developer revelers from the night before. They don’t smell very good, and you have to watch where you step. [Laughter.]

What should a responsible lender do in a circumstance like this? You clean up the mess, and you send the junkies packing.

But what are we in the lending community doing? This is the dilemma facing my colleagues today.  The lending world by and large continues to funnel money, resources, and most of all, benign tolerance for an unsustainable business model. By not forcing a radical set of changes on this merchant energy sector, what we are doing is condoning and perpetuating a folly that spark spreads will rebound, and that the good old frat house days will return once again.  They are not coming back. And by not forcing a fundamental change in perspective, we are lengthening the time during which we do not have the three R’s that need to take place in this industry: restructuring, recapitalization and renewal. By putting that day off, we are perpetuating the problem.

This industry is mired in malaise and plagued by procrastination. Poorly-capitalized, non-investment-grade credits cannot prosper in the merchant sector. Lenders need to reconcile themselves to the fact that a poor credit cannot perform adequate risk management, cannot properly hedge its positions, and cannot optimize its assets.

Lenders to this industry, I call upon you to realize the gravity of our collective problem and to transition troubled assets in your portfolios out of the hands of those misguided souls in the marketplace who have misapplied the funds and so fool-heartedly taken those assets and suboptimized them even to this day. [Applause.]

MR. KENDALL: Thanks for ruining my talk. [Laughter.] I wanted to say first that I’m really on both sides or neither side. As a relatively new entity, Carlson Capital fortunately does not have the past baggage of problems that almost everybody else here has. I also want to review some of the history. This is a relatively new industry. We really didn’t get started until the Public Utility Regulatory Policies Act, or PURPA, was enacted in 1978. We really didn’t have a merchant business until the 1990’s. So the industry is still in its infancy.

Also, the amount of value destruction that has occurred is just gigantic. If you go back to January 2001, the market capitalization of the top 10 players was a little over $200 billion. If you go back a little bit earlier this year, the combined market capitalization of the same top 10 players was about $25 billion.  The market destruction on the debt side is probably more significant than on the equity side. So, clearly, many, many mistakes have been made.

Very few bankruptcies have occurred so far, but also very few problems have been solved. I think we are merely deferring the problem until 2005, 2006 or 2007. It will be a fun and interesting world when we get up to that point in time.

We are in a new world.  This is a commodity business. We have moved from a regulated framework where you did not have the risk we have today to a world where you have part deregulation, part regulation, and you are subject to ups and downs and the supply and demand issues of the normal commodity business. We do have very high fixed costs. We do have many technical issues. It is not easy to store electricity.  Transmission requires a lot more technical expertise than is required to deliver groceries and other similar services. Add to this the fact that companies in this business have operated with very high leverage.

We have had a huge number of bad business models. Some of those I think can be changed. Some will have to be destroyed and the companies start over again. I agree with Larry Kellerman that there was far too much cheap capital. I have talked to a number of developers who said lenders forced them to take money. In my view, both sides are to blame because, yes, the developers are taking what is cheap, but they did not identify something rational to do with it.

We are about to see some major changes with the entry of new players. There are probably as many ex-El Paso people here as Chadbourne people, but probably only two or three of them are still with El Paso.  This is typical of the shift in the industry. In the future, attendees at these types of meetings will be from a host of new entrants.

A couple things are worth noting about the new world. We will have dramatically modified behavior. A few years ago, generating growth and trading volume was the focus. Today, the focus is much more substance over form. By that, I mean let’s do trading where it is profitable and not just to create volume so that the company can be ranked number one.

You are also going to see a huge decrease in the attempts at manipulation. Handcuffs work. We will see more prosecutions in other areas where there has been fraud.  We will see major migration toward trading platforms. There will be improved price transparency. There will be better ways to understand where the risks are and are not in the business.  There will be much more attention paid to price and credit risks. Many painful lessons have been learned from the current debacle.

History should be studied because it can repeat itself. Fortunately I wasn’t involved in it, but one of the early failures in this industry that hit a number of players in this room was the AES Deepwater project. It was done as a very high-capital-cost-project because of a relatively low-cost petroleum coke fuel.  The contracts did not match.  Their base was dependent on gas prices remaining high. My recollection is that GE Capital’s gas forecast at that time said gas would never fall below $4 again. Before the project completed construction, I believe gas was under $2. And before GE funded its lease equity commitment, the project was in default.

Those things will happen time and time again. It is a simple lesson in project finance 101. You need to make sure that the revenue and expenses match and that people work to mitigate risks.

MR. CHEW: It seems I’m in the midst of role reversals. My colleague has said all the lenders are wrong. It sounds to me like my opponent just said that the developers are wrong.

At the risk of muddling the issue further, let me go back to at least a couple of the questions that were asked and give a perspective from Standard & Poor’s.

What is the end game? I agree with what Mr. Kilgore said: the merchant model is dead.  Where I disagree is whether the lessons have been learned.  There are two issues we see in particular. First, what was the problem? A lot of it has been the failure of the business model. However, we believe that the business model is only part of the failure.  The real wreckage — the real source of value destruction — is the matching of a weak and, in fact, very risky business model with very high-risk finance strategy. There was an increase in leverage at exactly the point that the business risk was increasing. Look, we moved from franchise monopoly markets to competitive markets. Business risk automatically increases when that occurs and, somehow, we have leverage increasing sharply at the same time.

I am not sure from listening to the comments from the chastened developers on the other side and from my lending colleagues that this lesson has been learned. Yes, you have heard the call for lower leverage. I think the real lesson is that the leverage must match the specific business risk that is still contained in some of the reconstructed business models we have seen.

Second, another lesson that remains to be learned is the big challenge is dealing with some of the compound credit risks that are embedded in the merchant model even today in the firms that remain in trouble. The problem is there is a basic conflict in the trading model that is embedded in these firms.  Trading requires enormous capital. At the same time, it creates additional exposure to credit risk.

It has been unclear to us for some time how the aggressive trading models can be maintained while the credit ratings at best for some of these operators are low investment grade. We look at the financial derivatives market, which is the closest thing to the financial trading that is taking place here. In that market, the counterparty credit for transactions is high investment grade or else the trades involve a structured derivatives product operation that protects against losses when the market turns sour.

Just to finish addressing all the questions, I think this sector will be able to attract new capital, but it will be on a risk adjusted basis.  There will be a true risk adjustment on the pure merchant model.  The debt component needs to be de minimus in order to continue to attract equity investors. The problem with enthusiastic lenders will remain.  The animal keeps choosing to play, as we heard in the discussion yesterday about the debt market reopening to further borrowing by merchant companies that were in distress just three months ago. That may indeed occur, but to be sustained over the long term, the companies will require much higher equity.

Finally, we have the question of whether the industry will remain plagued by asymmetric returns. I think the problem is excess capacity. It is not simply the return that is the problem. It is driven by the phenomenon that we have a lot of springing potential additional capacity that will come into play at exactly the wrong time. When we move from a regulated model to a competitive model, we often forget that the constraints on additional capacity that were supplied by certificates of need were supposedly replaced by the economics of the marginal cost barriers to entry. The difficulty here is that the marginal entry is off of a rate-based utility that does not respond in any sense to market incentives. Indeed, the utilities have the incentive to run additional rate base just at the level sufficient to drive the merchants down to very difficult prices. So over the long term, we expect there will be a real problem in avoiding boom and bust in this sector as long as we have a hybrid arrangement.

MR. SCHROEDER: As a current equity investor in this space and a recovering lender, I have reached step three in the five stages of working through loss. I see a bleak future for the merchant power business and merchant lenders.

I think that a false optimism has set in recently after some of the energy merchants and independent power producers restructured their debts.  The restructurings were nothing more than a full employment act for the lenders and for others involved in our business. Sweeping the problems under the rug for the next three or four years is not going to solve this crisis. It will only put it off.

The industry has more than $80 billion in debt that must be refinanced in the next six years. You have higher rating agency thresholds, some of which are egregious. You have deals that are coming into the market today with ultraconservative structures.  This is a hard way to finance future growth of this business. The energy merchants have given up their flexibility by pledging all their remaining collateral to get the recent refinancings accomplished.

As we heard yesterday, the companies and the banks are reluctant to take writedowns of assets. That will only hurt them down the road.  es, if any, of merchant assets in the near future. Anyone wanting to buy into the business must face the fact that this is a business with huge credit needs and heavy working capital requirements. The standard market design proposals by the Federal Energy Regulatory Commission remain a huge open question. Yet, without standard market design, the future outlook for merchants remains questionable. There is a new gas pricing environment that will bring increased volatility for players going forward. There will also be some shocks to the system from additional bankruptcies. The bottom line is I think the financial hangover will continue for at least another three to five years. The only way new plants will be financed is with a back-to-the-basics strategy. As Bob Cushman suggested yesterday, perhaps we will be back here in 2008 wondering why this merchant quagmire has not gone away. 

MR. KELLERMAN: My question for the Right Honorable Mr. Schroeder is why, in your opinion, should we lenders not seize any opportunity — actual default, technical default — presented by developers to foreclose on the outstanding loans and take ownership of these assets? Then, at least we will have control over the destiny of those assets going forward 

MR. SCHROEDER: A couple comments: first, I think you probably should, but banks are reluctant to do that in some cases because they do not want to take the writedowns that go with it. Second, some of these assets are not going to be rescued no matter who owns them. I am not sure the banks will do any better job managing the problem than the current owners. In fact, taking control of the assets creates regulatory problems that many banks would probably just as soon avoid.

MR. KENDALL: Perhaps the only parties who seem to have been more wrong than the developers and the banks are the rating agencies. How did they miss the paradigm shift in fundamentals? What is Standard & Poor’s doing about it in terms of being a predictor of credits rather than a reactor to credit changes?

MR. CHEW: I knew it was a danger exposing our end of the business to a parliamentary debate. [Laughter.] For that very reason, I think I will dare not speak for the rating agencies.

Interestingly enough, in fact we did hammer home a number of these issues for merchant projects, and that is one of the reasons why we rated virtually none of these projects. Our requirements, we were told seven or eight years ago when we put out our first paper on the subject, were absolutely outrageous in terms of our projections for price decline and in terms of the limits we wanted on lever-age. We were just out of the market. In fact, the lenders, we were told, were just delighted to lend at much higher levels of leverage and much lower levels of coverage.

Obviously, there are things we missed, but on the funda-mental issue of merchant project finance, I would argue that Standard & Poor’s was very much on target.

MR. SCHROEDER: Larry Kellerman, given the lack of creditworthiness of the counterparties in the merchant power business, do you think there is an opportunity for players like the big oil companies, Goldman Sachs, Morgan Stanley and others with big balance sheets to fill the void, take some risks and make some money? And do you think the risk for them is worth the return given the failure of some former blue-chip names who thought they were appropriately skilled to take those risks?

MR. KELLERMAN: There are not enough of us around to fill that void, and the reason is because there has been such a huge amount of overbilling. When you have reserve

margins the way they are today, there is a great trepidation to step into the merchant space. That point not withstanding, what you really need in order to optimize a merchant asset is a trading floor and the willingness to do proper risk management around that asset.

There is a growing handful of firms — Wall Street firms and some of the other larger integrated energy companies — that do still have an appetite and for whom trading is not a four letter word. That’s very important as the entire merchant sector has moved out of trading because the merchants have done a really bad job of it. It isn’t that trading is a bad thing. It is that merchant energy traders, most of whom have been centered in Houston, have done an awful job at trading. Those who can do a good job of trading — who tend to be centered more around the periphery of New York than around the 610 loop — have done, historically, a much better job of trading. And those, frankly, are the natural owners of assets for which you need trading to optimize value.

Therefore, I agree with you that either Wall Street firms, financial institutions, or large integrated energy companies are the right owners of those assets. There just are not enough of them around to solve the problem in whole.

MR. SCHROEDER: That answer scares me. I have heard the same point from some of your former colleagues at El Paso and others in the trading business. I am not sure that, just because you are in the trading business and are based New York City, you are in a better position to take on the risk without the customer base for the commodity.

MR. KELLERMAN: A firm like Goldman Sachs has been trading for over a century. We actually do it fairly well. Other firms that got into this business several years ago did not have the controls, did not have the systems, did not have the right grounding and management. People above me at Goldman Sachs understand trading. I don’t want to talk about my former employer, but there are very few in top management in the merchant energy space who really understand trading.

MR. WOODRUFF: This question is for Larry Kellerman. Why would a company like Goldman Sachs or any other trading organization need to own or control power plant assets if it chooses to speculate on commodity prices? And second, this talk of “managing or trading around the

assets,” doesn’t it blur the distinction between speculation on commodity prices, on the one hand, and the fundamental engineering and operational aspects of managing the assets, on the other?

MR. KELLERMAN: Good questions. The answer to the first question is the reason that a firm like Goldman Sachs and a number of other financial firms that are represented here today are interested in the asset space is because we don’t speculate. Speculation has been a hallmark of a number of the activities of merchant energy firms. Firms like Goldman Sachs and other firms manage risks, but they do not speculate. They do not take major long or short positions without having those positions effectively hedged. The electric power business, unlike a number of other businesses around which trading occurs, has a very, very strong physical component. And to be an active player in the traded markets in electric power means that one should not ignore the physical aspects of those markets, so that what a firm like Goldman Sachs sees is very strong synergy.

Trading can amplify the returns otherwise available from a power plant that is devoid of a trading capability. An asset can be put into an environment where that asset can be risk managed even if it is a contracted asset, where one has optionality in fuels, where one has optionality between generating or supplying the power by buying it elsewhere in the market. Those values can best be perceived in both forward markets and in real times where one has the integration between both the physical plant and a trading floor.

One of the key values that trading provides in any marketplace is the unleashing of the embedded optionality resident within positions. That can be done in a financial sense through extracting optionality, through trading derivatives around the product that exists. When one has a physical plant that offers different added forms of optionality in the form of “I can run, I cannot run, I can use A fuel or B fuel, I can sell to this market or that market based on my transmission interconnections.” That only amplifies the financial optionality that already is resident within a good solid trading floor and expands the number of options, the number of different parts that the trading floor can exploit.

I’m not trying to be too encompassing, but we’ve seen it on our trading floor. Goldman saw it with the Orion experience, which was a very positive one for Goldman obviously having gone out at the right time, but it is also seeing the current environment as a good opportunity to be able to buy the right assets at the right price.

MR. WENNER: This question is for Leanne Bell. The US government — through the Federal Energy Regulatory Commission — is pressuring the industry to keep generation separated from transmission and distribution functions. Indeed, Bob Mitchell from Trans-Elect said yester-day that there are additional basis points for his transmission company because it is only engaged in transmission and, were it to become a generation owner or affiliate, it would lose that benefit. There is also an issue that arises when one tries to put a merchant plant back into rate base. It goes in at the depreciated original cost, meaning that the returns might not be so juicy. How does this fit with your view that all the assets are headed eventually back into the rate base?

MS. BELL: Have we paid all our Chadbourne bills I guess is what it’s coming down to. [Laughter.]

We absolutely are participating right now in a vacuum and making as much money as we possibly can. I stand by my view. I will be around in 20 years because it may take that long to play out. But I actually do believe that over time this business is going to aggregate. Folks like Don Kendall will be part of the process against folks like Tom Kilgore over time. The aggregators will take all the fun out of whatever game we play in the next couple of years. They will come in with an early 15% after-tax return and then ultimately decide that it really is only 10%. And that is when you create

an opportunity for the investor-owned utilities again. They grab these assets, get the returns, make the case to their regulators, and we’re back to a different, but somewhat similar game to the original mess. I stand by the point.

MR. SEPLOW: Gail Nofsinger expressed strongly the views that banks should take possession of these assets they have lent against, and I have no doubt that Gail and other bankers will act on that at some point in the future. Once you get these assets, what will you do with them? How will you manage them? How will you liquidate the value in those assets in order to pay off your loans?

MS. NOFSINGER: None of the banks really wants to own the assets. Ultimately we want to get our money back that

we lent. To the extent that we can work together with the developers in the troubled projects to get out, we certainly would prefer that. It is a question of whether the sponsor is still creditworthy. Does it have the ability to put more equity in? Is there a way to get us through this situation? If we do end up owning the assets, there are lots of

capable operators who can be hired on a contract basis. Years ago, I used to lend to the waste energy business and lent in recycling, and I thought I had better not lend to this plant unless I want to be there picking the garbage off the conveyer. I feel like I am in that position today. I really do not want to be operating the power plant. I do not look good in a hard hat.

MR. SEPLOW: Can I ask Don Kendall, as someone who has been buying up debt of distressed projects, through what process will you realize the value that turns a nice profit on your investment?

MR. KENDALL: Unfortunately for us, or perhaps fortunately, what has happened is the high-yield bond funds have way too much money right now. If you look at our portfolio, the average price of bonds was in the 80’s when we bought. Almost all of them are returning at par or above today. How we are getting out is by selling the debt to the dollar investors and the high-yield bond funds. We do not see rational value at the prices at which the bonds are trading at today. So we will be doing more liquid things. Basically, we are buying something that is liquid so we can trade out of it. We are also trying to make sure we have done enough homework so if we are stuck with it, we know we can hold the debt and clip the coupons while it is being paid on a current basis or else be comfortable enough should we have to foreclose that there is economic value in doing so.

MS. BELL: Don Kendall, how do you manage to take over an asset and outsource the dispatching function and the O&M function where you’re outsourcing to two separate entities? How do you anticipate managing that process? Do you go to a toller and then go to an operator and they’re different without losing some synergy in the middle?

MR. KENDALL: Clearly, I think what the banks are focused on today is the O&M side. There are many people who will contract the O&M. What I think the banks are missing, and we have not solved it yet, is the risk management function. I don’t know whether Larry Kellerman at Goldman Sachs will be willing to provide that service to third parties. I have had three groups approach me wanting funding to start up a risk management business to run the banks’ assets.

MS. BELL: Will they also handle the O&M function, or will the banks still have to find a separate operator?

MR. KENDALL: Each bank situation is different, but my view is the banks will step in on some of the energy projects. It is easy to find a contract operator. It is not easy to find someone to handle the risk management side. At least that is our judgment so far. One of the reasons we are not buying distressed assets yet to control plants is I don’t know what I am going to do with a plant once I own it. If it is a contracted plant, it is reasonably easy, but you still want to optimize around the contract. Someone here may have solved the problem, but I don’t think many people have.

MR. KILGORE: Can there really be a third-party market for the risk management function? Isn’t there a conflict issue? Larry Kellerman is so good at this stuff. If he was marketing the output for your bank, isn’t there a risk that he would run it for his position and not yours? It would be impossible to sort that out.

MR. KELLERMAN: You’re right. It is very difficult for any trading company to put a box around a given asset and say this is the asset, and I am

only going to trade around that asset. It is hard to disentangle oneself. Whenever we have been approached with that kind of opportunity, we have said simply that we will give you a price. Let’s say there is a distressed combined-cycle gas-fired plant. We will say, name the period of time that you want to get this off of your system, and we will buy the tolling off of it. It may not be as good a number as you would like, but we will give you a good, solid, reasonable bid-sized offer, and we will take it off your hands and give you revenues for one year, two years, whatever period of liquidity you require. But when someone asks us to trade around an asset for him, that appears too ridden with conflict, and we have not figured out how to do it.

MR. CHAUDHRY: What is the road map, if there is a road map, for merchant companies to become solvent again?

MR. KILGORE: That’s a very good question, and I think it really depends on the nature of the merchant energy company, or former merchant company in our case. Having lost many great people to other institutions, we made merchant energy a non-core business segment and have been liquidating it rapidly since then. To return to best status, I think, one, we need to sell assets prudently. Two, there are sustained higher prices for basic commodities right now. We may not see it in electricity right now, but we certainly are seeing it in gas and fuel commodities. That gives us earnings power to return. Companies need to clean up the balance-sheet confusion by getting rid of mezzanine levels of capital. This is not something that will happen on a real-time basis, but rather over a period of at least a year or two. For some companies, it will take longer. Finally, you continue to argue your case vigorously in front of the rating agencies that just because they were slow in catching the knife on the way down doesn’t mean we need to be perpetually put in the basement until things move forward. We do that, and it is often well received if not quickly acted upon.

MR. CHEW: It may seem like the plummet that happened overnight, but the forces that generated it gathered over time. It will take some time to work out of the current situation. The asset sales and de-leveraging of the capital structure are key points. One other point is the need to get back to real, recurring operating cash flow. An awful lot of what passes for cash flow in this industry is still financing activity. You have to wash that out and get back to basic ratios.

MR. POLSKY: There are a lot of businesses similar to power plants — conversion businesses where you take one commodity and convert it to another one, and you get a final product. I might argue that a power plant is no differ-ent than a refinery. However, there is a tendency to view them like mines. Everybody thought that if they built a power plant, somehow they would create inherent value as if they placed a commodity in the ground — sparks in the ground.

Here is my question. Why isn’t a power plant just a broken business and until you create a business, there is no value there? Why do the banks feel that by simply locking the door on the power plant, it becomes worth more three, four or five years from now? Where does it say that a business with a lock on its door becomes more valuable three years from now than it is today?

MS. NOFSINGER: I don’t think the banks want to close down the power plants. We want to get our money back. I’m not involved in any plants where we have actually locked the doors.

MR. POLSKY: But why do you feel that in three years, it will be worth more than it is today?

MS. NOFSINGER: The consultant reports. At some point, the power could be valuable. Maybe today it is not.

MR. POLSKY: The point I’m trying to make is the power plant is just a conversion place. It is not like owning gas in the ground. With power plants, you have to buy inputs, you have to convert, you have to structure the business properly, you have to produce outputs, and you have to decide how you sell output. Just because the electricity price is going up does not mean the power plant has value.

MS. NOFSINGER: I guess our point is we are looking for cash flow, and if it is costing us more to run it than to shut it down, why would we run it? At some point, the banks will sell it for a loss and take a writeoff.