US Fire Sale?

Most merchant power companies in the United States have been under pressure from the rating agencies and the banks, since Enron collapsed, to sell assets in an effort to pay down debt. Private equity funds have organized to buy power plants. Yet, the big selloff that was predicted has not occurred, in part because a wide gap remains between the prices at which the current owners of the projects are willing to sell and the prices at which those with money are willing to buy. The following are excerpts from a discussion that took place in April at Chadbourne in Washington.

The panelists are Jay Beatty, a prominent investment banker with long experience in the utility sector and who is currently managing director of New Harbor, Inc. in New York, John Cooper, an independent director and consultant who was, until January, senior vice president and principal financial officer of PG&E National Energy Group, Tony Muoser, a managing director of Citibank, William Conway, a principal in a new company that is raising private equity to buy distressed energy assets, Charles Wilson, director of business unit finance for Duke Energy Corporation, Dr. John Paffenbarger, a vice president at Constellation Energy who manages the company’s search for power plants to buy and who was principal administrator for electricity at the International Energy Agency in Paris from 1995 to 2000, and Robert Shapiro, a utility lawyer at Chadbourne.

The moderators are Roger Gale, president of GF Energy, an energy consultancy in Washington, and Keith Martin, a Chadbourne partner and editor of the NewsWire.

MR. MARTIN: The question before the house is whether the United States is the right place and this is the right time to be buying power plants that are for sale.

Future for Merchant Plants

MR. GALE: I recall some interesting aphorisms. Those who have the best aphorisms are not always the best performers. One aphorism that Enron used often was the New Hampshire state motto “Live Free or Die” — and, of course, it tried both. However, it had another one: “The best way to tell whether competition is working is to show that there are failures; that winners and losers prove that the underlying conditions for success are present.”

With that thought in mind, I would like to ask each of the panelists, starting with Bob Shapiro, whether — despite the failures in the US power market which are obvious, and despite the terminology we are using today, “Fire Sale,” which denotes things aren’t going well — we have an industry that will recover, and are we going to have enough buyers and enough potent and capable, well-credited people to run this business in the future? Or are we in a very, very long insoluble kind of situation?

MR. SHAPIRO: The short answer is it will take time. Part of the problem is we have tremendous regulatory uncertainty in this country. For example, we thought that we had put to rest questions about sanctity of contracts. Yet, the California experience has shown that when things get bad enough, there will be pressure to reopen contracts. The Federal Energy Regulatory Commission has the opportunity in the next several weeks to bring more certainty to the market by how it rules on the effort by California to set aside long-term contracts it signed to buy electricity when electricity prices were at their peak. A majority of the commission has signaled an interest in maintaining the sanctity of contracts. Such a decision could begin to rebuild the confidence in the US regulatory scheme that is essential to facilitate transactions.

MR. PAFFENBARGER: The short answer is, from 1997 to 2000, something like 100,000 megawatts of generation changed hands in the US. By 2001, it was clear the party was over. In 2002, equity holders, who had taken on a lot of debt to build or acquire their generating assets, suddenly realized they were in financial trouble and started a process of trying to get some cash out of those assets. It took the better part of that year for them to come to the realization that the value they had ascribed to those was assets was too high. I think it will take some time this year to discover the true value of the assets.

MR. BEATTY: I think we are still searching for the business model where these assets can be put to use. Historically, it was thought that if you had the asset, you had a business. That is not true in other areas of the economy.

We have today investor-owned utilities where load and generation are hooked together. For businesses that are just a generation business, we need a better notion of what assets one needs to make a go of it and what a successful generation-only business model looks like.

One of the queer things that we probably have learned — and it is surprising that it took us so long — is that if you are in a commodity business, you really cannot have 50, 70, or 80% percent debt. Large oil companies have 10 to 15% debt.

MR. COOPER: Let me build on what Jay said. I do not see a long-term viable future for standalone merchant energy companies. In order to have merchant generation, you need a risk-management function — call it trading, call it whatever. In order to run a viable risk management function along with an asset portfolio, you need significant amounts of capital, much more than the model that was developed before would call for. You need less leverage. I am not sure the rates of return that can be extracted from this industry will support that level of capital.

Therefore, the longer-term model will either be merchant generation hooked to a company with a large balance sheet to support the credit needs or some sort of a longer-term contractual-based industry — in other words going back to what we had under the Public Utilities Regulatory Policies Act.

MR. MUOSER: The industry will come back together. The big question is, “In what shape and form and when?” The industry is too important not to come back together again. The regulatory issues are preventing capital from flowing back into the industry. There is a political process that must be completed before banks will feel comfortable relending to the sector. Creditworthiness must be reestablished. I agree with John Cooper; the merchant power business cannot survive without access to tremendous amounts of credit.

MR. WILSON: In the long run, it is a viable business. Supply of electric energy is a public need. The forward price curves suggest a recovery across the country in the next two to five years. In some regions it may be sooner than that. We are already seeing it in pockets of the west.

The likelihood that new power plants will be built in the future is extremely low. Significant new construction may have to wait until the next round of deregulation. We are currently in a type of halting deregulation. The last couple years proved that halfway deregulation is worse than no deregulation. Money was invested on the assumption of a continuous and basically homogenous nationwide deregulation scheme that has not come to pass. After California blew up, everybody stopped. For instance, Duke has both a regulated and unregulated business. The regulated business was teed up and ready to divest its generating assets. Divestiture has stopped cold in the Carolinas, and it probably will not restart until the Federal Energy Regulatory Commission implements its plans for standard market design.

MR. CONWAY: There is nothing fundamentally wrong with the independent power industry. We got here because of over-exuberance and anticipation of supply, excessive leverage, and — let’s not forget — greed. When you look at the industry fundamentals, they remain good. It is much too late to put the toothpaste back into the tube when it comes to competition. Yes, we will see regulatory retrenchment, but not an end to competition. Independent power is here to stay. I don’t know yet what is the right business model for the industry going forward. In the short term, we are in for more financial turmoil. Obviously, the reason we are all here today is some of us see an opportunity to profit in the midst of that turmoil.

Why Few Sales?

MR. GALE: When we first began thinking about this workshop, we were of the view — a bit more than we are today — that we would see a fair number of projects sales in 2003. There would be deeper pocketed people, if we could find them, buying these distressed assets — a typical fire sale, as we called it.

Here we are in the second quarter of the year, and we are not seeing a high volume of transactions. And many people are not expecting a huge barrage of ownership changes. Why don’t we have a large number of transactions? What do you foresee for the remainder of 2003?

MR. CONWAY: I think one must think of this in risk and reward terms. Transactions have closed. The deals that are closing are most with long-term offtake contracts and creditworthy offtakers. There is plenty of capital available buy those kinds of projects. At the other end of the spectrum are the projects that present pure merchant risk. You have a lot of private equity waiting around the edges, waiting for capitulation on price.

The most interesting spot is in the middle where one finds quasi-merchant situations — for example, projects with short-term rather than long-term contracts. There is an opportunity for creative people to figure out how to do deals in this middle ground.

MR. PAFFENBARGER: I’m still looking for the catalyst that makes these transactions happen. I wrote down a headline from The Wall Street Journal last week, “Banks Stand Tough, But Avoid Squeezing Energy Firms on Loans.” I think it will take time this year for creditors to come to a better understanding, through the sales that do occur, of the value of the assets underlying their loans. Until that process plays out fully, the opportunities will remain one-off transactions where individual companies are looking for a little extra liquidity and have a few assets to sell or companies are selling assets as part of a strategic repositioning where they want to get out of a certain region or market. I do not see a big wave. I do see a steady stream of individual opportunities.

MR. BEATTY: Certainly, it is true that contracted plants are a separate group. You are factoring a receivable; you push the F9 button on your Excel spreadsheet, and you know what the price should be, with the exception of projects that are selling to California.

The trouble with merchant plants is greater uncertainty. The AES Mountainview plant was a combination of merchant and California, which is probably too much for anybody to bear without breaking into tears.

The issue with most merchant plants is — let us assume someone just hands you the keys — do you have enough capital to withstand owning that merchant plant? It is clear, if you look at how the rating agencies view anyone who owns a material number of merchant facilities, you are in business position six or seven, which means that to remain a triple B credit, you need a funds flow for operations of almost six times interest.

If you don’t own any merchant plants, then you need only three or four times the funds flow. So owning merchant plants is almost like a contagious disease. It is the electrical equivalent of SARS. As soon as you touch one, you are infected. Under the circumstances, how do you find anyone willing even to take the keys to the plant?

The other option is to let the banks take it. Notice that the banks — even though they need liquidity and receive ratings just like any other company — don’t have this infectious disease problem, at least not at the moment.

There really are no other options. Of course, you have the private equity funds circling. The trouble with private equity for merchant plants is that they do not have credit. They have lots of cash, but they have no credit.

As John Cooper pointed out, this is a risk-management business. People do not just arrive with trucks and take electrons away every day. Somehow you have to manage risk. You have to enter into collateral agreements. You have to have credit behind contracts. The better the terms of the contract you sign, the more credit you have to put behind it. Private equity funds have lots of money, but they have no credit.

MR. GALE: So, there are no knights out there for some of these plants at this time?

MR. BEATTY: There are very few. The amount of Arab money left in this world, as you probably found, is small.

MR. PAFFENBARGER: One thing we should add to the description you have given — which to me sounds dire — is customers. A company with load-serving obligations can match the merchant risk with its customers.

MR. BEATTY: Or, another way a plant can be matched with customers is by turning it back into contracted plant. Remember, you have two choices: Do you want to play the merchant game or do you want to be a contracted plant? If you are a contracted plant, then you are back to factoring receivables. I can do that. But keep in mind the way the Financial Accounting Standards Board is heading, if you enter into a long-term contract for a specific plant, that contract must go on the balance sheet.

MR. CONWAY: It does, but I think that load-serving entities are not as tough on sell-side credit as traders. At least that has been our experience.

There may not be much ability to turn merchant plants back into contracted plants with 10- or 15-year contracts, but there is room for 3-year contracts, and if the private equity funds have enough confidence in business cycles — prices will eventually turn around — then they are going to invest.

MR. GALE: Bill Conway, with whom would you sign those contracts?

MR. CONWAY: Load-serving entities.

MR. GALE: What entities are solid enough to do that?

MR. CONWAY: Electric cooperatives, municipal utilities, and investor-owned utilities. They are not as bad as traders when it comes to sell-side credit.

MR. GALE: Tony Muoser, from the banking perspective, are there many players with whom a new merchant owner could sign a contract to supply electricity and whose credit would support financing for the power plant?

MR. MUOSER: A very small number. I agree with Jay Beatty. A much smaller number of project sales has taken place than anybody expected. The projects that have been sold have had good contracts with end users. It is difficult to finance a contract with a trading company on the other side. Anyone planning to own a merchant plant must be part of a big trading operation with credit. There are very few parties who can offer that right now. The banks are in the process of evaluating whether to take over plants or not. A key question for banks in this position is how much more money they would have to spend to put the plants into operation. Many are still under construction.

More Consolidation?

MR. GALE: The common wisdom is that competition leads to consolidation. Over the medium term, the big players get bigger and eventually four or five players command 40 or 50% of the market — just as has happened in banking. Is that where we are headed in the power sector? There may be plenty of smaller niche players, but will it take consolidation among the larger players to get these assets realigned and repackaged?

MR. MUOSER: I think there is a new process going on where new entities are entering the market specifically for the trading business. These entities have strong credit. They are still small in number, but it is progress. This opens up possible solutions to the banks’ dilemma. Some risk could be shuffled to these new entities. The question is at what price.

MR. PAFFENBARGER: I’m not a student of other industries, but I think in this one, mergers will be difficult to pull off right now. The debt load of many of the companies that are in financial trouble prevents it. You can get a nice package of assets if you have a huge amount of cash or a strong balance sheet, but you have to accept the liabilities if you are doing a merger. That is a huge obstacle to further consolidation. It will take time for the credit deficit to work off.

MR. WILSON: Add to that the taint from the trading and marketing scandals and litigation. We don’t see the picture clearing up — certainly not in California — for a while.

MR. GALE: Jay Beatty?

MR. BEATTY: There’s a problem with consolidation in trading businesses. No trader really wants to own much more than 15 to 20% of a market, because if you own much more than 15 or 20%, you are the market, and that’s not your business. You want to be able to lay off risk and move it around and trade. Therefore, consolidation cannot lead to a situation where you have fewer than 10 or 12 companies because below that level, you do not have a functional trading market. It is not even clear that you do at that level.

Market power creates issues, not the least of which is a financial problem for companies that hold it. How can you hold all that risk, because you have nobody to lay it off against?

MR. WILSON: The consolidation model was the one people were chasing when they thought things were going to go right. The theory was that a lot of people would jump in, and then a lot of people would sell to the bigger guys or be gobbled up like Pac-Man. Eventually, you would have five to 10 major, dominant generators because of the economies of scale. But that was all predicated on continuing deregulation, homogeneous deregulation improvement, and not degradation and strained credit.

The only people who are getting into the trading area today are banks. Banks have taken out marketing licenses, and they are just dabbling right now. They are seeing if they can make any money by bringing a balance sheet to it. Even Duke has struggled in this market, and we are one of the bigger, more well-capitalized players. We don’t have the appetite to consolidate, because every time anyone talks about consolidation, the rating agencies come down on you like a ton of bricks.

MR. GALE: So, we have no one who can buy the worst assets. We have no one who can manage the trading. What else don’t we have?

MR. SHAPIRO: We also have the rating agencies telling us that that this is a bad business to be in. And we have regulators who are saying that they do not like the volatility of merchant or spot and who want to drive the industry back to longer-term contracts. I think most of us believe that would be a good remedy for this industry — to return to contracted assets.

The problem is you do not have a federal law that mandates it. You have standard market design proposal from the Federal Energy Regulatory Commission that is strong in content, but weak in implementation because the states are not buying into it. You do not have any real interest by state regulatory commissions to force the utilities to contract for long term power. The commissions are not sure what the regulatory model should be if they are going ultimately to deregulate, eliminate the load-serving requirement, and install pure retail choice. Why saddle their regulated utilities with long-term contracts while the outlook is so unclear?

MR. COOPER: What else do we have? We also have an asymmetric risk profile in the US power industry. Traders and merchant generators are looking to make money when prices are high or when there is significant volatility. However, because electricity is perceived as being in the public interest, when you have significant volatility or price spikes, they are likely to be capped by regulation. Thus, one ends up with all the downside, but with no ability to recoup from the upside.

MR. PAFFENBARGER: I do not want there to be left the impression that no one is willing to buy. Constellation is in the market. We are looking for assets. We have a strong balance sheet. We have a trading organization. We have investment quality credit. The ingredients are there.

We talked earlier about contracted assets. The advantage of contracted assets is they give a price signal. Merchant assets are more difficult to value, but we are looking for merchant assets as well.

MR. COOPER: Granted, there are buyers, but the problem also is the bid-ask spread. Everybody is looking at similar price curves. The banks expect that things will eventually return to normal when their loans will once again be worth 100 cents on the dollar. The bids today are significantly below that figure. There is no incentive for those who own the assets not simply to hold the assets for a couple years until the market turns around. The situation cannot get much worse than it is already.

It seems to me there is an intermediate stage. Maybe there is a risk-sharing model that could evolve between those who hold the assets and people who want to invest without actually buying them at a deep discount. There is room for people who are willing to inject capital for a share of the upside when it accrues, but without having to take a lot of the downside risk.

MR. BEATTY: I would also say that the ability or the willingness to take merchant assets in PJM [the Pennsylvania-New Jersey-Maryland power pool], or the northeastern US generally, is higher than in other places. This has been particularly true in the past couple weeks as you see the amendments that are being added to the national energy bill in Congress. Mr. Conway knows this a hell of a lot better than I do, but it looks like the ability of the Federal Energy Regulatory Commission to regulate this industry is in danger of being curtailed, and it is putting a pall over potential transactions in the southeastern US and other places where it was hoped that a single market design might emerge.

Regional Differences

MR. GALE: Let’s pursue the regionality that you are raising, Jay Beatty. Do you see recovery and restructuring varying in time by region — perhaps because prices firm up in some places earlier than others and recovery of asset value is easier to determine? You mentioned PJM and the northeastern US being relatively stable, and the south being highly perplexed by what’s happening in Congress.

MR. BEATTY: Well, historically no one could build in the southeast, and no one can build there today. It’s a regulated box. All you have to do is walk over the line into the south central US and ERCOT to find a much different environment. The West, in many ways looks great. But you have the sense of garlic and crosses out there. You do not want to get too close to it.

MR. CONWAY: Half of life is just showing up.

MR. MARTIN: What’s the other half?

MR. CONWAY: The other half is perspiration, for sure. The turmoil about which we have heard so much this morning creates opportunity for the next generation of new companies. That is why you would think there is a greater chance today than before of creating something new, precisely because the market is open only to those who are willing to take a chance.

As for what is happening in Congress, energy legislation is very hard to enact. A bad idea has an awfully long way to run before it makes it to the finish line. I don’t get terribly worried about the latest crazy notion on Capitol Hill because I count on the fact that eventually it will iron itself out and someone will reconsider.

MR. WILSON: I think you need to add to the regional differences another factor, which is locational-based pricing. This is part of the standard market design that the Federal Energy Regulatory Commission is proposing. Anybody buying a power plant needs to keep it in mind. Focus first on how advanced the local deregulation is and in which direction regulation is headed. Focus next on how the power plant would fare if locational-based pricing is implemented as proposed by FERC. This takes a lot of very complicated modeling.

For instance, we have a plant in Maine. Maine is an interesting situation, because a bunch of people went up there and located plants, ignoring the fact that there is a transmission constraint. The power is needed in Boston, but it can’t get there. Locational-based pricing is a way of pricing for transmission of electricity so that the right economic signals are sent to people who might build additional transmission lines.

MR. MUOSER: It has become a key criteria for the banks in making decisions about what to do with some of these assets. Regional differences are very important. We are much more aware of the transmission issues. There are situations where we have power plants with contracts, but the offtaker is in serious trouble, and it may be difficult to move the electricity to someone else because of transmission constraints. No one paid enough attention at the time to transmission issues. They are weighing heavily now in our consideration. For us, taking over a project means we have to have an exit strategy, because banks do not want to hold on to these assets long-term.

MR. MARTIN: Bob Shapiro, what is locational-based pricing?

MR. SHAPIRO: The value of a power plant depends on whether it can get the electricity to the customer, or load. There is a cost to moving electricity from the generator to the purchaser of that power.

MR. MARTIN: It is the charge for transmitting the power across the grid?

MR. SHAPIRO: There is a wheeling charge, but there is also a separate cost that must be reimbursed for adding to congestion.

MR. MARTIN: So, to pick up on what Charles Wilson said, if one buys a power plant in Maine hoping to ship the power to Boston, the cost of moving the electricity is more than just the wheeling charge. There is also a congestion charge?

MR. SHAPIRO: It can be even more expensive than appears at first glance to get the electricity to load.

MR. WILSON: The owner of the power plant realizes a lower price than he would if the plant was located near the load center. PJM is the only market that had locational-based pricing from the start. The PJM grid has as many as 1,600 different nodes. You could have up to 1,600 different prices in theory to transmit power across the grid, whereas other grids have charged a uniform price in the past to all users of the grid.

MR. MARTIN: This is the cost of transmitting the electricity. A node is a place where the owner of a power plant can connect to the grid?

MR. WILSON: The node is where the generator essentially is.

Two Kinds of Projects

MR. MARTIN: I heard the group of you talk earlier about two types of power plants — ones that have long-term contracts and pure merchant facilities that do not. John Paffenbarger, you made the point that there are buyers who are interested in both kinds of projects. But the greatest interest is for the projects with contracts? Is that correct?

MR. PAFFENBARGER: Not necessarily. We would have an interest in contracted projects, but we have a regulated utilities business as well. You can call us a merchant utility. We own merchant plants. We try to have a mix of steady cash flows from regulated activities, plants with long-term contracts, and plants where you are selling to the merchant market. There are both contracted plants and merchant plants. We are looking to grow both sides of our business.

MR. MARTIN: Are prices for projects with long-term contracts pretty much at the bottom now or are they expected to fall further?

MR. PAFFENBARGER: I don’t think they have changed.

MR. MARTIN: There’s no change? They are not going up, and they are not going down?

MR. CONWAY: It is a war of who has the lowest cost of capital. That’s all it is ever going to be. There are plenty of players who want quasi-annuities. There will never be any end to capital that will come into those deals.

MR. WILSON: I think that you view the market as having segments. You have high-quality assets; we talked about contracted plants. You have low-quality assets that we typically call merchant. Then you can divide the contracted assets into lower and higher quality, as well.

I think the better assets have been sold. They have already changed hands because they were the ones that people who were in desperate need for cash could sell quickly. I include in this category things like gas pipelines, gas storage facilities and a limited number of old independent power projects. The people most interested in contracted assets are the financial buyers. They are financial engineers.

Then have a separate group of strategic buyers who have balance sheets, and maybe a viable trading and marketing operation. They might be a little more adventurous in a selective way and chase the lower-quality assets.

MR. MARTIN: What makes a long-term contract high or low quality?

MR. WILSON: The creditworthiness of the offtaker. All you are left with in this market are the lower-quality contracted assets. An example is a power project where the offtaker is a trading and marketing outfit that has been downgraded close to bankruptcy level.

MR. MARTIN: Bill Conway, what’s the key to winning a bid for a contracted project?

MR. CONWAY: Have the lowest cost of capital. You might get lucky and see something that no one else sees, or you might have a creative idea for restructuring, but fundamentally it’s going to turn on who has the lowest cost of capital. There are new players appearing on the scene who meet this criteria who have never owned a power plant and who do have a low cost of capital and a low return expectation.

MR. COOPER: Another thing that makes contracted projects attractive is there are so few other opportunities to earn a reasonable return. Therefore, even high single-digit returns may be attractive in the current market. Where else can you buy a bond at that rate?

Price Gap

MR. MARTIN: Bill Conway, coming back to you again, you made the point earlier that what people are waiting for on the merchant assets is capitulation on prices. How big is the gap between what buyers are willing to pay and sellers want to receive?

MR. CONWAY: Wide in my experience. I am sure Tony Muoser can speak to this, but my impression is that the banks want to see 100¢ on the dollar. Perhaps if they can see 100¢ on the dollar coupled with an extension of time to repay the debt, some risk sharing and an adjustment in the interest rate, some sales of merchant assets will occur. However, the notion that there will be a fire sale on a brand new, highly-efficient, combined-cycle gas unit — it is not going to happen. The banks understand that such power plants have fundamental value. They will not let them be sold at distressed prices.

At the end of the day, the banks do not want to be in the business of power generation. If they see a reasonable deal that respects value, they will try to work it out.

MR. MARTIN: How big is the gap between bid and ask prices?

MR. COOPER: I don’t know what the gap is, but the reason the expectation is there that merchant plants will at least have the value of the debt at some point is simple. And it is probably valid. Say a new combined-cycle gas-fired power plant is the most efficient asset in the fleet. The project is leveraged at 60%, and the banks take it over. At some point, it will run no matter how much over-build there is in the local region. Increasing demand for electricity and retirements of older power plants are certain over time to give the new merchant plant value. And the wait may not be very long because we have a volatile price cycle. That is the reason why the banks are willing to hold out at 60 or 70% leverage. At some point, the cycle will recover. The bank is certain to get at least 70% of the plant’s value by selling it after the cycle recovers.

MR. MARTIN: Charles Wilson, how big is the gap?

MR. WILSON: The gap between bid and ask prices for new gas-fired assets, which is predominately what we are talking about, ranges from about 20% to 80%. John Cooper is right. Most of them are leveraged at the corporate level or the project level at around 50 to 60%. Our internal valuation is a hold case with very pessimistic curves. However, it justi-fies a 60% or more value if you have time to hold the plant. The problem is anyone purchasing one of these plants will need a lot of working capital to get through the current trough. He may not have to pay much for it, but the need to inject lots of working capital and the uncertainly about how long it will be before the market recovers is scaring off a lot of potential buyers.

Bank Attitudes

MR. MARTIN: Jay Beatty, how long can the banks sit there with these loans that are not paying?

MR. BEATTY: It depends on which banks. A lot of these syndicates have 15, 20 or 25 banks in them. A number of those banks are non-US banks — especially European banks— who are under enormous pressure in terms of their own ratings and in terms of their own political issues back home. Therefore, within the bank groups, there are distinct groups. The large US banks tend to be of the view that they have the working capital to manage this, even if the wait is three or four years before things turn around. There is another distinct group in any syndicate — 20 to 30, even up to 40% of the bank syndicate — who just want out. What’s more, they are selling their participations to people with short-term outlooks. John Cooper can tell us a lot about the frustrations of dealing with bank syndicates.

MR. COOPER: Thankfully I don’t have to do that any more. MR. BEATTY: The frustration comes from having to negoti-ate with a whole set of people who are themselves jockeying amongst themselves in the syndicate. A lot of the issue require 100% consent within the lender group to settle.

MR. MARTIN: If the banks are able to hold on, how long do they need to hold on? Is it two years, three, four before this turns around?

MR. MUOSER: It depends on the specific situation. It could be two years. It could be six or seven years. That is an impor-tant question as the bank syndicates decide what to do. If it is a two-year holdout period, then it is easier for a borrower to persuade the bank syndicate to restructure.

There are situations where the plant is not yet completed. Equity has basically disappeared. The banks thought they would have 50% leverage, but the only way to get to completion is for the banks to inject more money — in other words, increase the leverage. This is a much more diffi-cult situation for the banks than if the power plant is already completed, the debt is 50% of the construction cost, and the equity is wiped out. There is a reasonable expectation to recover the debt at some point.

The point is we need to distinguish between the different merchant plant fact patterns. It is impossible to make general statements about how the banks view the potential sale of merchant plants.

MR. MARTIN: Tony Muoser, you made the point on a conference call we had last week that Citibank has not received any unsolicited offers to purchase distressed power projects. What would it take — what would someone have to tell you — before you would be interested in selling?

MR. MUOSER: Well, let me point out first that there are not dozens and dozens of situations where we are being forced seriously to consider taking over assets. There are a few cases. The banks will probably end up with the assets where the sponsor is gone or lacks the ability to work with the banks.

In other situations, the banks are still trying to work with the project sponsors. If the recovery will be within a two- to five-year span, some sponsors might be willing to inject new money to buy themselves an option to get back on track. The banks might be flexible and work with them.

MR. GALE: Can we examine for a minute this two to five year cycle? It is predicated, I assume, on firmer electricity prices, and on gas prices being in a range that the spark spread is such that you can make a margin. What are the underlying assumptions?

MR. COOPER: The values of power plants are down because of significant overcapacity in the US market and. Many economists are predicting about a 2% load growth in a normal year in most regions. Look forward five or eight years and that absorbs 10 to 12% of capacity, which basically brings you down to reserve margins that are more in line with historical levels.

MR. CONWAY: I would say the US market will take four to five years — not two years — to recover. Fundamentally, it is demand driven.

There are limits to how much consolidation there can be in the trading business. No trader wants to own more than 15% or 20% of a market.

MR. COOPER: A lot of it has to do with what happens with deregulation. In certain regions, if electricity demand increases enough to justify construction of new power plants and utilities build their own assets and put them into rate base, then the merchant plants may be worth less than we think.

MR. MUOSER: That is an important point. We made the mistake once before with saying it is just a question of supply and demand and the markets will be perfect and balanced. Government regulation is the component that is the most difficult to assess. It may also be the case that new merchant plants will be built once demand recovers that can out compete the existing plants on which the banks are sitting. Technology could improve.

MR. CONWAY: I think lessons learned in the past couple of years will discipline the next cycle. Until you get an effective demand response in the market, you will always have boom-bust cycles. Hopefully, the next one will not be as extreme as we saw this time.

Boom and Bust

MR. MARTIN: John Cooper made the point that the merchant power companies receive asymmetric returns. They have all the downside risk of falling prices, but not all the upside benefit since electricity is too important a commodity. The regulators limit how high electricity prices are allowed to rise. Do we really have “boom and bust” or do we have “bust and a partial boom”?

MR. CONWAY: A boom-bust cycle, if it is modulated, is not the worst thing in the world. Society will tolerate it because — setting California aside — let’s remember who has suffered the most in this cycle. It has been the equity, and equity takes risks. What’s wrong with that from a societal standpoint?

MR. WILSON: What is truly wrong with the merchant model is that it is asymmetric. The theory was that you had a trading organization and some physical generation, and you knew there was going to be a lot of volatility, but you might even have welcomed it because traders thrive on price change. It does not matter in which direction.

It is no longer a viable model for a lot of reasons.

Therefore, we have to move back to a contracting model. It sounds boring, but the United States will have to move to the old independent power project model for most of the market. You will have a small segment of the power business that will sell its output in the spot market — you need this to set prices — but it will not account for a large share of the market. Most electricity will have to be sold under long-term bilateral contracts, because that is the only financeable model in this market.

As I understand the proposal the Federal Energy Regulatory Commission made on standard market design, load-serving entities will be required to purchase a certain minimum reserve margin. Who knows whether this will be part of the final rules. However, where is the best place to look for this reserve margin? It is to contract with these exist-ing plants that are sucking wind rather than put new iron into the ground.

MR. SHAPIRO: I am not as optimistic about the imple-mentation of standard market design, particularly in the area of contracting. I don’t see the legal authority for it. I think FERC is being extremely optimistic that all the utility industry’s problems can be solved merely by giving authority to a regional transmission organization. It would take years to implement such an approach. The states are not going to permit it. They are not to allow certain resource decisions to be taken over by the federal government.

MR. BEATTY: I think it is important to get away from focusing on putting iron in the ground and what happens to the plant and focus instead on what business we can construct that uses these assets. One trouble with the IPP model is that everybody is in the business of selling rectan-gles, all right? A generator wants to sell “x” thousand megawatts for “y” hours a year. That’s not what people want to buy when they buy electricity. They want to buy triangles. They want to buy shaped stuff. There is no power plant that makes shaped stuff.

What is needed is a business model of a well-capitalized company that is willing to take the risk to be a trading business. Trading businesses sell shaped stuff. Anyone trying to do a deal today has to go to a Morgan Stanley or UBS. Look at the characteristics of those trading organizations. They are highly capitalized, meaning they have essentially 80 or 90% equity. They can make a lot of money in this business because no one else is able to put together triangles. They can buy. There is a big competition if you put out a request for proposals to buy 1,000 megawatts for “x” thousand hours a year. You will have people biting off fingers as they try to get the RFP out of your hand.

The electricity itself is not the high-value commodity. The high-value commodity is the shape of power. There is room for a high-credit organization that can effectively deal with the wholesalers.

Look at how the natural gas industry has developed. You were aggregating small producers, primarily in west Texas, and then selling a package to Bethlehem Steel when Bethlehem Steel was still a good credit, or to somebody else. You were essentially an aggregator, and you were making a spread. You were buying at $2 an mmBtu, and you were selling at $3 an mmBtu. That is a viable business.

MR. WILSON: That is true at Duke. We have almost completely dropped out of proprietary trading — the highly volatile markets where people thought they could make a lot of money. Almost everything we do now is origination. It is trading around physical assets, structuring contracts and

shaping.

MR. COOPER: What everybody is saying is a very simple premise that was lost in this business, which is you need customers. But it is an integrated business as well.

That’s the reason oil companies got into the integrated business from gas stations up through oil in the ground and refineries. An independent refinery is in no better position than a merchant generator. It may make money in two years out of 10. You need a marketing or trading organization in the middle to aggregate the supply. You probably need some generating assets, but you can also buy capacity in the market.

What gets lost in all this discussion is you have to start at the other end of the spectrum, which is where the demand is — not where the supply is.

MR. GALE: What, two years from now when this market starts to recover, are the customers going to want? What kind of contracts? What will the business look like as it matures — a customer-driven business that it should have been from the beginning?

MR. WILSON: Unfortunately, with electricity prices so low at the moment, the generators have little incentive to lock themselves into long-term contracts. You are going to have to have some return in price volatility before both sides feel the incentive to sign long-term contracts.

MR. BEATTY: One striking thing about the current market if you look at the load-serving entities, if you look at the industrials, is that everybody is staying short right now. But prices will eventually spike some summer and, all of a sudden, the utilities and industrials will wonder why they didn’t put together a portfolio when they had the chance. Lock in some prices over a three-year period. Lock in others over five years. Buy some electricity in the day-ahead market.

MR. GALE: Who’s going to bundle together these portfolios and put them before the customer?

MR. PAFFENBARGER: We’re doing it. MR. COOPER: The load-serving entities.

MR. SHAPIRO: It is most likely to happen in forward-looking states — those that want utilities to contract in that way. Some states will force the load-serving entities to sign a mix of contracts. Other states that are really interventionists will not.

Sensible Buyers

MR. MARTIN: Let me bring back the discussion to who should be buying merchant assets. I have the impression from listening to all of you that a purely financial player who lacks the ability to sell triangles — as Jay Beatty put it — should not be playing in this market. True?

MR. BEATTY: In the merchant market with merchant assets.

MR. COOPER: I think they can play. They can contract for these services. You can contract with people who have viable trading operations. The question then is the cost of laying off the market risk. Will it cut so deeply into your rate of return that the returns no longer justify what the private equity funds require to play.

MR. MUOSER: I think it will be a very high cost to buy the credit, if you don’t already have it, to be able to trade. You can farm out the operational part if you do not have it, but the energy management component is key.

MR. MARTIN: Let me probe further. This view that you need a real trading operation and a big creditworthy owner in order to play in the market: isn’t it called into question by the fact that the two independent power companies that are closest to the edge right now are two utility affiliates, NRG Energy and the PG&E National Energy Group? What’s wrong with this picture?

MR. COOPER: Neither parent of those affiliates was able to support the subsidiary for various reasons.

MR. WILSON: They had too big an unregulated operation. It hits a crossover point where you are not going to let it drag down the good business. The model works where there is a better balance.

MR. PAFFENBARGER: In the PG&E case, there were credit issues at the parent level. The PG&E utility went into bankruptcy. Under the circumstances, the parent holding company had little room to support NEG.

MR. GALE: What do you think the bottom line will be in terms of the ratio of physical assets to contractual assets? You had the “Enron lites” who felt they could exist simply as traders. You had other entities that owned hard assets, and hard assets are in trouble today. What will the entities that are successful in the future look like?

MR. CONWAY: It will be a mix, but with a heavier weight-ing than in the past toward physical assets. There will still be a vital role to play — as Jay Beatty says — for the triangle builders. The lesson, if you can reason to the future from the past, is that the trading entities that survive are the ones that are backed up by big capital and are just merciless in terms of their credit requirements.

MR. WILSON: The “asset lite” model has been completely discredited, unless the environment changes dramatically. The reason is there is a lot of stealth capital. People thought they could get into it without having to lay down the capital necessary to build plants, but that was wrong because you need a balance sheet. You need lots of working capital to maintain the kind of credit required to trade. The longer the periods for which you contract, the more working capital you need. If you are downgraded, you will need even more. What all of us with trading operations discovered is that it is not that you need the capital to put immediately on the table, but you must have it available. The rating agencies are all over this. They finally figured it out. They are making very conservative assumptions about the amount of working capital required.

MR. BEATTY: If you look at the major players now in this market — Morgan Stanley, UBS and BP, certainly among the top five, if not the top six traders — if any of them has any physical assets, it does not have many. What each has is a huge balance sheet.

Foreign Buyers

MR. MARTIN: Switching gears: what would be a sensible strategy for a foreign company that is looking to invest in the US market?

MR. BEATTY: The question for a foreign company is, “Are you willing to be a trader? What business do you want to be in?” The answer to that question drives the strategy. If you want to be a trader, then you will probably need at least some assets to support the trading business. Or are you an engineering-driven company that wants to buy contracted plants because you like operating things? Those are two very different business models. People get confused because they both make electrons. If you really like operating plants, and you think you can take a contracted plant and somehow reduce the heat rate from 7,000 to 6,000, God love you, that’s the business for you. If, on the other hand, you really want to be in the business of making rectangles into trian-gles, then you must bring a big balance sheet and you will have to figure out which and how many assets you will need to support the trading operation. What we see is people get confused. They end up with a mix of the two business models. Or I suppose another option is buying a regulated business.

MR. MARTIN: John Paffenbarger, what is a sensible strategy for a foreign company looking to invest in the US market?

MR. PAFFENBARGER: If you are coming in cold to the US market, then you should try to find a partner or talent there on whom you can draw — someone who understands what has happened here in the past few years.

MR. MARTIN: Tony Muoser?

MR. MUOSER: What John Paffenbarger said is absolutely correct. Coming in from the outside, I think you would want to team up with a partner. You will need a huge balance sheet if you want to look at merchant assets. Somebody with global reach like a multinational oil and gas company would be well positioned. Anyone who can play on the gas side has the potential to create a nice integrated business with a natural hedge.

MR. MARTIN: What I can’t tell is whether there is an opportunity for such companies today in this market to pick up assets at low prices. It sounds like there is not.

MR. SHAPIRO: Those utilities or those foreign players who have lower-cost capital and lower return thresholds can play in the contracted asset game currently. And also to lower their risks, they can play in the regulated game. There are opportunities to buy transmission assets at somewhat elevated — just over typically regulated — returns in view of some new incentives that the Federal Energy Regulatory Commission has put in place. And there are still electric distribution companies to be bought at regulated returns.

MR. GALE: Let’s talk about distribution and transmission for a minute. Will there be a lot of transactions in this area in the next couple of years, and who will be the transactors and transactees?

MR. SHAPIRO: You are already seeing in the transmis-sion area some major players coming in as a form of limited partner — as the money men. You have to structure the participation in a transmission project around current restrictions under the Public Utility Holding Company Act in order to avoid becoming subject to US utility regulation as a registered holding company. For anyone willing to engage in creative structuring, I think transmission is probably a good play.

MR. BEATTY: I think there are a lot more available distribution properties for sale now than there have been in a long time. That’s a function of the fact that most of those distribution properties probably have to be purchased for cash, not stock. Therefore, most of the US players really can’t buy them. On the other hand, I must tell you that compared to six months ago, the interest among non-US — that is, European — players to buy distribution properties in this market is at an all-time low.

MR. GALE:Why is that?

MR. BEATTY: For political reasons. Look at the potential European purchasers of US distribution assets. They are almost all on the front page of the local papers.

MR. GALE:They are freedom players, are they?

MR. BEATTY: Yes. I don’t think that goes away for a while. I think that that means that European buyers of American distribution utilities are probably not in the picture, depend-ing on how the Iraq situation unfolds, at least for a while.

MR. GALE: What about Japanese companies?

MR. BEATTY: I don’t see the demand there at all, for obvious reasons. Historically, our experience has been that the Japanese have shown less interest in distribution proper-ties than generating properties, which is surprising.

MR. MARTIN: There is a perception among many foreign investors that the US is a pretty unstable regulatory environment. They have read about California. Maybe they are familiar with the debate about standard market design — this notion of opening up the market further for wholesale electricity providers. Is the United States almost like a developing country in terms of its regulatory platform?

MR. CONWAY: California has always been an outlier. It has always been a special case. When you set it aside, the rest of this doesn’t look terribly disturbing.

MR. GALE: But what about the point that you have courts and regulatory authorities looking at whether to overturn long-term contracts that California signed two years ago to buy electricity when prices were high. Aren’t there questions in the US about the sanctity of electricity contracts?

MR. SHAPIRO: If the Federal Energy Regulatory Commission comes out with an order that modifies the long-term contracts in the west that were signed during the California energy crisis, then you will have a lot of people thinking twice about investing in contracted assets.

MR. PAFFENBARGER: The US is not the only country that is still in the process of deregulating its electricity market. In fact, the Europeans are going through the same process. For example, the UK operated for almost ten years under one set of rules before realizing that the rules needed some major adjustments. The point is even in Europe, there has been a lot of discussion, debate, and changing of the rules — stop and start in certain instances. The US is no different.

MR. MARTIN: Is the trend in the US still toward deregula-tion — at least in the wholesale electricity market?

MR. PAFFENBARGER: I think we are at a standstill. MR. WILSON: The trend is to hold still for a while.

MR. CONWAY: It depends on the region of the country. For example, there is no progress toward deregulation in the southeastern US.

MR. WILSON: Duke planned to get behind deregulation in the Carolinas. It put a plan in front of the regulators to sell our transmission and distribution business and retain the generating assets. We would have had a contract with the divested transmission and distribution company to supply electricity for a transition period as was done with the utili-ties divested in New England. However, after California, that plan stopped dead in its tracks. No one wants it because electricity prices are so low in the Carolinas. No one sees an upside. There is only downside. The regulators worry they would have California all over again.

MR. MARTIN: John Paffenbarger, you were about to say something?

MR. PAFFENBARGER: I don’t mean to say there is a stand-still still in the will and activity to advance deregulation, but the visible signs of progress are going to stop for a while. The Federal Energy Regulatory Commission has a lot of work to do to push forward its proposal for a standard market design. The issues will take a while to work through.

MR. WILSON: We are not going back, and we are still moving in the direction of deregulation, but any progress will be halting.

MR. MUOSER: I think that’s why the FERC position on the California contracts will be extremely important. If there is no sanctity of contracts, then it will be very difficult to restructure outstanding debts and create a flow of funds back into the power industry.

MR. SHAPIRO: Contracts to sell electricity in this country are subject to the continuing jurisdiction of the Federal Energy Regulatory Commission as “public utility” contracts. Until the California energy crisis, there had been consistent policy that changed economic circumstances are not a basis to modify contracts. If this changes, it will be a huge blow to independent power companies, as they need enforceable long-term contracts to sell their output in order to arrange financing for their projects.

MR. MARTIN: Jay Beatty, you get the last point before we turn it over to the audience for questions.

MR. BEATTY: One of the things I see, especially with the banks — not necessarily Citibank, but the banks with a capital B — is they appear to be looking for ways to reduce their exposure to this industry. I hear this over and over again. I show up with a triple A credit, 7,000 heat rate, the perfect plan. My banker says, “You know, I’d like to finance your project, but I can’t get it past my credit committee. We have “x” billion in exposure to this industry, and I can’t see us taking on any more.”

MR. MUOSER: That’s a fair assessment. Some players have exited the bank market. They don’t want to play at the same level any longer. We have to be realistic when we talk about the size of transactions that can be placed in the market.

Certainly, we are talking about smaller size now. But we also have additional sources of capital that we can access. The bond markets are much more open than the bank market given the right structure and good credit. We recently did a transaction that went very well — contract-based, all offtake contracts with very, very strong credit. Not only was the deal well received, but it was also way oversubscribed. There is capital to invest in the right deal.

MR. MARTIN: Questions from the audience?

MR. SIEGEL: I’m John Siegel with Bechtel. If you could get a creditworthy offtaker, what kind of leverage can you get? What kind of leverage can you get today, and what do you think will be possible in a couple years from now when the situation is a little better?

MR. WILSON: That depends entirely on the term, the tenor, the price, the shape, and the counterparty credit risk. I think what you are striving for is 80% leverage.

MR. SIEGEL: All things being equal, is the leverage the same as it was two years ago?

MR. MUOSER: For contracted plants or assets, it has not changed much. The longer the contract, the higher leverage you can get. Lenders and equity investors are looking much harder today at the debt-service coverage ratio. That is the main factor that drives the leverage. Coverage ratios for contracted assets where you have acceptable credit as the offtaker are in the 1.5 to 1.6 times range today.

MR. COOPER: I was going to ask what the range is. That’s basically what it used to be. That actually used to be a triple B minus credit. I don’t know whether the rating agencies would still abide by that.

MR. RANDALL: Rich Randall from Credit Lyonnais. It was mentioned that utility holding companies must be careful about the mix between the regulated and unregulated assets they hold in order to maintain their investment grade ratings. What do you think is the proper mix between the two businesses?

MR. MARTIN: What do we think the proper mix is or what do we think the rating agencies think it is?

MR. RANDALL: What the rating agencies think it is.

MR. WILSON: That’s a tough one because it depends on the stability of your regulated business. I would say that if your operating income from the unregulated businesses exceeds 50% of total operating income, then the rating agencies start getting really nervous. They will look very carefully at the business risks and leverage levels. On the unregulated side, they want to see people getting their lever-age down to 40% or less, and they are willing to live with 60% or maybe more on the regulated side. That leads to a blended leverage in the 50% range. A lot of companies are way above that today, and they are working hard to reduce their debts.

MR. PAFFENBARGER: I believe our mix — in net income terms — is about two-thirds merchant and one-third regulated. That appears to us to be sustainable and adequate.

MR. MARTIN: The following question from one of our viewers over the web — Patrick Burdett of El Paso Corporation. “How will geographic region and heat rate affect the wait until plants are back in the black? It seems that highly efficient merchant plants in regions with less efficient power should be getting economic dispatch really quickly.” Any thoughts from our panel?

MR. BEATTY: Everybody who has a plant in the south central US believes that. And it may come to pass, but it is certainly not true today. One of the problems with the dispatch models is they rely too heavily on forward price curves for electricity and overlook the fact that dispatch decisions turn on the relationship between the economics and how the market actors operate — politics with a small “P.”

MR. WILSON: Look, these models were suspect from the beginning. It’s the proverbial “garbage in, garbage out.” You have to look closely at the region. Another huge factor that the models sometimes get wrong is the retirement of exist-ing utility assets. Halting deregulation kept retirements from happening. You have a lot of plants that are very inefficient at the margin, but they don’t have any fixed costs. The models also got wrong the expectation that environmental regulation would become increasingly stringent and start forcing retirements. The merchant power companies and the banks put too much emphasis on the models. Depending on what region you are in, a 7,000 heat rate sounds great on the surface, but if you are competing with an 11,000 heat rate steam unit that has no fixed costs, your plant will not be dispatched.

MR. MUOSER: The problem with the credit analysis is the models got these things wrong. As we are re-evaluating some of these assets, we are learning also that the transmis-sion aspect looks much different than it did two or three years ago.

MR. PAFFENBARGER: I’ll make the sole vote as someone who says that in certain markets, the plants will be dispatched more or less as expected. I don’t think all the markets are dysfunctional.

MR. GALE: Is there a consensus about the level of retirements? Obviously it will vary from market to market, but will there be a significant number of retirements of the old amortized units?

MR. PAFFENBARGER: The biggest single factor is environ-mental regulation, which is not yet clear. I’m talking mainly about coal-fired power plants.

MR. WILSON: Some of these plants were bought by the merchant power companies. They are the ones who can least afford continually to invest in them. Those plants will go off line quickly.

MR. COOPER: Another assumption that was underlying these models was retirement of a lot of nuclear plants, and you are seeing re-licensing of nuclear plants, which has altered the economics in certain regions where you basically have very large units that are likely to stay on line for another 20 years.

MR. BEATTY: And gas prices at $6.00 to $7.00 have not helped this process.

MR. GALE: So, the bottom line is the higher the gas prices and the less environmental ratcheting up on the old plants, the more likely we will be to see the large old coal-fired and nuclear baseload plants continue to operate, which will tend to put more pressure on the new plants?

MR. PAFFENBARGER: I would almost take nuclear out of the equation. Unless there is some unforeseen event in the industry, they will keep operating for a very long time.

MR. MARTIN: Next question?

MR. RUSH: I’m Barney Rush. I’m currently on my own, but previously I was with Mirant Corporation. My question is: even assuming that the conventional wisdom is correct and there is some massive rescheduling of debt that will allow these merchant power companies to get through the next couple of years, what happens to them then? Assuming they are operating their power plants but they are still very weak credits, what’s the future for them? Do they end up having an independent life? Do they end up being merged?

MR. BEATTY: He gets the best question of the day award. MR. RUSH: All I need is an answer.

MR. BEATTY: I think the question answers itself. Let’s take Reliant as an example. We know what the deal is. The deal is you extend the debt for five years. Reliant gives its lenders security so that they have a secured piece of paper, and the lenders extend the tenor for five years. From the banks’ perspective, this is a lot better than going into a bankruptcy or insolvency proceeding because the loan doesn’t become “non-accruing.” On the other hand, it is no different than being in a bankruptcy proceeding because the company is as constrained in its actions as if it were in bankruptcy. If Reliant were to dip into bankruptcy in the future, its lenders are now secured, and the loan will not become non-accruing merely due to the bankruptcy filing.

Now, in view of everything we talked about this morning, if you are going to run merchant plants, what is the one thing you need? Credit.

Reliant has given its lenders security, so therefore the creditworthiness of it as a counterparty on an unsecured basis with other people in the industry just sank dramati-cally. It is not clear it can even be rated. Beginning with “C” doesn’t even start it. Therefore, the company is stuck either giving full cash collateral on any sales it does, and the better the sale, the more the market moves with it, the better the company’s income is, the better its earnings are, the more cash it has to put up or, alternatively, it is only selling the day-ahead market. I don’t know how anybody is going to make money in the day-ahead market, except for that July 26th at some point when all of a sudden money comes in.

MR. CONWAY: But let me ask a question. That debt eventually gets brought down, doesn’t it?

MR. BEATTY: How? I don’t see how.

MR. CONWAY: Maybe the process is a slow one and the company has to do mostly day ahead marketing in the meantime, but eventually the debt burden is reduced. If it is not, then this whole notion of extending, extending and reextending eventually has to end.

MR. BEATTY: Right, but at that point, the banks are fine because they are secured.

MR. CONWAY: That means you are projecting eventual doom here, right?

MR. BEATTY: No. It’s not doom. The assets come out. The parties end up in a bankruptcy proceeding.

MR. COOPER: The assets have to change hands. MR. BEATTY: They change hands. It’s not doom.

MR. CONWAY: But aren’t the parties better off going through the bankruptcy proceeding now and recapitalizing the company so that it can play in this market rather than leaving it in a position merely to limp along?

MR. BEATTY: I have to tell you, I think the managements of these companies have made a Faustian bargain. They are stuck, and they will eventually go into a bankruptcy proceeding, because I don’t know that they can pay down any of this debt in the day-ahead marketplace. What’s more, if anything bad happens — and this is an industry where bad things seem to happen with remarkable regularity, they are sunk.

MR. CONWAY: But the market does eventually come back, right? At least that has been the premise that, within a couple of years, it comes back.

MR. BEATTY: Yes. I don’t believe the day-ahead market comes back. What happens is, at some point, somebody — your load-serving entity — is willing to either buy the power plant or contract for its output.

MR. COOPER: Because the load-serving entity is worried about getting caught short.

MR. BEATTY: That doesn’t help the distressed merchant power company because it cannot contract with the load-serving entity because it lacks the collateral to put behind the contract.

MR. CONWAY: That’s too absolute a statement. For one thing, you are not going to have that problem with coal-fired power plants. Why? Because that counterparty is going to think, “No matter what happens, this will be least-cost electricity.”

MR. BEATTY: But remember the way the contracts work is the more cost effective a contract is — the better the deal for the utility — the more collateral the generator will have to post to ensure performance.

MR. MARTIN: Mark Comora.

MR. COMORA: Mark Comora, Fortistar. I would like to ask a follow-up question. Given this bleak outlook, how do the banks get comfortable, during the next three to five years while they wait for the market to turn around, that they have professional managers of their assets? The borrowers who got into this situation are power companies. One would have thought if anyone knew the business, they do.

MR. PAFFENBARGER: If that scenario plays out, and I’m not convinced that it will, I don’t know. But if the debts are restructured, the logical thing is to let the companies in trouble operate the plants and market the output as they have been. I don’t think the outlook is so gloomy that they will not be able to have enough credit to trade in markets other than the day-ahead market. If the restructuring allows cash to accumulate, a company can build up collateral to allow its power marketing operations to continue. I do not think the banks will want simply to cast everything to the wind and say, “Let’s get a new operator; let’s get a new power marketer, and a new fuel management company.” My company, Constellation, is offering that service. We do it now. We hope the banks will eventually want it, but it remains to be seen how great a demand there will be for the service.

MR. WILSON: The bargain is the bank syndicate lets you live if you operate the assets on its behalf. There is an option value to the equity investment. If things turn around, it could be worth a lot, but in the near term you are only going to be generating as much revenue and paying down as much debt as you can. I don’t know if anyone thought about this, and it would probably be situational, but in some cases where the banks are pregnant with the paper, they may step up and write letters of credit to provide the necessary collateral in order to enter into the long-term contracts to sell the output. They would benefit directly from such contracts.

MR. MARTIN: Here is another question from the web audience — from Seth Parker with Levitan & Associates. Which regions of the country are most attractive today for merchant plants, and which are least attractive, and why?

MR. COOPER: The least attractive is probably the south central United States.

MR. MARTIN: The most attractive? MR. WILSON: The west, still.

MR. MARTIN: Why do you pick the west?

MR. WILSON: The market dynamics are different than in other parts of the country. They are driven by hydroelectric projects. Prices are firming up in some parts of the west. Weather conditions are dry. It is very difficult to get regulatory approval to build a new plant. This creates a barrier to new entrants. There are also shortages of transmission capacity in the west.

MR. COOPER: Also, because the western US is so depend-ent on hydroelectric power, the reserve margins have to be significantly greater than in other parts of the country in order to absorb the weather flows. I think New York is also a good market because it also has barriers to entry. It is hard to build power plants near New York City.

Hard-Earned Lessons

MR. MARTIN: Final question: The Washingtonian magazine runs an interview in each issue. The last question asked the person being inter-viewed is invariably, “What lessons have you learned about life?” I want to change the question slightly. You have all been around the power industry for a while. There are many people watching this webcast who are not as familiar as you with the US market. What hard-earned lessons have you learned that you would convey to someone who is thinking about entering the US market? Bill Conway?

MR. CONWAY: My advice is, if we assume that most assets will be sold in auctions in the future, bidders will need to marry capital with an experienced management team to succeed. I would advise anyone outside the US with capital to find a capable management team as early in the process as possible. It will maximize the chances for success.

MR. MARTIN: Charles Wilson, a hard-earned lesson?

MR. WILSON: Don’t extrapolate from simplified deregula-tion models.

MR. MARTIN: Tony Muoser?

MR. MUOSER: Don’t trust anybody. Second guess everything.

MR. MARTIN: Spoken like a good Swiss since the Swiss are always neutral.

MR. MUOSER: Also, the local knowledge is extremely important. Location in this business is key. You should work with a consultant who really understands the specific local market. There is no national model or national approach to this.

MR. MARTIN: John Cooper, hard-earned lessons? You must have several.

MR. COOPER: I agree with Tony Muoser’s admonition to challenge all assumptions. The popular wisdom in the past was that the fact it took $700 million to build a power plant provided a barrier of sorts to entry, and that everyone would be rational at these prices and not overbuild. That did not happen.

MR. MARTIN: Jay Beatty.

MR. BEATTY: Forget the Excel spreadsheets and discounted-cost-of-funds models and think of credit in a more abstract sense. Focus more on how the rating agencies will react and less on what the internal rate of return will be over some period of time.

MR. MARTIN: John Paffenbarger?

MR. PAFFENBARGER: Having come from Orion which was bought out by Reliant, not quite at the top of the market, my advice is timing is very important. The market is in a trough. Everyone is trying to figure out when the cycle will turn up again.

MR. MARTIN: Bob Shapiro?

MR. SHAPIRO: People forget that electricity is a vital commodity. There is no tolerance in this country for the kinds of price spikes that we have seen in California and some other places. Be advised that the volatility we saw in 2001 in California will not be permitted in the future.