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.
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.
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?
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