"Pivot points" in the new energy bill
Chadbourne hosted roundtable discussions in New York on August 24 and in Houston on September 14 about the massive new 1,724-page energy bill that President Bush signed into law on August 8.
Americans pride themselves on having a free market economy, but the truth is the government takes away opportunities, it creates new markets, and it shifts capital through changes in law. People who were smart enough to understand the opportunities created by the new Public Utility Regulatory Policies Act in 1978 made fortunes. That statute created the independent power industry in the United States. The question is whether there are similar opportunities in the new energy bill.
The following are excerpts from the discussion. The New York transcript is first, and it is followed by excerpts from the roundtable discussion in Houston.
The speakers in New York were Jay Worenklein, president and CEO of US Power Generating Co., Jonathan Weisgall, the chief lobbyist in Washington for MidAmerican Energy Holdings Company, Roger Gale, president of the consultancy GF Energy, and John Veech, managing director and head of global project finance at Lehman Brothers. The speakers in Houston were Peter Gaw, global head of utilities and power for ABN AMRO Bank, Dr. Robert Kelly, a principal with Houston energy firm DKRW and a former senior Enron executive, and Donald Kendall, managing director and CEO of Kenmont Capital Partners, a hedge fund. Two Chadbourne lawyers, Robert Shapiro and Adam Wenner, joined in the discussions in both New York and Houston. Keith Martin moderated both sessions.
MR. MARTIN: What types of deals will people do more of as a consequence of this bill?
MR. WENNER: The biggest opportunity is for utility acquisitions and mergers. The Public Utility Holding Company Act has been repealed effective next February. This opens the door to two types of transactions -- combinations of utilities that are not in the same geographic region and takeovers of utilities by companies, like Microsoft or Starbucks or General Electric, that either are not already in the utility business or have diverse interests beyond utilities. It was possible in the past to merge utilities that are geographically connected -- for example, because they sell into the same power pool -- but PUHCA repeal has opened the door much wider.
MR. MARTIN: John Veech, will we see a lot of US utility mergers or acquisitions in the next few years?
MR. VEECH: I think a couple things. First, PUHCA repeal will help the three high-profile mergers that have already been announced reach closing. Second, I think you will see some transactions, but not the land rush that some on Wall Street are predicting. The transactions still need to make strategic sense, and you will still have to deal with state regulators who may have a more prominent role now that PUHCA has gone. The questions will be whether there are enough synergies to justify the transaction, and whether the state regulators will approve the deal. You will have at least two sets of regulators where two utilities are merging. Each of them will want 75% of the synergies shared with local ratepayers.
MR. SHAPIRO: Not only do the states have jurisdiction over utility acquisitions, but the federal government also retains jurisdiction. The Federal Energy Regulatory Commission has authority to review utility mergers. This authority has been slightly expanded under the new legislation. The only thing that was eliminated was the need for approval for the deal from the US Securities and Exchange Commission under the Public Utility Holding Company Act, and frankly, in the last 20 years, that has not been difficult to obtain.
MR. MARTIN: Is there anybody on this panel who thinks there will be a rush of utility consolidations?
MR. WEISGALL: No. I tend to agree with John Veech. We are going to see a greater role being played by state regulators now that PUHCA has been repealed. It is not clear that state regulators will entertain companies like Microsoft and Starbucks coming into the utility marketplace. Oregon turned down a bid by the Texas Pacific Group to acquire Portland General. The decision was that ownership of an electric utility by a hedge fund may not be in the best interest of the local ratepayers.
MR. WORENKLEIN: We should temper our expectations and recognize that we are not likely to have the floodgates open with deals. That said, there are opportunities, in theory, for cost efficiencies through consolidation. Whether they can be achieved in fact through mergers, and how long it will take to realize them, are another matter. All of this leads me to believe some deals will be done that make a lot of sense. The good news is that companies no longer have twist themselves into pretzels to get such deals done. We will inevitably see deals slowly coming to market, and the utility landscape in this country will be changed as a result.
MR. WEISGALL: There are almost 4,000 entities in the United States that sell electricity. That is the sum of investor-owned utilities, about 2,000 municipal utilities, about 900 electric cooperatives, and a large number of power marketers. Japan has seven to nine utilities. Are we going to see some consolidation? Yes, we will. How much? We are not going to get down to nine.
There is one other point about opportunities created by the new energy bill. There may be some secondary M&A activity as a consequence of utility mergers. Utilities that merge may have to divest some of their assets in order to gain regulatory approval.
MR. WENNER: I worked a number of years ago with Enron when it was trying to sell Portland General. The first thing we did was draw a circle around the possible buyers. Because of PUHCA, we were limited to potential buyers who were already in the utility business and who could buy a utility in the Pacific northwest without running afoul of PUHCA. Had the PUHCA constraint not been there, any utility in the country would have been free to acquire Portland General, and the Oregon commission at that time would have been very happy for that to happen.
Remember that competitive analysis is a problem when neighboring utilities merge. However, if an Exelon or a Duke proposes to buy Portland General, there is no concern about too much market power. More distant suitors may have an edge in this sort of competition.
MR. MARTIN: John Veech, if Adam Wenner is right and PUHCA repeal means that a lot more companies are now potential suitors for US utilities, wouldn't you expect stock prices for utilities to go up in anticipation of this demand? Has that occurred?
MR. VEECH: Logic would dictate that if you increase the number of bidders while the supply of potential targets remains unchanged, then prices will increase. However, we have not seen any clear movement in utility stock prices since the bill was enacted. If you look at the utility index for the period starting a month before the bill passed through today, the prices for utility stocks have been remarkably stable.
MR. MARTIN: Have we opened up a Pandora's box? Is it better to have one federal statute or 50 different states moving in to fill the void? Will utilities come eventually to regret PUHCA repeal?
MR. GALE: On balance, there is no regretting. PUHCA should have been repealed a long time ago. Repeal is in the public interest. We have had consolidation in virtually every other industry, and there have been benefits from greater cost efficiencies. This is the only major industry with such a vulcanized structure. At the same time, it is clear that the states are not going to roll over. Consolidation will not be easy to achieve.
MR. SHAPIRO: The states retain full authority over changes in control of utilities in their jurisdictions. They have always had this power. They may be a little more demanding in the concessions they want to approve mergers in the future. They hold all the cards at the end of the day in what costs they will allow utilities to pass through in rates and what return they will allow on rate base.
MR. MARTIN: Bob Shapiro, you mentioned earlier that the Federal Energy Regulatory Commission will have broader authority to review proposed acquisitions. Do you see FERC exercising this authority aggressively, and is its exercise of the authority likely to change many outcomes?
MR. SHAPIRO: No, I don't think it will change many outcomes. But the bill does expand FERC authority to review a group of transactions that the commission lacked jurisdiction previously to review. For example, much of the generation that was spun off in California by Pacific Gas & Electric and Southern California Edison was done without FERC approval because the utility sold only its generating assets and retained the interconnection lines. Such a sale will not avoid FERC review in the future. Many power plant sales may require FERC approval in the future, but, at the end of the day, I don't see FERC being an obstacle to such sales.
MR. MARTIN: One more quick question -- there has been a lot of talk about private equity money coming into this sector. Are private equity funds appropriate bidders for utilities? They have short time horizons to hold assets and high hurdle rates, certainly higher than the regulated rates of return allowed in this sector. Jay Worenklein?
MR. WORENKLEIN: That's a tough question. It depends on the situation. Some private equity funds have time horizons as long as 10 years. A private equity fund may be able in that time to fix a lot of problems and leave the utility is better shape with a significantly higher enterprise value.
MR. SHAPIRO: You have to wonder about the returns that people can reasonably expect from a regulated enterprise, particularly in the distribution area, which is really what PUHCA frees up for acquisition. States control those returns. They are not as high as the returns in other sectors, and certainly not at the hurdle rates set by private equity and hedge funds.
Private equity funds may be better off focusing on transmission rather than electric and gas distribution companies because, with transmission, you have only to contend with federal regulation, and the federal government is rewarding transmission investment with higher returns. Returns are in the 13% or 14% range on invested equity, which is 3% or 4% better than the returns that state regulators allow for a distribution company.
MR. WEISGALL: Following up on that, another reason we may see more investment in transmission companies is the energy bill gives the federal government a power of eminent domain that it can use to push through new transmission projects in areas of the country where there are transmission bottlenecks. I believe this is the first time that the federal government has been given this power in the electric transmission area. The government has had similar authority to help with interstate gas pipeline projects for a long time because such projects were seen from the start as involving interstate commerce. The specter of federal authority -- rather than the actual exercise -- may spur states to move more quickly on transmission projects on their own. This will help with investment.
MR. MARTIN: Let me explain for the audience. The new energy bill gives the federal government a year to take an inventory of where transmission is constrained, and the government will then have the power in the regions it identifies to take property through eminent domain proceedings to make room for new transmission lines. Is that right, Bob Shapiro?
MR. SHAPIRO: It is a little more cumbersome than that, unlike the Natural Gas Policy Act where the Federal Energy Regulatory Commission can exercise eminent domain authority immediately upon application. The US Department of Energy must first do a study. The study will identify specific corridors where exercise of federal eminent domain authority is needed. Then a project developer must petition a state to move on his project. If the state fails to act within a year, then the Federal Energy Regulatory Commission can use the federal eminent domain power. This is a more cumbersome process than developers go through to build an interstate gas pipeline.
MR. GALE: I agree with my colleagues that we will see a lot more investment in transmission in the future. An additional catalyst to such investment will be utility consolidation because, as utilities merge, they may be forced by market power concerns to shed their transmission lines, opening the door for others to get into this sector.
MR. MARTIN: John Veech, Lehman looks for opportunities in the market and tries to figure out how best to spend its time. Is transmission an area where Lehman is putting its resources?
MR. VEECH: Yes, I agree with the others on this panel. Transmission is one of the big winners in the bill. Other reasons to expect more investment in transmission, besides the ones already mentioned, are this is an area where utilities have seriously underinvested for the past 20 years, and there are new tax incentives in the bill to invest more. There are also tax benefits for utilities to shed their transmission lines. Finally, there is a huge appetite potentially from both private equity and strategic investors. If FERC gets the tariffs right for transmission, it will encourage a lot of people to jump all over this opportunity.
We took the International Transmission Company public a short while ago. This is the old Detroit Edison transmission system that was bought by Kohlberg Kravis Roberts & Company and Trimaran. The equity markets loved the story. The International Transmission Company is trading at 25 times earnings on a forward earnings basis compared to about 15 times earnings for more traditional utility stocks.
What the markets loved about it really were two things. One is the stability of earnings, because you can basically figure out the future earnings on your pocket calculator from the tariff. The other is the clarity of earnings growth. You have a transmission system that requires a lot of additional investment. The new owners plan to make those investments over time, and they will be allowed to earn a return on the additional capital expenditures. The company has a clear growth story. It is a perfect example of how once the government gets the tariff right, the capital will follow.
MR. MARTIN: So far, we have talked about two regulated businesses that may be interesting targets for additional investment. Roger Gale, does the new energy bill create other opportunities?
MR. GALE: I think there will be an additional shift of capital toward the renewables sector, but I don't think it will be huge because there are significant limits on what we can do with renewables in this country. They are a single digit -- 4% or 5% -- source of electricity supply. I am skeptical whether they can get to 10% in the next 20 years. There is a limit on the extent to which we can rely on wind turbines for our basic power needs. The bill throws significant money at renewables through tax incentives. This will spur more interest in the short term; the tax incentives are temporary. Congress has yet to address the problem of long-term continuity and strategy.
MR. WEISGALL: I think the bill is a mixed bag when it comes to renewables. On the plus side, Congress extended a production tax credit for renewables. It gave developers another two years to put renewables projects in service to qualify for five or 10 years of tax credits on the electricity output. If I am not mistaken, this is the first time that Congress has extended the deadline for putting such projects in service before the tax credit expired. There has been a boom-and-bust pattern to development of renewables projects in this country because the tax credits keep expiring and then time passes before they are renewed.
Also on the plus side, if you add up the dollars in the tax title, fully 20% of the tax subsidies are going to renewables, which make up about 2% of the US power sector.
The minus side is that Congress gave developers only another two years to complete their projects. That works for wind farms, which take only six months to build, but it is a tough timeline to meet for biomass, geothermal and other projects, even if you already have a permit to start construction.
Congress failed in the energy bill to adopt a federal mandate for renewable electricity. Twenty states and the District of Columbia require utilities within their borders to supply at least a minimum percentage of electricity from renewable sources. Congress could not agree on a national standard. It may be just as well because many of the existing state standards are already well above the national target that was under discussion. Any federal mandate would have turned into just another area for federal-state tension, a recurring theme in all the subjects we have discussed so far today.
MR. MARTIN: There is also an opportunity to take existing renewable plants and rebuild them so that they qualify for another five or 10 years of production tax credits. The credits can only be claimed on new projects. However, an existing plant is considered brand new if it is substantially rebuilt.
MR. WEISGALL: By the way, the bill creates a new acronym CREBS, for clean renewable energy bonds.
MR. MARTIN: Explain what those are.
MR. WEISGALL: I was afraid you would ask. The bill allows municipal utilities and electric cooperatives to issue bonds to finance renewables projects. No interest has to be paid on the bonds. The lenders get federal income tax credits in place of interest. There are a lot of municipal utilities in California looking at renewable energy. The federal government subsidizes private projects through production tax credits, but municipally-owned projects do not share in this subsidy. Clean renewable energy bonds are a way to let municipalities share in the tax subsidies for these types of projects.
MR. MARTIN: You make an interesting point. Institutional investors who are looking to invest in renewables projects and who are able to take part of their returns in the form of tax benefits now have two ways to invest in such projects. They can put equity into private projects, or they can lend to municipal projects. Either way, they get tax credits.
MR. WEISGALL: Congress chose in the energy bill to use a carrot rather than a stick. It gave institutional investors tax credits to encourage them to invest in renewable energy projects, but it declined to follow the states in ordering utilities to supply a certain percentage of their electricity from renewable sources.
MR. MARTIN: Roger Gale, are IGCC plants another opportunity as a result of this bill and, if so, why?
MR. GALE: IGCC is a stalking horse. It is a big leap in technology. It has wonderful promise. It is a way to sequester carbon dioxide emissions if we ever get to the point of ordering US industry to reduce greenhouse gas emissions. It is a way to beautify coal. However, I think we are going to see a lot of traditional coal plants built with huge capital expenditures on scrubbers and other pollution control equipment before we see many IGCC plants built. The problem with IGCC plants is they are more expensive than nuclear plants to build.
MR. MARTIN: Bob Shapiro, explain what an IGCC plant is.
MR. SHAPIRO: The acronym stands for integrated gasification combined cycle. Basically, you take coal, turn it into gas, run the gas through a gas turbine to generate electricity, use the exhaust from the gas to heat water to produce steam and then run the steam through a steam turbine to make more electricity. IGCC plants do not lend themselves easily to project finance because of their high costs. They are more likely to be built by regulated utilities, with approval from their regulators to put the cost into rate base, than by independent power companies.
MR. MARTIN: There are a lot of incentives in the bill for IGCC -- a 20% tax credit as well as federal grants and loan guarantees.
MR. WEISGALL: I am looking at $3 billion in authorizations. We are throwing a lot of money at this particular type of project, but I agree with the other speakers. It is an old joke that soccer always has a great future in the United States. We may be saying the same thing about IGCC for decades. I am not sure, but if the technology fails to take hold, it will not be for lack of government subsidies.
MR. MARTIN: Congress spends money through a two-step process -- it first authorizes the money to be spent, and then it appropriates it. You said there are $3 billion in authorizations in the bill, but the money will not truly be available until it is appropriated. When do you see that happening?
MR. WEISGALL: The appropriations bill for the US Department of Interior has already passed Congress. The energy and water appropriations bill is in a conference committee. Those would be the two logical places for the appropriations. My guess is we are not going to see funding until next year's appropriations cycle.
MR. WORENKLEIN: Let me add just one point on IGCC. The technology should not be viewed simply as gasifying coal and then running the gas through a turbine, because many IGCC projects are essentially complex chemical facilities. The real benefits of the IGCC plants that are being proposed in many parts of the country are production of other products -- diesel fuel, carbon sequestration and numerous other energy-related outputs that go beyond the question of power. That is where I think the real benefits are. I disagree with some of what has been said. Some of the projects that have been proposed make tremendous sense, particularly if you view them as industrial plants that turn out an array of products. My view is you will see a real takeoff of this technology.
MR. GALE: I think the reality is that we will see a lot of additional coal-fired power plants built. The costs will be higher than we expect. The cost of IGCC is in the stratosphere, relatively speaking. We will find it hard enough to build traditional coal.
MR. WENNER: What about the discounting for the cost of anticipated carbon control? Won't that be a compensating factor in favor of IGCC?
MR. GALE: This is going to sound like a ludicrous statement, and perhaps you would say it is, but the best way I think to reduce carbon dioxide emissions in the medium term is to build pulverized coal plants that replace the existing fleet. Those new plants would be 15% or 20% more efficient, you would get a 10, 20 or 30% reduction in CO2 emissions and, by doing something traditional, you would get a very big bang for the buck.
MR. MARTIN: Let's move to three other opportunities briefly and then on to a different topic. John Veech, are nuclear power plants an opportunity as a result of this bill?
MR. VEECH: There are obviously some intricate political dynamics to take into account; it is not enough to look solely at the subsidies for new nuclear plants in the bill. I think it is unavoidable that the country will need more nuclear capacity. If gas prices stay at $10 or $12 an mmBtu and oil is at $60 or $70 a barrel, then people will start to look at building new nuclear plants quite apart from any government subsidies.
MR. MARTIN: Jon Weisgall, you teach a course at Georgetown law school in energy law, and you told me before the session today about a question that you ask your students.
MR. WEISGALL: I have taught the class now for 15 years. I tell my students you can live in one of two places -- within three miles of a coal slurry plant or within three miles of a nuclear power plant. Which would you choose? Class after class, year after year, they vote to live near the coal slurry plant. We all know the health risk. They would rather risk lung disease from coal dust than the far more remote, but potentially more catastrophic, harm caused by a nuclear plant disaster.
MR. MARTIN: Does this suggest that the climate isn't right yet for new nuclear plant construction?
MR. WEISGALL: Perhaps. Congress has done all it can in this bill to say we want to change the climate. The amount of money potentially thrown at nuclear in the bill is staggering. Nuclear plant owners get a production tax credit like the credit given to renewables projects. They get massive loan guarantees and even delay risk insurance.
MR. GALE: We have done a survey since 1992 of the power industry. When you ask senior executives at US utilities whether they think any new nuclear power plants will be built, the percentage who answered yes as recently as 1997 was in the single digits. Last year, more than 60% said yes. The climate is changing, but the reality is it is an evolutionary process. We are still buying and selling used nuclear plants in this country; that is a much safer bet for anyone who wants to invest in nuclear. I don't think the engineering firms that would build the next generation of nuclear plants are ready yet to take on this challenge.
MR. MARTIN: Can a nuclear plant be built before the nuclear waste issue is addressed by Congress?
MR. GALE: That will be 50 years from now.
MR. WEISGALL: I would ask whether we are going to export our nuclear waste; will that be the answer?
MR. VEECH: On the nuclear waste issue, it will ultimately be a question of which party in the transaction must bear that risk. If you can structure a deal where waste disposal risk is not on the utility, then I think nuclear plants will be built before there is a complete solution to the waste disposal problem. The waste disposal problem must be solved, but it is going to take some time.
MR. MARTIN: Pollution control. John Veech, you see this as a potential opportunity.
MR. VEECH: Yes. There will be increased spending on pollution control. When you look at oil and gas prices, it is clear that there will have to be heavier reliance in the US on coal. Coal cannot be used without significant spending on pollution control. The energy bill encourages such spending with a couple tax subsidies -- faster depreciation and the ability to get a refund of taxes paid in the recent past if the money will be put toward pollution control. Utilities will probably pay for pollution control on a corporate finance basis, but it is clear there will be an increase in spending in this market segment.
MR. MARTIN: The bill encourages more use of coal. Isn't one consequence of that the need for more spending on pollution control?
MR. SHAPIRO: Perhaps by regulated utilities, but not by independent power producers. Independent power plants facing a soft market are more likely to shut down than put in additional pollution control, since they have no ability in such a market to pass through the costs. That may be what Mirant is thinking with its plant in the Pepco service territory. The bottom line is that whether we are talking about IGCC, new nuclear power plants, retrofitting of existing coal plants or pollution control, it looks like the regulated utilities are in a better position to take advantage of the tax and spending subsidies for these activities in the bill.
MR. MARTIN: Another thing the bill encourages is production of ethanol and biodiesel fuels.
MR. WEISGALL: The bill requires US refineries to double the amount of ethanol that they blend currently with gasoline. Given the wind and ethanol incentives in the bill, the midwest comes off as a very big winner. The ethanol market is already booming, at least judging from the number of new plants under development to make ethanol using corn as the raw input. Probably the greatest new opportunities are in biodiesel and production of cellulosic ethanol, both of which qualify for tax credits.
MR. MARTIN: The debate in the ethanol market is whether, with all the new plants under development, we risk having the same over-build situation we had a few years ago in the merchant power market. That is not yet a concern for biodiesel. We do not produce much biodiesel in this country.
MR. WEISGALL: Very low numbers, but biodiesel output is expected to increase 10- or 20-fold in a relatively short period of time.
MR. MARTIN: Are there any other opportunities that we have not mentioned?
MR. VEECH: One thing no one has mentioned is the bill improves the siting process for liquefied natural gas receiving terminals. This could have a significant effect on the gas equation in this country. There is already enormous upstream and midstream investment around the LNG business, but siting of receiving terminals -- particularly in North America anywhere near population centers -- has been a vexatious issue. The bill should make it easier to build new terminals. That will have an effect, in turn, on longer-term gas prices.
If you look at domestic gas production in the United States, most of it is either mid-continent or along the shelf. Projections show a significant decline in output within the next five to 10 years. There are not a lot of alternatives in the medium term other than to increase imports of LNG. We may ultimately build a ton of new coal-fired power plants, but that is 10 to 15 years down the road. It is the period five to seven years out where there is clearly a gap around natural gas, and LNG will have to be a part of the solution.
MR. MARTIN: What effect will the bill have on fuel prices? If the bill encourages greater use of coal, then won't that cause coal prices either to increase or at least remain on their current upward trajectory? If it will lead to construction of more LNG terminals, will that lead to a decrease the price of gas?
MR. WEISGALL: This winter, natural gas and home heating prices will go up 30 to 60%, which will make the gasoline spike look like a walk in the park. So short term, no, but perhaps yes in the longer term.
MR. MARTIN: Any other effects on fuel prices? Nobody has mentioned oil. High oil prices were one of the driving forces behind this bill.
MR. WEISGALL: The bill does little to affect oil prices.
MR. MARTIN: Adam Wenner, in some parts of the country, one fuel sets the electricity price and, in others, a different fuel sets the price. Is there an opportunity for windfall profits for people, in regions where coal sets the price, who are using a different fuel?
MR. WENNER: Yes, in areas where electricity is priced in a real-time or day-ahead market. The amount an electricity supplier who is selling into the spot market receives is set by auction. As the price of coal rises, everything else rises along with it. Electricity suppliers who rely on other fuels will benefit.
MR. SHAPIRO: I think you have to look at the bigger picture. In New England or New York state, gas is on the margin, and existing coal plants in those areas make money. The problem is those plants are very old and will need to be retrofitted. The cost of the retrofits will have to come from somewhere.
MR. VEECH: Also from a Wall Street perspective, it's an interesting question what will happen if, as Exelon predicts, it is able to increase the efficiency of the PSE&G nuclear plants. Does the additional return from greater efficiency end up getting passed through to the ratepayers in lower rates, or does it end up benefiting the shareholders of the company?
MR. MARTIN: John Veech, looking at the bill as a whole, who comes out ahead -- independent power companies or utilities?
MR. VEECH: That's a tough one. I think there are some important provisions that will help generators, because the main thing that a generator needs is a customer, which means the generator needs either a contract or a very vibrant liquid market. One impediment that generators face when trying to reach customers is transmission, which is to say a generator may well have customers, and it may well have power, but it also needs a significant, significant enhancement to the transmission system. The enhancements will not happen overnight, but perhaps over a five or even 10-year period, you are going to have better markets as a result of this bill. You will have a generator with plants in one region and customers in another region. If you fix the underinvestment in transmission, that ultimately will be a great benefit for generators. It won't happen overnight.
MR. MARTIN: One more topic -- PURPA changes. Bob Shapiro, an audience member who is watching over the web asks what effect the PURPA changes in the bill will have on merchant wind projects. Perhaps, you can explain what the bill does on PURPA and then answer the question.
MR. SHAPIRO: The bill relieves utilities of any legal obligation to buy electricity from cogeneration facilities and small power plants that use waste or renewable fuels. It does so only in some parts of the country -- those places where such generators have another outlet for their electricity besides selling it to the local utility. Any generator with an existing PURPA contract to sell his output to a utility is not affected. Existing contracts are grandfathered.
The utility purchase obligation is most likely to disappear in markets that are served by regional transmission organizations, or RTOs. Wind projects that are under 80 megawatts in size will still have the ability to force utilities to buy their output in areas where PURPA remains intact because there are no alternative outlets for the power. One potential problem is that states have been reluctant, for the last 10 years, to force utilities to sign long-term contracts, at least in states where the state is not otherwise trying to force utilities, through renewable portfolio standards, to supply a certain percentage of their electricity from renewable sources. PURPA has not been a terribly effective tool, as a result, in getting utilities to sign long-term contracts.
MR. WEISGALL: PURPA repeal doesn't change much. One benefit of being a qualifying facility under PURPA was that it exempted the project from regulation under PUHCA. However, in 1992, Congress created another way to avoid such regulation -- by making an independent power plant into an EWG, or exempt wholesale generator. Many new projects were developed after 1992 as EWGs -- rather than PURPA qualifying facilities -- because that let them avoid some of the restrictions that applied to QFs. The projects had no trouble getting long-term contracts to sell their electricity to utilities.
Today, both QF and for non-QF projects have trouble getting long-term contracts. That's because, in a partially-deregulated world, utilities are reluctant to sign contracts when they cannot be sure they will have an outlet for the power. The wild cards for the utilities are consumer retail choice in many states and possible cost issues with the local regulators.
MR. MARTIN: John Veech, does it matter any more whether a project is a QF?
MR. VEECH: I would think it doesn't matter all that much. The real challenge for anyone developing a plant is getting a long-term contract, and his ability to do so has been driven more by economic forces more than legal regulation. The lessons of the late 1990's, when too many merchant power plants were built and wholesale power prices collapsed, are still resonating with the regulators. I do not think we will see a return to a situation where utilities are forced to sign long-term contracts.
MR. MARTIN: My next-to-last question is for each of you -- what did you find most interesting about the energy bill? Jay Worenklein, let's start with you.
MR. WORENKLEIN: I found it interesting that the Senate, the House and the Bush administration found it palatable politically to affirm the importance of nuclear power as a critical part of our future energy policy. That, in my mind, is revolutionary. What the bill basically says is it may take 10 years or it may take 20 years for us to see really a number of nuclear power plants on line, but we will see them. Now, that begs the questions of how we go about financing them and whether there is any board of directors brave enough to take on the challenge. My guess is the answer is no, because boards will remember that in the mid-1980s, we saw several utilities on the brink of bankruptcy, or specifically in bankruptcy, because they put on line nuclear power plants. These concessions of $500,000 or so, they are not enough. We had $5 billion problems in the 1980s. So we have a big issue still about how we are going to do this. But the fact that it is politically palatable to do it in principle means that the field is open for discussion.
MR. MARTIN: Jon Weisgall, what was the most interesting part of the bill for you?
MR. WEISGALL: There were two things. Number one is the fact that this is a significantly greener bill than I would have thought. The energy bill that Congress very nearly passed in 2003 was a fairly green bill, but it failed to cross the finish line. Beginning in 2005, Pete Domenici, the Senate Energy Committee chairman, said whatever we pass must be a bipartisan measure. Every single staff meeting on the Senate side included both Democrats and Republicans, and the result was 71 votes in the Senate for the final bill. In that sense, this was a defeat for Tom DeLay. The bill was legislators legislating, making compromises, and the sausage that results from that kind of process is pretty ugly.
The second thing I find interesting is the acronyms that are not in the final bill. CAFE, or fuel economy standards for automobiles, did not make it. There is nothing in the bill to decrease US reliance on imported oil. ANWR, or drilling in the Alaskan national wildlife refuge, is not in the bill but will be addressed in a later budget bill. RPS, or a federal renewable portfolio standard, is not in the bill. A lot of these items were dropped in the give and take of legislative compromise. But, in the end, the bill is a decent step forward.
MR. GALE: Let me also mention two things. I bumped into a Senator the other day and wound up sitting with him on the plane while we talked about the energy bill. He called it a potpourri, which is a surprising thing for a member of Congress to say about a measure that was sold as a national energy plan for the United States. But he is right. The bill has a little of everything. If you look at the bill from the point of view of those who had to pass it, they were worrying about whose interests they were going to serve. It is nearly a miracle that, on some level, it serves just about everybody's interest, with a few notable exceptions like the MTBE lobby. It gives extended tax credits to renewables, even though the renewables community failed to get a national renewable portfolio standard. There is a little for everyone -- the American way.
The second, related observation is that we have not collectively been able to say in one sentence what this bill will do for the energy market because the bill lacks cohesion. There is no strategy in it. We do not have the leadership nationally on these issues that one would need to have any real sense of direction. And that is a real tragedy. The tragedy is that we were unable to have some semblance about where we want to go and how we want to spend our capital to get there and how we do it while minimizing the harm to the environment.
MR. MARTIN: Adam Wenner, what did you find most interesting about the bill?
MR. WENNER: I also have two items. The first is that Congress has been moving to repeal PUHCA since 1981. Repeal measures have passed in one or the other house several times. But after all that time, the draftsman still managed to screw up the merger provisions of the Federal Power Act that were added as part of the PUHCA repeal so that the new law, read literally, now requires the parent company of an Afghan utility that wants to acquire the Pakistani parent of a utility to ask the US Federal Energy Regulatory Commission for approval. That's a power grab! It will require a technical correction.
The second thing I found interesting is that now, with PUHCA repeal, you could have a merger among utilities that take you from the redwood forests to the Gulf stream waters to the New York islands.
MR. SHAPIRO: I think the most critical shortage in the power industry is transmission. Everyone has recognized this for many years, and I am heartened by the fact that there is finally -- although it is not strong enough -- some federal fact finding that will lead to federal siting and eminent domain authority and that may lead utlimately to construction of needed transmission lines. The places where the coal is and where the wind is are not where the load is, so you have to build massive amounts of transmission, and the federal authority might finally be the thing that helps.
MR. VEECH: The bill, as I see it, should be effective in directing flows of capital to discreet areas that were beneficiaries. Let me list them in order of priority. Renewables and wind, in particular, are big winners under the bill. Transmission is number two. Coal generally and LNG are my numbers three and four.
MR. MARTIN: Now to the final question -- is this energy bill just the beginning of the energy policy debate in this country? Is it even the end of a big chapter in that debate? I read in the Wall Street Journal yesterday that Republicans are already talking about the giving states the ability to override a federal prohibition on offshore drilling for oil and gas, and they will be looking for a legislative vehicle for such a measure this fall. The subject of drilling in the Alaskan national wildlife refuge will also come up for debate this fall as part of a budget reconciliation package. Jon Weisgall, are we going to see another energy bill in short order?
MR. WEISGALL: ANWR will happen because there is an agreement to deal with it in the budget bill. However, beyond that, I am of two minds. On the one side, it is so difficult for Congress to pass energy legislation that there is a part of me that thinks there is no way Congress will be able to put together another energy bill in the short term. For example, the Republican leaders may want to revisit the federal ban on offshore drilling, but if Virginia wants an inventory and Florida doesn't and New Jersey doesn't, well, we had that vote already. I don't see Congress reopening a lot of these issues.
On the other side, as we continue to see natural gas prices rise in the short term and have this oil problem, there will be continued pressure to do something more significant on energy. Therefore, we may see action sooner than a veteran lobbyist thinks.
The other point is I do feel that, no matter what happens in the larger energy debate, we are going to move very quickly to a debate on climate change and global warming. It will start soon and, in that sense, we are at the end of one chapter and the beginning of another.
Finally, let me respond to Roger Gale. It is probably a good thing that we can't say in one sentence what is in a 1,700-page bill. It is not unlike the report of the Cheney task force that said we have to develop all our energy resources in environmentally responsible ways. The bill has 17 titles. We have talked today about the stuff for coal, LNG, renewables, transmission and the overall electric sector, but it is a big bill. The markets move forward. We will move on to another act in this drama pretty soon.
MR. MARTIN: Have the rest of you seen people with whom you deal starting to worry about carbon emissions, and how is this affecting their behavior? Roger Gale, you are nodding yes.
MR. GALE: I think there is a general recognition that was not evident a year ago -- and it wasn't a consequence of the energy bill -- that we are going to have carbon issues. My company did a survey of utility executives recently, and the one question on which more people agree -- 93% of the respondents -- is that the climate issue is going to become more important.
MR. MARTIN: John Veech, are carbon emissions a topic at Lehman for your clients?
MR. VEECH: Yes. I think people are very focused on carbon emissions. There is a consensus that regulation is inevitable. There will be winners and losers. People are already thinking about how the coming regulation will affect the economics of their deals. People are baking their expectations about what will happen into their projections.
MR. SHAPIRO: California already has in its procurement requirements for utilities and adder of sorts, so that people who bid and will emit CO2 or other greenhouse gases will be at a disadvantage to other bidders whose technologies don't.
MR. MARTIN: Joe Kelliher, the new FERC chairman, said that new energy bill is the most significant piece of energy legislation to become law in the last 70 years. Do you agree with that assessment?
MR. SHAPIRO: It is a very significant bill for people who want to buy utilities. It is a very significant bill for the franchised utilities. For wholesale generators, I think the Public Utility Regulatory Policies Act in 1978, and the Energy Policy Act in 1992, were more significant.
MR. MARTIN: Are there any dissenting views? PURPA, the 1978 statute that Bob Shapiro just mentioned and that was a foundation for the independent power industry, caused a seismic shift in the shape of the power business in this country. Will this bill do the same?
MR. GAW: The 1992 act had a much more significant shift in the profile of the utility industry. It created a partially competitive marketplace. A partially competitive marketplace led to the issues that we all faced three years ago. Outside of PUHCA repeal, which I think is a very significant step, this latest energy bill looks like a bill that took about four years to come together. It is more like a Christmas tree than a bill. I do not believe it will lead to a significant change in the landscape, but we will find out in the next five or so years what the impact will be on investment decisions. I doubt the legislators who passed this realize fully what the impact of those decisions will be.
MR. MARTIN: Bob Kelly, is this bill an energy policy?
MR. KELLY: It is not a policy in any great sense. The repeal of PUHCA will lead to some consolidation of the electric power sector. I don't think the consolidation will be easy to achieve because of the state impediments. The bill is an effort to shift capital into particular sectors, like coal gasification. The bill is not very comprehensive. It is not very strategic.
MR. MARTIN: Don Kendall, you made an interesting point when I spoke to you before this session about the contrast between this bill and PURPA.
MR. KENDALL: I think the main change is repeal of the Public Utility Holding Company Act, but the effect will take a long time to be felt fully. One should expect major consolidation of utilities in the long run and a handful of new issues around that consolidation.
PURPA had a much more dramatic impact, but no one understood in 1978 when PURPA was enacted how it would reshape the US market.
This new bill is clearly not an energy policy act. It is a grab bag of stuff related to power. The impact will be piecemeal. It will have nowhere near the ripple effects of PURPA.
Most Significant Legacy?
MR. MARTIN: PURPA changed the landscape. There was one thing that came out of PURPA. It was the independent power industry. Is there one thing that we will be able to say 10 years from now came out of this bill?
MR. WENNER: I'll call it the Starbucks of utilities. I am a little more bullish that there will be real consolidation of electric utilities now that the Public Utility Holding Company Act has been repealed. There are still barriers at the state commissions, but just look at the MidAmerican-PacifiCorp, Exelon-PSE&G and Cinergy-Duke mergers that have been announced recently. Duke and Cinergy said in their testimony to the regulatory commissions, for example, that this is just the beginning, and they view the merged utility as a platform on which to expand further.
MR. MARTIN: So you think the one thing that we will be able to say 10 years from now came out of this bill is fewer utilities. Does anyone else see one thing?
MR. WENNER: Or bigger utilities.
MR. GAW: I think the other thing we will be able to say was the result of this bill is the construction of new nuclear power plants. My first financing as a banker was to refinance the Three Mile Island nuclear plant. I have often said that the next Gaw who finances a nuclear plant will be one of my grandchildren. About three years ago, that changed to the next Gaw will be one of my daughters. Now, I have changed that to the last deal that I will do in my career will be a nuclear power plant financing. The nuclear provisions in the bill are a very important watershed moment in this country.
MR. MARTIN: I noticed the Joint Tax Committee staff estimated that it would be 2013 before there will be any revenue loss from the tax incentives for nuclear in the bill. When do you expect to see the first nuclear plant built, and when do you expect to retire?
MR. GAW: I have three daughters, and three college educations and three weddings to look forward to, so I have plenty of time. No one knows how long it takes to build a nuclear plant in this day and age. I doubt we will see any new plant in commercial operation before 2015. It may even be 2020. Six plants have been identified already as possible candidates for construction. However, I do know we will see development work done on them. For example, British Fuels is looking today to divest Westinghouse Electric's nuclear division. If it had tried to sell the same subsidiary three years ago, there would have been a very limited response. I think you will see some large players start to become more prominent on the nuclear side of the business.
The United States is not the only place in the world that is taking a renewed interest in nuclear. There are other countries that have always been more comfortable with nuclear power -- countries like France and Korea. I do not see nuclear turning suddenly into a bonanza for developers or bankers or equity investors, but there will be a gradual renaissance worldwide.
MR. MARTIN: Don Kendall, there has been a lot of discussion about whether Wall Street is impressed enough by the incentives in the bill for nuclear to finance new nuclear plants. What do you think?
MR. KENDALL: They will get funded, but a lot of the risk will have to stay with regulated utilities. They will require significant amounts of equity to finance. This will be a long process. The last such projects to be financed were 15 years in gestation.
MR. MARTIN: Adam Wenner or Bob Shapiro, I think Don Kendall just suggested that the next wave of nuclear plants will have to be done on a rate base because these are pretty risky ventures. They take an enormous amount of time. Will the state regulators allow such risky ventures to be put on the backs of the ratepayers?
MR. KENDALL: Let me interrupt. I didn't necessarily say "rate base," but I think a creditworthy entity will have to stand behind any new nuclear plant. It could well be a utility making the assessment. A regulated utility can get such a project financed. But I think the financings will be different. They will be more like we did at the end of the last wave of nuclear plant financings where lease financing was used. This had the effect of levelizing the payments and avoiding the shock of putting the entire cost into rate base with a commensurately large immediate increase in rates.
MR. MARTIN: So there may be new demand for all the leasing experts at banks who have been laid off?
MR. KENDALL: I don't necessarily think it will be third-party leasing. I think it will be inter-company leasing, like you are going to see for some of the large advanced coal plants for the purpose of smoothing the revenue stream.
MR. SHAPIRO: I agree nuclear will not be a developer play. It will be a utility play because of the risks and potential delays in permitting. There is some coverage in the new energy bill for the cost of delay, but it is for just the first few plants, and the amount of money is limited and the coverage is available only for a limited period of time. These are risks that can only be borne by captive customers of utilities. Considering the long lead time from development to completion, that is a very long time for a developer to carry that kind of risk without repayment.
MR. WENNER: Let's not overlook the intersection of the two themes about which we have been talking -- the possible revival of interest in nuclear at the same time that utilities are consolidating. My view, exemplified by the Exelon-PSE&G merger, is that we will have a handful of large, nuclear-focused utilities that are in a better position to undertake these risks.
MR. GAW: I think you are absolutely right, but I will tell you not only are the lenders going to demand some assurances on cash flow stream and payment, but the equity holders are going to demand it, too. Some of us are old enough to remember the disallowances the last time around. It was a fairly big club that suffered. Especially big bites were taken out of the shareholder positions. I don't think you will have a deal until it is wrapped on the financial side through a lease arrangement or a large safety is provided by the federal government.
Let me tell you this: Don Kendall is right. This is a 2020 prospect. Who knows what the constituency is going to look like in 2020? Who knows what ratepayers are going to be paying for electricity in 2020? Who knows what the price of natural gas is going to be in 2020? It may be that the legacy of this energy bill will be several new nuclear plants that are costly in relation to other power stations. I doubt that, but it cannot be ruled out as a possibility.
MR. MARTIN: Bob Kelly, do we have any choice on nuclear? If we're going to bring greenhouse gases under control, don't we have to turn to nuclear?
MR. KELLY: I think there are other options. The dark horse is how much penetration solar energy gets by mid-century. There may also be new ways to sequester emissions from coal. My problem with nuclear is its high cost. There is also the problem of the nuclear waste. You still have a lot of opposition not just from local communities on siting, but also from shareholders. These are huge impediments. Unless the federal government becomes a lot more proactive on siting, nuclear is not going to happen.
MR. MARTIN: That's an interesting point. There is the so-called Yucca Mountain dispute in Congress about what to do with the nuclear waste. Congress has not been able to settle it. Can you have a nuclear plant before we know where the waste can be deposited?
MR. KELLY: I don't think so. Congress will have to come up first with a policy for nuclear waste disposal for the existing waste, let alone the new waste from incremental investments in nuclear power.
MR. MARTIN: So, here may be one place where the energy bill did half the job? Congress put some incentives in place. Maybe they are enough. Maybe they are not. But the waste issue must still be tackled.
Let me move back to something on which Bob Shapiro and Adam Wenner touched, and that is consolidation of US utilities. Don Kendall, you have scoured the market for opportunities for investment. Presumably one of those opportunities is utilities that are potential takeover candidates. How do you spot such a candidate?
MR. KENDALL: First, let me comment on the speed with which I see the sector consolidating. I think it will happen gradually. I think you are going to see virtually no hostile takeovers in the utility industry, because utilities tend to have the support of the local politicians. This means the acquisitions need to be friendly transactions. The two private equity firms that were bidding recently on utilities -- KKR and Texas Pacific -- both failed because they were unable to muster local support for their bids.
In terms of scouring for opportunities, we tend to like opportunities where utilities are mismanaged. The difficulty there is dumb management is not often smart enough to sell the company when it should. Those are the companies that should be taken over by a better-managed company, because the takeover is a win-win for the shareholders and potentially also for the ratepayers.
More often, I think what you will see are situations where a CEO who is close to retirement and thinking about his legacy is willing to be taken over by somebody.
MR. GAW: I agree on the speed issue because, in all honesty, PUHCA has been Swiss cheese for the last five to 10 years. It did not prevent utilities that are determined to merge from doing so.
I think mergers are based on value. I don't think anyone here believes we will be down to 50 utilities in the United States within the next five years. I don't see it happening because of the constituencies behind the various electric utilities. Many utilities are electric cooperatives or municipally-owned utilities. Those of us who have spent time with them know it is a religion. It isn't a business. These people are very fervent about what they are doing and about control over their assets.
At the end of the day, value must be created for the shareholders. There must be real synergies. One of the obstacles for global foreign players thinking about coming into the US market is they don't understand our regulatory framework. The new energy bill solves only part of that problem. It sweeps away some federal regulation but leaves 50 different state regulatory schemes intact. Second, they really cannot get to the same level of synergy that the utility next door can.
MR. KELLY: Don Kendall made the point that the types of firms that you would look to acquire are poorly-run firms that have undervalued assets. But typically in the utility business, if a company is poorly run and not performing well, chances are that it is at odds with its rate makers. And if the company is at odds with its rate makers, then it is going to be a damn hard thing to come in as a new investor and get a good deal on rates.
MR. KENDALL: What I think makes sense is more like the Exelon acquisition where you take two utilities that have a particular expertise -- nuclear, for example -- or two utilities trying to become the market leaders in a new coal technology. You may well see combinations to form larger transmission companies.
MR. MARTIN: Have you bought any stock of a utility that you expect to be a target?
MR. KENDALL: We are much more on the fixed-income side, and generally we wait until a deal is announced, if we are in that business, as opposed to trying to speculate. My view is these are going to take an awful lot of time. I think I would be too impatient to buy a stock in somebody that should be taken over, because I just don't think the consolidation will happen quickly.
MR. WENNER: I have been reading a lot of testimony lately in proposed utility mergers. Here's a dichotomy that, I think, is a useful way to look at them. The pros are economies of scale, and I think such economies are real, even if the two utilities are not contiguous, because of back-office operations, reduction in number of officers and other things like that.
But there are no economies of scale, as PacifiCorp found out, in dealing with regulators. The fact that you know how to deal with one regulatory commission does not mean that you will be able and equipped to deal with another.
MR. GAW: It is obvious that everybody will have his home market, including US utilities. But when I talk to European utilities, perhaps they are trying to be polite because I'm an American, but they some say that they have a keen interest in investing in the United States. They just don't know how to make it work.
I agree. The likelihood of somebody coming in and buying something is low, but utilities around the globe face the same challenge, especially in OECD markets. They have very limited capacity for growth in their home territories. They have growing cash balances, and they are looking for alternative investments. So, either you go buy drug stores and real estate and all the other things that people did in the 1970's that proved unsuccessful, or you stick to what you know best.
I think there will be a shift at some point. I don't know when that inflection point will occur. You will see people starting to venture again into markets with which they are unfamiliar. At least they will be remaining in a business with which they are familiar even if the market is different.
MR. MARTIN: Does anybody foresee a private equity fund taking over a utility in the next year?
MR. GAW: Maybe you should ask the opposite question. Do we not foresee that? I think one of the things we haven't talked about is the role of private equity and financial sponsors. I think the more interesting question is not so much which utilities will buy other utilities, but really which financial sponsors will play in this space in a big way. I do think you will see private equity come. It may be very targeted. It may be in the transmission business where although the returns are regulated, they are higher. Or it may be the renewable sector. I expect private equity to play a fairly significant role.
MR. SHAPIRO: I agree. I think transmission is particularly well-suited for private equity and not only because the allowable returns will be higher. A transmission-only entity is a federally-regulated entity that can get out from under the state control that we have said is a problem for mergers or acquisitions of distributions companies.
MR. KENDALL: The only way transmission works for private equity is with double leveraging. If you have FERC looking through to the holding company, you are going to have problems. However, as long as FERC continues to permit double leveraging, which is what the CIBC entity did with KKR -- the actual rates of return on the deal are pretty rational. The reason you can do that, again, is through the right capital structure. But if there is a piercing of the structure -- and that was one of the issues with the Texas Pacific acquisition of Portland General -- once the regulators saw the internal documents and how much the bidder was making on leveraged equity, what the bidder said about lower returns and helping the ratepayers didn't ring as true. The same issue is present in transmission projects. If FERC decides some day to look at the actual leveraged equity in terms of transmission, there could be some real pressure to get the regulated return down.
MR. MARTIN: Is another way of describing double leveraging that you are allowed to earn a regulated return on a hypothetical capital structure?
MR. KENDALL: Exactly. In effect, you are showing more or less a 50% equity capital structure and 50% debt. The 50% equity is leveraged further at the level of a holding company.
MR. MARTIN: What returns are transmission companies allowed to earn?
MR. KENDALL: Independent transmission companies are allowed something like a 13% return with the hypothetical 50% leveraged capital structure. There is something like a 1% adder for independent companies.