By David Schumacher

Municipal utilities are again using the proceeds from the sale of tax-exempt bonds to prepay for long-term supplies of natural gas. A significant number of these gas prepayment transactions closed in 2006. More are likely in the future. A prepaid gas deal is a structured transaction in which one or more municipal utilities, through a special-purpose entity often called a “joint-action agency,” use proceeds from the sale of tax-exempt bonds to prepay for a supply of gas that will be delivered over a long period, such as 15 years.

The joint action agency that issues the bonds uses the proceeds to buy the prepaid gas and then resells it to the municipal utilities that participated in forming the joint action agency. Structured finance transactions fell out of favor after Enron collapsed. Interest in prepaid gas deals cooled. However, since the Energy Policy Act passed in August 2005, the deals have been making a comeback. The Energy Policy Act provided standards for determining whether a prepaid gas transaction meets certain federal tax code requirements. More than $5 billion in such transactions closed in 2006. Both the utilities and gas suppliers can benefit from such deals. The utilities benefit from a long-term gas supply with a creditworthy gas supplier. The structure usually enables the municipal utilities ultimately purchasing the gas to buy gas at a discount from the market price when the gas is actually delivered.

The gas supplier benefits from a low-cost source of capital that is repaid through the long-term delivery of gas to what is viewed as a stable market. The municipal bonds are nonrecourse obligations of the municipal issuer and its participating municipal utilities. For repayment, the bondholders look only to the collateral in which the municipal issuer grants a lien in favor of the bondholders. The collateral is usually limited to the transaction contracts, the revenues the municipal issuer will earn from resale of the gas to its member utilities, and various reserve accounts established under the bond indenture.

The tax-exempt nature of the bonds is key to the transaction. The Internal Revenue Service will tax interest payments on state or local bonds if the bond proceeds are considered a private loan or if proceeds are used to prepay for property or services the primary purpose of which is to receive an investment return. The IRS issued regulations in 2003 providing guidance on the type of gas prepayment transaction that would not run afoul of IRS rules. Congress provided more clarity in the Energy Policy Act of 2005. The criteria generally require at least 90% of the gas that a municipality purchases must be used to serve the retail load of the purchasing utility or of other government-owned gas utility systems.

Structure

The typical prepaid gas deal involves four main parties: a special-purpose municipal entity that issues the bonds and uses the proceeds to prepay for a long-term supply of gas, the gas supplier, the municipal utilities that take and pay for the gas, and one or more counterparties to a hedge that has the effect of shifting gas rice risk.

The issuer of the bonds is often a joint action agency, formed by municipal utilities, whose primary purpose is to enter into and manage transactions of this sort on behalf of member municipal utilities. This type of issuer usually has no assets. The structure allows the municipal utilities that will use the gas to avoid incurring debt directly and allows more demand to be aggregated to support the transaction.

The gas supplier must have the means to deliver gas over a long time period and, because it also has certain payment obligations if a problem arises in the transaction, it must have good credit. The credit of the gas supplier, or its guarantor, plays a significant role in determining the rating given to the tax-exempt bonds.

The gas price risk inherent in these transactions is typically mitigated through the use of gas price hedges. Each of the gas supplier and the municipal issuer enters into a hedge with the same counterparty. The creditworthiness of the hedge counterparty or its guarantor is also important to the rating on the bonds.

The contracts used to implement the deal must address six main risks. The gas supplier could fail to deliver gas.The municipal issuer could fail to take delivery. The municipal utilities that are the ultimate users could fail to take and pay for gas. The counterparty to the hedge could fail to make payment on the hedge. A force majeure event could prevent delivery or receipt of gas. The bonds could fail to qualify as tax-exempt debt.

Contracts

The main transaction contracts are a gas supply agreement between the gas seller and the municipal issuer, gas purchase agreements between the municipal issuer and its members, at least two gas price hedge agreements, and any guarantees that are needed to support the obligations of the gas supplier, the hedge counterparties and municipal utilities.The reserve accounts usually include a debt service fund into which amounts are deposited periodically to pay debt service on the bonds and an operating reserve established at inception to guard against revenue shortfalls.

The municipal issuer enters into a gas supply agreement with a creditworthy gas supplier. The gas supply agreement obligates the gas supplier to deliver a scheduled quantity of gas each day over the contract term.

The municipal issuer uses the bond proceeds to make an upfront payment for all of the gas supply to be delivered over the term. The prepayment is calculated using a forward gas price curve. If the gas supplier itself is not creditworthy, then the obligation of the gas supplier to deliver the prepaid gas must be guaranteed by a creditworthy entity.

 In some transactions, the municipal issuer enters into multiple gas supply agreements. This is done either to mitigate the risk of relying on one gas supplier or to create a structure where each gas supply agreement is dedicated to serving a particular municipal utility.

Risks associated with the failure of the gas supplier to deliver gas, or the municipal issuer to take gas (including due to the failure of a municipal utility to take gas from the municipal issuer or force majeure), are often mitigated by requiring the gas supplier to remarket the untaken gas. The gas supplier, in turn, earns a remarketing fee. The gas supplier will pay the municipal issuer from the proceeds of the remarketed gas an amount adequate to cover debt service on the bonds. If the gas supplier fails to deliver gas, then the gas supplier must compensate the municipal issuer for both the incremental cost of replacement gas and debt service. If a force majeure event prevents delivery or receipt of gas, the gas supplier usually must pay the municipal issuer an amount to cover its debt service. Finally, if the gas supply agreement is terminated early due to either a gas supplier default (including the gas supplier’s persistent failure to deliver gas or a bankruptcy of either the gas supplier or its guarantor) or a municipal issuer default, the gas supplier must make a termination payment in an amount needed to redeem the bonds.

The municipal issuer also enters into gas purchase agreements with each of its members. The terms are substantially similar to the terms of the gas supply agreement between the gas supplier and the municipal issuer. The rating agencies will view a prepaid gas transaction more favorably if the gas that the municipal utilities intend to purchase is not a significant source of their daily gas supply requirements but merely a complement to their other supply sources.

The municipal utilities commit to take and pay for a fixed quantity of gas over the term of the transaction.They pay a price linked to the market price of gas at the time the gas is delivered, often less a discount. Each municipal utility covenants that payments for this gas will be treated as system operating expenses and thus will be paid before debt service on its outstanding debt.

The credit of the municipal utilities is often supported by a surety bond or other insurance product. The municipal issuer can call on this credit support in the case of a municipal utility default. The obligor on the credit support typically caps its exposure under the credit support instrument. For example, if the credit support obligor must make a payment based on the market price of gas at the time of the municipal utility default, then the market price of gas used in that calculation could not exceed a set price. Moreover, the credit support obligor’s obligation to pay could continue for only a fixed period of time.

Both the gas supplier and the municipal issuer usually mitigate gas price risk by entering into hedges. The price risk arises from the difference between the fixed gas price that is used to determine the amount of the initial prepayment for the long-term supply and the market price for gas at the time the gas is delivered. Both the gas supplier and the municipal issuer face marketprice risk. The gas supplier is exposed because it must purchase gas in the market periodically as each quantity of prepaid gas is delivered; the municipal issuer is exposed because it resells the gas to its members at the prevailing market price at the time of delivery (often with a further discount).

To mitigate the municipal issuer’s gas price risk, the hedge counterparty pays each month to the municipal issuer a fixed price for a notional quantity of gas, while the municipal issuer pays an index price (less a discount) to the hedge counterparty on this notional quantity of gas. The fixed price is tied to the gas price used to determine the prepayment. The index price (less the discount) is the price that the municipal utilities pay to the municipal issuer for gas delivered during the relevant month. The notional gas quantity is equal to the quantity of gas scheduled to be delivered to the municipal issuer that month. Thus, if the market price of gas (less the discount) in the relevant month is higher than the fixed price payable by the hedge counterparty, then the municipal issuer must make a payment to the hedge counterparty. The municipal issuer has the revenues available to make this payment, without threatening its ability to pay debt service on the bonds, because the municipal utilities have paid for gas at the same index and discount. Conversely, if the fixed price is higher than the market price of gas (less a discount), then the hedge counterparty must make a payment to the municipal issuer. This payment helps the municipal issuer fill a revenue gap that would arise because the price at which it resells gas to the municipal utilities is less than the price used to determine the amount of the prepayment.

The hedge provider enters into a similar gas price hedge with the gas supplier.However, instead of paying a fixed price, the hedge counterparty pays the gas supplier the market price prevailing when the gas supplier delivers gas (less the same discount used to determine the municipal issuer’s payment obligation under its hedge with the counterparty), and the gas supplier pays the hedge counterparty the same fixed price that was used to calculate the prepayment under the gas supply agreement between the gas supplier and the municipal issuer. The notional quantity of gas is the same under both hedge agreements.

The credit of the hedge counterparty is important in determining the rating given to the bonds. Thus, if the hedge counterparty is not adequately creditworthy, then its payment obligations under the hedge will have to be guaranteed by a creditworthy entity.

A mechanism is usually put in place to address a payment default by the hedge counterparty or its guarantor. This mechanism usually requires the gas supplier and the municipal issuer to find a replacement hedge counterparty within a given time period. If such a replacement counterparty cannot be found, then the gas prepayment transaction can be unwound. If this were to occur, then there may not be adequate funds to repay the bonds unless the gas supplier is obligated to make a termination payment for the full bond redemption price upon termination of the transaction.