Lessons learned from the PG&E bankruptcy
Two senior bankers who are active in the California market, and the general counsel of a prominent renewable energy developer based in California, talked in late July about what effect the PG&E bankruptcy has had on the ability to finance renewable energy projects in California and what, if anything, they are doing differently in new transactions to reflect lessons learned from the bankruptcy. The following is an edited transcript.
The panelists are Paul Pace, senior vice president and team leader at Key Bank, Pascal Uttinger, managing director at MUFG, and Kevin Malcarney, general counsel and senior vice president of Clearway Energy. The moderators are Jim Berger with Norton Rose Fulbright in Los Angeles and Christy Rivera with Norton Rose Fulbright in New York.
MR. BERGER: Paul Pace, will Key Bank lend to a project whose main source of revenue is a long-term contract to sell electricity to a California investor-owned utility? And do you differentiate between Pacific Gas & Electric, on one hand, and Southern California Edison and San Diego Gas & Electric on the other?
MR. PACE: Yes, we will lend to California utilities.
Do we differentiate? For a while we certainly differentiated in that PG&E was un-financeable while it was in bankruptcy. Today, there are other issues for why PG&E is a little different than the other two utilities. We check the credit ratings and assess where our claims will be on both a secured and an unsecured basis. That does not rule out a loan at this point. It is more of a matter of how best to deal with the risk.
We look at the regulatory environment in the state as a whole. The state regulators did a good job of balancing what was right for the bondholders, what was right for wildfire claimants, and what was needed ultimately to keep the lights on and keep pace with milestones under the renewable portfolio standard.
The bottom line is we are still willing to lend to projects that have offtake contracts with investor-owned utilities in California.
MR. BERGER: Pascal Uttinger, same question. Will MUFG lend to projects with California utility offtake contracts, and do you differentiate between PG&E, on one hand, and SCE and SDG&E on the other?
MR. UTTINGER: The short answer is yes, we are still lending, and I echo the comments that Paul Pace made about a supportive regulatory environment in California.
MUFG has been an active lender to California utilities and to projects with offtake contracts with California utilities for years. We witnessed both PG&E bankruptcies first hand and have a lot of direct experience in the California market. We concluded early on that PG&E was unlikely to abrogate any contracts for renewable electricity or for gas-fired generation, especially with the backdrop of the state renewable portfolio standard and the bad precedent that abrogating any contract would set.
Like most, if not all, project finance lenders, we have concentration limits for California risk and certain offtake risks. As long as we operate within our own concentration limits, we expect to remain active in California.
Moving to the second part of your question — whether we view PG&E differently than the other utilities — there are a couple points to make.
It makes sense that the market assigns a premium to PG&E versus the other two utilities. We currently see a premium in the 25- to 50-basis-point range for project finance transactions. PG&E is not rated investment grade as a corporate borrower. We expect the premium to disappear over time as the bankruptcy gets smaller in the rear-view mirror and PG&E is ultimately upgraded.
At least two deals are in the market currently with PG&E offtake contracts, and we expect those transactions to go well.
MR. BERGER: Kevin Malcarney, how does Clearway, as a long-term owner of assets, approach projects with California investor-owned utilities? And do you differentiate between PG&E, on the one hand, and SCE or SDG&E on the other?
MR. MALCARNEY: Within California, we do not differentiate among the big three California utilities other than to try to balance our portfolio. We prefer not to be heavily weighted to one over the others.
We also focus on improving the geographic diversity of our portfolio by investing in projects outside California.
MS. RIVERA: PG&E was not pushed into bankruptcy because it had too many debts or because its revenue is shrinking. It was pushed there by wildfires. To some extent, wildfires are an unknowable risk. To another extent, they are probably a direct effect of climate change and will be more likely in the future.
With that in mind, let's drill down into two types of risk: bankruptcy risk and wildfire risk.
Pascal Uttinger, starting with you, how do you price bankruptcy risk in a project financing?
MR. UTTINGER: Offtake credit risk is a major driver for pricing in any non-recourse project finance transaction. The probability of default by the offtaker, including as a result of a bankruptcy filing, is a key pricing metric. The higher the possibility of default, the lower the rating and the higher the price of the loan.
That said, if there is a foreseeable material risk of an offtaker bankruptcy, then lenders will simply not lend. There is no price at which a regulated bank would lend where the offtaker is expected to file for bankruptcy. As the rating falls, you would get the higher price to offset that risk, but a default would have to be unexpected to lend at all.
MS. RIVERA: Paul Pace, are there other considerations that you take into account when you are considering bankruptcy risk for a project?
MR. PACE: Yes, the regulatory environment in the state. There is not a huge difference in general among investment-grade utility offtake contracts. Whether the utility is an A- or BBB credit, we do not see much difference among utilities in terms of pricing and bankruptcy risk.
Another consideration in pricing is the all-in costs of borrowing under corporate revolvers. It would be odd to price inside of those spreads on a single-asset offtake contract that is entirely dependent on that single offtaker. You should not really price such a loan at a tighter spread than the spread on revolvers, but sometimes that happens.
Another key metric is where the utility's bonds are trading. If the bond market is saying that something is X basis points over Treasury yields and you swapped over LIBOR, you should probably be pricing at an equivalent spread to Treasury bonds.
All of that said, at the end of day, it is a competitive market in which something like a PG&E bankruptcy happens once every 20-plus years. I don't think the banks are that concerned about bankruptcy risk. They look at spreads on revolvers and bonds, and the spread in a project financing ends up wider or near the other spreads.
MS. RIVERA: Kevin Malcarney, as an asset owner that wants to finance his projects, you are probably concerned about bankruptcy risk, but for different reasons. Can you describe how Clearway looks at this risk, and do you look at bankruptcy risk differently when you are thinking about a construction or other contractor versus an offtaker?
MR. MALCARNEY: The big questions for Clearway are whether the project can continue to perform and generate revenue through the bankruptcy and how our credit agreements function in a bankruptcy situation.
An offtaker bankruptcy, as far as I know, is always an event of default under both the power purchase agreement and any financing agreement.
Some of the questions we have to ask are whether there is a risk of the agreements being rejected by the debtor, how soon after bankruptcy filing we can get a good read on the likelihood the contract will be rejected, whether our cash distributions will be trapped and, if so, how soon the cash will be released, and whether we can continue to service project debt and ongoing operating costs without injecting additional equity into the project.
We need to look at the total picture and determine whether the project will survive through the offtaker or contractor bankruptcy or whether the project itself may need to avail itself of the protections afforded by the bankruptcy code. Fortunately, we have not had to have any project file for bankruptcy.
Many power contracts with PG&E allow the utility to pass through the amounts the utility pays for electricity to the ratepayers. Rejecting those contracts would not have significantly increased the bankruptcy estate or the amount recoverable for wildfire victims, creditors and other stakeholders.
While the risk of rejection is always there until you get a confirmation order in place, it did not seem to make much sense that PG&E would reject those contracts.
As far as contractor bankruptcy goes, they do not always trigger an event of default under either the PPA or the financing, so that situation is a little different. If it is a material contractor, then we need to analyze whether the contractor is likely to survive the bankruptcy. If not, the issue is whether we can easily replace its services with some sort of temporary credit support that will not affect the non-recourse nature of the project under the financing agreement, but that would let the project survive through the bankruptcy and come out on the other side.
MS. RIVERA: Let's go back to the banks. How do you take into account wildfire risk? Do you look at the track records of utilities? The physical terrain where they are located? Paul Pace?
MR. PACE: That all comes into play. We look at where the project is located, who the utility is, and how vigorously the utility is taking steps to prevent its equipment from causing wildfires.
An issue is California inverse condemnation. Even if PG&E did all the right things, it is on the hook. There is no need to prove negligence to hold it accountable. This was problematic to say the least. That was one thing that was probably underestimated when we looked at PG&E.
We look at the spend that needs to go into preventative maintenance, and how utilities plans to cover the cost.
MS. RIVERA: Pascal Uttinger, how do you address wildfire risk?
MR. UTTINGER: I see two parts to this question.
There is a direct risk to the project itself. To assess that risk, we do standard project finance diligence, meaning we attempt to cover off wildfire risk as it would threaten a particular project. The lenders work with the independent engineer to make sure that there are sufficient fire-mitigation measures being taken. We look for any history of wildfires in the place where the project is located.
Then, separate from that type of diligence, we also make sure that the insurance package is adequate and includes business interruption insurance. If it is an existing project, lenders might run some cases based on what the project has encountered in the past with respect to fires and outages it has suffered because of them.
The second part is obviously the utility exposure to wildfire risk. For that, I think there is a differentiation between PG&E and the other two California investor-owned utilities. The PG&E service territory is far vaster and also covers more rural parts of central and northern California. Communities are expanding into areas that have vegetation that is more prone to fire risk.
I agree with Paul Pace that this risk was under appreciated in the past. There have been recent legislative and regulatory changes in California to mitigate the risk and make it more feasible for lenders to continue lending to California utilities and projects.
MS. RIVERA: Kevin Malcarney, how does Clearway look at wildfire risk? Do you use a higher hurdle rate for an asset that has this risk?
MR. MALCARNEY: The PG&E situation made everybody focus on inverse condemnation and wildfire mitigation strategies. From our point of view, risk includes the ability to manage wildfire risk and recovery liabilities. We take this into consideration when making investments.
I can't get into specifics about higher or lower returns since we view projects on an overall basis. It is important to note that the overall regulatory construct in California has improved with the passage of AB 1054, and the utilities are making significant investments and trying to change some of their strategies for mitigating wildfires and the negative effects.
People are really trying to manage that risk a lot more than they did in the past and are paying attention to it a lot more. This should help the industry overall.
MS. RIVERA: There are other risks. We have been focused on wildfires, but sea-level risks are an example. Are there any other climate-change-type issues that you think about when you look at projects in California?
MR. PACE: On an individual project level, we are more focused on climate-change issues, whether it be floods, projects that are built near shores or in areas that are prone to storms. The risks can be mitigated with insurance and the right amount of engineering.
The difference here is that the utility did not handle the climate-change issue, and that is what threw it into bankruptcy. The issue was not the location of any project.
On top of it, there is no way to underestimate the amount of tragedy in loss of life and property. With flooding, a rising sea level and similar issues, the utility is not going to cause the damage. The issue is climate change and how the utility manages it.
What we worry about most with all these things happening is the insurance market. Will insurance become prohibitively expensive on projects we would like to finance?
MS. RIVERA: You went exactly where we wanted to go. Kevin Malcarney, are you worried about what this does to the cost of insurance for renewable energy projects?
MR. MALCARNEY: We worry about the impact of legislative and regulatory responses to the environmental changes on insurance markets. You cannot de-risk everything. We try to stay on top of legislative and regulatory developments so that we can be in a position to respond to market changes and continue operating in a safe way.
MR. BERGER: The root cause of the PG&E bankruptcy was wildfires which are clearly a risk in California.
After PG&E filed last year, we heard that lenders not surprisingly stopped lending to projects with PG&E offtake contracts. Many lenders took a wait-and-see approach with the other California utilities.
There seemed to be a lot of hope that AB 1054 would further thaw the financing market. The new statute is already being put to use after the California Department of Forestry and Fire Protection announced that the Kinkaid wildfire was caused by PG&E's electrical transmission lines. The Kinkaid fire was not addressed in the bankruptcy case; hence victims will not receive compensation from the wildfire victims trust created by the case. Instead, a separate wildfire fund created by AB 1054 will be the source of recovery.
Paul Pace, do AB 1054 and the state wildfire fund give you comfort to lend to projects with California utility contracts?
MR. PACE: Yes. The fact that PG&E must present plans for preventative maintenance and will be held responsible also help. It helps to have an extra set of eyes on the issue. Having more than $20 billion of loss coverage in front of you helps. We like having reserves in banking. The state fund is one more reserve to make sure the utilities remain healthy.
MR. UTTINGER: Project finance at its core tries to analyze risk and then make sure the right parties are bearing the appropriate risks for those parties and that the transaction overall is priced appropriately in light of the risk profile. What makes it challenging to do is there may be risks that are really hard to quantify or predict, such as wildfires causing a utility bankruptcy. Something like AB 1054 was needed given the inverse condemnation reality in California.
It was a thoughtful approach to address the risk. I think we will see that it is serving exactly its intended purpose, and lenders will start lending to projects with PG&E offtake contracts, which would probably have been extremely challenging to do if it were not for AB 1054 or something like it.
MR. BERGER: Kevin Malcarney, does AB 1054 play into Clearway's analysis?
MR. MALCARNEY: Yes, it does. I don't have a lot to add to what Paul and Pascal said. The Kincaid fire is a chance to see how well the fund works.
MR. BERGER: Is there anything else that you wish the California legislature or the California Public Utilities Commission would do to give developers and financing parties more comfort? Obviously eliminating inverse condemnation would be one step, but there seems little chance that will happen.
MR. UTTINGER: If things play out as expected, I don't think anything else is needed to bring liquidity back to the market.
The state renewable portfolio standard is so fundamental to California that if the state were to fall behind its goal, I think it would be addressed quickly. There is a collective will in the state not to let that happen.
MR. PACE: PG&E did not have any secured bonds before the bankruptcy. It does now.
It would have been nice to see the bonds issued unsecured. Making them secured bonds changed the dynamics in terms of what would happen if PPAs were to be rejected and what priority project-finance banks would have. This does not really involve the legislature. I am just pointing out one thing that has changed since pre-PG&E bankruptcy back in January 2019.
MR. MALCARNEY: Obviously first and foremost in everyone's mind is the protection of people and properties in California that are affected by wildfires. I don't think inverse condemnation is the right way to deal with that, but I don't have a better idea, so I guess until somebody comes up with something better . . . . Having the utilities improve their strategies for how to eliminate wildfires is moving us in the right direction.
MR. BERGER: If wildfires are the big unknown in terms of potential liability for a utility, one way to reduce that risk is not to contract with a utility.
California has a couple dozen community choice aggregators where cities and counties may buy electricity for residents in their communities. These CCAs do not deliver the electricity, but they use a local utility for that purpose. They do not have the same wildfire risk. However, because most of these CCAs are not rated, they do not have much of a balance sheet. Deals with CCA offtakes are harder to finance if they are financeable at all.
Are you concerned about bankruptcy and wildfire risk when doing a project with a CCA offtake contract?
MR. UTTINGER: From a portfolio theory, risk and risk-mitigation standpoint you should expect to see more lender interest in CCA offtake transactions. The CCA model is a completely different risk profile than the utility model, and there are some positives such as no wildfire risk, but there are also negatives.
CCAs are not exposed to wildfire risk because they do not have any material physical assets. That is both good and bad. If the regulatory and political support behind the CCA model were to wane, then their credit risk would increase much faster than for an investor-owned utility.
Where does all that net out? From our standpoint, we would expect CCAs to continue to play an increasingly significant role in the California market. Lenders should view this as allowing them to diversify their loan portfolios further, thereby reducing exposure to wildfire risk.
Lenders set concentration limits. Adding CCA offtake contracts to the mix allows banks to expand their lending in these markets by having new counterparties on the books. On a limited and appropriate basis, they should be able to be more active in these markets.
MR. PACE: At Key Bank, we have done deals with CCAs as the offtakers. This was accepted practice before the PG&E bankruptcy, and I think Pascal is right that a surprising consequence of this is that not having physical assets has become a positive when looking at CCA credit risk.
CCAs have their own set of challenges that are unrelated to wildfires, but having a CCA that has a slightly different business model and slightly different risk profile, but still has the same sort of bankruptcy risk protection in a lot of ways is something that has given them even better standing in the market than they had before.
MR. MALCARNEY: Our overall focus is on long-term power purchase agreements with creditworthy offtakers. The offtaker can be a CCA or a utility; we put the project through the same rigorous review before making an investment decision. Part of that analysis includes wildfire risk.
MS. RIVERA: The big issue in the PG&E cases was whether PG&E would try to take advantage of being in bankruptcy to shed or renegotiate its PPAs. Various PPA counterparties organized and took steps to ensure that their contracts would not be rejected.
Can you talk briefly about what Clearway did in response to the PG&E bankruptcy filing? Were you focused just on the bankruptcy proceedings or were you doing other things outside of those proceedings?
MR. MALCARNEY: We approached it from a couple angles. We were in constant communication with our lenders either trying to negotiate forbearance agreements or waivers. We were in constant communication with our other contract counterparties, including PG&E.
PG&E does not have the right unilaterally to renegotiate a contract. It can either accept the contract in whole or reject it in whole. If it rejects the contract, it can try to renegotiate it.
That was not what happened in this case. There was not a lot of discussion about the PPAs themselves. We joined in the Federal Energy Regulatory Commission case with other yieldcos and independent power producers to try to establish who has the final say over rejection of PPAs.
We were also actively monitoring all the different legislative and regulatory proposals in California so that we could be in a position to respond quickly to whichever ones made it through the legislature and the CPUC.
We watched everything related to the bankruptcy in an effort to assess where we were going to come out on the other side. We figured out relatively early on that it did not make sense for PG&E to reject its renewable energy PPAs, even though many of them were out of the money.
While we were keeping our eye on the bankruptcy proceedings, we were also trying to renegotiate our way through our various project credit agreements, since the bankruptcy declaration was an automatic default under those agreements.
MR. BERGER: The bankers had to decide whether the bankruptcy filing was an actionable event of default under the financing documents for projects with contracts to sell power to PG&E. Paul Pace, what was Key Bank's general approach to this question?
MR. PACE: Our general approach was to work with our clients to understand what they were going to do. We believed that interests were aligned in this case. We tried to work constructively.
We did not allow cash distributions, just in case something went against us. We would not have wanted to let the cash get away. Other than that, we spent time doing the same analysis that Kevin Malcarney described.
We put together internal memos. We talked to our senior management team. We told them how things were going to play out. We had a thesis. We talked to our legal counsel to understand more ramifications. Our thesis was that everything would be fine in the end.
For developers, the third-party events of default are probably what keep them up at night because they are out of the developers' control.
MR. BERGER: Pascal Uttinger, how did MUFG respond to the bankruptcy filing?
MR. UTTINGER: MUFG took a similar approach. We also strived to take a view early in the process so that we could get conviction around our thesis, which was that there was no benefit to the stakeholders in the bankruptcy to start abrogating contracts and increase the unsecured liabilities of the bankruptcy estate.
Bankruptcy is an automatic event of default in project finance documents to protect the lender in case the unexpected happens. We took the same approach as Key of not allowing distributions until that uncertainty is removed.
At the same time, we also quickly realized that our interests are aligned with the sponsors. We wanted to take as evenhanded and light a touch as possible and still protect the bank's interests.
MR. BERGER: Kevin Malcarney, what should developers do differently when negotiating project contracts, especially offtake contracts, having gone through this bankruptcy process?
MR. MALCARNEY: You can put a lot of words in a contract about what the bankruptcy of a contract offtaker means, but at the end of the day, you are largely at the mercy of the bankruptcy court and the debtor. Most of our projects are separately financed. Once you make an assessment as to whether it makes sense for the debtor to reject or assume the project PPAs, our focus quickly shifts to the financing agreement.
The lender's counsel often takes the most aggressive position with respect to when the event of default begins and ends.
An offtaker bankruptcy has often been an event of default without a defined cure period in the financing agreement. It could be helpful to clarify exactly when it begins. Is it the public notice that the debtor intends to file, which is the position that a lot of people took, or is it the actual filing that starts the event of default?
There is also uncertainty about when the default ends. Does it end upon assumption of the contract even if the bankruptcy case is still ongoing? Does it end with confirmation of the plan or filing of the emergence notice? There are some areas where it would be helpful to eliminate ambiguity or uncertainty around the process, which would allow companies like mine to allow for better planning of capital allocation decisions and decisions about changes to dividends.
I am not sure how much you can write into the PPA or loan agreement that will make a difference, but these agreements could be clearer about what happens after an offtaker event of default.
MR. BERGER: Pascal Uttinger and Paul Pace, what would you do differently the next time?
MR. UTTINGER: We feel good about how our process was handled, even though we saw an array of approaches being taken by other lenders. Some lenders quickly got their workout groups involved. Others pushed to change law firms to bring in workout counsel in reaction to the filing.
We did not take those more extreme approaches. There is nothing we would necessarily want to do differently the next time.
MR. PACE: We would not handle anything differently, but the bankruptcy court is a huge unknown and uncertainty, and I think you have to take each case on its own. You also have to look at each regulatory jurisdiction on its own.
Hopefully our approach of being deliberate about it, being smart about it, coming up with our thesis, and then working with our sponsors and hopefully having interests aligned is always going to be the right approach.