June 2002

"Lot"

by Roger Feldman  --   Bingham, Dana L.L.P.
(originally published by PMA OnLine Magazine: 2002/11/27)
 

Anxious proponents of power industry restructuring received an important Special Comment from Moody’s in May. But it was hard to tell if it was a warning from the Board of Health, a prescription from a physician, an autopsy from the coroner, a Delphic utterance from a fortuneteller, or a biblical injunction. The headlines on it that caught the general public’s eye were certainly ominous and bear repeating, but do not begin to communicate its underlying implications:

"Moody’s believes that energy trading, as presently configured, may lack investment grade characteristics unless it is ancillary to a more... sustainable cash flow...

We believe that fundamental restructuring will need to occur in the near term for this sector to regain investor confidence. Options include: a) sector consolidation... b) the establishment of a [functional] clearing system... or c) creation of... [independently ratable] derivative products companies..."

Here’s what this may well mean: the energy trading companies that have sprung up must be replaced and (probably not or) a whole new creditworthy energy trading market must be set up. Note, also, what the Special Comment does not say: if only FERC would hurry up with its RTO/market design restructuring initiative and get a handle on those market power problems that caused California, all will be well. The private sector must save itself.

With that frame of reference, one turns to the Special Comment’s analytic text and the following biblical analogy leaps up: Lot’s wife has looked back, seen the financial Sodom we have all observed in the newspaper headlines, and turned into a salty pillar. Moody’s ratings (if any) of many energy marketing players will limit their ability to be able to draw soothing liquidity from the capital market wells. They may find themselves pounding. . . salt. Major players have experienced this result already, and seen their appeal of Moody’s decisions rejected.

The Special Comment also is a biblical jeremiad: fix the following matters, merchant power players, and you may be saved. Fail to, and you will succumb to the second great principle of capitalism, viz., pigs get fat, hogs get slaughtered. (The first principle is, "That tulip can’t live forever.")

Three matters needing repair stand out in the Special Comment:

• Lack of Credible Earnings Measures. The meaning of the financial statements of energy marketing companies in the same basic business is obscured, not just because they may follow different risk strategies but because GAAP allows them to use different accounting methodologies. Specifically, accounting guidance on how to mark-to-market ("MTM") commodity-derivative transactions leave significant flexibility to individual power marketers, with the result that ". . .management has wide latitude as to how it chooses to treat a hedge, and thereby affect earnings recognition." ". . .While MTM makes sense for accounting for trading in a liquid environment, it can create significant discrepancies between book profit and cash flows on the longer dated contracts in which many energy merchants engage. . . As a matter of fact: "inappropriate MTM procedures can produce revenues that are inflated by the amount of trading activity and operation income that includes changes in the current market value of trading assets and liabilities." (In other words: Houston, we have a problem.) Truly segmented, transparent accounting and a tracking of income versus cash flow must be installed to forestall the problem.
   

• Excessive Leverage. The Special Comment lumps together investments by power companies in physical assets with those in trading assets and infrastructure in assessing the extent of trading company leverage. It condemns the obscuration of this leverage through the use of off-balance sheet or off-credit debt and pronounces a serious curse on the future of project finance. "We assess off-balance sheet, non-recourse debt to determine whether it is truly non-recourse or whether the company is likely to support such obligations – regardless of whether or not it has a true legal obligation to do so." Consequently, it views positively the desperate efforts of the trading companies to enhance their financial position since the end of 2001. Unfortunately for the traders, the markets are not similarly bemused.
   

• Cash Flow Focus. As far as the Special Comment is concerned, the "CFO" of the future for power companies is "Cash from Operations," to be measured against a variety of corporate financial exposure measures. Those metrics represent the beacon on which Moody’s relies to help see it past the high volatility it perceives as endemic to energy trading. It is this perceived need for credit quality that suggests to Moody’s that consolidation, master netting and collateralization agreements, and emergence of en hanced creditworthy market counterparties are the necessary developments in the future of the industry.

Of course, each of these three matters in need of repair is larger than the power industry. They are revealed sores on the entire body of U.S. corporate governance and operation structure. The resolution of them has become a political foothill in Congress already, but unless the power trading industry that grew up under the stimulus of deregulation can itself institutionally overcome the national systemic accounting system flaws broadly exploited in our recent gilded age (and exacerbated by certain practices of our financial institutions), it may prove not to be a business that continues to attract serious investors. It must deal with these issues now and by itself, even while the larger question of corporate governance remains the subject of ongoing national hullabaloo. There can be no nostalgic looking back, like Lot’s wife, to how a great deal of money was made briefly. The types of recommendations for restructuring suggested by the Special Comment must be a take-off point for industry action, especially since, as a practical matter, government implementation of those recommendations most likely will be unfeasible. That way lies salinization.

Perhaps the industry will heed the message of the Special Comment, in which case, as it says in 18 Proverbs, verse 18, "…Lot puts an end to disputes and decides between men of power."

Thanks a lot, Special Comment.

ROGER FELDMAN, Co-Chair of Andrews Kurth LLP Climate Change and Carbon Markets Group has practiced law related to the finance of environmental and energy projects and companies for 40 years.  In particular, he has analyzed and executed a wide variety and substantial value of project financings.  He chairs the American Bar Association’s Committee on Carbon Trading and Finance, serves on the Board of the American Council for Renewable Energy, and has been a senior official in the Federal Energy Administration.  He is a graduate of Brown University, Yale Law School and Harvard Business School.