June 2004

Storm Clouds Over Olympus

by Roger Feldman  --   Bingham, Dana L.L.P.
(originally published by PMA OnLine Magazine: 2004/06/27)
 

One of the risks of dwelling on Olympus, is what we call “opportunity costs” (hubris in Greek) i.e., being so wrapped up in dealing with the world as you choose to understand it, that you miss the threat posed by reality as it is. So it has been on Pennsylvania Avenue. So it is in microcosm at the FERC. The Commission has been perfect-ing its market power determination screens, while the financial state of the market has become more and more perilous for practical, long-term competition.

Case in point: FERC has been doing major tinker-ing with its rules for determination of whether market based rates (“MBR”) should be available to the owners of particular generating facilities. The approval of market-based rates has been at the core of FERC’s system of deregulation for a decade. Applying what is now acknowl-edged to be an outmodeled “hub and spoke” test, FERC approved virtually all MBR applications, up until the time a few years ago when it began to challenge receipt by MBRs for “unregulated” facilities owned or controlled by a utility within the utilities’ area of effective market power. Since 2001, FERC has first swung to a very rigorous “supply margin” test; then retreated somewhat to its just announced “two-screen” test, and now is designing a broad rulemaking proceeding (RM04-7) to consider under what circumstances market-based rates should be granted to an applicant. FERC is no longer exempting from MBR-examination the contract arrangements arrived at by parties just because they are situated in RTOs. While one expectation is that as a result more vertically integrated utilities’ facilities will qualify for market-based rates than under the prior interim rule, the further more troubling expectation is that, for IPPs, and should be for power asset acquiring entities, much ink and treasure will now have to be spent on what was a ministerial act.

Without going into the details on the various tests — which are bound to change some post-Rulemaking, it would appear that in these efforts, FERC is seeking to preserve some competitive balance between IPP suppliers and utilities, and thereby to protect the core system of competitive power it has labored to put in place. There is some merit in this objective. Nevertheless it represents an unintended diversion from the most important task which FERC (or someone in the Federal Energy chain of com-mand) should be monitoring: the efficient redistribution and absorption of the overbuilt asset fleet through the operation of orderly capital markets. The real story of 2004 continues to be uncertain independent supplier financial health and the reshuffling of the asset ownership deck.

The financial reality which the FERC is facing to-day is that a significant portion of the nearly 175,000 MW of gas fuel generation built between 1999-2003 falls into the “merchant” (i.e., not firmly contracted) category (and there remains, in addition other generation capacity that is par-tially built. As a result of the surge in gas prices, the spark spread on this capacity has waned to a level where project debt service cannot be met in many instances. There is a significant ledge of debt outstanding which is coming due with respect to this market power capacity — payment of some of which was merely pushed out through refinancing and will come due in the next five years. There is a significant body of sophisticated capital market opinion that this ledge of debt will not be rolled over again, partly because capital markets are not as robust as they have been, partly because faith in the fundamentals of reserve margin absorption has been eroded away, and partly because banks have gotten a better fix on temporarily running and then ridding themselves of power assets.

There have been large pools of capital accumulated to purchase what was perceived to be a golden opportunity to buy assets and later resell generating at bargain prices. But the market has already taken down a large proportion of the assets with supporting power contracts that are available. It is seemingly disinclined to swallow pure merchant power capacity at anything near cost on the basis of the hockey stick basis of the same story which created the untimely generation surplus in the first place (abetted by speculative issuance of developer debt.) The capital mar-kets have also taken notice of the fact that in this environ-ment of likely rising gas prices, it is more economic for generators to extend the life of existing coal plants and profit from the enlarging spark spread which results from the fact that at the margin the price paid i n many jurisdic-tions is based on the price for power produced from natural gas.

While the investment banking community currently is brokering some sale of merchant fleets through auctions, the market clearance price has been at a significant discount below initial cost and has also reflected seller or buyer tax benefits from engaging in the trans-action.

In addition, the asset sales that are occurring are, first of all, to “finan-cial” rather than operating sponsors and are financed to a significant extent with B loans, which are decidedly short term, or other high-yielding short-term debt. There are also strategic financial buyers, for the longer term, that focus on trading around assets, but most private equity funds and many large private equity investors, are looking for relatively short term exits. The successful sale of a restructured com-pany, NRG, highlights that there must be a significant debt reduction of debt through conversion into equity and facility operating enhancement through cost cutting if sale of a dis-tressed restructured firm is to be well received.

The current financial market scene also is characterized by move-ment of bank debt into fewer bands, abetted by skillful financial intermediaries; the extension of time for some asset foreclosures and th emergence of several experts companies in asset management. But it should be recalled that they are merely acting for the lend-ers to whom the assets have devolved. Good stewardship does not make a stable market environment by itself. Restructuring individual companies does not restructure power markets.

What should be the responsi-bility of a prudent regulator, survey-ing the financial wreckage of the power industry? Market deregulation worked almost too well: leading too many competitors into the market-place, backed by a willful lender loos-ening of credit market standards by lenders who endorsed the potential of merchant power approach in the face of both questionable market realities and in reliance on a national tidal wave of deregulations. Under the circum-stances, perhaps it is therefore unwise for regulators to enhance the uncer-tainties of the market by market fur-ther by raising new issues as to its pricing regimen and by reducing the governance significance of such re-gional transmission regulatory bodies as it has painfully put in place? Per-haps it is unwise to treat its role as perfecting a utopian model, in which the rating agencies have stated little faith, and into which traditional long term debt is reluctant to venture. Yet, that is the direction FERC is going. It has the potential to drive the industry forward into another perfect storm, based on recurring financial industry response to the overbuild which has overtaken the industry. The longer run threat to the industry is far greater than the market power issue proposed to be addressed by the new Rulemaking.

There are storm clouds over FERC Olympus. The local deities think the cloud relates to issues of protecting local market competition (or now as they would have it, the pursuit of the efficiency in the new century.) The capital markets think the clouds have more to do with the financial worth of some of the assets that competition has produced and the resultant viability of the IPP companies’ ability to compete. As they say at FERC: lord what fools these mortals be.

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.