November 1997

THE NEW MERCHANT MANTRA

by Roger Feldman  --   Bingham, Dana and Gould, P.C.
(originally published by PMA OnLine Magazine: 04/98)

Power privateers have looked to the new competitive markets as ones in which they could achieve greater refinanced value on their existing IPPs ("refi") and/or could try and enhance existing assets to a competitive state ("repow") and then refinance them. As the capital markets have begun to scrutinize these possibilities, at this early stage of deregulation, they have made timorous sounds of willingness to come forward with proper innovative adaptations, to be sure. To jump-start the process, power privateers have begun to employ some creative capital market techniques themselves. To do so, they have had to address the standards for private power credit earlier established by the rating agencies, and to familiarize themselves with emerging insurance risk management devices.

"Refinancing" - in the sense of improving capital structure - has been a traditional approach to seeking benefits from changes in market rates. Power market refinancing today has taken on a new meaning, as shifts in the underlying regulatory structure of the capital markets modifies the underlying cash flow prospects of what is being refinanced. Nowhere is this becoming more apparent than in efforts to utilize refinancing as a means of resuscitating existing assets which are becoming available as a result of restructuring. These include those assets made the subject of utility asset sales (potentially including nuclear plants). Candidates include also refugees from the last wave of deregulation: "stranded" IPPs and EWGs now facing a truly merchant market, and underutilized, or incompleted projects with potential future competitive value. Refinancing thus may be linked to repowering, in terms of need for market as well as capital improvement support.

Unfortunately, these refinancing efforts enter the world seeking to address the world of merchant powerplant financing, at a time when lenders and capital markets still are seeking to develop new benchmarks for evaluation: they have not yet departed from the clearcut rating standards forged laboriously several years ago so that Rule 144A financings could be >done for IPPs. Recently rating agencies have begun to focus on what the credit really is for a refinancing of a repowered facility. In their view, to date, electricity commodity trading markets have not had the depth to provide a basis for offsetting capital market risks. Protection for cash flow risks arising from "counterparties" entering over-the-counter trading arrangements are recognized to provide conceptually for such support, but to suffer currently from certain perceived deficiencies: uncertainty of parent support for non-recourse trading company subsidiary counterparty obligations; significant credit risk exposure as to counterparty financial strength (a concern common in commodities, but as yet not a major subject of focus in the power industry); and discomfort with the possibility that if the power marketer or other counterparty does not net its trades and enters Chapter 11, individual contracts (like those of the power privateer) may not be affirmed in bankruptcy.

Given these rating agency concerns, the obvious solutions for refi-repow privateers are the same (and as costly) as for new MPPs - more equity; less leverage; more efforts at partial offtake contracting; greater short term price hedging; more pressure on equipment suppliers not just to provide subordinated debt, but also equity (including possible monetization of future power sales as consideration for their upfront investment).

Another alternative is to enlist the creativity of investment bankers dealing with capital markets. This may well trigger efforts: pool multiple project risks; credit enhance the resulting pool; and issue derivative securities. Of course, a "chicken & egg" problem is presented by this possible solution: it is easier to pool cash flow from multiple projects when there is more MPP product on the market.

Given the shortcomings of those approaches, creative sponsors and bankers have been led to an effort to put new risk mitigation tools to work by themselves, with a view to improving projected cash flow either on individual projects or on specially constructed "synthetic" portfolios created with credit enhancement. The most clearcut of these techniques are securitization of project balance sheet item (not to be confused with utilities' efforts to securitize the "regulatory assets" expected to be derived from stranded costs) and the application of specifically targeted integrated risk insurance to portfolios of MPP risks. In effect, the use of sophisticated risk management and capital markets techniques by privateers may have to precede the willingness of capital markets to broadly supplant "one off" financings (frequently based on "toll financing" with fuel costs locked in and power prices are believed to be predictable, or net backed fuel supply arrangements).

In sum, the power privateer cannot focus only on the improved heat rate of the repowered facility to assure the success of its new refinancing. Attention to sculpting cash flows for capital market acceptance is essential. Implementation of a refi/repow strategy may require reinsure coverage ("recov") as well. A new mantra for our merchant times: repow, >refi, recov.

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.