October 1998

POWERING THE YANKEE MERCHANT CLIPPER

by Roger Feldman  --   Bingham, Dana and Gould, P.C.
(originally published by PMA OnLine Magazine: 10/98)

Yankee Clippers were the swift merchant vessels out of New England that opened up world trade. Were briefly, until steam powered vessels rapidly rendered them obsolete.

Are the high efficiency merchant plants proliferating on New England’s rocky shores an antecedent of the future — responding opportunistically to the attractions of high prices in certain markets (transmission constrained or otherwise); falling reserve margins (as nuclear plants tank and old plants prove inefficient and uncompetitive); by repowering (exploiting existing transmission rich sites) and by rising industrial and public/private interest in lower priced outsourcing and cost effective dispersed generation. Or are they, as Power Engineering recently suggested, doomed to Yankee Clipper-like extinction: "The merchant phenomenon will probably die out in the United States (perhaps as early as 2003, when proposed national legislation dictates full Customer choice") ... - as all power plants will ultimately represent "merchant capacity". Leaving aside the lawyers tendency to quibble with simple logic, i.e. if all plants become merchant, how can merchant plants be said to be dying out (and also to split definitional hairs, i.e. "It depends on what you mean by" "merchant power plant", cf W.J. Clinton 9/98), I believe the pragmatic answer is "No, merchant plants will not die out."

Not just because the markets are there, but because of the creativity and flexibility of the financial community. One clue: Standard & Poors has placed its current analysis of "merchant power plants" in immediate conjunction with its description of "Collateralized Loan Obligations" (CLOs) and "Collateralized Bond Obligations" (CBOs).- a tool it sees for future merchant plant development. Standard & Poors now refers to this means of financing as the "third way".

Under the CLO or CBO structure, capital market bonds are paid from the cash flow generated from a pool of loans made, for example, to individual merchant plant projects. The diversification of cash flow securing the CLO bonds improves their credit strength above the level for individual projects, and may be further enhanced by overcollateralization, i.e. more loan repayments than necessary pledged to secure the bonds. It is not alchemy: sound CLOs still depend on underlying sound transactions. But it is a new way to obtain debt and equity capital, which may be particularly appropriate for merchant plant projects. They are, after all, themselves, from a financial standpoint, nothing more than cash flow plays dependant on power markets, and the ability of power marketers to smooth markets, by using derivative structures.

The possibilities of CLO use are increased by the fact that while the world of deregulated power and power marketing has been changing, so too have the potential types and sources of risk management and credit enhancement for merchant deals. Increasingly larger, integrated capital pools for risk assumption are seeking ways not merely to provide a credit grade uptick, but to assume at least some portion of those specifically identified risks necessary to achieve financeablility. (In turn, these capital pools themselves back fall behind those risks throughout a mixture of commodity trading, risk spreading through reinsurance and development of appropriately priced financial products.)

Future prospects for merchant plants may well be through CLOs or CBOs, sponsored by large energy firms which are establishing the multiple building blocks of their globe encircling fuel-energy facility endeavors. There will be strategic partnering by these energy companies, with those utilities still possessing transmission capabilities. There may even be some privately sponsored - politically correct "green" merchant power "apples" serving specialized customer classes, bobbing in a surge of "microsoft" electrons produced for the mass retail markets by the mega-energy firms.

Correlatively, project finance will be restored to simply an alternative technique for getting the energy station funding job done - drawn from antediluvian ’80s , but adapted to new realities through securitization techniques.

While some bankers wring their hands about "immature" debt markets for merchant plants, next generation financial and internal corporate CFOs are already conceptualizing power revenues as merely another type of cash flow, which - once the risk management markets have gotten statistically comfortable with its aggregate forward price curve profile - may be credit enhanceable to a level where such securitization is possible. Securitization obviously has been done with mortgages and recently even utility receivables; it may be done with merchant plant revenues in the future.

This perception of the future role of merchant plant development, perhaps nascent in the US situation where multiple facilities simultaneously developed in a single region like New England, could well take hold first in non-US settings, such as Latin America, where corporate strategies of fuel-power multiple facility development of large scale facilities throughout allocated franchise territories are being implemented. Whether credit enhancers will be step up to corporate risks in such settings and do CLOs as a means of responding to the turbulent times overseas remains to be seen. The likelihood seems good that they will be done in the United States.

Certainly the direction portfolio financing - with or without credit enhancement - is the one in which many bankers assume merchant plant finance will evolve. Current merchant structures are perceived as simply a product of where expertise resides right now: a the stopgap while different regulatory requirements, auction processes and stranded costs recovery are sorted out.

Historically, project financed projects generally have been dismissed as not subject to mortgage-like portfolio finance because of their absence of heterogeneity, particularly where multiple sponsors, multiple power off takers and multiple credits have been involved. The perceived potential benefit of risk dilution via the law of numbers has in effect been trumped, thus far, by Murphy’s law, applied to each IPP investment. On the other hand in the merchant plant arena, there is an emerging field of transactions where the structural issues key to financing are coming into clear focus. The rating agencies have articulated those standards, and new techniques for conforming these risks are emerging daily. With this in mind, the possibility of credit enhanced merchant plant portfolios looks increasingly bright.

Far from premature obsolescence, the prospect of the Yankee Merchant Clipper is to use structured finance to catch the winds of the capital markets and deliver the goods in many parts of the world.

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.