Understanding How Securitization Can Help with Power Plant Retirements

Power companies across the nation are being pressured to retire fossil-fueled power plants and transition to cleaner energy resources. But many existing fossil plants have not been completely paid off or depreciated, which means potentially big losses to shut them down. A tool called securitization may be able to help some companies manage the costs.

Power companies have always had to plan for the future. They have always conducted research to better understanding how load on their power system might change in the short and long term, and then, developed a strategy for meeting that demand. This is necessary because power plants can take many years to engineer, procure, construct, and commission. There are often land purchases and infrastructure upgrades required, in addition to permitting and financing hoops to jump through. It’s not a quick or easy process.

Furthermore, money spent on power plants is a long-term investment. Often, power companies expect the useful life of plants to be 30 to 50 years or more. In fact, some nuclear power plants have now had their licenses extended out to 80 years. It’s unlikely anyone involved in planning those facilities thought that would happen when the plants were first conceived in the 1960s and 1970s.

Prior to pulling the trigger on a project, power companies spend a lot of time evaluating alternatives. These good-faith efforts lead to what are always hoped will be smart decisions. Yet, the landscape is constantly evolving. New technology and changes in cost curves for alternative resources can make what seemed like a great investment in one decade, much less appealing in the next. Unfortunately, managers can’t go back in time and make different choices. The best they can do is attempt to find the least-cost way to alter course.

Why Plant Retirement Can Be Financially Challenging

One of the tools that electric companies in some states have available to them is called securitization (Figure 1). “Securitization is really just the process of refinancing an asset, and in effect, restructuring that asset into debt,” Brad Viator, vice president of External Affairs with the Edison Electric Institute (EEI), said during a presentation hosted by the Missouri Energy Initiative.

1. Michigan-based Consumers Energy used securitization to pay off the remaining balance it had on its books for D.E. Karn Units 1 and 2. The plant will be retired this year, saving customers a reported $126 million per year. Courtesy: America’s Power

Viator explained how securitization works with an example. He suggested the year was 1990. The local electric company serving parts of Kansas City is working with the Missouri Public Service Commission (MPSC) and leaders are evaluating if more power generating capacity is needed to supply the expected future demand from the growing population in and around the metropolitan area. The company proposes building a 1,000-MW coal-fired station and financing it for 40 years. The MPSC agrees and the project moves forward. The plant will be paid for and fully depreciated in 2030.

In Viator’s example, the electric company pays for the resource to be built immediately, in effect, financing that cost to customers. “They’re pushing these costs on to customers on a monthly basis, even though the cost of the asset was paid up front by the electric company,” he explained. The electric company is working much like a bank in this case, with the utility often authorized to receive a return on equity of from 7% to 9%.

In the first couple of decades after construction, everything goes smoothly. The plant operates well and provides cost-effective power to the region. However, customer expectations change over time. People become more climate conscious and decide they don’t want coal plants to be part of the energy future because of the carbon impact they have.

The problem is, by 2020, with 10 years remaining in the financing of that asset, there may still be 60% of the cost of the asset remaining to be paid back by customers. That’s because when you look at an amortization schedule, most of the money paid in the first 30 years is interest. Principal doesn’t exceed interest until year 32 of a 40-year loan. Therefore, to close this particular plant, the electric company would need to move the plant from an asset to a liability on its balance sheet.

What Is Securitization

One possible way to restructure the financing is using the securitization tool, if the state and PSC allow it. Continuing his example, Viator explained how securitization could be used. “We would restructure all of the remaining cash flows and create a debt instrument or a security, and then we would sell those securities to investors. So, in fact, that asset gets eliminated from the electric company’s books that owned it, and it becomes owned by investors, who purchased the bonds. And those bonds are secured by future payments for the remaining 10 years,” he said.

The bonds are often backed by what is called the “securitization property,” which most importantly includes the rights granted by the commission to collect the bond principal and interest payments from customers by charging them higher electric rates. The charges that appear on customer bills lead to a stable, predictable cash flow for bond investors, making the bonds very low risk. As a result, the bonds can be sold with low interest rates—generally, much lower than the return on equity the power company was getting—and thus the securitization method becomes a cheap way to finance the retirement of coal plants and saves customers money.

A number of states have allowed securitization to be used for disposing of stranded assets. Among them are California, Connecticut, Illinois, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Ohio, Pennsylvania, Rhode Island, and Texas. Colorado, Hawaii, Michigan, Montana, and New Mexico have all allowed the tool to be used specifically for coal plant retirements and/or clean energy investments. Several southeastern states, including Arkansas, Florida, Louisiana, Mississippi, and North Carolina, have used securitization to deal with storm damage costs. Finally, Idaho, Vermont, West Virginia, and Wisconsin have used it for some other purposes. Furthermore, there is some type of regulatory or legislative action being pursued in several other states to allow securitization to be used by power companies in some way.

“Securitization can be a useful tool, but it’s not a panacea,” Viator said. “Securitization as a tool, frankly, is not that different from bankruptcy—in bankrupting a particular asset.” The decision to use securitization is not something power companies can take lightly. “If you have a bunch of assets that you want to securitize and close, that’s going to have a very material impact on your ability to raise capital as an electric company going forward, and it could put companies in a pretty difficult position,” said Viator.

Four Steps for Success

In another session as part of the event hosted by the Missouri Energy Initiative, Ron Lehr, a clean energy consultant and attorney from Colorado, who was representing Energy Innovation Policy and Technology, a non-partisan energy and climate policy think tank, suggested there are four pieces in the plant retirement process. The steps include completing detailed financial analysis, filing a depreciation and rate case, refinancing, and reinvesting.

Financial Analysis. Lehr said utilities spend a lot of time “planning for new resources and reducing risk,” but what can be missing in the process is solid financial planning. “We would do a better job—we could create more benefits to be shared by everybody—if we brought that financial transition and those issues forward, and did them upfront and in a thoughtful and planned way,” he said. The financial analysis Lehr proposed is based on corporate financial models used on Wall Street incorporating publicly available financial data, much of it filed with the Securities and Exchange Commission and/or the Federal Energy Regulatory Commission.

“It’s a good way to go,” said Lehr. “Once you set up that financial model, it can serve you through this whole process of utility financial transition, by showing you what the financial options are and what impact they have, not only on shareholders but also on consumers.”

Depreciation and Rate Case. There are a series of dockets, many involving regulatory agencies, through which retirement decisions must pass in order to be approved. Consumer advocacy groups sometimes argue against what power companies have asked for, and it’s not a given that money requested for recovery will be allowed.

“It’s depreciation and rate case that pick up the questions of disallowance or partial disallowance or how much time it takes to get the money back—the depreciation schedule—that’s rate case work,” Lehr explained.

Refinance. Once decisions are made on what needs to be paid back, the question of how to handle it can be answered. “Is there a way to refinance it?” asked Lehr. “That’s where securitized bonds come in.”

At this point in the process, the equity on an early-retired plant (the regulatory asset) is typically removed from the books. That’s a hit to shareholders because securitized bonds reduce investment costs in rates.

Reinvest. Lehr, who has previously served as a commissioner and chairman on the Colorado Public Utilities Commission, as well as on the Denver Board of Water Commissioners, suggested utilities should be allowed to refill their rate base by owning some of the replacement power that comes online to replace the early-retired plant. “That’s very good for shareholders,” he said. “It’s very easy to make a utility whole, and more than whole, by allowing them to own some, but not all, of the replacement power.” Lehr suggested having fair competition for ownership of the replacement power was important to ensure the lowest cost for consumers.

A Win-Win-Win Outcome

Yet, when securitization is the right answer, it can be beneficial in several ways. “We think that there’s a triple-win outcome here,” said Lehr.

“Consumers pay less because the retirement reduces fuel and O&M [operations and maintenance] costs very substantially—there are typically hundreds of millions of dollars here. And the refinance savings—going from the utility’s authorized rate of return down to the AAA bond rating—is another big savings. Again, it can amount to hundreds of millions of dollars, so this is a big deal,” said Lehr.

Environmentally speaking, emissions are reduced when fossil-fueled plants are replaced with renewable energy. There are also opportunities for business development that come with the addition of more renewable power.

On the shareholder side, investors can get higher returns. “You respond to your investors who want to see utilities making this happen,” Lehr said, noting that Morgan Stanley and BlackRock are two big investors that have put a lot of pressure on companies to transition toward clean energy resources. Meanwhile, it offers a positive response to customers who are demanding cleaner power. “There’s a customer preference and customer defection issue. That’s a risk for utilities. You handle that,” said Lehr.

Much like Viator had cautioned, however, Lehr suggested securitization is not a one-size-fits-all solution. “Realize that your circumstances, wherever you happen to be, are going to be different and special and unique, and you have to adapt this stuff to those circumstances,” he said. “It’s never a case of never or always, it’s more nuanced than that.”

Aaron Larson is POWER’s executive editor.

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