So far, U.S. electricity generators have managed to survive the current credit slump and financial collapse. Things could get far worse if the economy continues to deteriorate and credit markets remain tight.
A panel of utility experts told the Federal Energy Regulatory Commission (FERC) at a technical conference in mid-January that most electric infrastructure projects to date have been able to attract the necessary capital to move ahead. But finding capital for needed investments is getting harder, and the result will be that customers will be paying more for electricity in the future.
At the same time as FERC held its technical conference on the impact of credit markets on the electricity generating industry, the Wall Street Journal reported that utility bonds had been a “bright spot” for financial markets in 2008. Overall, utilities with investment-grade ratings, the Journal reported, sold 47% more bonds than the $35 billion issued in 2007 and 77% more than in 2006. The total for 2008 was $47 billion, as the industry embarked on the greatest building boom since the 1970s.
The financial newspaper observed, “The 2008 increase marked one of the few bright spots in the overall bond market, which registered a decline in issuance of nearly 35%, to $645 billion from $987 billion in 2007, according to Thomson SDC.” But electric equity markets were soft, pushing the generators toward debt.
The newspaper account reported that the “spread” between Treasury rates and commercial rates for similar bonds “widened to about five-to-eight percentage points by the end of 2008 from about two or three percentage points at the beginning of the year.” The actual interest rate paid to bondholders didn’t change much, because the Federal Reserve Bank kept lowering its interest rate during that period, which translated into lower rates for Treasury bills.
That’s not really a rosy picture, the financial mavens told FERC.
Quality Counts, Now More than Ever
Morgan Stanley’s Anthony Ianno noted that the investment-grade debt market is very tight, even for tax-exempt utilities, such as munis and cooperatives. The market for non-investment grade (junk) bonds “is essentially closed,” he said. That’s important because a lot of non-utility generation projects over the past 20 years have been financed with high-interest junk bonds, grounded on solid purchase power agreements as a way to reduce risk.
Ianno and others noted that the interest rate spread between A-rated and BBB-rated projects has increased dramatically recently. This occurs at a point where the needs for capital-intensive projects—new generation and new and upgraded transmission—are tremendous, perhaps as much as $1 trillion over the next 15 years.
The last time the generation business went through this sort of capital expenditure explosion was in the 1970s. In those days, most utility bonds were A-rated. Not so today, said the FERC witnesses, so costs to the borrower (and returns to the lender) rise. Many utility borrowers have ratings at the BBB level, the experts observed. A lot are at the threshold of junk status, some below.
Paul Bowers, chief financial officer of Southern Co., the Atlanta-based giant investor-owned utility (IOU) whose companies are mostly still living under cost-based price regulation, said the industry faces a “critical time.” Bowers was testifying on behalf of Southern and the Edison Electric Institute, the trade group for the IOUs.
Bowers noted that the utility industry is facing enormous infrastructure challenges, driven by the need to upgrade existing facilities while building new generation and transmission to serve growing loads, and by the requirements of state renewable energy portfolio standards. The new Obama administration and Congress may make those renewable standards mandatory across the country, and the prospect of that happening sends financial chills down the spines of utilities.
The generation business, Bowers observed, “is the second most capital-intensive industry in the U.S.,” only behind railroads. He added that, historically, electric utilities have had ready access to low-cost capital. No more. Bowers also pointed to the growing gap between A-rated and BBB-rated debt while overall electric industry ratings have been sliding.
Bowers added that some utilities are even having problems accessing the short-term commercial paper market, making day-to-day operations more expensive. He said upfront costs of debt have also increased dramatically. In the past, the starting costs to borrowers were in the range of 10 basis points (a tenth of a percent). Now, they are running to 150 basis points and above. “By and large, we are managing through the crisis,” Bowers said. But the result is higher costs, passed on to customers.
The Damage from Downed Credit Lines
Robert Trippe, chief financial officer of American Municipal Power-Ohio, an A-rated municipal joint action agency that generates and distributes power to its distribution utility members, said his firm has been able to continue borrowing for AMP-Ohio’s $7 billion capital project plan through 2013. But that ability could be in jeopardy going forward.
Trippe said a major problem for municipal borrowers has been a developing situation of “little or no” bond insurance, as the rating agencies have come under increased scrutiny and financial insurers such as AIG have crashed. Munis use bond insurance to keep interest rates low. Trippe said he’s assuming that in 2009 there will be “no bond insurance that is economically available,” meaning higher interest rates on the muni financing.
Tax-exempt bonds, noted Trippe, are seeing all-time high yields, which means all-time-high interest costs. The current financial crisis ultimately “threatens AMO-Ohio’s credit expansion program.” That, in turn, he said, “threatens reliability.”
Bruce Levy, North American president of International Power, a major non-utility generator, said that the financial crisis disadvantages competitive generators, although the market “remains available to properly structured projects” around the globe. In the past, Levy noted, generators had “unprecedented access” to low-cost capital. That’s changed, as the generators now face a “credit-constrained” world.
Additionally, said Levy, the worldwide recession has also hurt equity capital markets for electricity projects. The recession results in a drop in demand for electricity. That creates uncertainty for investors in independent generating projects, who face the prospect of falling share prices because of slumping sales and profits.
The financial meltdown, Levy said, particularly threatens organized wholesale competitive electricity markets, such as the PJM Interconnection. He said five-year power purchase agreements (PPAs) in organized markets are inadequate in today’s unsettled environment. He would like to see 15-year PPAs until financial markets calm. He warned FERC against a retreat in policy from competitive markets and a movement toward cost-based regulation. That’s a real threat as a new, regulatory-oriented administration arrives in Washington, said Levy.
Michael Polsky, CEO of Invenergy, a Chicago wind power project developer, told FERC the current economic situation makes it “more and more difficult” to build new wind projects. In 2008, said Polsky, “equity capital all but disappeared” for new wind generation. Polsky made the point that wind development is “policy driven,” not a product of free market economic forces. The prospects for wind depend on continued policy incentives, as the wind industry can’t make it without subsidies to overcome market barriers, he argued.
The Bottom Line: State Lines
So what can FERC—or, more broadly, the federal government—do about the threat of financial meltdown as it impacts electricity infrastructure? Not much, noted outgoing FERC Chairman Joe Kelliher. He said that the solutions or actions that could repair credit markets for energy projects are largely “beyond our authorities.” He added that the crux of the issue lies in the age-old puzzle of the boundary between state and federal authority.
That caused a warm-and-fuzzy reaction among many veteran FERCologists, who have long pondered with much appreciation the far-from-bright line that separates state and federal authority over electricity policy. That fuzzy line keeps them in business.
—Kennedy Maize is executive editor of MANAGING POWER.