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Credit Outlook U.S. Power and Gas

Return to Risk Limited website: www.RiskLimited.com. Credit Outlook U.S. Power and Gas. Richard Hunter Managing Director, North America Global Power Group Energy Finance & Credit Summit, Houston, February 2004. Topics. Capital Markets Environment Credit Environment Major Themes

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Credit Outlook U.S. Power and Gas

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  1. Return to Risk Limited website: www.RiskLimited.com CreditOutlookU.S. Power and Gas Richard Hunter Managing Director, North America Global Power Group Energy Finance & Credit Summit, Houston, February 2004

  2. Topics • Capital Markets Environment • Credit Environment • Major Themes • Outlook for the Sectors • Utilities • Utility Parent Holding Companies • Competitive Gencos & Energy Merchants

  3. Capital Markets Environment

  4. Equity and Debt Capital Markets

  5. Equity and Debt Capital Markets 1Q 03 Source: Merrill Lynch, Bloomberg

  6. Near-term Outlook • Gas price volatility and commodity price risk • Merchant power overbuilt in nearly all regions • Pendulum swings back toward integrated utilities and regulation • System reliability and environmental protection require higher capital spending • Low interest rate environment is benign for capital intensive and over-leveraged sector, but higher rates may lie ahead • Mergers and consolidations are likely

  7. Longer- Term Issues • Global Warming • Carbon tax in our future? • Price elasticity, “demand destruction” and demand-side management, obsolete technologies • Is wired distribution of power a post-mature industry? • How much new investment is needed? • Distribution and transmission: • Patch up the old system, or • Invest heavily in an intelligent wired network • Power production • Retrofit old thermal generation, or • Invest in new technologies

  8. Credit Environment • 2003 vs. 2002 Credit stress increased through 2002 and stabilized in 2003. Source: Fitch Ratings

  9. Positive Negative Stable/Evolving Credit Outlook by Sub-sector January 1, 2003 Parent Companies Distribution Utilities Diversified/Merchant Energy Integrated Utilities January 1, 2004 Note: Refers to the percentage of senior ratings in each sector with Positive Rating Outlook or Rating Watch status, Negative Rating Outlook or Rating Watch status or Stable Rating Outlook/Evolving Watch status.

  10. Credit Environment • Total Sector Power & Gas 2003 2002 • Upgrades to downgrades 1:2 1:12 • Stable outlooks (at year end) 80% 64% • Negative to positive outlooks 2:1 6:1 • Ratings stable, but low: Median Rating • Competitive wholesale energy B • Regulated utility A- • Utility group parent BBB+

  11. Affiliate action as the largest single cause … Credit Environment Investor-Owned Power & Gas companies, All Rating Actions, Source: Fitch

  12. Regulated Utilities • The Morning After…

  13. THEMES “Back to Basics” Gas and power price fluctuation Mandated capital spending for increased reliability and supply security IMPLICATIONS Lower credit risk Risk for utilities with fixed tariffs and obligation to serve Higher external financing needs (Potential mitigant: a clear regulatory recovery mechanism) Credit Outlook: Regulated Utilities

  14. Risks faced by Regulated Utilities • Commodity price risk • Ability to hedge commodity price risk • Mergers and Acquisitions • Debt burden • Unsuccessful merger/ consolidation implementation • Regulatory risk • Low interest rate, ergo low ROE • Shifts in policy

  15. Risks faced by Regulated Utilities • Lower Returns on Equity? Source: PUR Utility Regulatory News

  16. RoE impact on coverages Operating Cash Flow/Interest Expense assumes 50:50 debt:equity funding, 7% cost of debt, 35% tax rate

  17. Risks faced by Regulated Utilities • Success Rates? Source: PUR Utility Regulatory News

  18. THEMES “Back to Basics” in 2004 Prior unsuccessful diversification activities Industry consolidation ahead IMPLICATIONS Lower business risk Need dividends from utilities to reduce parent debt; affects ability to fund capex Event risk for both acquirers and targets Credit Outlook: Parent Companies

  19. Credit Outlook: Parent Companies • Analytical Issues • Parent-level debt service coverage • Tax-sharing • Management fees • Subsidiary injections • Recovery Analysis • Non-consolidation in bankruptcy • Parent-subsidiary notching

  20. Competitive Wholesale and Merchant Energy Companies Equity Asset Sales Cash Flow …exiting the debt hole

  21. What Does it Take? • Example: Interest Cover Source: Fitch Ratings

  22. How Deep is the Hole? Debt Outstanding Source: SNL, Inc. Data as at 9-30-03

  23. Sector High Yield Debt Maturities Source: Fitch Ratings

  24. High Yield Debt Maturities * assuming successful execution of refinancings currently in market Source: Companies, Fitch Ratings

  25. Appetite for Roll-Over?

  26. Whose Loss is it Anyway? Classified Commitments Classified as % of Commitment "Classified" Commitments on Syndicated Loans in excess of $20m Source: Shared National Credit Survey, U.S. Federal Reserve Board

  27. Wholesale Energy MarketCompetitive Generation Current Status • Excess capacity, low spark spreads • Speculative-grade ratings a barrier to negotiating term contracts • Bankruptcies and restructurings • Asset values at a cyclical low or permanently impaired? • Jurisdictional issues about contract rejection

  28. Near-term Outlook Pendulum swings back toward integration and regulated utility power generation Examples: CA; AZ; WI Load-serving entities shun executory contracts and dependence on gas Cost of capital advantage for utilities versus gencos Wholesale Energy Market Competitive Generation

  29. Option A Equity

  30. Equity performance Monthly average share prices, indexed at 100 as at Jan. 1, 2002 Source: Bloomberg

  31. Option B Asset Sales

  32. Who's Buying? Source: Henwood Energy Services

  33. Sales characteristics • 22GW sold in past two years for c.$11bn • Much of the value in contracts • 60GW left on the block • Older contracts running off • Munis - self-build or fire sale? • LSEs - FERC warning shots? • Energy majors - Opposite direction? • Financial companies - Speculative??

  34. Regulatory and policy gridlock Bankruptcy Court versus FERC jurisdiction Congressional wrangling over Energy Policy Act FERC versus states on RTOs MISO members change their bets Wholesale Energy MarketCompetitive Generation

  35. If FERC prevails: If Bankruptcy Court prevails: Lower asset recoveries for genco investors Utilities and PSCs will see greater risk to public in supply contracts Steeper cost of capital for gencos More incentive for utilities to build or buy power generation Gencos less competitive Gencos less competitive Wholesale Energy MarketFERC versus Bankruptcy Court A no-win situation for wholesale market competition

  36. Option C Cash Flow

  37. Outlook: Competitive Wholesale Generators and Merchants Based on published and senior unsecured debt ratings, weighted by capacity Source: Fitch Ratings

  38. Outlook: Competitive Wholesale Generators and Merchants Based on published and senior unsecured debt ratings, weighted by capacity Source: Fitch Ratings

  39. Outlook: Competitive Wholesale Generators and Merchants Based on published and senior unsecured debt ratings, weighted by capacity Source: Fitch Ratings

  40. Outlook: Competitive Wholesale Generators and Merchants Based on published and senior unsecured debt ratings, weighted by capacity Source: Fitch Ratings

  41. Regional Wholesale Markets Market Clearing Price (Spring 2003) Market Clearing Price (Fall 2003) Source: Henwood Energy Services, Fitch Ratings

  42. Regional Wholesale Markets Net Revenues, hypothetical CC gas plant* (Spring 2003)(Fall 2003) * Based on a combined cycle gas plant with a 6,900 Btu/Kwh heat rate, $2/Mwh variable O&M, and a 2% forced outage factor.

  43. Wholesale Energy MarketLonger-term Outlook • Wholesale energy market will still exist, but no guarantee that players will be the same. • Broken models will be replaced by new and different models.

  44. Wholesale Energy MarketLonger Term: Model 1 Consolidation and Reintegration Merchant Producer Distressed asset sale Utility Merger Merchant Producer Self-build

  45. Wholesale Energy MarketLonger Term: Model 2 Project Developer Build & transfer Plant Operator Service Contract Utility Asset lease Project Developer Preserves roles for specialists in project development and operation, but not a major role.

  46. Wholesale Energy MarketLonger Term: Model 3 Supply contract priced at floating market index Merchant Producer Utility Tariff adjustments Financial hedge Financial hedge Financial Counterparty Financial Counterparty Consumers Both parties get the benefit of ‘Forward Contract’s provisions on the financial Hedge Contracts Both assure physical supply and off-take in the Supply Contract

  47. Fitch Global Power Group

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