Credit Crunch: Restoring Confidence among Jittery Investors

Credit Crunch: RestoringConfidence among JitteryInvestors

After two dismal years, the U.S. power industry is in thedoldrums. It sorely needs to recover from the currentcredit crisis and get on a new, firm footing. This won’t beeasy, but there are strategies to help recover from thecrisis of confidence.

Mark Griffith and Fereidoon P. (Perry) Sioshansi

Mark Griffith is Director ofStrategic Risk Analysis at Henwood

Energy Services Inc., Sacramento,California. He is responsible for a

wide range of projects in the fields ofasset and portfolio valuation, risk

management, and power marketanalysis, and has prepared

independent market studies for over$7 billion of successful financings

and asset transactions. Prior tojoining Henwood, Mr. Griffith was

manager of market development andrisk management at Kansas City

Power & Light Company. He can bereached at

[email protected] P. (Perry) Sioshansi is

Senior Project Manager withHenwood. Prior to joining Henwood,

he was the president of MenloEnergy Economics. Dr. Sioshansihas worked at National EconomicResearch Associates (NERA), theElectric Power Research Institute(EPRI), and Southern California

Edison Company (SCE).

I. The Utility Industry’sFinancial Woes

After a stellar 2000, the utility

industry racked up a weak 2001

and an utterly dismal 2002, as

reflected in the performance of the

Dow Jones Utility Index, which

consists of 15 major electric,

gas, and combination utilities

(Figure 1). Several of the listed

companies—including Williams

and AES—had an exceptionally

tough year.1 The two big Cali-

fornia-based utilities, Edison

International and PG&E Corp.,

are still mired in the aftermath of

the state’s restructuring fiasco,

while TXU suffered a serious

setback with its European opera-

tions in 2002, contributing to the

company’s stock being down-

graded to junk status in mid-

December by Moody’s Investors

Service.

A comparison of stock prices

for selected utilities

between October 2001 and 2002

provides yet another indicator of

what a tough year 2002 has been.

With the sole exception of

Entergy, 10 major U.S. energy

concerns listed in Table 1 showed

significant loss in stock value.

April 2003 # 2003, Elsevier Science Inc., 1040-6190/03/$–see front matter doi:10.1016/S1040-6190(03)00033-2 79

http://[email protected]

II. Role Reversal: FromPositive to Negative Bias

Following the fall of Enron

and the collapse of the energy

trading business, the credit rating

agencies have come under fire for

having been too lenient on the

industry. The three agencies that

dominate the credit rating busi-

ness have become very tough,

downgrading investor-owned

utilities (IOUs) with newfound

vigor. Standard & Poor’s (S&P),

for example, downgraded a total

of 182 companies in 2002. There

were only 15 upgrades for the

year. In the fourth quarter alone,

there were 48 downgrades and

only one upgrade.

I n this context, investment

analysts as well as credit rat-

ing agencies have become overly

conservative, putting companies

with even a small amount of

exposure to risks on credit watch.

Standard & Poor’s, for example,

now ranks a mere 2 percent of the

industry with a positive outlook,

and 54 percent as stable. This has

had serious repercussions on

utility stock prices.

In a recent issue of Utilities &

Perspectives, S&P says, ‘‘the

negative credit momentum is

expected to continue in 2003,’’

though it expects ‘‘the pace of the

negative rating actions will mod-

erate.’’ At the same time, S&P

warns that it ‘‘does not discount

the possibility of additional

bankruptcy filings.’’

W hy such a bleak outlook?

S&P attributes its nega-

tive bias to ‘‘a proliferation of

higher-risk business strategies,

refinancing risk, weak competi-

tive positioning, regulatory

uncertainty, industry restructur-

ing, and volatility in the whole-

sale power market.’’

S&P is not alone in having a

negative bias. Fitch Rating’s

assessment of the U.S. power and

gas sector, released in a report in

December 2002, lists a large

number of U.S. utilities with

significant risk exposure. The

study concludes that the scope of

the problems is more widespread

than initially believed. Worse yet,

the current debt crisis is likely ‘‘to

dominate the U.S. power sector in

2003,’’ and could extend into

2004. Fitch estimates that some

$25 billion worth of debt has to

be refinanced in 2003 in an

‘‘inhospitable lending environ-

ment,’’ forcing those who have to

refinance to mortgage additional

assets in the process. According

to Fitch, some 40 percent of the

U.S. utility holding companies—

and over half of the merchant

generators—that it rates would

‘‘face possible downgrades’’

before the crisis may be

considered over.

Table 1: Stock Prices of Selected U.S.Energy Concerns—October 2002 vs.October 2001*

Company 2001 2002 % Change

TXU 45.48 12.31 �72.9

Mirant 28.00 1.65 �94.1

Aquila 29.93 3.84 �87.2

Dynegy 39.31 0.92 �97.7

Duke 38.84 19.54 �49.6

Reliant

Resources

15.31 1.66 �89.2

El Paso 50.00 7.87 �84.3

Xcel 28.87 10.55 �63.5

Entergy 38.00 43.16 13.6

Williams 39.90 33.98 �14.8

Source: The Utilities Journal, November 2002; Data-

stream.* Many of these stocks have fallen further since

October 2002.

Figure 1: Performance of the Dow Jones Utility Average, 1993–2002�

80 # 2003, Elsevier Science Inc., 1040-6190/03/$ – see front matter doi:10.1016/S1040-6190(03)00033-2 The Electricity Journal

T he outlook for the sector as a

whole is not good for the

near future, certainly not for 2003.

The current glut in capacity has

resulted in depressed wholesale

electricity prices across North

America.2 The sluggish U.S.

economy has not helped matters

either. It is in this context that

Duke Energy’s Chairman and

CEO, Rick Priory, declared that,

‘‘Our forecast now is based on no

optimism going forward—and

considerable pessimism. It’s a

pretty Draconian projection.’’3

III. Strategies forDealing with the CreditCrunch

Despite these sobering pro-

spects, there are useful strategies

to get out of the current credit

crunch. Affected companies fall

into three broad categories, and

depending on where they fall, a

different strategy may apply:

� Solid companies caught in the

cross-fire;

� Companies with decent pro-

spects but needing to adjust their

risk exposure; and

� Overextended companies

who need to adjust their portfolio

and reduce their debt burden.

The first category includes

many with solid finances, tangible

assets, and excellent prospects for

good performance once the cur-

rent market doldrums subside.

These companies, we believe, are

being treated unfairly by analysts

and credit rating agencies simply

because investors cannot tell them

apart from those who are over-

exposed and vulnerable. They

can—and should—make an effort

to set themselves apart from the

others. In today’s environment,

investors are craving for solid

ground, and for more transpar-

ency in an attempt to sort out the

bad apples from the barrel.4

The second category includes

companies with decent prospects

but significant risk exposure. For

these companies, the portfolio of

assets, contracts, obligations, and

liabilities are essentially out of

sync given the current turn of

events. In some cases, contracts

that made good business sense

only a year ago have turned into

serious financial liabilities. Like-

wise, a particular mix of genera-

tion assets and contracts that

made perfect sense during the

market boom of a couple of years

ago might have turned sour.

These companies can get back on

solid ground once they make

adjustments to what they own,

what they owe, and reduce their

exposure to risks resulting from

the current market downturn.

The third category includes

companies who are clearly

overextended and vulnerable.

These companies have already

been downgraded once or more

and/or are on credit watch. They

are, by and large, already taking

the necessary steps to reduce their

risk exposure, increase liquidity,

reduce and refinance debts.

A three-step process—with

different levels of urgency—is

needed to restore confidence in all

three cases, but particularly for

the first two categories. The basic

steps are briefly described below.

The challenge facing today’s

energy companies is to examine

their current portfolios vis-a-vis

today’s market realities. This

requires the identification as well

as the quantification of the risks to

which they are or may be

exposed. The next step is to make

adjustments to their portfolio,

taking future expectations into

account. Finally, the results are to

be made available to investors.

A. Risk identification

Broadly speaking, players in

the electric power business are

affected by several kinds of

risks:

� investment risks, which tend

to be lumpy, long-term, and

significant;

� price risks, with respect to

both input (e.g., fuels used to

generate electricity) and output

(e.g., electricity generated and

sold in competitive wholesale

markets);

� volume risk, such as the

demand for the products

(e.g., offtake from a plant) and

services;

Despite thesobering prospects,there are usefulstrategies toget out of thecurrent creditcrunch.


� technical risks, such as the

performance, costs, and output

of the plants, transmission assets,

and distribution networks;

� regulatory risks, including

unpredictable changes in state

and federal policies on retail or

wholesale prices, market rules,

and transmission and distribution

charges;

� environmental risks, includ-

ing global warming, nuclear

energy, and renewable mandates;

and

� paradigm shift risks,

including major new initiatives

introduced by the Federal Energy

Regulatory Commission (FERC),

and changes in investment prac-

tices introduced by the likes of the

Securities and Exchange Com-

mission (SEC), Financial

Accounting Standards Board

(FASB), or the Commodity

Futures Trading Commission

(CFTC).

B ecause energy investments

are long-term and chunky,

and because demand and prices

for energy tend to be highly

unpredictable, the industry is

particularly vulnerable.

Under monopolistic regula-

tions, many of these risks were

partially or totally covered, i.e.,

borne by the captive customers

once regulatory approval was

granted. In recent years, the reg-

ulatory protection has disap-

peared in many areas, exposing

the players to more risks. Utility

stocks, for example, traditionally

considered safe and solid, are no

longer safe, nor solid. The bank-

ruptcy of Enron and Pacific Gas &

Electric Company, and the serious

liquidity crisis facing major

energy companies are examples

of how risky the business has

become.

B. Risk quantification

Risk quantification is the tech-

nical process of determining a

company’s potential exposure to

risks, including an assessment of

its assets, liabilities, obligations,

and future operations given the

uncertainties in today’s energy

market. For a typical merchant

plant operator, for example, the

process includes an assessment of:

� complete set of off-take

agreements and fuel supply

contracts for each power

generation facility operating,

under construction, or planned;

� the operations and mainte-

nance (O&M) and capital budget

for each facility;

� short-term and non-plant-

specific power sales and/or pur-

chase agreements currently in

place;

� specific cost and operating

data for each generating station in

the portfolio; and

� assessment of future worth of

contracts, obligations, and other

liabilities.5

One way to assess the exposure

to risks is through stochastic

analysis. Since the future values of

these significant variables are

intrinsically uncertain, stochastic

analysis explicitly accounts for

this uncertainty by allowing

these variables to assume

different values over time. This

type of analysis allows managers

to assess the effect of multiple

variables taking on different

values over a period of time.

For example:

� the load to be served is

assumed to vary from its assumed

level, defined by a distribution of

loads with assigned probabilities;

� plants’ outputs is similarly

allowed to vary from their

assumed levels, also defined as a

distribution;

� fuel prices are allowed to

vary from their expected values

based on distributions derived

from historical data; and

� the price of electricity in the

wholesale market, a highly

uncertain parameter, is also

allowed to vary stochastically.

S ince some of these variables

may be correlated, the sto-

chastic analysis must account

for any such correlations based

on historical and empirical data.

In this way, the stochastic

analysis can show the effect of

variations in major variables on,

say, the profitability of invest-

ments in power plants or other

assets. Integrated firms with

multiple assets and operations

can take an even broader view of

Because energyinvestments are

long-termand chunky,the industry

is particularlyvulnerable.


the uncertainties and their risk

exposure.

A typical stochastic analysis

may consist of 1,000 Monte

Carlo iterations of the future state

of each uncertain variable, where

each major variable is allowed to

deviate from its expected value

according to a defined distribu-

tion of possible outcomes. The

study may include the perfor-

mance of each component of a

portfolio in each of the 1,000

iterations. These results may be

aggregated to assess the firm’s

total risk exposure, or other

purposes. For example, a typical

study may consider the firm’s:

� current and future off-take

agreements and fuel supply

contracts for each generation

facility;

� current O&M and capital

budget for each facility; and

� current and future contracts

or obligations.

The analysis provides a band of

confidence around expected prices

(or other key variables). Figure 2

shows expected market clearing

prices (MCP) for the PJM West

area, plus the 10 and 90 percen-

tiles. For an investor, having this

type of information is far more

useful than a single expected

value. The uncertainty in price

and volume can then be rolled up

to illustrate the uncertainty in the

financial performance for various

components of a company’s

energy portfolio.

The exposure to risk may come

from a variety of sources. The

analysis has to capture the sources

and the level of exposure. Once

the fundamentals are understood,

steps can be taken to hedge

against the risks, or mitigate.

Figure 3 provides an illustration

of the components of risks for one

particular energy concern, and

how they may be hedged.

Clearly, stochastic analysis

allows an assessment of the cur-

rent risk position of the com-

pany’s energy portfolio,

providing a clear view of the risk

exposure and how well it con-

forms to the business plan.

C. Portfolio adjustment

Given the turmoil in the energy

markets, chances are that the risk

assessment process would identify

major areas of risk exposure. This

Figure 2: Stochastic Results for Market Clearing Prices (MCP) for PJM West Region,2003–04, $/MWh

Figure 3: Analysis of Energy Portfolio Components


step is focused on the question of

what needs to be done if the risks

are too large or inconsistent with

what the firm has been telling its

investors. In this case the company

has two options:

� either it can adjust its

portfolio—and hence risk

exposure; or

� it can inform its investors of

the new risks (and rewards) to

which they may be exposed.

This may be accomplished

through:

� Project assessment. If the firm

is short financially (i.e., it has

entered into power off-take

agreements but is still developing

the generating facilities) there may

be opportunities to re-negotiate

future off-take contracts.6

� Risk hedging. Risk can be

reduced through long-term,

structured forward sales in the

form of power purchase agree-

ments (PPAs), tolling agreements,

and call options. However, with

the current low price expectation

in the forward markets, the

implicit cost of such hedging is

much greater than in the past.

� Off-take contract renegotia-

tion. Low prices in the cash

markets are creating significant

pressure from off-take contract

purchasers to reduce prices in

existing contracts.

� Fuel contract optimization.

An assessment of the company’s

total fuel contract position can

identify the corporate exposure

embedded in these contracts and

identify financial market syner-

gies within the portfolio.

T he means through which a

company can reduce its risk

exposure includes strategies such

as:

� Technological diversity.

The portfolio valuation process

recognizes the ‘‘physical reality’’

of power plants.7

� Regional diversity. By taking

advantage of the regional differ-

ences in electric and fuel prices,

each region’s specific market

volatility, and the correlation

among geographically dispersed

markets, companies can effec-

tively reduce their risk exposure.

� Debt restructuring. The

probabilistic nature of the port-

folio valuation process allows for

the explicit measurement of the

default risk for identified combi-

nations of assets and financings.

� Asset swaps. The portfolio

valuation process allows for the

quantification of the value of

swapping assets.8

IV. Risk Transparency:The Bottom Line

Having suffered major losses in

the past two years, today’s

investors want to know the risk

exposure of energy companies,

including the value of their future

contracts. Investors do not want

other Enrons in their portfolio. In

the current climate, the tendency

is to dump energy stocks at the

first sign of problems, and ask

questions later.

This erosion of confidence and

lack of transparency has clearly

had significant implications for

energy developers, traders, and

others. Consequently, under-

standing, quantifying, and mana-

ging risks has become of utmost

importance—as is communicating

the relevant information to the

investors, credit rating agencies,

and the financial community.

For companies who believe that

they are unfairly treated, the do-

nothing strategy can lead to

further damage and potential

downgradings. These companies

owe it to their investors to set the

record straight. A reassuring

report card from an independent

party with solid credentials

should go a long way to sooth the

nerves of jittery investors.

T he same goes for companies

who need to fix their port-

folios and re-balance their finan-

cial positions. If they don’t, they

could very well drop into the

third category, forced to liquidate

valuable assets in a buyers’ mar-

ket. The options and their conse-

quences, we believe, are crystal

clear.&

Endnotes:

1. AES, for example, posted a loss of$2.77 billion on revenues of $2.21billion for the fourth quarter of 2002.


2. Although the recent surge in nat-ural gas prices has created a significantincrease in wholesale electricity prices,the ‘‘spark spread,’’ or gross operatingmargin for natural gas-fired genera-tion, still remains small.

3. Conference call with financial ana-lysts on Jan. 13, 2003.

4. See Henwood’s Briefing Report,Risk Transparency in the Electric PowerIndustry, dated Feb. 2002.

5. Currently, there is no standard wayto assess how much future contracts orobligations (either to buy or sell) areworth and how they should be re-ported on the books. This is not amajor issue for contracts that stretch a

few months, but highly problematicfor contracts stretching a decade ormore. For risk assessment purposes,Henwood favors the use of a cash flowat risk metric.

6. In some cases, the developer mayhave the right to substitute alternativepower sources as long as the buyer isheld economically indifferent. In othercases, such as contracts for tolling orthose for which potential ancillaryservices revenues are significant, thebuyer may be dependent on the facil-ity’s physical location or technology. Inthat case the counter-party will wanteconomic compensation for contractchanges. In cases where the developerfaces contract cancellation fees for

equipment (e.g., turbine generators)the risk analysis of the portfolio ad-justment provides an assessment of thecost trade-offs.

7. For example, by explicitly includingoperating considerations such as thechange in heat rate as a function ofload level, forced and plannedoutages, the time and costs associatedwith start-ups, the ability of a unit tofollow rapid changes in demand, andto provide ancillary services.

8. The value can come from severalsources, including regional marketdiversity, fuel market diversity, gen-eration technology diversity, or cor-porate infrastructure.

Mass., in Truth,Is a Good Exampleof Sustained DSM

R ichard Pierce (in ‘‘Deja Vu

All Over Again,’’ March ’03)

is precisely wrong in asserting

that Massachusetts ‘‘abandoned

their prior mandatory, ratepayer-

funded DSM programs’’ in 1993.

In fact, in 1997, the Great and

General Court (the Massachusetts

legislature), with broad stake-

holder support, codified into

statute what Mr. Pierce accurately

describes as one of the most

aggressive DSM programs in

the nation. The result of just

one year of DSM investment,

according to the latest report

of the Commonwealth’s

Division of Energy Resources,

is $295 million in savings

(that is, more than twice the

investment) over the life of the

measures at a cost 55 percent less

than what would have been

required to buy electricity instead.

At the same time, one year of

DSM investment reduced emis-

sions of NOx and CO2 by the

output of more than 50,000 cars

and created 1,183 jobs, which

added $73 million to the gross

state product.

Perhaps the time has come to

consider these common-sense

economics in the rest of the

nation.&

Jerrold Oppenheim, Esq.

Gloucester,

Massachusetts

Address correspondence to:

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Credit Crunch: Restoring Confidence among Jittery Investors