Eric Lammers

McManus & Miles

Reports of utility plant sales and new merchant plants being developed are surfacing weekly. On the utility plant side, more than 60,000 MW of historically regulated generating capacity has recently been sold or is subject to purchase agreements. On the new development front, over 30,000 MW has been proposed for the New England Power Pool (NEPOOL) alone, a market with only 23,000 MW of peak load. With so many generating assets trading hands and the announcement of unprecedented levels of new development in some markets, how will all of these assets be financed?

With the advent of utility deregulation, traditional financing of new construction through the issuance of corporate utility debt and equity is becoming increasingly rare. Those utilities that remain in the electricity generation market increasingly will be subject to performance-based ratemaking or go through the process of functional disaggregation-spinning their generating units into unregulated subsidiaries.

The demise of traditional regulated, rate-base ownership of power assets with a fixed rate of return on invested equity will give way to a greater management focus on earnings per share and financial exposure. As such, utilities` financing choices will incorporate both more appropriate capital ratios and more creative financing vehicles. For example, special-purpose financing entities such as limited partnerships and leasing trusts will be added to the traditional mix of long-term debt, preferred stock and common equity.

Additionally, we are seeing the end of independent power producers (IPPs) financing of new construction off the strength of long-term qualifying facility (QF) contracts with the local utility. Thus, IPPs have been forced to become more creative to increase their number of megawatts of ownership.

The financing solutions for both utilities and IPPs will continue to evolve to meet a particular asset`s and company`s capital needs in a merchant environment. Specifically, financing techniques aimed at hedging risk, optimizing tax results and improving earnings per share will become more popular.

Leveraged tax leasing

In November 1998, the U.S. Generating Co. (now PG&E Generating) raised $480 million by selling and leasing-back the Bear Swamp Pumped Storage generating plant previously acquired through competitive auction as part of New England Electric System`s (NEES) generation divestiture.

This transaction was the first in an increasing trend of financing generating plant portfolio acquisitions with long-term tax leveraged leases of one or more of the plants acquired. This trend has continued with closed or pending leases of plants by The AES Corp., PP&L Global and Edison Mission Energy. These new operators, who are now running the facilities in a deregulated environment, are motivated to lease by the more rational matching of operating income and GAAP financing expense. Due to the fact that an operating lease has a level GAAP income impact, asset acquirers find earnings per share results of leasing more reflective of an acquisition`s true value than traditional ownership with debt financing. Additionally, leases can more efficiently use valuable tax benefits and another source of financing that is non-recourse to the acquirer`s balance sheet.

PPA buydown

The AES Corp. agreed to restructure its power purchase agreement (PPA) earlier this year on its Thames facility with Northeast Utilities subsidiary, Connecticut Light & Power (CL&P). Under the terms of the restructuring, AES will receive a $549 million prepayment for the above-market portion of the contract, making it one of the largest buyouts in the industry to date. CL&P will continue to receive power from the plant, at substantially reduced rates, for the remaining 16 years of the contract.

In 1997, IPPs operating under Public Utilities Regulatory Policies Act (PURPA)-mandated PPAs produced over 750,000 GWh of electricity. Although these PPAs are widely viewed as inflexible generating assets which expose many utilities to significant stranded cost exposure, companies are increasingly finding opportunities in these assets.

Through the use of the right buydown structure, many utilities are able to not only quantify, but also mitigate, these stranded costs. This is often an important step in cleaning up a utility`s balance sheet in order to compete effectively in a newly deregulated environment. These results can also be achieved without resorting to the extreme actions taken by Niagara Mohawk.

From the IPP perspective, restructuring PURPA PPAs can provide a new source of off-balance sheet financing when future PPA obligations are reduced or removed entirely in exchange for a large up-front payment, which can be used to fund new investments. By reducing future PPA obligations in a win-win manner, an IPP can also significantly reduce its financial exposure to particular regulatory regimes. Finally, if properly structured, PPA restructurings can be tax- and GAAP earnings-advantaged to both the utility and the IPP.

Non-tax lease

Regulated Southern Co. subsidiary Mississippi Power sponsored a non-tax synthetic lease of a new facility being built to meet rising demand in its service territory. Although another entity will "own" the facility, but Mississippi Power will retain considerable control over the assets. In another transaction, KeySpan acquired operating control of the $425 million Ravenswood gas-fired generating facility through a non-tax lease rather than buying it directly in the Con Edison divestiture.

Although not appropriate for many situations (existing assets already owned by utilities and IPPs do not typically qualify), non-tax synthetic leases provide a way for companies to maintain tax ownership while avoiding rate or earnings "hits" often associated with building or buying an expensive new generating plant. Similar to a tax lease, a synthetic lease avoids the front-ended impact of depreciation and interest expense on a company`s income statement, in favor of levelized lease rental expense which provides an earnings per share result that better reflects a generating plant`s true value.

Tolling agreements

LS Power and Cogentrix Energy recently financed the construction of the 837 MW Batesville combined-cycle, gas-fired facility in Mississippi on the strength of two long-term tolling agreements with Virginia Electric and Power Co. and Utilicorp United subsidiary Aquila Power Corp.

With the demise of the PURPA-mandated PPA, IPPs have begun to look at new ways to finance greenfield generating plants. The use of tolling agreements is becoming an increasingly popular way to mitigate merchant power risk. A long-term tolling agreement that hedges both fuel cost risk as well as power sales volume and price risk with a credit worthy company can provide an extremely stable operating income stream, which allows a new IPP plant to be highly leveraged. In return, the tolling agreement counterparty receives a committed source of generation to support its native load or power trading activities as well as a customer for its gas supply business.

Outlook

As deregulation of the nation`s electricity markets continues, additional utilities will exit the power generation business. However, utilities, either directly or through unregulated affiliates will continue to be important players in the generation of electricity.

Deregulation and competition will continue to drive the creative development and application of tailored financing techniques for utility and non-utility owners of generating assets alike. The convergence between utilities and IPPs will continue and the distinctions will narrow in the ways in which investor owned utilities (IOUs) and IPPs finance non rate-based generation.

Project financing will continue to accelerate as companies are attracted to the risk mitigation and other structural aspects provided by tailored financing structures, and as the credit markets continue to gain greater comfort with merchant risks. Utility divestitures will continue to be actively financed on a pooled-project basis. Due to the urgency of capital needs, however, newly constructed assets will rely more upon single-asset financing with structural mitigants to merchant risk. We will also see increased use of holding company financing, often based on geographic considerations, to provide additional leverage for generating investments.

From the financial markets` perspective, the minimal amount of new plant construction in the 1990s, combined with utilities reducing their long-term capital structures through bond retirements and stock repurchase plans, has left excess demand for power investments. While power investors have not reduced their investment discipline, they are increasingly willing to accommodate utilities` and IPPs` desires for creative structures that make demonstrated business sense. However, with an increasing number of financings on the horizon, financial markets will become increasingly critical of uneconomic investments in merchant power.

Refinancing options

When considering how to finance or refinance a utility`s generating assets, it is more important than ever to know the company`s unique strategy and the subtle details of the particular assets to be financed. A structure that adds considerable value to one situation might reduce value for another situation. For example, if a utility does not have a ready source of capital (from competitive transition charges or otherwise) to fund a PPA buyout, a restructuring might merely replace a known obligation with another less palatable obligation (and one which regulators might not approve).

Separately, tax-leveraged leases can increase the internal rate of return on many power plant investments, but can also result in large tax bills on mature assets sold and leased-back.

It is important to continually explore new financing alternatives as structures are constantly being created or enhanced. Additionally, planning ahead can allow greater flexibility in choice of structure as well as improved financial execution. The plan of financing should be considered an early and integral part of any new generation investment.