Energy Merchant Turmoil
Merchant companies may struggle to stay in business for years
Peter Rigby, Standard and Poor’s
after their ‘worst-case’ scenarios became their ‘base case’ realities.
In less than a decade, US energy merchant companies have gone from and marginally profitable, at best. And the economy appears to need
the cradle to the graveside, if not the grave itself. much less electricity than many expected, due in part to a shrinking
In just two years, well over $100 billion of energy merchant market manufacturing sector.
capitalization has disappeared as almost everything that could have Finally, the short but tumultuous history of competitive power
gone wrong with the nascent energy merchant industry did. In the last suggests that the industry must intrinsically contend with low and risky
year, three companies have filed for bankruptcy. Bond spreads suggest margins, much as petroleum refining does.
that investors expect more of the same. Based on current data, both the energy merchant sector and the
Credit ratings for a dozen companies owning over 200,000 MW of credit prospects for the debt that financed the sector’s growth will be
generation worldwide have fallen from investment grade (in most subject to further downward pressure. Indeed, it is difficult at this point
cases) to low, noninvestment grade levels. Many believe that it is too to construct a credible optimistic forecast.
early to dismiss the energy merchants, arguing that matters have
improved from a year earlier when these 12 companies were struggling The Longevity of Plants
with almost $25 billion of debt maturing in 2003. By the beginning of An interpretation of Michael Porter’s competitive industry analysis
December 2003, that sum had fallen to about $800 million maturing model suggests that competitive power generation faces inherent
by year-end as the energy merchants, with the reluctant assistance of obstacles to realizing the substantial profits whose allure drew so many
their banks, pushed many maturities out several years (see Figure 1, companies into the sector. The structure of the competitive power, or
following page.) merchant energy, model indicates a fiercely competitive and fragmented
Were the well-publicized 2003 debt reschedulings wise decisions? environment in which profit margins are painfully narrow.
Who can tell? What seems apparent, at least at this juncture, is that Unless something changes, such as an unlikely public policy shift
significant economic and business factors indicate that through the back to vertically integrated utility structures, the competitive power
remainder of the decade, energy merchants could well have to struggle industry will have to contend with low and uncertain returns. That so
to remain in business. Energy merchants face nearly $65 billion of many investments in unregulated power generation have fared so poorly
loans coming due by the end of 2010 out of a total debt burden of reinforces the point.
$125 billion – as indicated by ratings in the single B category or lower. In particular, two inherent qualities of merchant energy, which
Based on current data, it is unlikely that unsecured lenders to bankrupt include the activities of merchant generation and energy marketing and
energy merchants will see anything near par recovery, though secured trading, suggest that the industry may be doomed to long-term mediocre
lenders may, on the basis of recent bank loan ratings forecasting performance. First, while the construction costs and the often
recovery, fare better. protracted difficulties of siting and permitting of new power plants would
Why the gloomy forecast? In short, almost every worst-case scenario seem to be viewed as obstacles to their wholesale development and
that these companies and their lenders considered possible, but construction, some 200,000 MW of new capacity built since 1999
remote, has become its base-case scenario. indicates that these obstacles may not have been as formidable as
Business positions, always risky, have deteriorated, and financial originally believed. The lesson to be drawn is that the sector knows how
profiles are generally much worse than two years ago. The independent to overcome these problems and regularly does so. Hence, the barriers
power industry built more generation, most of it gas-fired, than the to entry are low for new power generation.
market could possibly use. Natural gas prices, low for many years during The second quality of merchant energy keeping industry returns low
the gas bubbles of the 1980s and 1990s, have now moved to levels is the near permanence of power plants. Most facilities built during the
that potentially threaten natural gas’ status as “fuel of choice.” last 50 years or even longer still operate. Generating companies may
Contrary to the assumptions of many market and feasibility disappear, either through bankruptcy or through consolidation, but their
studies, the retirements of older coal
plants and nuclear plants did not occur.
Indeed, many older plants have Peter N. Rigby is a director of utilities, energy, and project finance at Standard & Poor’s. With over 25 years of experience
displaced their new gas-fired combined in energy, he is a frequent speaker and writer on power and energy issues and one of the firm’s principal contacts for
cycle competitors. Energy marketing and ratings in the power, energy, and project finance sectors. Mr. Rigby holds a B.S. in petroleum and natural gas engineering
trading proved to be expensive to pursue and a B.A. in arts and sciences from The Pennsylvania State University, and an M.B.A. from the University of Michigan.
Positioning for Growth 47
Energy Merchant Turmoil
Company (Source: Standard and Poors) Credit Ratings Change Credit Measures
Dec 2003 May 2001 Leverage FFO/Interest FFO/Debt
Aes Corp B+ BB 95% 1.20 3.9%
Allegheny Energy, Inc. B A 72% 1.04 6.0%
Aquila, Inc. B BBB 64% 0.60 -3.2%
Calpine, Corp. B BB+ 79% 1.30 4.0%
Dynegy, Inc. B BBB 63% 4.10 17.1%
Edison Mission Energy (EME) B BBB- 75% 2.20 10.9%
El Paso Corp. B BBB+ 74% 2.32 8.6%
Mirant Corp. D BBB- 71% 1.00 2.8%
National Energy & Gas Transmission Inc. (NEGT) D BBB 135% 1.80 3.4%
NRG Energy, Inc. B+ BBB- 67% N/M N/M
Reliant Resources, Inc. B BBB+ 59% 1.30 2.5%
The Williams Companies, Inc. B+ BBB+ 76% 1.70 9.6%
FFO/Interest = (funds from operations + interest) / interest
FFO/Debt = (funds from operations after interest) / total debt
N/M: Not meaningful as NRG Energy, Inc. is coming out of bankruptcy
Figure 1 Energy Merchants Rated Single-B or Lower
power plants remain. While plants may be mothballed, they can easily lines may be available, the older and much smaller lines around
return to service if market conditions improve. Prior to the sector’s population load centers create bottlenecks preventing potentially
capacity expansion, most market studies and the developers and cheaper power from reaching markets. The broad absence of market-
lenders who relied upon them assumed that older coal plants and based transmission operations constrains merchant power sales
nuclear power plants would be retired. They weren’t. opportunities, a problem that FERC has attempted to address with its
Indeed, the opposite happened. New owners acquired the older Standardized Market Design.
plants, invested in upgrades and retrofits and dramatically increased Finally, merchant generation, in some parts of the country competes
plant efficiencies and availabilities. In addition to the economic forces against generation held in rate base by vertically integrated utilities.
that have kept older plants in service, some regulated utilities that still The resulting competitive advantage in favor of rate base supported
own generation have persuaded regulators to allow unused power plants generation makes it difficult for merchant power to recover its capital
to stay in their rate base to provide reliability and backup in the future. costs, especially in the overbuilt generation market that dominates
Consequently, merchant power competes in a world where new much of the United States.
entrants can easily clear entry obstacles, and their power plants rarely Consequently, in a market characterized by the absence of long-term
disappear. Such is the foundation for a fragmented industry. contracts, energy merchants find it difficult to earn the stable returns
that regulated industries earn or the high profits that industries with
One of the Many Poor high entry barriers enjoy.
Competing in the fragmented merchant power industry largely condemns
its participants to thin and risky margins. The primary reason for this is Poor Industry Fundamentals
that public policy in the United States prevents merchant power plant A destructive consequence of operating in a fragmented industry
owners from owning significant or controlling market share. Hence, the with low barriers to entry is a susceptibility to “boom-bust” cycles,
market structure forces merchant power into a “price taking” position. not unlike the mining and chemical industries. Moreover, the
In practice, the ability to transport electricity is limited. Unlike other lumpiness with which new generation enters the market and its
commodities, electricity does not typically transport far from its source. longevity may threaten extended time frames at the bottom of the
Therefore, because power generation cannot always reach the most merchant business cycle. Now at what appears to be the end of a
desirable markets, it tends to compete regionally instead of nationally. build-out period, energy merchants may have to confront surplus
A negative reinforcement to this regional focus has been the lack of reserve margins for years. Should that happen, energy merchants
investment in transmission facilities in the United States for the last 20 will continue to find that poor industry fundamentals and depressed
years, as well as a governance structure that has on occasion restricted operating margins will frustrate capital recovery. And without the
access to transmission and customers. Another problem is that many liquidity on the balance sheet necessary to sustain these companies
developers have built new generation away from load centers and out of through the bottom of the cycle, some may be forced to leave
sight of potential public opposition. While bulk capacity transmission the business.
48 w w w. U t i l i t i e s P r o j e c t . c o m
Finance & Forecasting
Declining Manufacturing retard recovery prospects because of the inherent volatility of
It is unlikely that the US economy will provide much help to the energy merchant power revenues.
merchants. Over the years, the historical correlation between GDP The second credit measure that points to distress is the “funds
and electricity demand has been weakening. Electricity demand in from operations to interest” ratios (FFO/interest). Most coverage levels
megawatt-hours since 1990 has grown at an annualized rate of 1.8 for the 12 trailing months prior to mid-2003 are below 1.6x1 and well
percent per year while GDP in real 1996 dollars has grown more below the sector median of just over 3x1.
rapidly at about 3 percent per year (4.9 percent in nominal dollars). The most telling measure is the “funds from operations after
Peak demand has grown faster at about 2.2 percent per year, but still interest expense to debt” ratio (FFO/debt). Weak and declining
at a rate slower than GDP. FFO/debt ratios are empirically among the clearest indicators of
financial distress as cash flow is declining or debt is rising, or both.
Eight of the 12 companies have FFO/debt ratios of 6 percent or less
and all are below 17 percent. By comparison a solid investment grade
electric utility traditionally enjoys a FFO/debt ratio of at least 25 percent.
Outlook for Debt
As matters now stand, the energy merchant business model is under
... the energy merchants must find a siege. The shared strategy of rapid and debt-funded growth premised
upon rapid deregulation of the US electricity industry and open
competition has not played out.
way to reduce their crushing debt Against this backdrop the energy merchants must find a way to
reduce their crushing debt burdens and do so fairly quickly if they are
burdens and do so fairly quickly if to survive. But the task promises to be formidable, even for those
with “nonmerchant” power. Lenders may look at upcoming maturities
in light of the possibility of excess reserve margins through the
they are to survive. decade and decide to retreat from the energy sector, especially if their
overall lending portfolios improve with a strengthening economy.
Hence, energy merchants will likely have to either slowly grow their
Electricity demand has grown more slowly than GDP in part because way out of their debt problems through an improving economy or,
the US economy has become more efficient over the last decade. failing that, look to reorganization strategies in bankruptcy to improve
But the more influential demand driver probably lies with the economy their financial positions.
becoming more service-oriented as manufacturing moves offshore. Structurally, the nascent competitive power industry resembles
Electricity demand per dollar of GDP has been steadily declining since other capital-intensive industries in which assets tend to remain in
1990 at the latest. service for a long time and where barriers to entry are not difficult to
overcome. These factors are the traditional basis for fundamentally low
Poor Credit Fundamentals and uncertain returns occasionally punctuated by a brief surge of great
By almost every measure, the 12 energy merchants exhibit surpassingly profits – a situation that few energy merchant companies, their financial
weak credit fundamentals. Given the sector’s poor fundamental credit advisors, or their investors anticipated almost a decade ago.
characteristics, its degree of fragmentation, and their $125 billion debt And therein lies the message for the energy merchant business: while
overhang, the group will struggle to improve their credit measures. competitive power fundamentals may never point to great businesses,
Thus, consolidated leverage is at least 60 percent for each of some firms in other industries can survive under similar circumstances
the merchants. Such leverage, combined with about 100,000 MW of and may even do well, but they do so under much more conservatively
merchant capacity in the US – much of it natural gas – will very likely financed structures than many energy merchants first envisioned. ■
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Positioning for Growth 49