Credit Outlook U.S. Power and Gas

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Credit Outlook U.S. Power and Gas
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• Richard Hunter
• Managing Director, North America
• Global Power Group
• Energy Finance Credit Summit, Houston, February
  2004

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Topics

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

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Capital Markets Environment
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Equity and Debt Capital Markets
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Equity and Debt Capital Markets
1Q 03
Source Merrill Lynch, Bloomberg
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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

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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

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Credit Environment

• 2003 vs. 2002

Credit stress increased through 2002 and
stabilized in 2003.
Source Fitch Ratings
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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.
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Credit Environment

• Total Sector Power Gas 2003 2002
• Upgrades to downgrades 12 112
• Stable outlooks (at year end) 80 64
• Negative to positive outlooks 21 61
• Ratings stable, but low Median Rating
• Competitive wholesale energy B
• Regulated utility A-
• Utility group parent BBB

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Credit Environment

• Affiliate action as the largest single cause

Investor-Owned Power Gas companies, All Rating
Actions, Source Fitch
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Regulated Utilities

• The Morning After

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Credit Outlook Regulated Utilities

• 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)

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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

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Risks faced by Regulated Utilities

• Lower Returns on Equity?

Source PUR Utility Regulatory News
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RoE impact on coverages
Operating Cash Flow/Interest Expense
assumes 5050 debtequity funding, 7 cost of
debt, 35 tax rate
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Risks faced by Regulated Utilities

• Success Rates?

Source PUR Utility Regulatory News
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Credit Outlook Parent Companies

• 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

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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

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Competitive Wholesale and Merchant Energy
Companies
Equity
Asset Sales
Cash Flow
exiting the debt hole
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What Does it Take?

• Example Interest Cover

Source Fitch Ratings
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How Deep is the Hole?
Debt Outstanding
Source SNL, Inc. Data as at 9-30-03
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Sector High Yield Debt Maturities
Source Fitch Ratings
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High Yield Debt Maturities
assuming successful execution of refinancings
currently in market
Source Companies, Fitch Ratings
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Appetite for Roll-Over?
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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
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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

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Wholesale Energy Market Competitive Generation

• 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

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Option A
Equity
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Equity performance
Monthly average share prices, indexed at 100 as
at Jan. 1, 2002 Source Bloomberg
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Option B
Asset Sales
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Who's Buying?
Source Henwood Energy Services
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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??

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Wholesale Energy MarketCompetitive Generation

• 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

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Wholesale Energy MarketFERC versus Bankruptcy
Court

• If FERC prevails

• If Bankruptcy Court prevails

A no-win situation for wholesale market
competition
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Option C
Cash Flow
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Outlook Competitive Wholesale Generators and
Merchants
Based on published and senior unsecured debt
ratings, weighted by capacity
Source Fitch Ratings
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Outlook Competitive Wholesale Generators and
Merchants
Based on published and senior unsecured debt
ratings, weighted by capacity
Source Fitch Ratings
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Outlook Competitive Wholesale Generators and
Merchants
Based on published and senior unsecured debt
ratings, weighted by capacity
Source Fitch Ratings
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Outlook Competitive Wholesale Generators and
Merchants
Based on published and senior unsecured debt
ratings, weighted by capacity
Source Fitch Ratings
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Regional Wholesale Markets
Market Clearing Price (Spring 2003) Market
Clearing Price (Fall 2003)
Source Henwood Energy Services, Fitch Ratings
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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 OM,
and a 2 forced outage factor.
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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.

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

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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
Contracts provisions on the financial
Hedge Contracts Both assure physical supply and
off-take in the Supply Contract
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Fitch Global Power Group