In less than a decade, US energy merchant companies have gone from the cradle
to the graveside, if not the grave itself.

In just two years, well over $100 billion of energy merchant market capitalization
has disappeared as almost everything that could have gone wrong with the nascent
energy merchant industry did. In the last year, three companies have filed
for bankruptcy. Bond spreads suggest that investors expect more of the same.

Credit ratings for a dozen companies owning over 200,000 MW of generation
worldwide have fallen from investment grade (in most cases) to low, noninvestment
grade
levels. Many believe that it is too early to dismiss the energy merchants,
arguing that matters have improved from a year earlier when these 12 companies
were struggling with almost $25 billion of debt maturing in 2003. By the beginning
of December 2003, that sum had fallen to about $800 million maturing by year-end
as the energy merchants, with the reluctant assistance of their banks, pushed
many maturities out several years (see Figure 1).

Were the well-publicized 2003 debt reschedulings wise decisions? Who can tell?
What seems apparent, at least at this juncture, is that significant economic
and business factors indicate that through the remainder of the decade, energy
merchants could well have to struggle to remain in business. Energy merchants
face nearly $65 billion of loans coming due by the end of 2010 out of a total
debt burden of $125 billion – as indicated by ratings in the single B
category or lower. Based on current data, it is unlikely that unsecured lenders
to bankrupt energy merchants will see anything near par recovery, though secured
lenders may, on the basis of recent bank loan ratings forecasting recovery,
fare better.

Why the gloomy forecast? In short, almost every worst-case scenario that these
companies and their lenders considered possible, but remote, has become its
base-case scenario.

Business positions, always risky, have deteriorated, and financial profiles
are generally much worse than two years ago. The independent power industry
built more generation, most of it gas-fired, than the market could possibly
use. Natural gas prices, low for many years during the gas bubbles of the 1980s
and 1990s, have now moved to levels that potentially threaten natural gas’ status
as “fuel of choice.”

Contrary to the assumptions of many market and feasibility studies, the retirements
of older coal plants and nuclear plants did not occur. Indeed, many older plants
have displaced their new gas-fired combined cycle competitors. Energy marketing
and trading proved to be expensive to pursue and marginally profitable, at
best. And the economy appears to need much less electricity than many expected,
due in part to a shrinking manufacturing sector.

Finally, the short but tumultuous history of competitive power suggests that
the industry must intrinsically contend with low and risky margins, much as
petroleum refining does.

Based on current data, both the energy merchant sector and the credit prospects
for the debt that financed the sector’s growth will be subject to further
downward pressure. Indeed, it is difficult at this point to construct a credible
optimistic forecast.

The Longevity of Plants

An interpretation of Michael Porter’s competitive industry analysis model
suggests that competitive power generation faces inherent obstacles to realizing
the substantial profits whose allure drew so many companies into the sector.
The structure of the competitive power, or merchant energy, model indicates
a fiercely competitive and fragmented environment in which profit margins are
painfully narrow.

Unless something changes, such as an unlikely public policy shift back to vertically
integrated utility structures, the competitive power industry will have to
contend with low and uncertain returns. That so many investments in unregulated
power generation have fared so poorly reinforces the point.

In particular, two inherent qualities of merchant energy, which include the
activities of merchant generation and energy marketing and trading, suggest
that the industry may be doomed to long-term mediocre performance. First, while
the construction costs and the often protracted difficulties of siting and
permitting of new power plants would seem to be viewed as obstacles to their
wholesale development and construction, some 200,000 MW of new capacity built
since 1999 indicates that these obstacles may not have been as formidable as
originally believed. The lesson to be drawn is that the sector knows how to
overcome these problems and regularly does so. Hence, the barriers to entry
are low for new power generation.

The second quality of merchant energy keeping industry returns low is the near
permanence of power plants. Most facilities built during the last 50 years
or even longer still operate. Generating companies may disappear, either through
bankruptcy or through consolidation, but their power plants remain. While plants
may be mothballed, they can easily return to service if market conditions improve.
Prior to the sector’s capacity expansion, most market studies and the
developers and lenders who relied upon them assumed that older coal plants
and nuclear power plants would be retired. They weren’t.

Indeed, the opposite happened. New owners acquired the older plants, invested
in upgrades and retrofits and dramatically increased plant efficiencies and
availabilities. In addition to the economic forces that have kept older plants
in service, some regulated utilities that still own generation have persuaded
regulators to allow unused power plants to stay in their rate base to provide
reliability and backup in the future.

Consequently, merchant power competes in a world where new entrants can easily
clear entry obstacles, and their power plants rarely disappear. Such is the
foundation for a fragmented industry.

One of the Many Poor

Competing in the fragmented merchant power industry largely condemns its participants
to thin and risky margins. The primary reason for this is that public policy
in the United States prevents merchant power plant owners from owning significant
or controlling market share. Hence, the market structure forces merchant power
into a “price taking” position.

In practice, the ability to transport electricity is limited. Unlike other
commodities, electricity does not typically transport far from its source.
Therefore, because power generation cannot always reach the most desirable
markets, it tends to compete regionally instead of nationally.

A negative reinforcement to this regional focus has been the lack of investment
in transmission facilities in the United States for the last 20 years, as well
as a governance structure that has on occasion restricted access to transmission
and customers. Another problem is that many developers have built new generation
away from load centers and out of sight of potential public opposition. While
bulk capacity transmission lines may be available, the older and much smaller
lines around population load centers create bottlenecks preventing potentially
cheaper power from reaching markets. The broad absence of market-based transmission
operations constrains merchant power sales opportunities, a problem that FERC
has attempted to address with its Standardized Market Design.

Finally, merchant generation, in some parts of the country competes against
generation held in rate base by vertically integrated utilities.
The resulting competitive advantage in favor of rate base supported generation
makes it difficult for merchant power to recover its capital costs, especially
in the overbuilt generation market that dominates much of the United States.

Consequently, in a market characterized by the absence of long-term contracts,
energy merchants find it difficult to earn the stable returns that regulated
industries earn or the high profits that industries with high entry barriers
enjoy.

Poor Industry Fundamentals

A destructive consequence of operating in a fragmented industry
with low barriers to entry is a susceptibility to “boom-bust” cycles,
not unlike the mining and chemical industries. Moreover, the lumpiness with
which new generation enters the market and its longevity may threaten extended
time frames at the bottom of the merchant business cycle. Now at what appears
to be the end of a build-out period, energy merchants may have to confront
surplus reserve margins for years. Should that happen, energy merchants
will continue to find that poor industry fundamentals and depressed operating
margins will frustrate capital recovery. And without the liquidity on the balance
sheet necessary to sustain these companies through the bottom of the cycle,
some may be forced to leave
the business.

Declining Manufacturing

It is unlikely that the US economy will provide much help to the energy
merchants. Over the years, the historical correlation between GDP
and electricity demand has been weakening. Electricity demand in megawatt-hours
since 1990 has grown at an annualized rate of 1.8 percent per year while GDP
in real 1996 dollars has grown more rapidly at about 3 percent per year (4.9
percent in nominal dollars). Peak demand has grown faster at about 2.2 percent
per year, but still at a rate slower than GDP.

Electricity demand has grown more slowly than GDP in part because the US
economy has become more efficient over the last decade.
But the more influential demand driver probably lies with the economy becoming
more service-oriented as manufacturing moves offshore. Electricity demand per
dollar of GDP has been steadily declining since 1990 at the latest.

Poor Credit Fundamentals

By almost every measure, the 12 energy merchants exhibit surpassingly weak
credit fundamentals. Given the sector’s poor fundamental credit characteristics,
its degree of fragmentation, and their $125 billion debt overhang, the group
will struggle to improve their credit measures.

Thus, consolidated leverage is at least 60 percent for each of the merchants.
Such leverage, combined with about 100,000 MW of merchant capacity in the US – much
of it natural gas – will very likely retard recovery
prospects because of the inherent volatility of merchant power revenues.

The second credit measure that points to distress is the “funds
from operations to interest” ratios (FFO/interest). Most coverage levels
for the 12 trailing months prior to mid-2003 are below 1.6×1 and well below
the sector median of just over 3×1.

The most telling measure is the “funds from operations after interest
expense to debt” ratio (FFO/debt). Weak and declining 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 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.

Against this backdrop the energy merchants must find a way to reduce their
crushing debt burdens and do so fairly quickly if they are 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 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
way out of their debt problems through an improving economy or, failing that,
look to reorganization strategies in bankruptcy to improve their financial
positions.

Structurally, the nascent competitive power industry resembles
other capital-intensive industries in which assets tend to remain in service
for a long time and where barriers to entry are not difficult to overcome.
These factors are the traditional basis for fundamentally low and uncertain
returns occasionally punctuated by a brief surge of great profits – a
situation that few energy merchant companies, their financial advisors, or
their investors anticipated almost a decade ago.

And therein lies the message for the energy merchant business: while competitive
power fundamentals may never point to great businesses, some firms in other
industries can survive under similar circumstances and may even do well,
but they do so under much more conservatively financed structures than
many energy
merchants first envisioned.