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FitchRatings 1 Credit Outlook U.S. Power and Gas Richard Hunter Managing Director, North America Global Power Group Energy Finance & Credit Summit, Houston,

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Presentation on theme: "FitchRatings 1 Credit Outlook U.S. Power and Gas Richard Hunter Managing Director, North America Global Power Group Energy Finance & Credit Summit, Houston,"— Presentation transcript:

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2 FitchRatings 1 Credit Outlook U.S. Power and Gas Richard Hunter Managing Director, North America Global Power Group Energy Finance & Credit Summit, Houston, February 2004 Return to Risk Limited website: www.RiskLimited.comwww.RiskLimited.com

3 FitchRatings 2 Capital Markets Environment Capital Markets Environment Credit Environment Credit Environment Major Themes Major Themes Outlook for the Sectors Outlook for the Sectors Utilities Utilities Utility Parent Holding Companies Utility Parent Holding Companies Competitive Gencos & Energy Merchants Competitive Gencos & Energy Merchants Topics

4 FitchRatings 3 Capital Markets Environment 1999 -2002 Excessive capital market exuberance Late 2002- January 03 Reaction: Liquidity Black Hole Credit market and bond market showed a strong linkage to the equity market Bank consolidation has reduced diversity 2003 2003 Capital and credit market access restored Private investment sources provided liquidity Pure utilities & public power retained market access Current 2004 Low interest rates, good market access

5 FitchRatings 4 Equity and Debt Capital Markets

6 FitchRatings 5 Equity and Debt Capital Markets 1Q 03 Source: Merrill Lynch, Bloomberg

7 FitchRatings 6 Near-term Outlook Gas price volatility and commodity price risk Gas price volatility and commodity price risk Merchant power overbuilt in nearly all regions Merchant power overbuilt in nearly all regions Pendulum swings back toward integrated utilities and regulation Pendulum swings back toward integrated utilities and regulation System reliability and environmental protection require higher capital spending 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 Low interest rate environment is benign for capital intensive and over-leveraged sector, but higher rates may lie ahead Mergers and consolidations are likely Mergers and consolidations are likely

8 FitchRatings 7 Longer- Term Issues Global Warming Global Warming Carbon tax in our future? Carbon tax in our future? Price elasticity, demand destruction and demand-side management, obsolete technologies Price elasticity, demand destruction and demand-side management, obsolete technologies Is wired distribution of power a post-mature industry? Is wired distribution of power a post-mature industry? How much new investment is needed? How much new investment is needed? Distribution and transmission: Distribution and transmission: Patch up the old system, orPatch up the old system, or Invest heavily in an intelligent wired networkInvest heavily in an intelligent wired network Power production Power production Retrofit old thermal generation, orRetrofit old thermal generation, or Invest in new technologiesInvest in new technologies

9 FitchRatings 8 Credit Environment 2003 vs. 2002 2003 vs. 2002 Credit stress increased through 2002 and stabilized in 2003. Source: Fitch Ratings

10 FitchRatings 9 Credit Outlook by Sub-sector January 1, 2003 January 1, 2004 Parent Companies Integrated Utilities Distribution Utilities Diversified/Merchant Energy 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. Positive Negative Stable/Evolving

11 FitchRatings 10 Credit Environment Total Sector Power & Gas2003 2002 Total Sector Power & Gas2003 2002 Upgrades to downgrades 1:2 1:12 Upgrades to downgrades 1:2 1:12 Stable outlooks (at year end)80% 64% Stable outlooks (at year end)80% 64% Negative to positive outlooks 2:1 6:1 Negative to positive outlooks 2:1 6:1 Ratings stable, but low:Median Rating Ratings stable, but low:Median Rating Competitive wholesale energyBCompetitive wholesale energyB Regulated utility A-Regulated utility A- Utility group parentBBB+Utility group parentBBB+

12 FitchRatings 11 Credit Environment Affiliate action as the largest single cause … Affiliate action as the largest single cause … Investor-Owned Power & Gas companies, All Rating Actions, Source: Fitch

13 FitchRatings 12 Regulated Utilities The Morning After… The Morning After…

14 FitchRatings 13 Credit Outlook: Regulated Utilities THEMES Back to Basics Back to Basics Gas and power price fluctuation Gas and power price fluctuation Mandated capital spending for increased reliability and supply security Mandated capital spending for increased reliability and supply securityIMPLICATIONS Lower credit risk Lower credit risk Risk for utilities with fixed tariffs and obligation to serve Risk for utilities with fixed tariffs and obligation to serve Higher external financing needs (Potential mitigant: a clear regulatory recovery mechanism) Higher external financing needs (Potential mitigant: a clear regulatory recovery mechanism)

15 FitchRatings 14 Risks faced by Regulated Utilities Commodity price risk Commodity price risk Ability to hedge commodity price risk Ability to hedge commodity price risk Mergers and Acquisitions Mergers and Acquisitions Debt burden Debt burden Unsuccessful merger/ consolidation implementation Unsuccessful merger/ consolidation implementation Regulatory risk Regulatory risk Low interest rate, ergo low ROE Low interest rate, ergo low ROE Shifts in policy Shifts in policy

16 FitchRatings 15 Risks faced by Regulated Utilities Lower Returns on Equity? Lower Returns on Equity? Source: PUR Utility Regulatory News

17 FitchRatings 16 RoE impact on coverages Operating Cash Flow/Interest Expense assumes 50:50 debt:equity funding, 7% cost of debt, 35% tax rate assumes 50:50 debt:equity funding, 7% cost of debt, 35% tax rate

18 FitchRatings 17 Risks faced by Regulated Utilities Success Rates? Success Rates? Source: PUR Utility Regulatory News

19 FitchRatings 18 Credit Outlook: Parent Companies THEMES Back to Basics in 2004 Back to Basics in 2004 Prior unsuccessful diversification activities Prior unsuccessful diversification activities Industry consolidation ahead Industry consolidation aheadIMPLICATIONS Lower business risk Lower business risk Need dividends from utilities to reduce parent debt; affects ability to fund capex Need dividends from utilities to reduce parent debt; affects ability to fund capex Event risk for both acquirers and targets Event risk for both acquirers and targets

20 FitchRatings 19 Credit Outlook: Parent Companies Analytical Issues Analytical Issues Parent-level debt service coverage Parent-level debt service coverage Tax-sharing Tax-sharing Management fees Management fees Subsidiary injections Subsidiary injections Recovery Analysis Recovery Analysis Non-consolidation in bankruptcy Non-consolidation in bankruptcy Parent-subsidiary notching Parent-subsidiary notching

21 FitchRatings 20 Competitive Wholesale and Merchant Energy Companies Asset Sales Equity Cash Flow …exiting the debt hole

22 FitchRatings 21 What Does it Take? Example: Interest Cover Example: Interest Cover Source: Fitch Ratings

23 FitchRatings 22 How Deep is the Hole? Debt Outstanding Source: SNL, Inc. Data as at 9-30-03 Source: SNL, Inc. Data as at 9-30-03

24 FitchRatings 23 Sector High Yield Debt Maturities Source: Fitch Ratings

25 FitchRatings 24 High Yield Debt Maturities Company Total 5 years Peak Dec. 17, 2003 Feb 17, 2004 Dec. 17, 2003 Feb 17, 2004 Reliant Resources & Orion Power $ 6,400 1Q 2007: $ 4,877 Calpine & subs $ 9,286 4Q 2004: $ 1,048 $ 2,500 $ 2,500 4Q 2004: $ 1,048 $ 2,500 $ 2,500 AES Corp. $ 3,018 $ 2,048 3Q 2007: $ 1,193 3Q 2007: $ 693 El Paso Corp. $ 5,176 2005: $ 1,600 2006: $ 1,732 2005: $ 1,600 2006: $ 1,732 Allegheny Energy Inc. A E Supply $ 2,460 $ 662* 1Q 2005: $ 1,077 3Q 2005: $ 300 1Q 2007: $ 300 Dynegy Holdings $ 1,742 1Q 2005: $ 1,139 Aquila Inc. $ 1,272 2Q 2006: $ 445 Source: Companies, Fitch Ratings * assuming successful execution of refinancings currently in market

26 FitchRatings 25 Appetite for Roll-Over? Oil, Gas, Pipeline & Utilities ($ bn) 2003200220012000 Loans + Commitment 198.1226.1224.5174.5 Classified38.017.04.34.0 Special Mention 12.315.57.01.0 % Classified % Classified19.5%7.5%1.9%2.3% % Special Mention % Special Mention6.2%6.9%3.1%0.6%

27 FitchRatings 26 Whose Loss is it Anyway? Classified CommitmentsClassified as % of Commitment "Classified" Commitments on Syndicated Loans in excess of $20m Source: Shared National Credit Survey, U.S. Federal Reserve Board

28 FitchRatings 27 Wholesale Energy Market Competitive Generation Current Status Excess capacity, low spark spreads Excess capacity, low spark spreads Speculative-grade ratings a barrier to negotiating term contracts Speculative-grade ratings a barrier to negotiating term contracts Bankruptcies and restructurings Bankruptcies and restructurings Asset values at a cyclical low or permanently impaired? Asset values at a cyclical low or permanently impaired? Jurisdictional issues about contract rejection Jurisdictional issues about contract rejection

29 FitchRatings 28 Wholesale Energy Market Competitive Generation Near-term Outlook Pendulum swings back toward integration and regulated utility power generation Pendulum swings back toward integration and regulated utility power generation Examples: CA; AZ; WI Examples: CA; AZ; WI Load-serving entities shun executory contracts and dependence on gas Load-serving entities shun executory contracts and dependence on gas Cost of capital advantage for utilities versus gencos Cost of capital advantage for utilities versus gencos

30 FitchRatings 29 Option A Equity

31 FitchRatings 30 Equity performance Monthly average share prices, indexed at 100 as at Jan. 1, 2002 Source: Bloomberg

32 FitchRatings 31 Option B Asset Sales

33 FitchRatings 32 Who's Buying? Source: Henwood Energy Services

34 FitchRatings 33 Sales characteristics 22GW sold in past two years for c.$11bn 22GW sold in past two years for c.$11bn Much of the value in contracts Much of the value in contracts 60GW left on the block 60GW left on the block Older contracts running off Older contracts running off Munis - self-build or fire sale? Munis - self-build or fire sale? LSEs - FERC warning shots? LSEs - FERC warning shots? Energy majors - Opposite direction? Energy majors - Opposite direction? Financial companies - Speculative?? Financial companies - Speculative??

35 FitchRatings 34 Wholesale Energy Market Competitive Generation Regulatory and policy gridlock Regulatory and policy gridlock Bankruptcy Court versus FERC jurisdiction Bankruptcy Court versus FERC jurisdiction Congressional wrangling over Energy Policy Act Congressional wrangling over Energy Policy Act FERC versus states on RTOs FERC versus states on RTOs MISO members change their bets MISO members change their bets

36 FitchRatings 35 Wholesale Energy Market FERC versus Bankruptcy Court If FERC prevails: If Bankruptcy Court prevails : A no-win situation for wholesale market competition Lower asset recoveries for genco investors Steeper cost of capital for gencos Gencos less competitive Utilities and PSCs will see greater risk to public in supply contracts More incentive for utilities to build or buy power generation Gencos less competitive

37 FitchRatings 36 Option C Cash Flow

38 FitchRatings 37 Outlook: Competitive Wholesale Generators and Merchants Based on published and senior unsecured debt ratings, weighted by capacity Based on published and senior unsecured debt ratings, weighted by capacity Source: Fitch Ratings

39 FitchRatings 38 Outlook: Competitive Wholesale Generators and Merchants Based on published and senior unsecured debt ratings, weighted by capacity Based on published and senior unsecured debt ratings, weighted by capacity Source: Fitch Ratings

40 FitchRatings 39 Outlook: Competitive Wholesale Generators and Merchants Based on published and senior unsecured debt ratings, weighted by capacity Based on published and senior unsecured debt ratings, weighted by capacity Source: Fitch Ratings

41 FitchRatings 40 Outlook: Competitive Wholesale Generators and Merchants Based on published and senior unsecured debt ratings, weighted by capacity Based on published and senior unsecured debt ratings, weighted by capacity Source: Fitch Ratings

42 FitchRatings 41 Regional Wholesale Markets Source: Henwood Energy Services, Fitch Ratings Market Clearing Price (Spring 2003)Market Clearing Price (Fall 2003)

43 FitchRatings 42 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 O&M, and a 2% forced outage factor.

44 FitchRatings 43 Wholesale Energy Market Longer-term Outlook Wholesale energy market will still exist, but no guarantee that players will be the same. 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. Broken models will be replaced by new and different models.

45 FitchRatings 44 Wholesale Energy Market Longer Term: Model 1 Utility Merchant Producer Merchant Producer Distressed asset sale Merger Self-build Consolidation and Reintegration

46 FitchRatings 45 Wholesale Energy Market Longer Term: Model 2 Utility Project Developer Project Developer Asset lease Build & transfer Plant Operator Service Contract Preserves roles for specialists in project development and operation, but not a major role.

47 FitchRatings 46 Wholesale Energy Market Longer Term: Model 3 Merchant Producer Utility Supply contract priced at floating market index Financial Counterparty Financial Counterparty Financial hedge Consumers Tariff adjustments 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

48 FitchRatings 47 Fitch Global Power Group


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