406 Dirksen EPW Hearing Room
Managing Director, Morgan Stanley
Good morning. My name is Jim McGinnis, and I am a Managing Director in Morgan Stanley’s Investment Banking Division, with responsibilities in providing advice on capital raising, restructuring and mergers and acquisitions involving companies in the energy sector. I have focused my work on power and energy providers, utilities and unregulated competitors alike, through a 15-year period characterized by nearly continuous, and episodically chaotic structural change in the sector.
My comments today will address certain of the potential effects on capital formation in the power industry which we expect from the enactment of multi-emissions technology legislation. In particular, I will focus my remarks on the need for and benefits of clarity in the context of a major capital expenditure program such as the one this legislation envisions. Also, I will discuss a few indicators of the economic health of the industry at this time, one characterized by companies seeking to repair balance sheets and regain investor confidence following a tumultuous period in the sector
My predecessors, colleagues and I at Morgan Stanley have been very active in raising new capital on behalf of companies in this industry since the Firm’s formation some seven decades ago, through sharply different market environments and economic cycles.
I believe that we institutionally understand the challenges faced by our industry clients today in competing for investor capital through new issues and consistently providing a competitive return on such capital to ensure access to capital for future projects. But today, just as in past decades, providing access to capital on reasonable terms to this industry is not just a business niche; it is a critical underpinning of a healthy national economy.
The utility industry is a reasonably large user of domestic investor capital, with over $800 billion of institutional and individual investment dollars deployed in the nation’s power and gas utility and generation sectors. Yet, despite that large number, investor sensitivities to cash flows, requirements for debt repayments or significant new capital spending can sharply affect any individual company’s access to capital. An event-related swell of concern in the market can, and has in the past twelve months, effectively cut off capital access for even financially sizeable companies for significant periods of time.
Interruptions or limitations on capital access in our industry sector can have far-reaching impacts - impacts as gradual and relentless as forcing power-intensive industries to relocate facilities elsewhere in search of cheaper power; or as immediate and dramatic as rolling blackouts in times of supply crisis.
The Need for Clarity
Our focus on multi-emissions legislation today is a particularly important dimension of this continuous provision of access to capital. I believe the various sets of actors in the industry – its senior management, workforces, local regulators, employees, customers and investors generally recognize and accept the impending, reasonably-sized investment in emissions control technologies as a necessary and useful expenditure.
Indeed, we can observe that some such impending expenditures are expected by the market – a fact made evident by the market’s neutral-to-slightly positive response to Dominion Resources’ recent announcement, made April 18th, of its $1.2 billion agreement with the Environmental Protection Agency to reduce emissions across its 24,000 MW generation portfolio. This agreement, achieved by a financially strong entity with supportive local regulatory treatment provided clear costs and benefits to its signors.
In contrast, capital providers to the industry can be expected to react poorly to financially significant expenditures required of utilities and unregulated generators in the absence of clarity and permanence, but rather in the context of potentially shifting requirements, unproven technologies and uneven regulatory treatment. This need for clarity has heightened importance now, at a time when industry participants have been roiled by unprecedented financial disruptions and failures, and by persistent uncertainties elsewhere in the public policy arena. Investors and company leaders are currently wrestling with a variety of fundamental uncertainties: state-by-state changes in policies related to industry restructuring; purchased power contract disputes, as in California; accounting standards revisions related to energy purchasing, trading and hedging activities; uncertainty over aspects of currently pending energy legislation such as PUHCA reform; FERC transmission policy, transmission siting rules, and transmission-related tax policy on transfers in ownership; and certain aspects of bankruptcy code reform, just to name a few.
Clarity as to the durability of legislative requirements is, for investors in the power sector, not just a modest benefit, it is a defining attribute. Typically, utility companies’ economics depend predominantly on the policy decisions of state regulators, and the framework of regulatory decision-making has very significant comparative impacts on those companies’ access to and cost of capital. To wit, California utilities, which, in my view, have experienced many years of regulatory antagonism and turmoil, exacerbated by and culminating in the 2001 statewide energy crisis, trade at a consistent discount to non-California utilities. For example, today, the average non-California utility enjoys a 32% price-to-earnings valuation premium to the average of the three major California investor owned utilities. It is in the context of such selective localized uncertainty that Federal policies related to large, new emissions-reduction expenditures must be unambiguous and durable.
One important attribute of legislation to reduce power generator emissions which supports the objective of clarity is the abundance of market signals from freely traded emissions allowances. Allowance trading improves the ability of affected companies to make clear choices as to the most cost effective of various strategies they can deploy in meeting emissions-reductions targets and promotes capital efficiencies when capital is scarce.
Stress in the Sector
The basic requirement for clarity in policy decisions related to what one of your prior witnesses has identified as one of the largest private industry investment initiatives ever conceived comes at a time when the financial health of the industry is, at best, on the mend from a dramatic and troublesome financial cycle.
Rather than recount the multiple factors and contributing exogenous occurrences which created the downturn in the merchant energy sector and its related impacts on utilities, I will focus on its current health and the cost-of-capital implications of that current state.
One co-determinant of the cost of funds and access to bond investors for industry participants is the credit rating agency’s public assignment of a rating to a particular issuer or a particular security issued by a company. In a stable industry and economic environment, investors might expect to see an equal number of upgrades to downgrades to such ratings.
The electric sector industry is in the midst, though perhaps the trailing end, of the worst ever period for credit rating deterioration. Since January 1, 2002, we have seen 232 separate rating downgrades (some of multiple rating categories at one time) versus only 18 ratings upgrades. These downgrades are a symptom, and effect of massive investor losses on bonds and bank loans to companies in the sector, and in the merchant power generation market in particular.
Whereas underlying US Treasury yields have improved materially and access to high yield or sub-investment grade bond markets has also improved markedly over the last twelve months, these helpful indicia should not obscure a central point: the industry has been systematically downgraded in relative risk/reward terms. This fact may well have a large, adverse impact on cost of and access to capital long after the current rally in Treasuries or junk bonds subsides.
Also, during the two years ending March 31, 2003, equity losses for investors have been staggering as well. The collective equity market capitalizations of seven selected merchant power industry participants alone, even excluding Enron, declined by $93 Billion from two years earlier, when the same entities were capitalized by the market at $102 billion, a staggering loss across some of the then most admired names in the industry.
There are broader impacts on the power sector of the recent merchant power sector value destruction episode. In recent years, statewide restructuring in California, New York, Illinois, Texas, Pennsylvania, Ohio, Delaware and Washington, D.C., has resulted in the large legacy generation portfolios of incumbent utilities to be transferred in those locations to unregulated power merchants, many of which have experienced a sharp decline in financial strength. This creates some potential for new counterparty exposures for electric distribution companies who rely on unregulated megawatt-hours to meet supply needs.
Indeed, some 2/3’s or more of the generation capacity sold by ConEd in New York City, by DQE in Pittsburgh, by Pepco in Washington, D.C., by Commonwealth Edison and by Illinova in Illinois, is now owned by one of the merchant power owners caught up in the financial turmoil referred to above. These generation companies are rated significantly below investment-grade rated by the credit rating agencies and are experiencing limited access to new capital.
Thus, in some cases, even those utilities whose parent companies did not embark upon a growth-focused expansion into unregulated merchant power in 2001-2002 now find a different, vexing credit issue: a weak counterparty on which they depend for the bulk of their reliable power supply. These unregulated counterparts are poorly equipped to absorb a large financial obligation, particularly in the context of any lack of clarity on the costs and benefits of such expenditures.
Clarity Will Drive Capital Access
In evaluating legislation to reduce power generator emissions which envisions one of the nation’s most ambitious private industry investment programs ever conceived, I would submit that Committee Members examine several important market dynamics: multiple critical uncertainties in upcoming energy policy and regulatory decisions, uncertainties related to fuel cost and availability, and, generally, the weakened financial capacity of the industry’s generation participants.
In this context, moving forward with legislation that provides clarity, durability and an efficient means to allocate expenditure decisions can be an important step toward assuring that sufficient, well-priced capital will be available from private investors to make such significant future expenditures. That assurance is important both for the success of an emissions-control policy objective, and also for the health of a critical infrastructure industry in this nation’s economy.