Increased competition brought about by market forces and new legislation is prompting electric utilities to rethink traditional business practices. Several issues will have a significant effect on the industry's ability to operate more efficiently, including proposed changes in federal regulation, a shift to more open transmission access, and state regulators' emphasis on cost reductions.
As competitive barriers fall, one area poised for continued growth is non-utility generators, more commonly known as independent power producers (IPPs). Accounting for approximately 5.0% of the nation's generating capacity, this figure should more than double by the year 2000, with annual funding requirements exceeding $5 billion. IPPs are expected to contribute an even higher percentage of installed electric generation in the mid-Atlantic states, upper Midwest, and West Coast.
Until now, almost all IPP financing was obtained privately through banks, insurance companies, or other direct lenders. Supported by abundant capital, attractive interest rates, and lenders' confidence in these project financings, there was little need to access the public markets.
But this appears to be changing. More restrictive lending criteria, fewer active financial institutions, and bigger, more capital-intensive projects increase the need for new funding sources and greater use of the public capital markets. To facilitate public issuance and increase the liquidity of existing IPP loans, the use of debt ratings for these projects will increase, prompting Fitch to set forth its criteria for rating IPPs.
This criteria is aimed primarily at plants starting construction, as well as projects entering commercial operation seeking alternative, fixed sources of capital. While most new projects are expected to be high risk and rated below investment grade, some of the stronger IPP credits may warrant investment-grade ratings.
To achieve an investment-grade rating, a project needs to be well structured, both legally and financially. It must demonstrate sufficient demand for the power at a competitive price and have in place all necessary permits and wheeling arrangements. Proven plant technology, an experienced development team, and local support for the project are essential. A strong correlation between movements in project fuel costs and revenues derived from variable energy prices of the purchasing utility are important. In addition, the power purchaser's financial strength, and that of the steam host for qualifying facilities (QFs), must be adequate to support the rating. Finally, by definition, estimated financial results should provide sufficient debt service coverage to ensure bondholder protection.
Fitch's rating approach to investment-grade IPPs is detailed below. Implicit in the analysis is a recognition that qualitative factors vary widely among IPPs, making direct rating comparisons difficult.
Project: As a single-site facility, the degree of risk associated with an IPP is much greater than for most other utility systems. Typically, the project owner and debtholders are paid only when the unit is operating or available, making reliability a key element in rating power project financings.
Developers: Fitch's evaluation of a project begins with its owners. The quality of the management team, staff personnel, an understanding of their business philosophy, and a review of past projects are important credit factors. A developer with a track record of successful projects and a longer-term commitment to the industry is a positive. Stronger and better capitalized owners are viewed as providing additional stability to startup projects. Also, strong community support for the project is a prerequisite.
Technology: Plant technology is another rating consideration. While this carries no greater weight than any other credit factor, Fitch believes that the use of standard plant technology, such as a gas-fired combustion turbine, presents less of a risk than newer technologies that are not as well tested. The number of similar units successfully built and their past performance is closely analyzed, focusing on plant availability and level of operating performance.
Permits: Air quality, together with other major permits and approvals, is expected prior to the start of construction. An environmental audit addressing any site-related issues must be conducted. State public service commission (PSC) approval of the power purchase agreement (PPA) and a certificate of need, if required, must be obtained. If the project is a QF, ongoing Federal Energy Regulatory Commission (FERC) certification also must be met. All necessary transmission arrangements should be in place, with pricing formulas agreed upon.
Contracts: The construction contract should include fixed-price, "turn-key" agreements with experienced builders. The construction budget needs to incorporate reasonable contingencies for potential delays or cost overruns, including a realistic completion schedule. Performance guarantees and securities by the builder help ensure satisfactory facility performance. If performance guarantees are not met or if the completion date is delayed, the project will be entitled to liquidated damages, which could benefit the debtholder. A long-term operations and maintenance agreement with an experienced project operator is required. This contract should be structured to limit expenses and provide financial incentives for efficient plant operation.
Contractual Agreements
The PPA provides for the sale of capacity and energy by the project owner to the purchasing utility for a specified period. For an investment-grade rating, the PPA should be structured so that the amount of the capacity payment, or an equivalent charge, is sufficient to meet fixed costs associated with the project.
The energy purchase price, which primarily is composed of the fuel component plus other operating and maintenance expenses, should closely match expected fluctuations in the price of the base fuel for the project. It also should approximate and be indexed to the expected future change in project costs for fuel, transportation, and other associated expenses. The closer the match between types of fuels and the cost of fuel for the project and revenues received from the purchasing utility, the better.
State PSC jurisdiction and regulatory procedures over individual agreements are considered on a case-by-case basis. Continuation of an investment-grade rating assumes ongoing support by the PSC for all legal and financial provisions contained in the project documents.
Under the steam sales agreement, the project owner is obligated to deliver a specified amount of steam from the project to the customer (steam host) in accordance with the requirements of the Public Utility Regulatory Policies Act of 1978 to maintain its QF status. The loss of QF status could have a negative financial impact on the project. To mitigate this risk, Fitch examines the economic strength of the QF and expects other replacement steam hosts to be available.
Ideally, fuel contracts are long-term, dedicated supply arrangements with fundamentally sound suppliers. Conventional fuels, such as coal and natural gas, are viewed more positively than those with less of an operating history. Fuel contracts should provide a pricing structure that closely matches fuel cycle costs to energy revenues under the PPA.
Power Purchaser
The ability of the purchasing utility to meet its contractual obligations under the PPA also is pertinent. Primary emphasis is placed on the utility's financial and operating strength. In determining creditworthiness, Fitch examines traditional financial ratios, the utility's reliance on purchase power arrangements, and how the facility fits within the mix of existing generation, as well as the expected financial benefits and liabilities that result from the purchase agreement.
While a financially sound power purchaser can be beneficial to an IPP's rating, given the conditional nature (take-and-pay) of the contractual agreements used to finance these projects and the risks associated with building and operating a single-site facility, the debt rating assigned to a new IPP typically is lower than that of the purchasing utility.
Legal Issues
The legal structure is one of the more important aspects of an IPP's rating. This is particularly true due to the limited obligation of the power purchaser and developer if the project does not perform to specification. Fitch's evaluation of the legal framework focuses on several key areas including: security structure; legal covenants; flow of funds; events of default; and remedies in bankruptcy. Typically, the tighter the structure, the higher the rating.
As to reserve funds, the amount in the debt service reserve generally approximates one year's debt service and is fully funded at the time the financing is completed. Cash or a financial commitment from a high-grade credit provider is sufficient for this purpose. A working capital reserve and a reserve for repair and replacements also are required to fund outages or necessary improvements to the project. Adequate insurance coverage also is a prerequisite.
Project Economics
In addition to the various legal and financing agreements and project information, demand for the power and the cost of the electricity are evaluated. While Fitch's rating approach for IPPs takes into account numerous factors, the importance of fundamentally sound project economics cannot be emphasized too strongly. This is because a well conceived project with good demand for its power at reasonable rates is much less likely to be challenged by intervenors or reviewed by regulators.
Financial structure also is analyzed to determine if the proposed capitalization provides sufficient credit support for the new project. Fitch has no specific policy on the appropriate mix of debt (senior and subordinated) and equity, but owner's equity ranging between 10%-20% is an appropriate minimum level. While owner's equity approaching 20% provides added cushion, the lower level may be acceptable for projects with strong cash flow, rapid debt retirement, and sound overall credit quality. The withdrawal of surplus equity by the projects' sponsors should be limited until certain cash flow tests are met.
Financial forecasts by an independent consulting engineer should analyze future revenues and expenses to determine the project's economic strength and sensitivity to changes in underlying assumptions. A base case, together with appropriate stress tests, also is required. Principal assumptions and considerations should be part of the financial model.
For an investment-grade rating, minimum debt service coverage in the first three years of operation should average approximately 1.35 times. In subsequent years, coverage would be expected to increase to reflect the retirement of debt and improved operating performance.
