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Reign of the Bond Kings
on capital in a relatively uncompetitive environment, he says. Enron focused people's minds on how much capital is going into the business versus its return, and generally, focused the entire industry on how revenues were being generated, he says.
Echoing that idea is John C. Diaz, managing director for energy, at Moody's Investor Service. As he puts it, "the Enron debacle put a spotlight on the fragility of the merchant model.
"The cash flow of that model was weak … the returns that those companies were showing were primarily paper profits based on a lot of assumptions, and based on their ability to manipulate the accounting."
Diaz says Enron showed how credit was allocated among the traders, and the fundamental flaws in credit triggers that was highlighted by the Enron debacle. He remembers walking into a crowded room and asking several companies if they knew their exposure to credit triggers if they were downgraded:
"Nobody knew. Nobody could put a number on it."
Diaz recalls how utilities promised that their debt or leverage would never climb above a certain level. But it soon became clear that utilities could not hide behind their merchant affiliates and keep the holding company (or the regulated side) completely insulated from severe commodity price risk. Then the question changed: How would utilities issue the equity needed to get their balance sheets back in line?
Diaz explains that most of the downgrades that have occurred for utilities have been at holding companies with unregulated subsidiaries, reflecting higher leverage and greater risk.
Capital Structure: No Magic Bullet
Ratings agencies do not believe in the notion of an ideal capital structure.
"There is no ideal debt ratio. It depends what rating you want. If you decide that it is capital efficient to run as an AA-plus utility, you will have a lower debt ratio than if you decide you can run quite comfortably at BBB," says Hunter.
A better question, he adds, is what is the most appropriate rating for somebody who is seriously interested in expanding a merchant energy business?
"I think it is difficult to say that you can run an expanding and successful merchant energy business while being mid-to low-BBB range. We have heard that time-in and time-again from different market participants. They have all said we all thought we could do this with a solid BBB rating.
"The difference is that many integrated utilities with a solid BBB rating would have had higher leverage on average than other industrials. So, you are already talking about there is less headroom for them to take on exciting activities like merchant energy. You are probably looking at [needing] a single A rating to be trading energy."
When it comes to merchant energy trading, Diaz of Moody's says that first you have to get comfortable with the fact that the profitability is real, and that the accounting being shown is real and translated into cash profits. "Moody's has said that energy trading should be carried out by companies that have strong balance sheets and strong credits," he says.