By some measures, merchant power assets look like a bargain, selling for well below their replacement cost. But whether low prices signal a buying opportunity or a value trap depends on the...
2007 Finance Roundtable: Pricing Regulatory Risk
Despite a favorable outlook for utility finance, cost pressures are straining rate structures.
Nastro: We see three main catalysts prompting increased volatility. First is subprime contagion. Some rumors suggest the subprime meltdown will cost as much as $150 billion. Second are failed LBO financings. The short-term pipeline is teed up with $400 billion at this point. Third is concern about liquidity. Central banks are providing liquidity support, but problems are lingering, especially in the A2/P2 commercial-paper market.
And then there’s the general concern, is there another shoe that has yet to fall?
Cortright: Everyone is waiting for the other shoe to drop.
Liquidity is definitely strained. Bankers are taking a good deal longer to find investors, but they are finding them. Companies are paying up a bit, repricing the exposures they have to contend with.
On the short term, commercial paper side, the A3 market is just gone. There’s nothing there. The A1 market is moving along basically uninterrupted, and the A2 market, where the bulk of issuers are, is seeing something of a slowdown.
Hempstead: I don’t know how long liquidity and credit concerns will take to work themselves out. But at the moment, we have a stable rating outlook for utilities. For the last five years the credit metrics for this sector have been good. They’re not as good today as we might have expected five years ago, but they are good.
Fortnightly: What does market volatility mean for independent power and below-investment-grade projects?
Bodington: It’s putting downward pressure on valuations. What’s underway is a classic flight to quality. We’re seeing an increase in spreads. Risky deals have to earn a higher rate of return compared to high-quality deals, and some of the riskier deals won’t get done at all, until their sponsors can cure some of the defects.
The real irony is the highest-quality assets might get even more aggressive. Their valuation actually will go up, because risk-averse buyers will say, “I’ve got a lot of money to spend and I don’t want to buy any risky assets, so I’m going to compete even harder to buy into the good deals.”
Maloney: The phrase “flight to quality” can translate into a flight to deeper pockets. On the merchant-power side of the business, if you have a bigger balance sheet, you are more able to handle risks. It means fewer entrepreneurs coming into the market and more market concentration, heading in the direction of market power.
Cortright: As disrupted as the markets are right now, they are looking for simplicity and certainty. There are special challenges on the unregulated side. To get financing they must have long-term contracts in place, and it adds an element of complexity.
Fortnightly: What lessons should utilities take away from the subprime meltdown?
Maloney: There’s a lesson to be learned here in risk management. It often takes a bad day in the market to show how bad the models are. You need to use a very structured process and constantly validate your models against market fundamentals.
Rogers: My personal view is the current market environment reinforces the prudence of staying ahead of your capital formation needs.