Have they gone too far? Have ratings agencies become overzealous in their efforts to rein in energy merchants? Many in the industry are coming to that belief after Aquila, one of the industry's most respected companies and leaders, announced it would exit the merchant energy trading sector in late July. It said it could no longer meet the credit requirements imposed by ratings agencies to maintain that business.
It is one thing, and right, to demand more transparency and disclosure from energy merchants after the Enron debacle-to insist on standard rules that protect energy consumers and investors alike from another Enron, and insure that energy merchants have enough capital to carry the risks that they take.
But it is altogether different for ratings agencies to dictate terms that some say are unfair and applied inconsistently. Such terms could destabilize wholesale energy markets by eliminating the able players, like Aquila. They could undermine FERC's initiatives to establish competitive markets, while killing off future investment in infrastructure at the same time.
In Prudential Financial's June 20 report, analyst Carol Coale says, "more than we can ever remember, the [ratings] agencies are dictating the short-term and now long-term strategies of many energy companies." She also criticizes Standard & Poor's and Moody's for recent reports on revised criteria by which energy traders will be rated, saying, "the two agencies do not appear to have a unified, coherent set of goals for the traders to achieve."
In its June 11 report on energy merchants, S&P waffles by stating that it requires an amount equal to about 25 percent of the sum of the market, operational, credit risk, plus all other identified capital requirements, to be in liquid assets. In the very next sentence, S&P says it will also evaluate, case-by-case, whether a higher amount is needed based on the trading company, its trading strategy, and its volume transactions particularly, in order to maintain investment-grade ratings.
Meanwhile, Coale sees problems with setting a target for a 50/50 debt/equity capital structure. Apart from forcing up the cost of capital, she feels that a 50/50 ratio could make the financing of future infrastructure more expensive. That could lead management to scrap certain projects that would have been considered viable under a more leveraged capital structure.
Not to mention that in an effort to shore up their balance sheets, companies would find they were forced to sell income-producing assets, or cut back energy trading activities in many cases, she adds. Of course, Moody's makes no bones about its warning that energy merchants with significant trading operations will be downgraded to junk status unless these activities are downsized, combined in a joint venture, or spun off into separate entities.
In its May report on energy merchants, Moody's said it expects there will be a consolidation of industry participants into a smaller number of well-capitalized companies with diverse asset bases and strong liquidity profiles.
"This includes the participation of financial institutions with solid credit ratings and trading operations that are broadly diversified by asset class, customer and geography," the Moody's report says.
Moody's cites investment banks like UBS Warburg and joint ventures like Entergy-Koch as examples of the types of companies it wants trading energy.
But banks have been fickle on energy trading in the past. In the last five years, J.P. Morgan and Merrill Lynch closed or sold their energy trading businesses. Credit Suisse First Boston, it was reported recently, backed away from plans to trade energy in Europe. Even GE Capital took a passive investment in the now infamous Power Company of America (PCA) as an entry to understanding the business, but turned tail when PCA lost $200 million during the 1998 Midwest price spikes.
Certainly, one might be optimistic about recent entrants such as UBS Warburg and Barclays, but who is to say they may not head to the exits in a New York minute, especially as UBS' investment is said to be not nearly as profitable as it was under Enron.
Morgan Stanley and Goldman Sachs have been consistent energy merchant players over the years, but the banking sector and less than a handful of diversified energy conglomerates does not a market make.
Furthermore, Entergy-Koch style tie-ups (as Moody's suggests) are great when they work, but artificially forcing the industry into greater consolidation could lead to less liquidity in markets, and more opportunities for market power abuse. The top five energy merchants make up the bulk of participation in energy trading. Cut the number of firms in half through partnerships or mergers, and you are suddenly looking at an oligopoly situation in which the idea of competition in wholesale markets is a fantasy.
Should ratings agencies have the power to dictate the strategy of companies (especially if it is inconsistent), and in doing so, dictate the size and competitiveness of wholesale markets, the liquidity of markets, and therefore potentially impede just and reasonable prices due to a lack of competition? I thought that was the job of an independent government agency-entrusted to set universal standards.
It seems a bit ironic that an agency that has spent so much time developing a standard market design (SMD) may not have enough players in the market next year to participate. In other words, the Federal Energy Regulatory Commission may have lost sight of the bedrock fact that you can't have a market without market players.
Many say FERC has done wonders in forwarding the cause of defining competitive markets, but has dropped the ball on defining and monitoring the role of energy merchant players, and because of this, other non-governmental agencies are eating FERC's lunch.
In fact, a recent General Accounting Office report concluded that FERC lacked the insight and resources to monitor effectively the wholesale electricity markets it is trying to create. Furthermore, the report found that FERC has been "attempting to implement a regulatory and oversight approach ... with an outdated legislative framework and using authorities that may not be adequate for today's competitive markets." Chairman Wood largely agreed with the report's conclusions.
Some say what is needed is for FERC to set reserve limits in much the same way the 1988 Basel Accords set bank capital standards for market risk (the risk that a bank's value may be adversely affected by price movements in financial markets). Or, at the very least, FERC should have a voice on the issue of what capital requirements it considers necessary for players in its markets. Yet, some say capital requirements and oversight should be left up to the Securities & Exchange Commission, or the Commodities Futures Trading Commission, while others ask why shouldn't the market designer participate in the discussion?
According to Prudential, as a rule of thumb, capital adequacy is being determined by a multiple of 3.5 times value-at-risk (VaR), adjusted for the 95 percent and 99 percent confidence level z statistics, which translates into an average multiple of 11.5-12.0 times VaR.
Meanwhile, all this concern over the future of energy merchants has many fearing the end of electric competition in wholesale markets.
But it is interesting to note that such fears have not slowed FERC regional transmission or SMD initiatives, nor has it stopped Congress discussing giving FERC greater authority to oversee wholesale markets. No, it seems the wholesale energy markets will continue to exist-the question is, will the players?
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