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So the Federal Energy Regulatory Commission (FERC) won't break up the electric utility industry. But it may happen anyway (em if not at the FERC's direction, then perhaps under pressure from state regulators who, some say, are threatening to link stranded-cost recovery to vertical disaggregation.

What would a breakup mean for bonds and bondholders?

As we reported last month ("New Corporate Structures Place Bondholders at Risk," May 1, 1996, p. 8), restructuring may hold surprises for the highly leveraged and capital-intensive electric utility industry. Bondholders, who have relied upon generating assets for collateral, may see their security vanish in a spinoff or reorganization. Will the debt follow the plant? Is that a good idea?

In its December policy decision on electric restructuring, the California Public Utilities Commission (CPUC) told Pacific Gas and Electric Co. (PG&E) and Southern California Edison Co. (Edison) to file plans for a voluntary sale or spinoff of at least half their fossil-fired generating assets.1 At the same time, it asked PG&E, Edison, and San Diego Gas and Electric Co. (SDG&E) to comment on the "feasibility, timing, and consequences" of corporate restructuring to "distinguish activities and assets" with respect to generation, transmission, and distribution.2

Corporate unbundling (em a full breakup in the style of the AT&T divestiture (em offers the ultimate fast track to a fully competitive electric market. But regulators may find that remedy too drastic. The FERC settled on functional unbundling (em an idea described by MIT professor Paul Joskow as "to behave as if they aren't vertically integrated." In fact, some commentators doubt whether the FERC has authority to force a full corporate divestiture.3

Of course, that hasn't stopped others from asking for more. Last year, the Justice Department's Antitrust Division and the staff of the Federal Trade Commission urged the FERC to consider mandatory operational unbundling (separating ownership from control) instead of enforcing regulations "to control behavior" under a functional regime.4

Many view a full breakup as inevitable, putting generation, transmission, and distribution in separate hands. Even FERC Commissioner William L. Massey has acknowledged as much in his many "stump" speeches on FERC merger policy: "I feel certain that some utility executives are merging in anticipation of disaggregation or even divestiture."5

Or, as New York lawyer David Falck puts it: "You can't stop the movement toward disaggregation. It's going to happen. You can only understand the process."

Cracking the Safe

"We've been looking at a lot of trust indentures lately. But we haven't met a mortgage that we can't disaggregate."

So says M. Douglas Dunn, a partner at the law firm of Milbank, Tweed, Hadley & McCloy. Dunn is talking about the arcane world of bond mortgages and mortgage trust indentures, which lay out rules on bonding ratios, impairment of security, and whether and to what extent the utility can replace bond collateral with replacement property in the event the corporation becomes separated from a sizable chunk of its assets.

Dunn is cautious, but optimistic. "Most utilities don't want to upset the bondholders," he says. "Someday they will need to go back to the market for financing."

If the utility spins off generation (em usually the lion's share of asset value (em management may want the debt to follow the production plant, or choose to release the generating plant from the mortgage by replacing the assets with other appropriate bonded property. Management may desire to exit a business that employs bonded property.

In a recent report, Moody's Investors Service noted that "virtually all" utility plant and equipment is pledged as collateral under the bond mortgage, but that bonding ratios (maximum outstanding debt as a percentage of collateral) range from 60 to 75 percent. Thus, between one- and two-thirds of utility property represents "excess collateral" theoretically available for bonding in the future, or to be "swapped" to replace other property subject to the lien of indenture. But pitfalls abound. Moody's notes that the trustee will value released property at "fair value," but replacement property at original cost, while also ensuring that the business that carries the debt can continue as a "going concern." The problem comes, says Moody's, when a property release and replacement undermines bondholder security.6

Dan Scotto, senior managing director at Bear Stearns and a long-time utility analyst, puts it this way: "If your bonding ratio is 66 percent, then you would need $150 in unbonded assets to float an additional $100 in debt."

Dunn notes that some bond mortgages allow an exchange of property "for notes, financed assets, or a pledge of securities." Others, he says, "limit the percentage of assets that may be financed. Or they may require an engineer to certify that the property is no longer used and useful. But you can't use a purchased-power contract as replacement for other bonded property."

Steven Kinney, Jr., a partner with Reid & Priest, warns that older First Mortgage Bonds (FMBs) often do not permit an vertically integrated electric utility to break up into a GenCo and a separate transmission and distribution (T&D) company and split the debt evenly between both entities. Instead, the indenture might force all of the bonds to go with the T&D assets, whose value is likely only a small fraction of the generating plant. That requires the GenCo to issue purchase-money mortgages back to the T&D company.

"Inflexible mortgages can chew up added bonding capacity and can inhibit restructuring," Kinney warns.

Should utilities forsake FMBs for debentures? Kinney notes that FMBs typically follow the property and earn interest during bankruptcy (and enjoy a first bite at the apple), while debentures (unsecured debt) are simply "thrown in with all the other creditors and tort claims." Nevertheless, FMBs can carry drawbacks, notes Kinney, since they require "periodic accounting and valuation" and incur a recording tax. Interest rates on FMBs are frequently "not that much different from senior unsecured debt," says Kinney. "Rating agencies don't seem to give as much credit to companies with FMBs. The market seems to be more concerned [today] with call protection than collateral protection."

Kinney believes that some companies are looking for ways to convert FMBs to debentures, which would allow some of the debt to flow to the GenCo in the example given above. He reports that, as of early April, Oklahoma Gas and Electric Co. was intending to issue FMBs under a new indenture that would convert to unsecured status once the old FMBs were retired. The company would couple the deal with a pledge not to undercut the newly issued senior unsecured debt with any subsequently issued but secured FMBs.

"Today's mortgages allow flexibility," Kinney observes. "Some utilities have exited the gas business, or have transferred generating plants to subsidiaries, and their mortgages permitted that."

"I haven't seen a covenant not to exit a business," notes Dunn. "But covenants usually require the utility to receive fair value for releasing property." If the utility retains generating plant but spins off T&D, the GenCo could sign a five-year contract to sell bulk power back to the spunoff T&D, says Dunn, as a "logical way to ensure that the GenCo will remain a going concern."

The Price Tag

The price tag varies for corporate unbundling, depending on who you talk to.

On March 19, PG&E and Edison both filed comments on the cost, feasibility, and advisability of breaking up into separate subsidiaries. On reviewing those two reports, David Falck (Winthrop, Stimson, NY) came away with the feeling that "PG&E has a friendlier attitude" [than Edison] toward vertical disaggregation.

Edison underscores the financial costs of a breakup (see sidebar this page). By contrast, PG&E notes property rights and market pressures that it believes will develop under the CPUC's new regulatory model, with the Western Power Exchange (WEPEX) and the independent system operator (ISO).

PG&E predicts that the ISO and WEPEX will force functional unbundling of costs, mitigating subsidies and precluding self-dealing and conflicts of interest. But it adds that separate subsidies for distribution and transmission could prove problematic for (em of all things (em the transfer of city and county easements and franchises:

"PG&E currently operates under . . . 46 county franchises, 39 charter city franchises, and 192 general-law city municipal electric franchises. Corporate separation would entail a split transfer of [rights] now covered by a single franchise. . . . Each franchise and any associated ordinances . . . would have to be individually assessed for transferability."

As Falck reads it, Edison believes it can satisfy conditions for releasing property from the lien of indenture but, for various reasons, wants to make the point, as Falck puts it, that "bondholders could argue that their rights were violated."

But Doug Dunn points out that much of the difficulty that Edison cites in its comments stems from the idea of shifting some portion of debt to transmission and/or distribution. Dunn's advice to Edison? "Leave the debt with the largest block of property."

In most cases, the largest block of property means generation. However, as Dunn notes, "With a utility like ConEd, the largest chunk of assets might be T&D because it's all buried under the streets of New York City."

Even so, is it practical to keep the debt with generation? As Dan Scotto points out, a competitive generating company will need a lot more equity in its capital structure than the traditional, vertically integrated electric utility. He noted last year that the electric industry's debt ratio reached 52 percent in 1994: "Debt leverage in the 52-percent vicinity will prove too high in a completely deregulated environment.7

In January, Central Maine Power Co. endorsed corporate unbundling in its initial comments filed in with the state commission on electric utility restructuring:

"CMP is prepared to pursue a complete, 'legal' separation of the generating assets, contracts, and obligations from transmission and distribution assets and obligations. We believe that the most efficient manner of achieving this separation in our case is to divide the company into two separate entities, distributing shares of the newly formed T&D company to our stockholders."8

David Falck notes: "To my knowledge, it's the only formal proposal so far by a utility." t

Bruce W. Radford is editor of PUBLIC UTILITIES FORTNIGHTLY.

The Obstacle Course

On March 19, Pacific Gas & Electric Co. and Southern California Edison Co. each filed separate comments with the CPUC showing how a voluntary divestiture of generating plants or a corporate breakup into separate subsidiaries might play out at each individual utility.

Here's a brief look at just a few of the hurdles cited by Edison:

. Vertical is Better. "Business units are a better alternative than separate subsidiaries." Staying integrated, says Edison, "requires fewer approvals, and is more flexible and less costly."

. If Breakup Occurs. Holding company would sell generation and transmission assets to two new subsidiaries, a GenCo and a TransCo; Edison would remain as the DisCo-distribution only.

. The Cost. The price tag to break up vertical integration "could exceed" $500 million: $245 million in one-time initial costs, and $150 to $350 million annually.

. Trust indenture. Lien dates from 1923, secures approximately $3.7 billion in outstanding bonds. Does not provide for early defeasance of bonds, unless bonds are callable by their terms. Forbids release of the mortgaged property as "an entirety." Amendments require OK by bondholders (80 percent of outstanding principal).

. Escaping the Lien. Release generation and transmission assets from lien; sell to new GenCo and TransCo subsidiaries; deposit cash with trustee to replace mortgage; withdraw excess cash, but only to extent that property still subject to lien exceeds 150 percent of bonds outstanding (condition implies a 66-percent bonding ratio).

. Capital Structure. Edison claims weighted cost of capital of separate subsidiaries exceeds current cost for integrated company by $100 to $300 million annually, for both debt and equity.

. Bond Retirements. Rebalancing capital structure would force bond retirements, but many bonds were issued with call restrictions-some not callable until after 2004-while callable bonds require redemption premiums above principal amount.

. Bondholder OKs. Would involve "inducements" to obtain 80-percent consent (see "Indenture," above).

. Shareholder OKs. Preferred stockholders ($560 million), according to Edison, "would have little reason to consent" to reorganization without "additional consideration," such as a tender offer tied to a consent solicitation, a special dividend, or an exchange of new, higher-yielding securities for existing stock.

. Agency Approvals. Would include CPUC, SEC, NRC, FERC, plus state and local agencies.

Bond Outlook: Up or Down?

An Interview with Dan Scotto

"There are two types of utilities right now: Those having no upside and those having only downside." That sobering advice comes from utility analyst Dan Scotto, now senior managing director at Bear Stearns, writing in his latest financial update, 1996 Electric Utilities Outlook: Is There Life After Deregulation? (Bear Stearns, February 1996).

And Scotto sees precious little relief for utility bondholders.

"Bondholders' prayers have been answered-and the answer is 'No.' The gap between utility dividend yields and the yield on the Treasury long bond is narrowing," he notes. "In fact, the two actually touched for a brief moment two years ago-on April 20, 1994-the date the CPUC issued its originally "Blue Book" proposal."

Does that mean we've seen the end of it?

"We aren't nearly fully discounted in the bond market yet," says Scotto. "Yes, utility bonds have underperformed, but at some point we're going to hit an air pocket. Then we'll see utility bonds really head South."

In the long-term, Scotto sees a 10-year transition on the way to two distinct industries: Commodity (generation) and wire services (T&D). The first five years (1996-2000) promise "event risk, asset revaluation, equity dislocations, and margin pressure." The second five will see an "equilibrium."

I asked Scotto whether consumers will wind up better off in 10 years, paying lower rates.

"I think the answer is clearly 'No,'" Scotto warns. "We still have excess capacity, but the cost is already installed. And based on our forecasts, reserve margins get thin (14 to 12 percent) in the 2003-2005 period. Extending this time frame to 2010, capacity shortages clearly surface, with reserves getting as low as 10 percent."

"If you're an IPP," adds Scotto. "You're not going to be satisfied with an 11.5-percent return on equity. You're going to want 18 to 20 percent. So the next building cycle will be more expensive."

Dan Scotto is senior managing director at Bear Stearns and head of electric utility research. His article, "Credit Parameters in Flux: When Assets are Liabilities," appeared in Public Utilities Fortnightly, May 15, 1995.

1. Proposed Policies Governing Restructuring California's Elec. Servs. Industry and Reforming Regulation, Decision 95-12-063, Dec. 20, 1995, modified by Decision 96-01-009, Jan. 10, 1996, 166 PUR4th 1, 42, 85 (Cal.P.U.C.). As an incentive to do so, the CPUC said it would offer a reward to each company of up to 10 basis points in return on equity for each divested 10-percent share of fossil plant. Id., 166 PUR4th at 42.

2. Id., at 166 PUR4th 40, 84.

3. Alex Henney, "The Mega-NOPR," Public Utilities Fortnightly, July 1, 1995, p. 29.

4. See generally, Joint Petition of American Public Power Asso. and National Rural Elec. Co-op, Asso., FERC Docket No. RM96-8-000, filed Jan. 17, 1996. In its Mega-NOPR comments, the FTC staff described operational unbundling as likely "more effective" but "less costly than industry-wide divestiture."

5. See, e.g., "FERC's Evolving Merger Policy," Address by William L. Massey, Commissioner, FERC, Edison Electric Institute Fall Legal Conference, Palm Beach, FL, Oct. 12, 1995.

6. Legal Disaggregation Threatens Bondholder Security, Special Comment, Moody's Investors Service, January 1996.

7. Scotto, "Credit Parameters in Flux: When Assets are Liabilities," Public Utilities Fortnightly, May 15, 1995, p. 29.

8. Re Electric Utility Industry Restructuring Study, Docket No. 95-462 (Me.P.U.C.), Initial Comments of Central Maine Power Co., filed Jan. 31, 1996.

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