Perspective

Fortnightly Magazine - October 1 1998

ANYONE AT ALL CLOSE TO the securitization scene agrees on at least one thing: The referenda in California and Massachusetts seeking to roll back restructuring have cast such a pall over the bond issues put out late last year by the California electric utilities to finance their stranded costs that any new issuer hoping for the same 'AAA' rating may as well get prepared to sacrifice his or her firstborn to the rating agencies.

One major firm called a press conference to confirm its ratings, but the call betrayed more worry than confidence, for those bonds had already diverged substantially from where they had first settled in trading after the offering was concluded. Everyone who bought the bonds and then sold within the first six months came out well ahead; but all that's changed now. The California bonds may have been oversubscribed by 10 or 15 times, yet the two ballot initiatives have dampened that initial enthusiasm.

Of course, bond counsel and the agencies continue to provide assurances that no harm will come even if the voters do adopt the proposals. They reason that the Constitution of the United States and the Constitution of the State of California will keep the bondholders whole. Yet the question on Wall Street, for buyers at either above or below par, is the question the whole industry is struggling with right now: Is the right measurement par (book) value or market value? What does it mean, to be made or kept whole? As Henny Youngman used to say: "Compared to what?"

No one has a clear answer, but the overwhelming weight of the law lies on the side of fair treatment for holders of this type of instrument. There is probably a lot of money being left on the table on Wall Street while traders stand paralyzed on both sides of the issue. In this way stranded costs and securitization are now linked on the market side, just as they were linked on the regulatory side when the state authorized these securities.

The ratemaking process, which forms the basis for any securitization financing in this industry, still remains problematic. Yes, Wall Street analysts have tracked ratemaking in gross or macro terms for years. Very rough and frequently overlapping categories of coverage ratios defined the quality of credit in the industry. However, securitization emerged, they never saw any need to link the technicalities and mechanics of ratemaking to a particular level of creditworthiness assigned by a rating agency to any entity or issue.

But now, if they cannot understand and assure the linkage between the ratemaking process and the payment mechanisms for the bonds, reaching any real level of comfort in this area is impossible for these analysts, given the many trapdoors that exist in utility accounting and ratemaking as it has evolved and become politicized.

At the end of the day, the utility commission still determines the recovery and the mechanism of securitization, whether it is achieved by a legislative or administrative process. Yet, the difference in nomenclature is telling. "Legislative" securitization is that done by a public utility commission following passage of a new statute (usually long, mechanical, technical and filled with legalese). "Administrative" securitization is that done according to the powers of a utility commission provided for by an existing statute (usually broad, simple and flexible). It is all a battle over a definition - in this case, of the word "property."

In California, the opinions of counsel that justified the 'AAA' ratings analyzed the term "transition property" - embedded at the center of the California enabling law (AB 1890) - but only by analogy to the definition of "property" under existing law. Counsel acknowledged that they could find no body of law on which opinions about the term "transition property" could be based. The statute was brand new. It was "back to the future" for any legal opinion. This approach prompts the question: Why take the extra step and reinvent the wheel?

Under administrative securitization, property is indeed the cornerstone, so there is no need to reason by analogy. The concepts involved in securitization lend themselves enormously well to the creation of a stable and assignable property right - the notion sought to be achieved in California. But in the end, it is only the PUC that can determine the amount of "transition" or other property for which recovery is provided and the rate path through which that is achieved just as with ratemaking.

To those who wonder why we adopt new policies when the old ones would have worked just fine, I have a suggestion. Instead of wasting all of this time drafting securitization legislation, let's use the regulatory framework that's already in place. Because, contrary to what most people in the industry think, specific legislation is not necessary for securitization.

The Statutory Models

Securitization first showed up for electric utilities when Puget Sound Power & Light couldn't meet the issuance tests for new bonds under its mortgage. That occurred soon after the Washington Public Power Supply System disaster, so investors were rightly worried about what a promise from a Washington company and its regulators would or would not be worth. The company's bankers suggested securitization - in this case, for intangible value in demand-side management, a popular conservation tool in the Pacific Northwest. It was also suggested, since this was a new technique and the company had a problem accessing the capital markets, that new legislation would prove useful to support the financing, and so a law was adopted to support a $225-million issue. (See, Andrea L. Kelly and Donald E. Gains, "Mortgaging Your Conservation: A Way Out for Standard Investment?" Public Utilities Fortnightly, Oct. 15, 1995, p. 24). However, a lawyer with a leading New York utility firm severely criticized the statute in question as inadequate from many legal points of view.

Several years later, along comes the California restructuring law. Again the bankers recommended securitization, this time for stranded generation, citing the Washington statute as the proper model, and saying that significant savings could be achieved by dissociating the credit of the transaction from the utility's corporate credit, the essence of any securitization deal. Thus is born Assembly Bill 1890, the California restructuring statute. A state agency, the California Infrastructure and Economic Development Bank, is given the role of conduit for the securitization.

Statutes soon show up in several other states, although some question whether California's lead should serve as "the model." Pennsylvania and Montana follow with statutes that differ from California's in most ways. About a year later, Massachusetts, Illinois and Connecticut follow suit, showing even greater divergence from the California approach.

Most of the rate savings attendant on the California deregulation are derived from the sunset of the Standard Offer 4 contracts for independent power producers and the lengthening of cost recovery periods on nuclear assets from the shortened lives adopted in recent rate proceedings. In other words, the California Public Utilities Commission had first shortened recovery periods to push the utilities toward competition, only to lengthen them again to cut current rates. Securitization provided less than 20 percent of the savings mandated under the law. However, securitization can provide meaningfully higher levels of savings than those that arose in California, subject to various interplays between capital structure, asset recovery periods and credit ratings.

Whether effective or not, the California rate reduction bonds proved oversubscribed when the deals came in December. The demand - 10 to 15 times greater than supply - drove the interest rates down through the prevailing rate for credit-card receivables, a previous benchmark.

The part of the story that follows is not rosy, and suggests the pitfalls new legislation provides. In Pennsylvania, PECO Energy saw its securitization deal become bogged down at the commission and in court. The trouble stemmed from several factors, including the company's own modest proposal for rate cuts, which inspired the Enron bid. More than a year later, however, PECO appears somewhat back on track. In Montana, Enron sued to stop securitization, alleging that the PSC had not followed the technicalities of the new law. The Massachusetts, Illinois and Connecticut legislatures all adopted legislation that provides a format for securitization but in many ways discourages it, since many see it as a form of utility bailout. In Illinois, securitization does not address standard costs at all, but just adds it as a financing technique.

Bypassing the Legislature

What about securitization without enabling legislation? Can that strategy achieve 'AAA' debt financing for utilities?

Many major investment banks are now discussing administrative securitization with their clients who have stranded cost exposure. While the concept was at first questioned by the financial and utility community, research papers and meetings with rating agencies have succeeded in promoting and assuring the existence and validity of this new financing tool for securitization under existing law. Any legal opinion must be researched state by state. Some states may lack all the necessary elements, but preliminary analysis shows that most states have all the tools they need to adopt this form of transaction and provide the rate reductions that flow from it. In fact, protocols for new orders and findings that would make non-legislative securitization transactions bulletproof are now being crafted.

In New York, for instance, the Public Service Commission has completed two of the three legs of the restructuring stool - retail access and divestiture of generation - on a utility-by-utility basis. The third leg, securitization of stranded costs, is very far along toward adoption at the administrative level as well. In other states, regulators are showing a good deal of interest. Regulatory assets, nuclear assets, and sometimes payments related to IPP contracts, are promising asset areas for this new technique. Given the power the commissions have come to exercise, it would be astounding if they didn't have the authority to do something that saves meaningful costs without affecting the utility's creditworthiness, and indeed occasionally enhancing it.

In the states that so far have passed enabling legislation, securitization authority generally takes the form of add-on clauses to basic language dealing with retail access and market power issues. Thus, these provisions have been little understood by the legislators involved. An article in the New York Times quoted various legislators in Connecticut as disclaiming any understanding of that part of the bill they were about to endorse. One legislator handed a telephone to his assigned lobbyist when a constituent called with questions.

An important point to consider is whether newly legislated securitization, which is readily tagged as a "utility bailout," is worth the bargaining chips a utility may need to use to obtain it. This tradeoff may not look like a good deal when utilities realize the same result can be accomplished under the existing regulatory scheme, including creation of a tariff-based financing, which could be rated 'AAA.'

In many ways, use of the existing statutory framework is simpler and easier than writing new law. The exposure of the utility to erosion of its position through the legislative sausage-maker may be meaningfully reduced. There may also be other reasons, based on a utility's corporate strategy and wish list, that could also make non-legislative securitization preferable.

Many observers and industry veterans agree that the three key elements necessary for securitization of utility rates - irrevocability, true sale and bankruptcy remoteness - exist in current regulation at least as strongly as they do not under the legislative model. With administrative securitization, moreover, the "property" concepts are not new ones and the legal path is in some ways easier.

One healthy development in the industry in recent years is the recognition that "best practices" doesn't just mean "the way we do it here." Rather, it means that there is more than one way to accomplish a desired result. For securitization that is certainly true.

New York Attorney J. Michael Parish is a frequent contributor to Public Utilities Fortnightly. The views expressed here are the author's and should not be read as, or taken to represent, views of his fellow law partners or of his law firm of Thelen Reid & Priest LLP.


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