Green investments require bulletproof financing.
J. Paul Forrester is a partner with Mayer Brown LLP in Chicago. Email him at email@example.com. Forrester acknowledges the help of his colleagues, Mary C. Fontaine, Carol A. Hitselberger and J. Bradley Keck. The views expressed are those of the author alone and not Mayer Brown LLP or its clients.
Originally developed to compensate U.S. electric utilities for regulatory assets rendered uneconomic by deregulation, so-called “stranded-cost” securitization techniques are finding new applications. Examples include financing mandatory pollution-control equipment and other similar investments; catastrophic storm reconstruction expenditures; and possibly “synthetic” carbon-emissions reductions for new fossil-fueled power plants or purchases.
For many U.S. electric utilities, deregulation of wholesale power supply markets in the late 1990s rendered substantial plant, equipment, and other regulatory assets economically obsolete. As compensation, the affected utilities, regulators, and consumer representative groups crafted stranded-cost securitizations to permit utilities to recover the related stranded costs through special rates charged to customers and the sale proceeds of bonds backed by such charges. These bonds in many cases were euphemistically referred to as “rate-reduction” bonds, although the securitization charges often increased rates to affected customers. In connection with such securitizations, the primary U.S. rating agencies developed specific criteria and methodologies for such stranded-cost securitizations. 1
To date, utilities have issued approximately $40 billion of stranded-cost securitizations. 2 That number could increase dramatically if the industry applies well-tested securitization techniques to the extraordinary costs it faces in the future.
Stranded-cost securitizations represent a refinement of several prior transactions, including: 1) the special transition charges that gas transmission and distribution companies were permitted 3 to collect as part of the resolution of disputes regarding so-called “take or pay” contracts when U.S. gas supply and transportation services were unbundled in the mid-1980s; 2) the securitization of special charges to customers of affected utilities to finance compensation payments to such utilities under legislated nuclear power plant moratoria in Italy and Spain in the early 1990s;4 and 3) a 1995 securitization by Puget Sound Power & Light 5 to finance a demand-side management program (essentially cash incentives to customers to replace less energy-efficient appliances with more energy-efficient items).
Ideally, the basic foundation for a stranded-cost securitization is a sound legislative and regulatory scheme that provides for the following:
• An adequate hearing on the merits regarding the costs to be recovered and the alternative means of financing these costs—with securitization found to be demonstrably superior to other such financing alternatives. This often will be the case since the securitization will allow a highly rated financing of 100 percent of such costs. Such a hearing will substantially mitigate the risk of later reversal or adverse modification of the related regulatory approval;
• A regulatory approval, usually referred to as a “financing order,” authorizes the issuance of bonds that are secured or otherwise backed by the recovery of the costs, and any related securitization, through non-bypassable charges to the utility’s customers. Sometimes this is referred to as a “network” charge, because the charge is payable by all customers using such network, and not readily avoided by electing utility services that are not subject to such charges;
• The characterization, as a separate property right, of the right to levy and collect the charges—and any increases required to true-up the amounts to be levied and collected to ensure full and timely repayments of the bonds backed by such charges;
• The “true sale” of the related property rights to the issuer in the related securitization to secure or otherwise back the issuer’s securitization; and
• A pledge by the applicable state not to impair such property right or securitization.
Additionally, as a practical matter, the charges (and any likely required increase for true-up amounts) should be sufficiently modest to reduce the risk of later impairment from customer or political objections. 6
The legal effect of such a state pledge, and applicable limitations on it, depend on constitutional protections under the contract clause 7 and against improper takings 8). Questions might arise about the degree to which prior orders of one regulatory authority bind a later regulatory authority, or the deference the prior order will receive in any subsequent regulatory proceedings. 9 However, the rating agencies apparently have become comfortable with these risks, since they rate these transactions in their highest rating categories.
On June 28, 2002, the Internal Revenue Service (IRS) issued Revenue Procedure 2002-49 10 (Rev. Proc.02-49) to clarify the conditions under which a state-regulated electric utility can securitize customer charges without recognizing immediate tax gain. Rev. Proc. 02-49 also expedited stranded-cost securitizations by eliminating the issuer’s need to seek a private letter ruling. Later, on September 12, 2005, Rev. Proc. 05-62, 11 expanded the scope of Rev. Proc. 02-49 beyond stranded costs, removing the requirement for level payments and adding a requirement that securitization payments be made at least semi-annually.
Historical performance of these stranded-cost securitizations generally has been sound 12 and, accordingly, prior investor experience with them has been positive. Notably, this history has included a related utility bankruptcy (Pacific Gas & Electric) and a utility merger (Northwestern’s acquisition of Montana Power).
Securitizing Pollution Control
Recently, utilities have used additional transactions utilizing stranded-cost securitization methodologies to finance mandated pollution-control equipment and to recover storm recovery and reconstruction costs. The rating agencies have duly noted these opportunities. 13
Perhaps the first attempt to extend stranded-cost securitization techniques to mandated pollution-control requirements was the proposed $490 million of so-called “environmental trust bonds” authorized 14 for issuance by Wisconsin Electric Power Co. (WEPCO) in October 2004 under 2003 Wisconsin Act 152.15 This Act authorizes Wisconsin utilities to use environmental trust bonds to finance environmental improvements on utility facilities. It calls for the environmental trust bonds to be repaid from revenues collected from a specified fee, and states that the bond issue is governed by a Wisconsin Public Service Commission’s financing order, which among other things, creates a property right to the collection of the fees from utility customers and to the collected revenues. The Act also provides that the utility will transfer this right to a third party, which will collect the fees for repayment of the debt. Further, the Act states that the debt associated with the bonds will not be shown on the books of the related utility.16
Several other states have adopted similar legislation, including Florida, Texas and West Virginia.
A subsequent attempt occurred in May 2007, when Allegheny Energy, parent of Monongahela Power (senior secured rating: Baa3) and Potomac Edison (senior secured rating: Baa3), issued $345 million and $115 million, respectively, of environmental control bonds under West Virginia Code §24-2-4e. 17 The bonds were used to finance the installation of flue-gas desulphurization units (commonly referred to as “scrubbers”) and related facilities on the Fort Martin coal-fired power plant in Monongalia County, W.Va. The bonds were rated AAA by Standard & Poor’s and Aaa by Moody’s Investors Services—superior to the related utilities’ Baa3 ratings. The required financing order18 was issued after a protracted proceeding and later was amended by joint stipulation to accelerate the securitization in order to take advantage of attractive interest rates and avoid the risk of further escalation of project costs for the scrubbers and related facilities.
The costs of implementing the Clean Air Act’s Phase II reductions under Title IV, §405, 19 as well as mercury limitations under the proposed Clear Skies Act, 20 are estimated to exceed $60 billion by 2020. 21 Of course, the U.S. Court of Appeals for the District of Columbia Circuit struck down EPA’s 2004 Clean Air Mercury Rule 22 on Feb. 8, 2008, for exempting power plants from more stringent mercury pollution requirements under the proposed cap-and-trade scheme. At press time, the EPA’s plans for a new mercury rule were unknown. In addition, this same court found “several fatal flaws” in EPA’s Clean Air Interstate Rule and, as a result, vacated the rule in its entirety and remanded the matter back to EPA to promulgate a rule consistent with the Court’s opinion.
Nevertheless, future clean air requirements likely will generate significant opportunities to finance mandated pollution compliance costs using securitization techniques—without burdening electric utility balance sheets with the related obligations.
Storm Reconstruction Bonds
Following Hurricane Andrew in 1995, commercial insurance for property or casualty damage to electric transmission and distribution facilities owned by coastal utilities became substantially more expensive — even with larger deductibles or self-insurance — or unavailable on commercially acceptable terms. For the next 10 years, coastal utilities often were permitted to charge rates in amounts thought sufficient to establish appropriate reserves for storm recovery and reconstruction. These reserves were depleted in the devastating U.S. hurricane season of 2005, which included Hurricanes Katrina, Rita and Wilma. 23
As a result, Florida, Louisiana, Mississippi, and Texas all passed laws facilitating storm-recovery securitization. 24 The first completed storm-recovery securitization transaction was FPL Recovery Funding’s $652 million of Senior Secured Bonds, authorized by a financing order for Florida Power & Light (issuer rating: A/A1 and short term rating: A-1/P-1) in June 2007. 25 The bonds were rated AAA by Standard & Poor’s and Aaa by Moody’s Investors Services and, as with Allegheny Energy, these ratings were superior to those of the related utility. Shortly thereafter came Entergy Gulf States’ authorized and partially consummated Louisiana 26 and Texas 27 transactions: The Texas transaction—Entergy Gulf States Reconstruction Funding’s $329.5 million of its Series A Senior Secured Transition Bonds—was rated AAA by Standard & Poor’s and Aaa by Moody’s and appears to have closed in July 2007 (Entergy Gulf States’ senior secured rating at the time of issuance was BBB/Baa3), 28 however, in the Louisiana transaction—Entergy Louisiana Hurricane Recovery Funding—only preparatory SEC filings have been made for an offering of senior secured storm-recovery bonds. 29
More recently, Cleco Katrina/Rita Hurricane Recovery Funding issued $180.6 million of its 2008 senior storm recovery bonds rated AAA by Standard & Poor’s and Aaa by Moody’s in April 2008, and once again the bond ratings were superior to those of the servicing utility—CLECO Power, whose senior unsecured rating at the time of issuance was BBB/Baa3. 30
Synthetic Carbon Reduction
With growing certainty that greenhouse gas (GHG) emissions will become regulated due to climate-change concerns, many affected industries actively are exploring ways to avoid, reduce or eliminate GHG emissions. Of course, fossil-fired power generation is significantly affected, especially coal-fired generation. Coal-fired power plants in the United States emitted almost 2 billion metric tons of CO2 equivalent in 2006, 31 representing almost one-third of the total 2006 GHG emissions in the United States.
With large-scale carbon reduction technology, including carbon capture and storage (CCS), for fossil-fired power generation not projected to be commercially available until around 2015, plant owners—and even more acutely, developers and sponsors—face limited and mostly unattractive options in pursuing coal-fired power plant development or retrofit. These options include waiting to see what the carbon-reduction requirements will be, while running the risk that appropriate technology might not be available on commercially reasonable terms. Second, developers and plant owners might opt for some unproven technology and hope that it works as projected. Third, they might anticipate likely carbon-reduction requirements and satisfy such requirements “synthetically” through tradable carbon-reduction instruments. 32 This third option buys time in which to determine the most appropriate technology to effect the anticipated carbon-reduction requirements and, theoretically, to allow for the most cost-effective means of achieving such carbon reduction.
Interestingly, in the case of several proposed fossil-fired power plants, community objections to carbon emissions (even though technically unregulated) led to negotiated commitments by plant sponsors to implement carbon-emission reductions. 33 Because it is impractical immediately to replace coal-fired capacity with alternative sources, including renewable energy or nuclear generation, the need to deal with anticipated climate-change requirements that limit or otherwise restrict emissions of carbon dioxide has become a significant issue in the near-term. This is particularly so because of announced new U.S. coal-fired power plants, with an aggregate capacity of around 50 GW, and an ever increasing number of plants either being abandoned or significantly delayed due to community objections 34 or regulatory concerns 35 regarding possible carbon constraints. In fact, the North American Electric Reliability Corp.’s annual 2007 Long-Term Reliability Assessment 2007-2016 36 found that long-term capacity reserve margins are inadequate and that action is required to restore such margins to adequate levels. 37 Areas of greatest concern include California, New England, Texas and the Midwest.38 It is unlikely this capacity will be achieved through demand-side measures or the addition of renewable or nuclear generation, which require special considerations for planning, design, and operation in bulk power markets. Renewable resources often are characterized by their remote location, interconnection over difficult terrain and, due to their variable nature, the related requirements for base-load dispatch flexibility, spinning reserves, voltage support, and other ancillary services for the related market.39
Because the carbon-reduction technologies that will be required remain commercially unproven, estimates of the associated costs are more speculative than usual. Nevertheless, the total seems likely to reach several hundred billion dollars. Again, the compliance costs, including proposed synthetic compliance, could be recovered using stranded-cost securitization techniques, which would provide efficient financing and greater flexibility when determining the most appropriate equipment and facilities to effect the required carbon reduction and when to install such equipment and facilities.
With the demonstrable success of stranded-cost securitizations, utilities likely will expand their use of this securitization method. Indeed, this already has been demonstrated successfully by some transactions for mandated environmental-control expenditures and storm-reconstruction costs.
The opportunity to use stranded-cost securitization techniques to satisfy community, regulatory and other requirements for GHG reductions, yet defer critical and potentially imprudent decisions regarding specific related plant and equipment for such reductions until the related reduction technology is commercially proven, should also be attractive to fossil-fired power plant owners, developers and sponsors.
1. See, for example, Fitch Research’s Guidelines for Rating Debt Backed by Regulatory Assets, Sept. 30, 1996 and Fitch Ratings’ Rating Criteria for U.S. Utility Tariff Monetization Bonds, Sept. 11, 2006. Similarly, Standard & Poor’s Securitizing Stranded Costs, Jan. 18, 2001.
2. Fitch Ratings’ Rating Criteria for U.S. Utility Tariff Monetization Bonds, Sept. 11, 2006, at p.1.
3. See Federal Energy Regulatory Commission’s Order 500, described at: http://www.eia.doe.gov/oil_gas/natural_gas/analysis_publications/ngmajorleg/ferc500.html (this link and, unless otherwise noted, all other links herein last viewed on Feb. 25, 2008) and the preceding superceded Order 436, described at: http://www.eia.doe.gov/oil_gas/natural_gas/analysis_publications/ngmajorleg/ferc436.html.
4. See, for example, Moody’s Investors Service’s New Issue Report for Nuclear Moratorium Asset Securitization Fund.
5. See Moody’s Investor Service’s New Issue Report, May 29, 1998 for Puget Power Conservation Grantor Trust 1995-1 (reprinted from an original report dated Dec. 15, 1995).
6. See, for example, Fitch Ratings’ Rating Criteria for U.S. Utility Tariff Monetization Bonds, Sept. 11, 2007 at p.9.
7. U.S Constitution, Contracts Clause. In addition, individual State constitutions often include similar protections.
8. U.S. Bill of Rights, Fifth Amendment.
9. Other reviews of stranded-cost securitizations include the Congressional Budget Office’s Electric Utilities: Deregulation and Stranded Costs, October 1998, available at: http://www.cbo.gov/ftpdocs/9xx/doc976/stranded.pdf.
10. Available at: http://www.irs.gov/pub/irs-drop/rp-02-49.pdf.
11. Available at: http://www.irs.gov/pub/irs-drop/rp-05-62.pdf.
12. See, for example, Moody’s Investors Service’s Stranded Utility Costs Securitization: An Energized Market, Feb. 4, 2000 and Stranded Costs: A Resilient Asset Class, Jan. 3, 2005. Similarly, Fitch Ratings’ Utility Tariff Monetization Performance Review, April 22, 2005.
13. See, for example, Fitch Ratings’ U.S. Utility Tariff Bonds: Adaptability of an Asset Class, Aug. 30, 2007 and Standard & Poor’s Utilities Rediscover a Powerful Tool For Recouping Environmental and Storm Costs, Oct. 4, 2007.
14. The related Oct. 12, 2004 financing order is available at: http://psc.wi.gov/apps/erf_share/view/viewdoc.aspx?docid=22888. The 90-page financing order includes extensive related findings of fact in connection with the proposed issuance. Subsequently, WEPCO announced it had determined not to pursue the proposed issuance, citing associated tax uncertainties. More recently, there are reports of Wisconsin legislators (including State Senator, Robert Cowles, who had originally sponsored 2003 Wisconsin Act 152) suggesting that WEPCO should be required to use such authorized bonds so that the related facilities would not be funded by stockholder equity on which a return would be allowed in rates charged to customers. See Asset-Backed Alert, Jan. 18, 2008 at p.3.
15. 2003 Wisconsin Act 152 is available at: http://www.legis.state.wi.us/2003/data/acts/03Act152.pdf.
16. Accordingly, the related environmental trust bond indebtedness will not affect the related utility’s regular rates and its external ratings and credit largely will be unaffected by such indebtedness, since such indebtedness belongs to the special purpose entity to whom the stranded-cost charges are assigned in the required “true sale” thereof, and is effectively backed and covered by the permitted charges that are securitized.
18. The original financing order is available at: http://www.psc.state.wv.us/scripts/WebDocket/ViewDocument.cfm?CaseActivityID=185663 and the amended order is available at: http://www.psc.state.wv.us/scripts/WebDocket/ViewDocument.cfm?CaseActivityID=199179.
19. Available at: http://epa.gov/air/caa/.
20. Available at: http://www.epa.gov/clearskies/.
21. See, for example, the estimate of $64 billion contained in Cambridge Energy Research Associates’ study described at: http://www.cera.com/aspx/cda/public1/news/pressReleases/pressReleaseDetails.aspx?CID=6992.
23. A more complete historical review is contained in Critical Electric Power Infrastructure Recovery and Reconstruction: New Policy Initiatives in Four Gulf Coast States After 2005’s Catastrophic Hurricanes, George Mason University School of Law, and Addendum thereto last updated Oct. 30, 2006.
25. The original financing order is available here and the amended order is available here. As with similar financing orders, this financing order includes extensive findings of fact the effect of which is intended to preclude or limit subsequent judicial or regulatory modification of such order.
26. The Entergy Gulf States original financing order is available here (click for Guest Document Access), the corrected order is available here, and the second corrected order is available here. The Entergy Louisiana original financing order is available here, the corrected order is available here and the second corrected order is available here.
27. The Texas financing order is available here.
28. The related prospectus was filed with the SEC under registration numbers 333-142252 and 333-142252-01.
29. The related form S-3 was filed with the SEC on Sept. 28, 2007 under registration numbers 333-146380 and 333-146380-01.
30. The CLECO Power financing order is available here.
31. See Emissions of Greenhouse Gases in the United States 2006, Energy Information Administration, November 2007, available at: ftp://ftp.eia.doe.gov/pub/oiaf/1605/cdrom/pdf/ggrpt/057306.pdf.
32. For example, the Carbon Financial Instrument traded on the Chicago Climate Exchange (CCX). For more information regarding such instrument, see: http://www.chicagoclimatex.com/.
33. See, for example, the press release regarding the agreement by Sierra Club with Kansas City Power & Light, Mar. 20, 2007 and available at: http://www.sierraclub.org/pressroom/releases/pr2007-03-20.asp.
34. See, for example, “Emotions High as Sides Collide at Coal-Plant Hearing,” The Gazette, Jan. 14, 2008.
35. See, for example, the denial by the Kansas Department of Health and Environment of a required air permit for the expansion of an existing coal plant near Holcomb, Kansas.
36. Available at: ftp://ftp.nerc.com/pub/sys/all_updl/docs/pubs/LTRA2007.pdf (herein, the “NERC Reliability Report”).
37. See, Finding 1 of the NERC Reliability Report at p.10.
38. Ibid, p.10.
39. See, Finding 2 of the NERC Reliability Report at p.13.