Own, sell or restructure

Unappealing
The result is that banks and bondholders who lent to these utility companies are now faced with taking over ownership of the plants, selling them or restructuring their debt. None of the options are appealing to the lenders.

Those affected range from international investment banks to UK retail banks just recently branching out into investment banking. The avenue they take will depend largely on how exposed they are to the US and UK energy markets. Diversified banking portfolios can withstand energy losses better than specialised energy financiers. The asset in question will also affect their decisions. New, state-of-the-art plants, with lower operating costs, are the least likely to be sold. Old, highly polluting plants that are nearing their retirement age might be closed down for good, with banks cutting their losses. There is no one-size-fits-all solution to the banks’ problems.

“What an individual bank decides to do will depend on several things,” says Rob Cormie, a director in corporate finance at KPMG in London. “Its attitude to the energy market, the size and age of the asset, its future appetite or outlook for energy risks – all these factors will affect the bank’s decision.” With little to no expertise in the running of power plants, banks are reluctant to take them over.

Selling plants may seem an obvious route, but it is not an appealing prospect at the moment, as banks would lose so much money doing so. Investors only want bargains and – distressed though the utilities, and thus their lenders, may be – there is a limit to how low the sellers can go. US utility company Entergy tried to sell one of its UK plants, Damhead Creek in Kent, to Goldman Sachs, but the investment bank’s offer was too low. Damhead has since been taken over by its bankers, which include Barclays, Bank of Scotland, Abbey National and HBOS, the merged Halifax and Royal Bank of Scotland.

The industry consensus seems to be that some banks will sell, especially if the asset is old or they are not overly exposed.

Potential purchasers include new, specialist companies looking to buy distressed plants. In the US, newly formed Miller McConville wants to partner with banks to restructure the loans, buy the plants at market price and then allow the assets to keep generating income for years. It hasn’t made any purchases yet, but is understood to be negotiating to buy up to 10 plants.

Karl Miller, co-founder of Miller McConville, says: “There is a 12–24 month window of opportunity to buy distressed plants. Things are likely to get worse during that time, as wholesale prices continue to decline before the supply-demand imbalance starts to improve. The banks want to make sure they get some money out of the plants. They are starting to recognise the debt problem and seek solutions. Now is the right time for us to look at these assets.”

Miller McConville is also considering running and maintaining US plants rather than buying them outright, in partnership with Scottish company Wood Group Power.

However, industry observers feel most banks will hold on to the plants until the market turns around. The assumption is that energy will remain a necessary commodity, there will always be a demand for it and thus it makes more sense to wait for the market to improve.

The problem is that it will be expensive – given the size of the assets in question – just holding on to plants. Even mothballing power plants incurs significant costs, especially when they are being putting out of commission then restarted again later. In the UK, there are rumours that some banks are pooling together and forming a company to run the plants for them, but because the banks are exposed in very different ways, some feel one pooling company is unlikely to be enough.

“You’re more likely to see groupings of banks with similar levels of exposure or similar structures, pooling their solutions,” says Bank of Scotland spokesperson Mark Elliot. “There are about five or six different initiatives under way in the UK, mainly fronted by law or accountancy firms. They are trying to bring the banks together and explore the options. As to when, whether or how any of the initiatives will come through, that’s anyone’s guess.”

And in the meantime, banks, law firms and accountancy firms are keeping very quiet about what the initiatives entail and who is involved, saying only that up to 40 banks are exposed in the UK. The only confirmed initiative involves UK power plant Drax bondholders who, according to Jan Willem Plantagie, a credit analyst at rating agency Standard & Poor’s (S&P) infrastructure finance division in London, have formed a steering committee to consider their options.

Renegotiating
Renegotiating power supply deals is another option. Four UK plants, including the country’s biggest, Yorkshire-based Drax, ran into trouble when TXU Europe, which had agreed to buy power from them at a set price, ran into difficulties. Finding another guaranteed buyer would help matters, although not completely, because power prices are still to low to cover debts and operation costs. TXU Europe folded originally because of low prices in the UK.

A slightly more unconventional way of getting money out of the plant is to sell the natural gas that would normally power it – gas prices have stayed healthy in recent months.

Yet by far the preferred option, especially when dealing with distressed American utilities, is to restructure the debt and refinance the deal. Extended tenors and debt-for-equity swaps are proving the most popular routes. In the UK, Drax owner AES could not meet payment on £250 million ($392 million) of subordinated debt in February and had negotiated a stand-still agreement with creditors, which expired as EPRM went to press.

But refinancing has its own problems, especially in the US, as banks may be looking at refinancing a deal for the third – rather than just the second – time. Last year, some utilities, already in distress, agreed to very strict refinancing terms to try to stay afloat.

Oklahoma-based Williams, for example, last year agreed to a 34% interest rate on a $900 million loan from investment bank Lehman Brothers and financial group Berkshire Hathaway. To meet that loan obligation, it will have to pay it off with interest this July or convince the lenders to roll over the credit agreement. The credit agreement was secured using Barrett Resources as collateral, for which Williams paid $2.8 billion, far more than the loan was worth. So failure to refinance or pay off the loan could result in the loss of this valuable asset.

Studies by independent research firm SNL Financial show that last year, when the energy sector was under intense pressure to reduce its debt, its borrowings grew to the $477.6 billion now outstanding from $450 billion at the end of 2001. Compounding the refinancing problem is that most utility companies have had their credit rating reduced to junk status after their liquidity problems last year.

But with US banks reluctant to take control of the plants, the only short-term option is to refinance the debt and then make provisions for the energy losses, especially given the sheer magnitude of the debt (see box).

However, it seems the situation is not disastrous. S&P says UK banks only have 0.3% of their portfolios in energy and can withstand the next few years. The situation is slightly more serious in the US, where rating agency Fitch Ratings estimates that 20% of bank and bond holdings are in the energy sector. But they are loans to the entire energy sector, not just to distressed power plants. Similarly, some of the power plants will produce profits, others will break even and others will just cause a headache for a few more years, say the banks and the consultancy firms.

In short, the banks can probably handle the situation. They now need to go back over their early-to-mid-1990s loan decisions and figure out where it all went wrong. Would better power price projections have helped? Should they have realised that too many banks were making too many loans and that some would have to pay the price? Was their risk management just too sloppy? Answers to these questions will help ensure that this year is as low as it goes for the energy markets – utilities and lenders alike.