volatile markets call for alternative business models

10 PUBLIC UTILITIES FORTNIGHTLY SEPTEMBER 2009 www.fortnightly.com

For the past decade, the power indus-try enjoyed broad access to plentiful andcheap capital from an assortment ofinvestors, including banks, mutualfunds, pension funds, insurance compa-nies, hedge funds, and credit defaultobligations. But the credit crisis has virtually dried up capital or made itextremely expensive, especially for themerchant-power sector. Even after thecurrent crisis resolves, structural changeson Wall Street that require lower debtlevels (de-leveraging) and maintenanceof tighter capital costs likely will perma-nently increase the yield spreads anddebt costs for the industry.

Should the power industry adapt itsapproach to capital markets in this envi-ronment? The answer, of course, is yes.

An independent analysis of both theutility sector and the competitive or mer-chant-generation sector differentiatestheir financing risks and demonstratesthe qualitative differences. The analyses,while providing a novel application ofthe discounted-cash-flow (DCF) model,concludes that multiple frameworks arenecessary to establish a power company’sor project’s current cost of capital, espe-cially under volatile capital market con-ditions. Finally, the analyses reveals thatin today’s capital markets, it is critical tobalance or combine the alternativeapproaches to the cost of capital in orderto develop a long-term view.

Before the Crisis

The U.S. utility industry uses corporatefinancing to fund capital expendituresand other needs in all segments of thepower industry. Debt funding is struc-tured with recourse to the corporateissuer, and thus is included in the balancesheet of the company. Utilities generallyhave enjoyed favorable debt financingterms, because they have relatively stableand predictable cash flows. The creditratings of utilities have drifted downfrom A and A- in recent years to BBBand BBB+, but they’re still investmentgrade. As a result it’s still feasible for utili-ties to finance capital requirements basedon their credit-worthiness, particularly ifmultiple companies join forces. Also, inrecent years there have been relativelyfew huge capital investments (e.g., in newcoal or nuclear projects) that wouldrequire massive spending on individualprojects. Even so, utility capital spending

has been high and is projected to remainhigh, as utilities invest in large transmis-sion, smart metering, energy efficiencyand environmental upgrades.

By contrast, the U.S. merchant-pow-er sector is focused largely on unregulat-ed wholesale generation plants, althoughthere are a handful of merchant trans-mission projects and companies in theU.S. market. Examples of merchant-power generators active in the UnitedStates include Dynegy, Mirant, NRG,Reliant, and Calpine; these companiescan be considered pure-plays for this sec-tor, because they all have a predominantfocus on deregulated power generation; a significant exposure to merchant powerrisk; a wide range of customers; a U.S.base with significant geographic diversi-fication; and significant economies ofscale in both operations and fixed costsbecause of the size of their generationportfolio. (NRG recently expandedbeyond this pure-play description byacquiring the Texas retail operations ofReliant Energy.)

All of these merchant-power compa-nies are rated below investment grade orin the high-yield class. Merchant proj-ects traditionally have been projectfinanced and carry market risk, as theircash flows may be exposed to thevagaries of spot-power prices unless theyhave power-purchase agreements thatmitigate such risk. Although most proj-ect finance deals involve leveraged loansfrom commercial lenders, the debt costsfor merchants generally approaches thereturns on publicly traded high-yieldbonds. Financing on a pure merchantbasis currently is extremely difficult

Business & Money

Crisis CapitalVolatile markets call for alternative financial models.BY ANANT KUMAR AND ELLIOT ROSEMAN

H ow is the financial crisis affecting the power sector? In short, in a big way. Theelectric power industry is second only to financial services in terms of relianceon credit markets and is second only to railroads in capital intensity. Of course,

the huge fixed-cost structure of the power industry stems from the need to invest billions of dollars each year in generation, transmission, and distribution assets.

Anant Kumar ([email protected]) isa manager, and Elliot Roseman ([email protected]) is a vice president withICF International. Both are located inFairfax, Va.. The authors acknowledgethe research contributions of AshishSingla of ICF’s New Delhi office.

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Investment grade utilities haven’t been spared thepinch. Debt costsapproached some utilities’ authorized ROE.


and power-purchase agreements are nowa pre-requisite rather than a unique sell-ing point. Recent examples of majorproject-financed generation plantsinclude Caithness Energy and NobleEnvironmental Power.

Many companies in the merchant-power business aren’t pure plays. Forexample, companies usually consideredutilities, such as Constellation Energy,have substantial merchant generation aswell as regulated utility assets, and com-panies generally thought of as mer-chants, such as AES, own regulatedutilities. For those companies, it makessense to look at a blending of themethodologies and approaches. How-ever, in carrying out valuations, thefinancial community tends to regard thefundamental risk profiles of such firmsas one type or another, rather than both.

In this regard, it’s important tounderstand the recent history of theleveraged loan and high-yield bond mar-ket. The high-yield bond market grewrapidly throughout the 1990s and wellinto 2007—starting at $200 million in1995 and expanding to $1 billion bymid-2007. Such bonds were used forfinancing leveraged buyouts and exitsfrom bankruptcy, and they fueled theexplosive growth of the sector in 2005and 2006. For example, Mirant emergedfrom bankruptcy in 2006 and 2008through the issuance of high-yieldbonds, while Calpine’s exit financing in

2008 was privately placed. But things changed rapidly, particu-

larly for merchant companies. Credit dra-matically tightened in 2008 and early2009 after a period of stable and relativelylow bond spreads (see Figure 1). Thespread is an important indicator thatshows the amount that companies pay forcapital over a benchmark such as theTreasury bonds or LIBOR. Until late2008, one of the reasons for the narrowspreads, low cost of debt, and rapidincrease in debt placement in the powerindustry was securitization, the packagingof groups of investments into a pool andthen sold as a single security. In the mort-gage market, securitization enabled theredistribution of substantial credit riskfrom originating banks to non-bankinvestors, and the power industry wit-nessed a similar dynamic through the col-lateralization of leveraged loan and high-yield debt instruments. In the 2000s, the

widespread use of securitized instrumentssuch as credit default swaps and collater-alized loan obligations in the powerindustry spread out the credit risksamong a much larger and diversifiedgroup of investors, leading to reducedspreads.

Both utilities and merchants enjoyedthis confluence of favorable conditionsfor both project and corporate financingfor an extended period of time. Unfor-tunately, the party couldn’t last forever.

Current Credit Conditions

The seeds of success contained thepotential for disaster. In specific, theexplosion of debt that provided a wind-fall for power companies—by addinglow-cost debt to their capital structuresand allowing them to substitute debt forequity—eventually led to levels of lever-age that couldn’t be adequately servicedthrough their cash flows. This is particu-larly true for merchants. Utilities, on theother hand, remained regulated, andgenerated sufficiently stable cash flowsto service their debt obligations.1 Afterinvesting in many non-utility industryor overseas operations in the 1990s andearly 2000s, most utilities went back tobasics. Since then, their steadierapproach has allowed them to retain sig-nificantly easier access to capital, as theircredit ratings didn’t suffer as much andtheir spreads have remained much nar-rower than they did for merchants.Additionally, because utilities are viewedas a defensive sector, they’ve enjoyedready access to capital—albeit at ahigher price. The market’s general flightto quality channeled investment dollarstoward utility securities, just as it didTreasuries.

As widely reported, the credit crisisin the U.S. (and global) financial mar-kets largely was due to the exposure ofbanks and investors to sub-prime mort-gages originated by banks and sold toinvestors as mortgage-backed securities.Financial institutions, primarily

The explosion of debtprovided a windfallfor power companies,but also led to leverage that couldn’tbe adequately serviced.

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FIG. 1 HISTORICAL HIGH YIELD BOND SPREAD

Source: ICF International based on Bloomberg data


investment banks, were the key investorsin these mortgage-backed securities andother structured products. These institu-tions issued large amounts of debt in themid-2000s to fund their purchases.When housing prices started to decline,the financial institutions faced largelosses on their investments.

No industrial sector—includingpower—has been immune to the cur-rent credit crisis, even if utilities havebeen less affected than merchants. Theloss positions of the banks and overlever-aging obviously have impacted theirability to provide financing and infra-structure project financing in the powersector, in general.

The significance of this change forthe power industry is that the credit cri-sis has caused de-leveraging (i.e., lessdebt and more need for equity) and hasled to a scarcity of capital for the sector.This scarcity has been reflected in theincreasing yields (interest rates) of high-yield bonds (see Figure 2). Since July2008 the yield on a non-investmentgrade “B” bond (the line labeled“Merchants 10 Year”) has risen from9.5 percent to 12 percent, after reach-ing a high of 16 percent at the onsetof the crisis. The spread has increasedby 250 basis points (bps), a significantmarket change in such a short period.Initially, the increased spreads wereslightly offset by lower Treasury bondrates, but recently the spreads havereduced partly because of higher Trea-sury bond rates. In fact, recently Trea-sury bonds are trading close to whatthey were in July 2008. The bottomline, though, is that non-investment-grade utilities and merchant playersstill need to pay appreciably more formoney now versus a year ago.

Even investment-grade utilitieshave not been spared the pinch ofhigher interest rates and spreads, andconsumers may be affected as a result.Utility bond yields (the red line in theupper part of Figure 2) increased from

6 percent in July 2008 to 6.75 percenttoday, after reaching a high of 8.5 per-cent, while utility spreads (the lower partof Figure 2) have increased by up to 75bps. Over the last three months, the cur-rent yields and spreads have reducedconsiderably from their November 2008peaks but remain materially higher thanhistorical averages.

It’s important to understand theincreasing utility yields in the context ofthe regulator’s allowed rates of return onequity. At the onset of the credit crisis,credit-rating agencies and utility execu-tives expressed concern that the increas-ing debt costs were approaching theauthorized equity rate of returns (ROE),and that the current levels of ROE inmany jurisdictions were inadequate com-pensation to investors who perceived asignificantly higher level of risks. Theirconcern was that the need for higherequity compensation could lead to utilityrequests for higher authorized equityreturns, regulatory uncertainty, and cor-

respondingly higher consumer rates.Recently, however, due to declining debtcosts, these concerns have been allayed,but this issue could return if capital mar-kets become volatile once again.

Determining Cost of Capital

Empirical frameworks show how thequantitative cost of capital to the powersector has been impacted due to the cur-rent credit crisis. Two well-known andoften-cited approaches to determiningthat cost are the capital asset pricingmodel (CAPM) and the discounted cashflow methodology (DCF). These mod-els can be used to further demonstratethe clear differences between regulatedand merchant entities.

The CAPM relies on historicallytraded stock prices for capturing equityrisk, and given that, typically uses a five-year estimation period, to mitigate theimpacts of recent stock price volatility.DCF also provides an alternative view ofthe cost of equity. Both approaches

Historical Yields

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Historical Spreads

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FIG. 2 HISTORICAL UTILITY AND MERCHANT DEBT COSTS AND SPREADS

Source: ICF International based on Bloomberg data

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have drawbacks, so using a combinationof these two methods is a reasonable solution.

The five independent powerproviders (IPPs) mentioned previouslyprovide a reasonable set of comparablecompanies for the merchant class. Forutilities, the Edison Electric Institute’s(EEI) regulated class of utilities 2 pro-vides a readily comparable set of compa-nies. Those in the EEI class have 80percent or more of their assets in marketswith a regulated rate-of-return marketstructure, allowing analysts to assess mar-ket risks at the low end of the spectrum.

By comparison, merchants are on ahigher future trajectory for the cost ofcapital, compared to utilities. However,this must be verified by determining thetwo groups’ weighted average cost ofcapital (WACC), including the twoprincipal components of WACC—theexpected return on debt (cost of debt)and the expected return on equity (costof equity).

� CAPM Methodology: TheCAPM approach determines the cost ofequity of a firm, and suggests that theexpected returns increase linearly with asecurity’s risks. The risks are measured inthe form of equity beta, which is thechange in the price of a stock comparedto change in the appropriate stock mar-ket index, such as the S&P index or theNYSE Composite Index. Beta is a meas-ure of the company’s market risk (bothbusiness risks and financial risks) and isdirectly observed from the historically-traded stock prices of the firm in relationto the broader market. A beta of 1.0 sig-nifies that stock is as risky as the market.The expected return on equity is a for-ward-looking approach, so accordinglyforward-looking beta estimates include afactor called the “Blume adjustment,”which assumes that over time, betas tendto move towards the average marketbeta, which is 1.0.

The general methodologicalapproach is relatively standard. First,

equity beta estimates for each of thecomparable companies are developed.The equity betas are then un-levered tostrip out the financial risk and calculatethe pure business risk of the firm. This isaccomplished by using an approachcalled the “Hamada equation,” with anadjustment for the riskiness of debt forthe merchant sector. The un-levered orasset beta are then unlevered at the tar-get debt-to-equity ratio to determine there-levered equity beta of the comparablemerchant class of companies. As a finalstep, the CAPM is used to develop theexpected equity returns.

In addition to these adjustmentsfrom the risk-free rates and the expectedmarket-risk premium, it’s important toconsider a size premium, since theCAPM doesn’t capture the difference inmarket risk between smaller and largerfirms, particularly for merchants. Withthe recent crisis, the average size of mer-chants has fallen to roughly $3.5 billionto $4 billion in market capitalization.Research conducted by the Center ofResearch in Security Prices (CRSP) atthe University of Chicago indicates thateven after adjusting for the market risksof small stocks, they outperform largestocks. 3 Hence, the addition of a sizepremium to the CAPM cost of equity is reasonable. This adjustment is in therange of 60 to 100 bps and is based onsize premium studies conducted by the CRSP.

� DCF Methodology: The mainprinciple behind this methodology isthat when investors price assets,

they’re implicitly indicating theirexpected return. Thus, a reduction instock prices would mean increasedexpected equity returns. Recent histori-cal averages of the market prices ofequity in conjunction with expectedcash flows have been used to yield anestimate of the cost of equity.

For utilities, the expected cash flowscome in the form of dividends. A two-stage dividend discount model is chosenfor both periods of interest—the pre-cri-sis period and recent post-crisis period.The first stage is modeled as explicit cashflow for a number of years and accountsfor growth phase (low growth or highgrowth based on economic outlook),while the second-stage model assumesstable long-term growth in perpetuity.

For the merchants, a free cash flow toequity (FCFE) model is used, as thesecompanies have scant payout historyand the retained earnings are either usedto finance growth opportunities or usedfor stock buyback to enhance share-holder value. The methodology also usesa two-stage model for the merchants. Asthe earnings of these merchant compa-nies are highly cyclical, the net income isnormalized by taking an average over thelast five years. Also it’s important to con-sider the historical growth in addition tothe analysts’ consensus earnings forecastas analysts typically ignore cyclicality,which means that these forecasts typi-cally show an upward sloping trend,regardless of whether the companieswere at the peak or trough of the cycle.

Just like the cost of equity, the cost »

FIG. 3 UTILITY AND MERCHANT COST OF CAPITAL (%)Source: ICF International

UTILITIES MERCHANTSPre-Crisis (July 08) Current (June 09) Pre-Crisis (July 08) Current (June 09)

CAPM DCF CAPM DCF CAPM DCF CAPM DCF

Cost of Debt 6.0 6.0 6.8 6.8 8.0 8.0 9.0 9.0

Cost of Equity 10.3 10.8 10.8- 11.8- 15.1 13.0 16- 18-11.5 12.5 16.5 21

Cost of 7.0 7.2 7.4- 7.9- 10.0 8.9 10.7- 11.7-Capital * 7.8 8.3 11.0 13.2

*Assuming a 50:50 target debt/equity ratio, though this would vary from one firm to another


of debt is a forward-looking concept, inthat it takes the future prospects of thefirm into account. Yet, unlike the cost ofequity, the expected return on debt canbe directly observed in the market. Thecurrent yield to maturity (or yield) onthe applicable debt best approximatesthe cost of debt. The cost of debt is theexpected return on the bond issued bythe security, and tends to be the same asthe yield to maturity (also called thepromised return) for investment-gradebonds. But for high-yield bonds,because of default risk, the expectedreturns on high-yield bonds (or highlyleveraged debt) undoubtedly are lowerthan the promised returns. Thus, for apower company (whether utility or mer-chant) with a significant probability ofdefault, the use of the promised yieldcould significantly overstate both thecost of debt and the WACC. In extremecases, the use of the promised yield asthe cost of debt even could result in theestimated cost of debt exceeding the costof equity. This unusual situation is verynearly the case given the current state ofthe financial markets and its impact onthe cost of debt for some firms.

Hence for highly-leveraged bonds, a correction needs to be made to theobserved yields to determine theexpected return on debt. One possibilityis to apply standard asset pricing modelslike the CAPM to risky debt throughestimation of a debt beta. Studies havereported debt betas in the range of 0.3to 0.5. With a historical market-risk pre-mium of 6.5 percent,4 the risk premium(or default component) could be in therange of 195 bps to 325 bps. But thereare several issues, such as debt maturity,debt retirements and re-financings thatcomplicate this calculation and affect the availability of a consistent price seriesto estimate a debt beta from a bondprice series.

As an alternative to these approaches, anapproach based on the “Merton model” 5

has been adopted. This approach strips

the default loss component from thepromised yield to maturity. This is supe-rior to the other approaches because bydoing so, one need not rely on a consis-tent debt-price series that might not bereadily available. For example, in thecurrent market environment, the cur-rent yield to maturities for B-rated debtis in the vicinity of 12 percent. However,as explained above, due to lack of consis-tency, it would be inappropriate to usethis as the cost of debt. The Mertonmodel estimates the default componentto be close to 2.5 to 3 percent, whichindicates a true cost of debt in the 9 to9.5 percent range.

Once the cost of equity and the costof debt have been determined, calculat-ing the after-tax WACC is a simple exer-cise. Figure 3 summarizes the results ofthe utility and the merchant class analy-sis, using both the DCF and the CAPMmethodologies. Note that these numbersare purely illustrative and based on bestefforts to create cost-of-capital estimatesusing empirical data.

The analysis projects an increase of 1percent or less in the cost of capital usingthe CAPM for both utilities and mer-chants. The DCF model estimates ahigher change—more than 1 percent forutilities and a greater than 3 percent changefor merchants. Most of the change in thecost of capital (especially in the DCF casefor merchants) is driven by cost-of-equitychanges, although changes in debt costsalso are a significant contributing factor.

As the results indicate, the CAPM

methodology is relatively less responsiveto fluctuations in market capitalizationsover a limited historical period due to itsreliance on longer-term historical dataand other offsetting risk parameters. Onthe other hand, the DCF methodology,by construct, is highly responsive to thechanges in stock prices and market capi-talizations and provides a more dynamicestimate of change in cost of capital dueto recent market fluctuations. The sig-nificantly greater change in the cost ofcapital for merchants as compared toutilities is partly explained by the relativedrop in stock prices, with the decrease in stock prices for the merchants farexceeding the drop for utilities.

Neither model is perfect—DCFfocuses highly, perhaps too much, onthe near term, while the CAPM mightover-emphasize the long term and mightnot take current conditions sufficientlyinto account. Hence, using an average ofthe two approaches is more prudent andmight provide a better sense for relativechanges in the cost of capital. Also,while the CAPM approach frequently isused for both utilities and merchants,the DCF approach seldom is used formerchants, though it is commonlyapplied to utilities. Given the currentvolatility of the credit and the equitymarkets, it’s critical to consider theappropriate approach to establishing along-term view of the cost of capital.

Financial Flux

The credit markets clearly are in a stateof substantial flux, and the availabilityand cost of capital—to utilities, mer-chants and others—will depend on howquickly credit can start flowing again.The public-private partnerships struc-tures recently announced by PresidentObama and Treasury Secretary Tim Geithner are intended to enable trou-bled banks to off-load toxic assets fromtheir balance sheets through equity par-ticipation from the federal reserve andprivate banks in conjunction with lever-

Banking and capitalmarket changeslikely will cause apermanent upwardshift in long-termcost of capital.

age from the Federal Deposit InsuranceCorporation (FDIC). The clear intent isto lower the overall riskiness of financialmarkets and hence the cost of capital,though it’s unclear whether privatebanks, including private-equity firms,actively will participate in this risk-shar-ing arrangement with the federal gov-ernment. The flow-through effect ofthese changes on the power sectornotably will affect both utilities andmerchants.

Whatever the timing of the marketrestoration, it’s clear that structural andregulatory shifts will place more onerousguidelines for capital ratios on the bank-ing industry, and restrict the use of secu-ritization structures and off-balance

sheet transactions. In the meantime,both utilities and merchants still have ahigh need for capital to finance largeinfrastructure projects. Banking andcapital market changes likely will cause apermanent upward shift in the long-term cost of capital for the power sector.In this context, the CAPM and DCFmodels must be recognized for whatthey are: models that attempt to capturethe financial outlook for a firm anddetermine its cost of money. By applyingthese models judiciously, perhaps incombination, and in new ways, utilitiesand merchant companies can determinethe best approach and the best timingfor the complex task of raising capitalwhen they need it. F

SEPTEMBER 2009 PUBLIC UTILITIES FORTNIGHTLY 19www.fortnightly.com

ENDNOTES:1. Even though utilities in some states were less regu-

lated than in other states, they all have reasonablystable cash flows to service their debt obligations asmany generate revenues through sales to affiliates.

2. See EEI Publication, 2008 Financial Review.3. Source: Ibbotson SBBI, 2009 Valuation Yearbook.

One explanation of this phenomenon from a trad-ing standpoint is that small firms are not very liquid(have high liquidity betas) and not frequentlytraded by hedge funds and other financial players,and hence there is an illiquidity premium thatshould be added to the cost of equity. Anotherexplanation is that smaller firms generally are per-ceived to be riskier and have fewer resources to fallback on in a crisis than large ones (though largefirms often fail as well).

4. Ibbotson SBBI, 2009 Valuation Yearbook.5. Based on “Estimating the Cost of Risky Debt,” by

Cooper and Davydenko, Journal of Applied Corpo-rate Finance, Volume 19, Number 3, Summer2007.

volatile markets call for alternative business models

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