American Public Power Association Joint Action Workshop December 6, 2004 Fitch s Take on Fuel Risk

Transcription

1 American Public Power Association Joint Action Workshop December 6, 2004 Fitch s Take on Fuel Risk Karl Pfeil III, Senior Director FitchRatings, Inc.

2 Fitch Ratings Global Power North America > Fitch is an international rating agency that provides global capital market investors with the highest quality research and ratings. > Public Power Group (seven analysts) rates over 130 municipal electric systems, rural electric cooperatives, and federal marketing agencies. > The public power group is part of Fitch's larger Global Power Group encompassing analysts with credit expertise in: > Investor owned utilities > Independent transmission system operators > Natural gas suppliers/pipeline distribution companies and natural gas aggregators > Merchant generators

3 Industry Outlook: Best Summed Up In Our recent Notching Report > Summary: > Public Power credits are better positioned today to handle potential cash flow volatility and event risk > In the current market environment, an issuers intrinsic credit quality often supersedes lien position. > Conclusion: > Less notching or rating differentiation by lien

4 Introduction: > Evaluation of Fuel Risk is One Piece of Overall Credit Puzzle > Understanding National/Regional Fuel issues > Fitch s Analysis of Natural Gas Transactions

5 Fitch Ratings Public Power Criteria > Management/Governance and Business Strategy > Financial Performance > Risk Management Practices > Power Supply > Liquidity > Rates > Regional Factors > Demographics > Regulation

6 Liquidity Matters! > Fitch focuses on measures that directly illustrate financial flexibility of the utility. > Greater volatility in electric and fuel markets requires increased access to liquidity. > Strong liquidity position relative to risk profile is HIGHLY supportive of a strong credit rating. > What is sufficient liquidity? > Based on: Issuers risk profile and available liquidity tools

7 Risk Profile Determinants > Electric Sales > Reliance on wholesale revenues. > Customer mix and demand patterns > Competitiveness > Embedded costs relative to competition > Electric rates relative to competition > Fuel > Fuel transportation reliability > Dominant fuel influence on regional electricity market-clearing prices > Fuel cost certainty (%) hedged > Basis risk in hedges > Power Supply > Power supply diversity > Reliability of power supply > Regional reserve margin > Spot market exposure > Electric market clearing price volatility > Outage insurance or reserve-sharing arrangements > Transmission > Transmission constraints > Regulatory > Existence of retail competition > Financial > Variable-rate exposure > Margin or collateral calls > General transfer policies

8 Risk Management Policy Should Address the Following: > Physical/Financial Hedge Strategy > Market Exposure > Reasonableness of Price Assumptions > Regional Characteristics > Counterparty Risk > Financial Risk

9 Typical Sources of Liquidity > Cash > Commercial Paper Program > Rate Structure > Operating Margins > Surplus Fuel > Borrowing

10 Financial Risk Management > Fuel Hedge > Market Exposure > Counterparties > Margin or Collateral Calls > General Transfer Policies > Variable Rate Exposure > Basis Risk > Termination

11 Understanding National and Regional Fuel Issues >The Fuels Dilemma

12 Credit Implications of Fuel Volatility Gas or fuel price Rising Declining Utilities > Utilities with frozen or capped rates at risk > Utilities with recovery clauses may have large deferrals > Beneficial cash flow environment > Risk of disallowance of over-market contracts or hedges Competitive Gencos > Increases cash flow of gencos with coal/ nuclear fleets > Lowers dispatch of gas-fired facilities > Reduces cash flow for coal/nuclear gencos > Raises dispatch of gas-fired facilities Energy Retailers Public Power/Cooperative Utilities > Discourages new entrants, favors incumbents > Utilities that face competition from retail choice are at risk > Potential loss of load of energy- intensive industrial customers load > Utilities with highly politicized rate process may experience cash flow traps > Higher cash reserves generally would be required. > Enables new entrants to challenge incumbents > Beneficial for utilities with rate mechanisms that are not automatically adjusted > Neutral for utilities with immediate rate-adjustment mechanism > Less cash reserves required

13 U.S. Power Capacity Additions 70,000 Coal Hydro Renewables Uranium Fuel Oil Natural Gas 60,000 Credit Crash Capacity Installations (MW) 50,000 40,000 30,000 20,000 10,000 0 CAA 1970 Vertically Integrated Utilities The Oil Embargo PURPA 1978 PURPA QF Era CAA Amendments 1990 RTO NOPR 1999 EPACT 1992 Rise of the Merchant EWGs Source: Henwood Energy Services, Inc.

14 Fuels for Power Generation 2004 U.S. Power Production by Fuel Types Coal Nuclear Natural Gas Other The Big Three: Coal, Uranium, and Natural Gas

15 Gas on the Margin: 2004 Gas determines electricity prices: % of the time only in ERCOT, Alberta, COB, NY load pockets % in West Less than 40% of the year in Midwest, Southeast Source: Fitch Ratings, Henwood Energy Services Inc.

16 Gas Price Outlook > Natural gas coming on line is not keeping pace with decline of existing reserves > Prices will remain high and volatile until significant new sources are developed > LNG imports > Increased drilling in new areas; frontier gas > Longer term, coal gasification

17 Gas Prices Used in Fitch Wholesale Power Model Fitch Gas Price Forecasts Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 Jan-19 Jan-20 Jan-21 Jan-22 Jan-23 Jan-24 Jan $MMBtu at the Henry Hub Jan-26 Jan-27 High Gas Case - $5.50 Fitch Base Case Low Gas Case - $2.50

18 Coal Price Outlook > Eastern coal > Production declines, rail bottlenecks, permitting problems > Long-term contracts prices higher, but current high spot prices are not sustainable > Western coal > Reserves are ample > Contract prices will increase modestly > Near term, rail transport constraints limit expansion > Stricter environmental rules in the future will alter capital and operating economics

19 Environmental Compliance > Four major pollutants > SO 2, NO x, Hg, CO 2 > Regulations fragmented and uncertain. > Carbon law expected in the future > Credit implications for public power 1 Based on prices of CO2 emissions ranging from $6 per metric ton to $37 per metric ton.

20 The Fuels Dilemma > Tradeoff Between Cost and Diversity > Uncertainty with Environmental Regulation > Your Fuel Mix Compared to the Regional Mix > Weather Related Issues > Will utilities invest in over-supplied regions to lower the reliance on gas? > Who can Afford to Make the Investments?

21 Analysis of Debt Financed Gas Transactions > Pre-Paid Gas Deals > Purchases of Gas Reserves

22 Major Credit Factors Pre-Paid Gas Transactions > Economics > Counterparty Risk > Supply or Delivery Risk > Volume Risk > Price Volatility > Regulatory Risk

23 Additional Credit Factors for Gas Reserve Purchases > Operating history of reserves > Experience of operator > Hedging strategy

24 Summing Up > Fuels Dilemma One of Many Credit Factors > Risk Profile Regionally Influenced > Natural Gas Transactions When Done Prudently Should Improve a Utility s Risk Profile and Add to its Creditworthiness

25 Conclusion > Fuel volatility and risk management is one part of the complete credit picture that if not understood or managed effectively can have a material impact on the credit quality of an issuer. > Greater volatility in electric and fuel markets requires increased attention to Risk Management and access to liquidity. > A well defined risk management strategy and a Strong liquidity position relative to risk profile is HIGHLY supportive of a strong credit rating

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