American Public Power Association Joint Action Workshop December 6, 2004 Fitch s Take on Fuel Risk Karl Pfeil III, Senior Director FitchRatings, Inc.
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
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
Introduction: > Evaluation of Fuel Risk is One Piece of Overall Credit Puzzle > Understanding National/Regional Fuel issues > Fitch s Analysis of Natural Gas Transactions
Fitch Ratings Public Power Criteria > Management/Governance and Business Strategy > Financial Performance > Risk Management Practices > Power Supply > Liquidity > Rates > Regional Factors > Demographics > Regulation
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
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
Risk Management Policy Should Address the Following: > Physical/Financial Hedge Strategy > Market Exposure > Reasonableness of Price Assumptions > Regional Characteristics > Counterparty Risk > Financial Risk
Typical Sources of Liquidity > Cash > Commercial Paper Program > Rate Structure > Operating Margins > Surplus Fuel > Borrowing
Financial Risk Management > Fuel Hedge > Market Exposure > Counterparties > Margin or Collateral Calls > General Transfer Policies > Variable Rate Exposure > Basis Risk > Termination
Understanding National and Regional Fuel Issues >The Fuels Dilemma
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
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 1973-4 PURPA 1978 PURPA QF Era CAA Amendments 1990 RTO NOPR 1999 EPACT 1992 Rise of the Merchant EWGs 1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 Source: Henwood Energy Services, Inc.
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
Gas on the Margin: 2004 Gas determines electricity prices: 60-100% of the time only in ERCOT, Alberta, COB, NY load pockets. 40-60% in West Less than 40% of the year in Midwest, Southeast Source: Fitch Ratings, Henwood Energy Services Inc.
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
Gas Prices Used in Fitch Wholesale Power Model Fitch Gas Price Forecasts 6.50 6.00 5.50 5.00 4.50 4.00 3.50 3.00 2.50 2.00 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-25 2004 $MMBtu at the Henry Hub Jan-26 Jan-27 High Gas Case - $5.50 Fitch Base Case Low Gas Case - $2.50
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
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.
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?
Analysis of Debt Financed Gas Transactions > Pre-Paid Gas Deals > Purchases of Gas Reserves
Major Credit Factors Pre-Paid Gas Transactions > Economics > Counterparty Risk > Supply or Delivery Risk > Volume Risk > Price Volatility > Regulatory Risk
Additional Credit Factors for Gas Reserve Purchases > Operating history of reserves > Experience of operator > Hedging strategy
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
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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