NEW YORK, June 8 Texas faces the increased possibility of power outages in the coming years unless new plants are built, according to a report commissioned by the Electric Reliability Council of Texas (ERCOT). The report published June 1 by the Brattle Group contends improved economic incentives are needed to ensure power reliability, potentially benefitting the economic prospects of the state's largest power producer Energy Future Holdings (fka TXU).
But, so far, TXU investor reaction to the report has been tepid.
Texas Competitive Electric Holdings Company's (TCEH) $3.8 billion of bank debt due in October 2014 failed to budge from currently depressed levels. Falling to 62 cents on the dollar from the low 80s over the past year, the loan has remained at those levels since last week. TCEH is Energy Future Holdings' power generation subsidiary and the largest wholesale electricity provider in ERCOT.
As well, neither the shape nor expensive pricing of TCEH's credit default swap (CDS) curve changed much after the report's release. The CDS curve spikes at two years and flattens beyond three years, suggesting that TCEH is unlikely to successfully manage its $29.8 billion debt load beyond that time frame. Currently, investors would need to pay $6.55 million upfront and $500,000 annually to protect $10 million of unsecured debt from default for two years, while three- and four-year protection contracts are respectively priced at $7.65 and $7.95 million upfront for the same amount of protection and annual payments.
In a separate May report, ERCOT forecast reserve margins, which measure excess power generation capacity during peak use, to decline to 9.8 percent by 2014. This projection falls well short of ERCOT's 13.75 percent target, which translates into a one power outage event in 10 years.
Power demand has been primarily driven by a robust Texas economy and 21 percent population growth over the last decade, according to U.S. Census figures. Recent extreme weather has further strained the power grid, enabling ERCOT to set several new records for peak use in the past year.
But after adding close to 25,000 megawatts of new coal and gas-fired plants over the last decade, power producers have largely halted new plant construction due to volatile economics and forward power prices currently insufficient to encourage new investment.
Natural gas prices, which represent the marginal fuel setting the price of power in ERCOT, have fallen to $2.45 mmBTU from over $4.00 mmBTU last year. In addition, the forward gas curve for the next two years does not project a return to last year's levels.
Unlike other power markets, ERCOT does not offer capacity payments to ensure generators are available for dispatch during peak power usage. ERCOT's deregulated retail market also enables customers to shop around, which discourages procurers of power from entering into long-term power purchase agreements with wholesale generators like TCEH.
Low revenue visibility then forces ERCOT power producers to rely on difficult to predict factors, including natural gas price swings and extreme weather, to drive economics.
To incentivize investment, Brattle Group discussed several potential solutions that include introducing capacity payments and raising caps on power prices from $3,000/MWh to $9,000/MWh when the grid is stressed. A higher $4,500/MWh cap has already been proposed for this summer by ERCOT.
"While a lot of positive steps to date have been taken to incentivize new investment, more needs to be done," said Stephen Byrd, senior utilities equity analyst at Morgan Stanley. "These steps should be generally positive for asset values if ERCOT wants to maintain their commitment to very high reliability."
Capital structure options
Aside from an in-court restructuring, TCEH has several options to offer creditors willing to take a longer-term view on market recovery and potential investment incentives from ERCOT. In its latest investor presentation, the company disclosed $750 million of first-lien and $1.88 billion of second-lien capacity that can be used to issue additional secured debt or execute exchange offers with debt holders. There is a nominal $1.5 billion of investment basket that could provide additional financing opportunities as well.
Investors have given TCEH some breathing room in the past. In April 2011, bank debt lenders extended $15.4 billion of maturities from 2014 to 2017 in return for higher coupon and upfront fees among other concessions. Over the past three years, Energy Future Holdings and TCEH have also reduced debt by repurchasing or exchanging bonds at a discount.
Even if lenders do not give additional time for TCEH to fix its balance sheet before the October 2014 maturity, one buyside source argued that owning TCEH assets through a restructuring still provides upside exposure to any increased economic incentives from ERCOT. Another buyside investor added that the Brattle report's policy recommendations are unlikely to dramatically improve the company's credit profile in time.
"While few people are building new generation in ERCOT, TXU has an untenable capital structure." said Bonnie Baha, head of global developed credit at DoubleLine Capital which manages $35 billion in assets. "Those involved with TXU are mostly distressed investors playing for recovery. The company is so levered towards natural gas prices that unless you see a sharp recovery, not much else can forestall a restructuring."