Overview -- Panda Temple Power LLC is issuing $340.16 million of senior secured debt to build a 758 megawatt natural gas-fired power plant in Temple, Texas. This represents a $35 million increase from our previous assumptions. -- We are lowering our preliminary issue rating to 'B' from 'B+' and changing the preliminary recovery rating to '3' from '2'. -- The stable outlook reflects our expectation that the project will be built on time and within budget, and that near-term hedges will provide adequate cash flow for debt service at the rated level. Rating Action On July 16, 2012, Standard & Poor's Ratings Services lowered its preliminary rating to 'B' from 'B+' and changed the preliminary recovery rating to '3' from '2' on Panda Temple Power LLC's (Temple) $75 million first-lien term loan A, $255 million term loan B, and $10.16 million letter of credit facility. The preliminary '3' recovery rating indicates meaningful recovery (50% to 70%) of principal in a default scenario. Cross-acceleration provisions exist between the term loan A and term loan B and all the debt is pari passu. The outlook is stable. Rationale The change in ratings reflects a higher amount of total debt and cumulative interest payments that are likely to be considerably higher than our previous assumptions. Our rating also reflects the project's construction risk, exposure to merchant energy prices, and a high degree of sensitivity to capacity factors and market heat rates. The project will use loan proceeds to build the Panda Temple Power Plant, a nominal 758 megawatt (MW) natural gas-fired facility in Temple, Texas. The unit will dispatch into the North sub-region of the Electric Reliability Council of Texas (ERCOT) interconnect. The preliminary ratings are subject to final structure and document review. Temple is a special-purpose, bankruptcy-remote operating entity. Panda Power Generation Infrastructure Funds and a consortium of other equity investors together own the equity in the project. Temple will service its debt from merchant energy revenues, buttressed by near-term revenue put hedges. The main risk to the project is the exposure to merchant energy markets, in our opinion, and limited refinancing risk. The initial debt is about $463 per kilowatt (kW), which falls to about $390 per kW under our assumptions by 2019. The 'B' rating results from high initial debt, greenfield construction risk, exposure to market prices, and high sensitivity to heat rate and spark spreads. Lack of diversity in cash flows also adds to cash flow volatility. Bechtel Power Corp. and Siemens Energy Inc. will build the project jointly and severally, under a fixed-price, date-certain turnkey engineering, procurement, and construction (EPC) contract. Given their long track record, market leadership in this industry, and the project's requirements, Standard & Poor's is comfortable that the creditworthiness of these counterparties will not limit the rating on Temple's debt. We view the fixed EPC arrangement as supportive of credit because it mitigates construction risk. Although the plant is completely exposed to merchant risk, it benefits from a revenue put option for 600 MW of generation capacity, which provides underlying supports for margins of $41 million per year between 2015 and 2018. The hedges provide a floor even as the project retains the upside should spark spreads widen or heat rates expand. Standard & Poor's believes this hedging strategy will improve the stability of margins during the initial hedged period. However, the hedges are financially settled and they may not be completely effective because gas is not perfectly correlated to on-peak electricity, and if gas is on the margin less frequently than expected, the ineffectiveness of the hedge would likely widen. In addition, the hedges do not cover for lower margins arising from weaker-than-expected operational performance. In addition, in various stress case assumptions, the debt service coverage that the hedges provide is considerably lower given our expectations of higher interest rates. Because there are no capacity markets in the ERCOT region, we expect plant cash flows to be highly volatile for the unhedged portion of the capacity, and starting in 2019 for the all the capacity once hedges roll off. However, we expect the realized margins will continue to strengthen due to declining reserve margins from increasing load and the planned retirement of coal units that is helping to improve market heat rates. We expect reserve margins in the ERCOT region to fall consistently below 5% after 2018, especially if current trends continue. In summary, the 'B' debt rating reflects these risks: -- High overall debt at origination of about $463/kW. In our stress case, total debt declines to about $390/kW in 2019, which still constitutes considerable refinancing risk. -- Higher-than-expected interest rates that lower the debt service coverage ratio to between 1x and 1.1x for several periods. -- Cash flow is highly sensitive to changes in operating heat rates and spark spreads. -- Greenfield construction. -- The project is exposed to merchant power prices for all of its capacity. -- In our sensitivities, power prices and capacity factors (which are partially influenced by reserve margins and the relative position of new-builds in the ERCOT stack) have the most effect. The project has no power purchase agreements and there are no capacity markets in ERCOT. -- Lack of diversity and being a single asset that relies on natural gas to back all cash flows. -- Exposure to losses arising from operational underperformance. -- Unhedged natural gas prices. The following strengths mitigate weaknesses at the 'B' rating level: -- Merchant exposure is mitigated with counterparty hedges from 3M Employee Retirement Income Plan for roughly all the base capacity from 2015 to 2018. -- A 100% excess cash flow sweep for term loan A reduces refinance risk. Term loan LB will also benefit from a 100% cash flow sweep after term loan A is paid off as long as its outstanding balance is above $100 million. -- Low reserve margin expectations in the ERCOT region falling from 13.5% in 2012 to below 5% from 2018 onward. If this trend holds, there could be considerable support for higher prices, which in turn would likely promote development of new power plants. -- The EPC contractors are market leaders with a strong track record of delivering on time and within budget. -- The sponsors have considerable experience in the industry, with more than 9 gigawatts of large power generation projects. A subsidiary of the sponsor also will provide operating and maintenance services. We use our current assumptions from our corporate natural gas price deck ($2 per million Btu in 2012, $2.75 in 2013, $3.50 in 2014, and rising with inflation thereafter) in our financial forecast. Debt coverage service ratios in this case averages about 1.1x during this period and is about 1.15x in 2019, on a consolidated debt basis. We also believe that the projected debt burden at maturity of about $390 per kW on a consolidated basis under our rated case assumptions, and is likely to be refinanced at reasonable terms given our recent experience. Liquidity Liquidity is limited to a debt service reserve covering six months of principal and interest, funded from cash, or backed with a bank letter of credit from 2015 onward. The transaction also has a maintenance account ($10 million), a working capital account ($4 million), and letter of credit funding ($10.2 million). During the construction phase, contingency fees and EPC contractor credit-support deposits also add liquidity. Recovery analysis The preliminary '3' recovery rating on the debt indicates expectations of a meaningful (50% to 70%) recovery if a default occurs. Outlook The stable outlook on the debt ratings reflects fairly steady cash flow through 2018 due to hedging positions and favorable cash flow prospects thereafter given asset efficiency and expected retirement of aged coal capacity. A downgrade is possible if our expectation of debt at maturity changes to greater than $400 per kW and if debt service coverage ratios steadily decline below 1.1x. This would likely result from construction delays, lower-than-expected spark spreads or operational performance, or higher operating and maintenance costs. An upgrade would require a large and sustainable improvement in merchant market prices that would reduce refinance risk to below $100 per kW. Related Criteria And Research Updated Project Finance Summary Debt Rating Criteria, Sept. 18, 2007 Ratings List Issue-Level Rating Lowered; Recovery Rating Changed To From Panda Temple Power LLC Senior Secured: $75 mil term loan A B(prelim)/Stable B+(prelim)/Stable Recovery rating 3(prelim) 2(prelim) $255 mil term loan B B(prelim)/Stable B+(prelim)/Stable Recovery rating 3(prelim) 2(prelim) $10.16 million LOC facility B(prelim)/Stable B+(prelim)/Stable Recovery rating 3(prelim) 2(prelim) Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column.