Edison SpA has grown over the years to become one of the most diversified energy players in the industry, dabbling in everything from agribusiness to chemicals. Now, roused by debt-woes and credit concerns, it is peeling back its non-core businesses in a bold bid to become, once again, what it used to be: a pure play energy company.

?The intention was to bring Edison back to its original activities ? gas and electricity,? says Paolo Gallo, formerly head of strategy for Edison ? which is also Italy's oldest energy company, dating from 1883 ? and now COO of Edipower, formed from the recently privatized generating company, Eurogen, majority acquired by Edison. He is unambiguous about this latest restructuring: ?Before it [Edison] was a conglomerate. Now, we have a more focussed company.?

Over the last two years, especially since its buyout by the Italenergia group (which formally merged with its target), Edison has been slashing its assorted product line, with almost EU9 billion in asset disposals until now, to concentrate primarily on electric power. it is to date Italy's leading independent power producer, with about 6,400MW of hydroelectric, gas-fired and wind-powered generating capacity. With its control of Edipower, the group is effectively in charge of around 10,000MW of generating capacity.

The strategy is to increase capacity by about 4,000MW through greenfield plant construction, while tacking on another 3,500MW through tolling agreements with Edipower. And the goal is to reach 14,000MW by 2007, which means a grip over 20% of the total deregulated Italian market.

For the most part, the plan seems to be working. But it has not just been about nostalgia. ?There was an economic rationale behind that. If you look at EBITDA by different sectors in 2001 the most profitable businesses were in the energy sector.?

As important to this strategy is Edison's tenacious defence of its investment grade credit rating (it's rated a ?weak? BBB by Standard & Poor's), which it has maintained aggressively through recent asset divestments and capital increases. The conglomerate was placed on credit watch negative last November, given what Standard & Poor's described as ?the risk of breaching the requirement in some of its finance agreements to maintain an investment grade rating.?

The problem was outstanding debt, Eu6.4 billion of it. According to Paolo Citi, analyst at Santander Central Hispano, in a note earlier this year, Edison's debt burden had been ?clouding the growth potential of a company generally viewed as one of the best positioned players to exploit the liberalization of Italy's energy market.?

Of course a downgrade to non-investment grade would have made access to credit drastically more difficult ? precisely at a time when Edison was setting out to strengthen its position in the Italian market.

So in a bid to stave off a costly downgrade, the company pushed for a capital increase of Eu2.1 billion, through a rights offering to stockholders. Then, this April, the group sold its lucrative gas assets in Egypt to Malaysia's Petronas, reducing its debt by Eu1.6 billion.

Says Gallo, ?generally Edison's financial situation has improved very much over the last few months after the successful divestment programme, and lastly with the sale of the Egyptian gas assets.?

The reserves were generally strong assets but were not expected to contribute substantially to the company cashflow before the medium term.

Monica Mariani, analyst at Standard & Poor's agrees: ?The company is strongly committed to keeping it [the rating], and they have behaved consistently to avoid that [downgrade]. This is very important as a signal to the market.?

Repowering

So now, more dexterous and animated than before, Edison is training its sights almost exclusively on home turf, with power generation as its primary focus. But the domestic power market, however, is still far from ideal. Says Gallo, ?The major issue now is to implement more capacity to respond to demand.?

The country is arguably on the brink of a supply crisis, Gallo points out. Installed capacity is around 76GW, but only 48.7GW is actually available for production. ?We recently reached a peak in demand this summer, 51GW,? he says. ?So our major challenge is to repower existing plants and to add new capacity.?

The Italian market made its first moves towards liberalization a decade ago. The government had introduced a schedule of subsidised electricity tariffs (CIP6) that were available to select private electricity producers. For Edison, this meant that it was able to sign preferential framework agreements with Enel for agreed tranches of capacity.

But it wasn't until the Bersani law came into effect in 1999 that there was generally more tangible progress. The law was designed to introduce competition in the market, while unbundling generation, transmission and distribution; it also required the incumbent state utility Enel to divest 15,000MW of its generating assets.

Though there are a number of sponsors contemplating power plants right now, ?the major problem is getting authorization to build a plant,? says Gallo. ?You need to get approval from many sources, including the local community. That has tended to be the major obstacle.?

A glance a statistics shows the scope of the problem: there have been requests for new plants at the Ministry of Industry for over 100GW of capacity, whereas the current installed capacity in Italy is half that.

But last year the Italian government issued the Sblocca Centrali Decree, to ease the building and repowering of plants. It introduced fast track permit procedures for projects over 300MW. In addition the Marzano decree was also issued last summer, to properly define all the rules of the market, in order to help kick start the market's opening. The decree is still being amended.

?The new legislation will be able to overcome some of the problems,? Gallo hopes. Edison is trying to take advantage of a gradually liberalizing market, and expects that new legislation, expected to simplify approval procedures for new plants, will speed the process. The company currently has three new plants under construction.

In any event, legal wrangling has meant that the introduction of the power pool has also been delayed, and without a clear set of rules prescribing the pool's operations, there's still a high degree of uncertainty in the industry. This has led to a slowdown in new capacity investments.

The problem, says Gallo, is that ?without a clear set of rules, banks are not willing to finance projects. Today deals can only be financed through bilateral contracts.?

?Once the regulatory framework is in place, it will be easier for power projects to raise financing.? He reckons it will be in place next year, though when next year is still a subject of much speculation.

Finding the funds

Edison, however, is largely undaunted. It enjoys a place of privilege as Italy's foremost independent power producer, and number two utility in the country. ?Today the role of the incumbent is very strong,? notes Gallo.

Edison led the consortium that acquired Eurogen, last year, the largest of Enel's three generating companies spun off under the Bersani law, through the special purpose company Edipower. Gallo points out that in general the spin offs represented a unique opportunity to acquire generating capacity.

?It brought to Edison in one shot both power capacity and authorized new build. It gives Edison 3.4?3.5GW extra capacity and scope for 4GW new capacity,? he points out.

The other key element for Edison was fuel mix. Almost all new authorizations are for gas fired plants, whereas the Edipower portfolio includes oil and coal fired plants. Although some of the Edipower assets will be repowered and transformed to CCGT, the portfolio will ultimately consist of gas, coal, oil remulsion, and old oil-fired plants.

?We need to have an Italian portfolio that meets demand,? says Gallo. ?We will have a nice portfolio in terms of fuel which helps manage better the increases in natural gas prices and oil prices, matching better the realities of the fuel market.?

Italy's overall portfolio of generating assets is quite different from the European average, and is skewed towards the thermal, which represents roughly 75% of the total. It is fed largely by fuel oil, and the bulk of which need repowering.

The Edipower deal called for a short-term Eu3.67 billion loan, which in turn brought a large element of refinancing risk to the Edison credit profile ? one of the factors contributing to its negative credit watch assessment by Standard & Poor's.

Says one banker close to the deal, ?the price paid by these gencos was most probably in excess of the actual value of the plants, because value was also related to the size and the possibility of revamping the units, since it's so difficult to develop a plant on a greenfield basis.?

Edipower's ownership structure is slightly more complex ? it is actually a consortium led by Edison and Italenergia (owned by Fiat, Edf, Tassara, Banca Roma, Banca Intesa, and SanPaolo), which itself was formed in 2001 to carry out the hostile takeover of the Edison/Montedison/Flack group.

That takeover was financed by a Eu6.5 billion loan put together by Deutsche Bank, SG, Banca di Roma, IntescaBCi and SanPaolo. The loan fell due in July. A 2.5-year Eu1.25 billion bullet revolver for Edison, refinancing that deal, closed in early July, 50% oversubscribed. The deal was lead arranged by IntesaBCI, MCC, SanPaolo, IMI, Bank of Tokyo Mitsubishi, Credit Agricole, HSBC, SG, and WestLB.

The deal remains non-recourse to the Italenergia shareholders. Margin on the deal is linked to Edison credit ratings, 200bp for the current Baa3/BBB, 275bp for BBB- and lower, 150bp for Baa2.BBB, 120bp for Baa1/BB+, 90bp for A3/A-.

Says S&P's Mariani, ?from our standpoint it has improved somewhat the maturity profile of the company's debt, though not exceptionally.? She adds, ?It has given some relief, though it has no particular provisions. It's more of a corporate loan.?

The deal is also important for its risk structure. Says a banker familiar with the transaction, ?it has been successful because it has benefited from its tolling agreements. Tolling risk is passed on to the sponsors while the lenders retain technical risk.?

But the deal's closure is important in another respect: it now paves the way for the Edipower refinancing. That deal falls due at the end of this year, and was originally arranged by Barclays, Credit Agricole, Interbanca, IntesaBCI, RBS, SG and Unicredito. But the assumption from that start was that Edipower would ultimately structure long-term funding on the basis of tolling agreements it struck with Edison, its major sponsor.

The initial deal was a hybrid corporate/non-recourse loan that mixed near equal guaranteed and non-guaranteed tranches. Of the Eu3.7 billion total debt component, Eu1.8 billion is non-recourse to Edipower's sponsors. The remaining Eu1.875 has recourse and splits into a Eu1.275 billion term loan, a Eu450 million facility and a Eu150 million revolver. The loan proved especially popular and hit the market 30% oversubscribed. But the final profile was notably thin on Italian banks.

The main lender concern at the time was offtake risk. Although a number of the plants in the genco profile were covered by the CIP6 agreements, others have had to take full offtake risk. At the time of debt negotiations, lenders were aware that discussions over a tolling agreement with Edison were still in being worked out.

The offtake issue encouraged Edipower to take Endesa's lead and opt for a short-term loan, as the latter had for its acquisition of Elettrogen, another of Enel's privatized gencos, comprising 5400MW.

Says a banker familiar with the deal, ?Edison financed this on a short term basis because at the time they still needed to organize amongst themselves for the structuring of a longer deal. They preferred this short term structure, which allowed them time to structure a better deal and the banking market accepted the bridge risk, since the leverage was not that high.?

Part of the forthcoming Eu2.3 billion refinancing of Edipower will be guaranteed by the shareholders, but the balance will contain non-recourse elements. ?Some of the financing will be done on a non-recourse basis. The non-recourse portion will be based on ability of single power plant to generate cash,? says Gallo.

?Edipower [refinancing] will be a piece of cake,? says a banker close to the deal. ?There's no merchant risk, the Italian market is very favourable, and banks have a huge appetite right now. I have no concerns,? he adds.

?The risk there is a general refinancing risk, given a big ticket expiring in September. Generally speaking, though, lenders are more conservative given the industry's situation across Europe,? says Mariani. ?But Italy is still regarded as a low risk, in the broader context,? she adds.

The last Enel genco to be spun off was Interpower, renamed Tirreno power, with 2600MW of capacity. It was sold to a consortium of Acea, Electrabel and the CIR-owned Energie Italiana group. In contrast to Edipower, the Tirreno deal is noteworthy for being the first to put in place a long term solution to its financing requirements. Banca Monte dei Paschi, BNL, Barclays, BNP Paribas, Credit Agricole and IntesaBCI put together a seven-year Eu875 million non-recourse loan which closed earlier this year.

The facility was split into a Eu260 million tranche, providing for the repayment of intercompany debt between interpower and Enel, a Eu415 million tranche to fund repowering, a Eu140 million acquisition line tranche, a working capacity facility of Eu47 million and a revolver of up to Eu13 million. It was a tough sell for lending banks, since they took up the merchant risk across the portfolio of plants, with no significant sponsor support.

But still, it was the first deal to move straight to long term funding, and as such sets an important new benchmark, which will be closely scrutinized by the likes of Edison.

Nevertheless, all the structural components for proper competition are not yet in place. Enel still exercises a strong influence on price formation in the liberalized market. And the operator will continue to hold a dominant position in electricity supply, at 55% of total capacity.

?In terms of the future of the power market, one of the major problems is that we don't yet have a pool,? says Gallo. But the electricity exchange is set to be launched and should bring with it a system of clearly defined daily and hourly electricity prices. Gallo believes the resulting price transparency will be a significant advance for the free market model in Italy.

Still, competition is not expected to grow fast in the medium term, which leaves players like Edison in a favourable position. Says Mariani, ?the position of utilities like Edison, which on average have good plans, is quite safe. They have a cushion represented by their subsidized contracts [under CIP6]. This means that a remarkable portion of energy they produce is sold to the market operator at better than market price. But going forward their share of protective contracts will change.?

In an interesting aside, Edison recently picked up some invaluable experience structuring project financings through a power deal in Brazil ? Ibirite, which it inherited from Fiat Energia. ?This project [Ibirite] is significant for Edison because it brings a lot of knowledge in terms of project finance.?

US Ex-Im and Italy's SACE are involved in the final package, with the former supplying a $66 million direct loan with a tenor of 12 years plus construction, and the latter providing a 12-year loan through BNP Paribas of $72 million equivalent in Euros. Finally, Banco Nacional de Desenvolvimento Econômico e Social (BNDES) is providing a $22 million equivalent in Reais with the same maturity as the other lenders.

Ibirite is a 226MW plant in which Edison holds a 50% stake and Brazilian oil and gas monopoly Petrobras the remainder. It is located in Minas Gerais state, and is expected to contribute to stability in the regional grid. It uses a 150MW GE7FA gas turbine and a 76MW Franco Tosi Steam turbine.

Will the company expand its power operations abroad? ?We are thinking about a foreign strategy but we don't currently have a defined strategy as such because we're focussing on the Italian market ? it's the largest for us and it needs all our attention,? says Gallo.

Foreign concerns

Since its theoretical liberalisation by the Bersani Law, the Italian power industry has thrown up many new opportunities for independent private players. But Italenergia's takeover of and subsequent merger with Edison raised another, perhaps more fundamental concern for the Italian energy industry: foreign state-ownership of privatized assets.

The concern was that Italenergia is itself 18% owned by Electricite de France (EdF), the French state-owned utility. So after EdF's effective acquisition of a stake in Edison, the Italian government passed a decree to reduce EdF's voting rights in Italenergia to 2% in the hope of blocking the French state-owned company from taking it over. This has led to a dispuite over EdF between Italy and the EU. Edf's purchase of privatized assets would effectively transfer them from Italy to France, so Italy has attempted to restrict the sale.

A result of all this was the ruling that no company would be allowed to acquire or hold stakes in more than one of the three generating companies being spin off from Enel, and no buyer could be more than 30% government-owned. This last requirement was to prevent Electricite de France (EdF) from acquiring the gencos.

Enel and Edf have been conducting their own negotiations to settle the dispute. The latter has offered Enel a stake in four French nuclear facilities in exchange for rescuing its voting rights in Edison. The situation is curious, and as yet unresolved. Says Gallo, ?what will happen in 2005, we don't know.?