There are not many sectors that have experienced a level of turbulence over the last few years on a par with that of the US power sector. From the California brown-outs to the Enron meltdown, the credit quality of power generators has taken a severe buffeting. The aftermath of these developments has seen the industry become increasingly polarised between the relatively stable regulated distributors and integrated utilities without merchant exposure and the volatile fortunes of major participants in the wholesale, merchant power and gas markets.

Other by-products of the past few years have also emerged in the power plant financing market: caution and transparency. These have become the mantras for power plant financiers with innovation definitely on the back burner for the foreseeable future. Also on the back burner is a raft of power projects themselves: by some estimates US projects totalling more than 75,000MW of capacity have been either mothballed or cancelled.

Given that sponsors are now extremely risk averse, the options for arrangers of power plant transactions have been markedly shortened. Products such as the synthetic lease, which had been used quite widely across the industry, have now been stopped dead in their tracks and new transactions are plain vanilla all the way down the line.

But while some off-balance sheet structures are frightening the customers, leveraged leasing has held up well in this sector, with several new transactions in 2002 making use of the product. However, will the new-found caution among US power companies spell a boost in leveraged leasing or are its growth prospects as a safe alternative to straight lending being overstated as there are simply not a sufficient number of solid potential lease participants and willing lenders out there?

?I don't think that we will see project leases to the same extent in the future,? observes Daniel Morash, managing director and global head of project finance at The CIT Group in New York. ?They were a cost-effective form of financing for the Gencos but I don't expect to see any more of these transactions going forward.? The reason for this is the deterioration in credit quality of the Gencos themselves and the consequent reluctance of investors to lend. ?Lenders have been much more comfortable lending at the asset level,? notes Hugh Weldon, power sector analyst at rating agency Fitch in New York. ?They like lending to be secured on the asset rather than at holding company (Genco) level.? Holding companies (Gencos) that have used leasing in the past include AES, Edison Mission, Mirant and Reliant Resources but most recent transactions have been single asset deals.

One of the sponsors to take advantage of project leasing last year was Kinder Morgan Power. The Kinder Morgan deal involved a $194.3 million financing of a 535MW CCGT plant in Jackson Michigan. The lessor, AlphaGen, leased the plant to Triton Power Michigan with lease equity for the 22 year deal provided by the CIT Group and Investment Management Holdings. Debt was arranged by Citigroup and included an $192 million private placement. Dynegy also used a leveraged lease in its Project Alpha deal as did PG&E National Energy in its Attala plant transaction. The Kinder Morgan and PG&E deals both used structured lease obligation bonds (SLOBs). The most recent US power sector project lease is that for a 440MW lignite-fired electric generation facility in Choctaw Country Mississippi which was signed in December 2002. The plant is operated by Choctaw Generation Limited Partnership (CGLP), a wholly-owned subsidiary of Tractebel. The $430 million transaction involves a total of $360 million non-recourse senior pass-through certificates and $70 million lease equity. Citigroup was joint lead underwriter of the debt portion together with Chase.

With merchant risk now completely out of the question, the crucial element in all power project leases ? and indeed in all power project financings ? is the tolling agreement. ?The hard part is not finding the opportunities for leasing [in the power sector] it is finding strong credits, low leverage, good coverage ratios and above all strong tolling agreements,? says Morash at CIT.

The Kinder Morgan deal has a 16-year tolling agreement with Williams Energy Trading and Marketing and the Choctaw deal has a 30-year power purchase offtake agreement with the Tennessee Valley Authority (TVA). This is a ?take or pay? contract and TVA is obligated to make capacity payments so long as the facility is available to supply power. Stable cash flow is crucial to any lease arrangement and this deal is also enhanced by the mitigation of fuel risk through a 30-year lignite sales agreement with Mississippi Lignite Mining Company. Any project needs as many solid offtake agreements as it can get in order to attract investors in the current climate. ?There is not much appetite for 25-year tolling counterparty risk,? reckons Morash. He points out that the 30% bonus depreciation allowance brought in post-September 11 is positive but many contracts were signed before this was brought in.

But while tolling agreements with solid triple-A credits are a must they are not the only concern for potential investors in a project lease. AJ Sabatelle, sector analyst at Moody's in New York, explains that residual value is also a considerable concern in a market where the asset can have a useful life of up to 60 years. ?The investor needs to know what value will be there at the end of the lease. There are two decisions to be made: does the party have the ability to make payments and what is the asset looking to be worth at the end of the lease?? The answer to the latter question is very much dependent on technological change over the lifetime of the lease and Sabatelle concedes that this is a real concern. As is the prospect of increased environmental tax risk the older the equipment gets.

The Choctaw project is unique in its combination of the size of the circulating fluidised-bed boiler, scale-up and the use of lignite as fuel. A number of problems were encountered during construction, which resulted in over a year's delay. Tractebel has also agreed to indemnify the project up to $11 million for modification and retrofitting of certain items. ?Technological risk for Choctaw is a moderate concern,? says an analyst at Standard and Poor's. ?Even though the CFB is a relatively established technology there are only a few CFBs that are in the 200+MW range and they have all been operating for just the past few years.?

?As long as there is a strong PPA in place then leases can be used to take advantage of the low interest rate environment,? says a New York-based banker who has worked on two recent project lease deals. He explains that in roadshowing these transactions investors raise concerns about technological obsolescence but a main area of discussion is the point at which the lease equity and debt meet. ?The concern is that the lease equity is not really equity ? it is subordinated debt,? he explains. ?There is therefore a great deal of discussion about who gets the most protection in a default scenario.? Certain exceptional rights usually have to be granted to the equity party. ?It is a trade-off,? says the banker. As with all leasing products another issue of concern is regulatory change and the need to indemnify lenders against the risk of the economics of a long-term transaction being unravelled by new legislation.

Clearly, one of the main drivers for any leveraged lease activity is tax and efficient cost of capital. But while those benefits are sufficient to justify leveraged leasing for some sponsors, they are widely seen to be no longer attractive enough to justify synthetic structures. Chris Kysar, treasurer at Southern Power (an affiliate of Choctaw), has said that ?I think that it [synthetic leasing] can theoretically give you some book accounting advantages on the balance sheet. We could probably benefit but in this market, to be totally honest, we want to be careful and we want to be transparent.?

This attitude sums up the caution now all-pervading among US power sponsors. ?The only alternative that we could consider to the leveraged lease was a plain vanilla, non-recourse transaction,? explains the New York-based banker. ?A lot of industries are still happy to use synthetic leases but US power companies definitely now want to keep things vanilla,? notes Weldon at Fitch. This is manifesting itself in the recent phenomenon of many companies in the sector beginning to unwind their synthetic deals and put them back onto the balance sheet. And this could prove to be a growing trend given the levels of off-balance sheet debt in the sector.

According to Fitch calculations Reliant Resources has off-balance sheet debt (at 30 September, 2002) of around $1.7 billion, Mirant had off-balance sheet debt of $2 billion and Dynegy had off-balance sheet debt at November 15, 2002 of around $2.7 billion. But the option of simply restructuring debt back on to the balance sheet is out of the question for many companies. Weldon at Fitch explains that capital efficiency is a problem that must be addressed across the wider industry. ?Leverage remains stubbornly high for many companies,? he says. ?For those companies making it through to 2004 more efficient use of capital will be the distinguishing feature of those which merely survive the current liquidity crisis and those which have a chance to recover previous rating levels.? According to Weldon, Reliant Resources is now talking about winding down its synthetics exposure and some refinancings of synthetic deals are starting to emerge across the industry. For example, Ferrellgas refinanced part of its off-balance sheet exposure at the end of last year.

It is not hard to see why the power companies were attracted to synthetics in the first place, often as interim take-out to construction financing ? usually of five to seven years. The deals are treated as an operating lease under GAAP and a financing for tax purposes. In order to qualify for this treatment they must have four features: firstly there must be no automatic transfer of the asset to the lessee at the end of the lease term; and secondly there must be no ?bargain? purchase option at the end of the lease term. Neither of these is likely to feature as the leases are written over such short tenors. The third requirement is that the lease term cannot be 75% or more of the economic useful life of the asset ? hardly likely to be an issue in an industry where the assets have such a long useful life -and the fourth requirement that the present value of lease payments cannot be more than 90% of the fair market value of the asset is also pretty much irrelevant in this sector.

But following on from the Enron scandal, sponsors are reluctant to be seen to be using any financing technique that could be considered in any way questionable and despite the fact that they are a legal, tried and tested technique, for many finance directors synthetics now seem to be one innovation too far.

It is clear that much of the synthetic refinancing that is now taking place is simply driven by these facilities reaching maturity and not being rolled over. ?Many synthetic leases were originally put in place with a view to being replaced by a leveraged lease on maturity,? explains the New York-based banker. And a leveraged lease can be an attractive solution: Weldon at Fitch points to the refinancing of a mini-perm for one New York-based distributor in October last year that went through at 250 basis points over Libor. ?Leasing can provide a much better cost of capital,? he says.

The take-out of synthetic leases and the glut of mini-perms due to mature in this sector is a likely source of leveraged lease business going forward but the problem, as Morash points out, is finding deals that fit the bill. ?When capital is in short supply people are in the position of having to use all the alternatives available and it is this need for capital that is driving the market,? he says. Sabatelle at Moody's agrees that the potential for transactions going forward is questionable. ?I am sceptical about seeing too many more of these transactions,? he says. ?There is a fair amount of overcapacity in the market already.?