Utilities have rarely captured the imaginations of the investing public, since their returns often failed to match those of their merchant power counterparts. American Electric Power (AEP) gained a reputation for remaining more focused on balancing its asset portfolio and cultivating its customer base than on new and then-profitable generation projects. It is not a player that many project finance banks will have dealt with. This will change.

As AEP emerges as a forerunner in newly competitive power markets, its relationship with banks, bond holders and investors has become increasingly crucial. The company is expected to begin separating its regulated businesses from its unregulated ones later this year to give investors the chance to earn superior returns.

The move should improve the P/E ratio as earnings targets are achieved and investors give more value to the company's balanced business portfolio, says Armando Pena, AEP's treasurer and senior vice-president.

This is similar to what Reliant Energy did in 2001, which is to break off its wires business from its generation and trading assets. AEP, however, maintains the separation gives it the flexibility to spin off any business ? although the company has made no decision to do that. The market should value more highly those companies with diversified, unregulated power project businesses that can be leveraged to create additional values, as long as earnings and cash flow can be understood by investors, claims Pena.

That is the impetus behind Columbus, Ohio-based AEP's power project acquisitions in the UK. By having those physical assets, the company can now lock in prices by selling some of that power to third parties as well as saving some to balance the more lucrative daily market through the load balancing structure implemented by the government last year. ?We trade around the assets to optimize value,? says Pena. ?We also provide physical energy needs in a cost effective way.?

AEP is focused on projects that meet its strategy and are certain to produce earnings and cash flow. Financing viability is always a key issue. AEP has stayed away from developing its own plants, saying that fundamentals did not support it. Instead, it has chosen to wait until the market is ripe for a fruitful acquisition. Hence the UK buys.

In the US, AEP's service territory covers portions of Arkansas, Indiana, Kentucky, Louisiana, Michigan, Ohio, Oklahoma, Tennessee, Texas, Virginia and West Virginia. The electric utility subsidiaries of AEP have traditionally provided electric service, consisting of generation, transmission and distribution, on an integrated basis to their retail customers.

Project Finance talked with AEP's Armando Pena to discuss the company's focus, financing strategies and initiatives to enhance its credit quality.

Project Finance: What and where is American Electric Power's investment focus?

Armando Pena: We are foremost interested in the US energy market. We have a strong physical presence in the middle section of the country, and have a lot of assets throughout our 11 states. Those assets include more than 38,000MW of efficient power generation, using a diverse mix of fuels: coal, natural gas, nuclear, hydro and wind. We also have intrastate natural gas pipeline systems and gas storage in Louisiana and Texas, coal mining operations and the fourth-largest inland barge system in the US.

We are also now beginning to create a presence in Western Europe, and specifically the United Kingdom where we just acquired two coal-fired power plants, a total of 4,000MW or about 6% of the generating capacity in the UK. We recently hired a very experienced global coal trading and marketing staff in London from Enron and also hired some of the staff responsible for Enron's market-leading Nordic energy offices in Oslo and Stockholm. This gives our European trading and marketing organization a staff of approximately 135 people, including traders, marketers, analysts and back-office support.

In the US, we are involved in wholesale markets for coal, power and natural gas, as well as emissions allowances. We are also in the energy commodity transportation markets through pipeline, barge and rail interests. We are replicating our US model in Western Europe, where our primary focus is the UK, Germany and the Nordic region. These are all wholesale energy operations. But we also have almost five million retail customers in the US and an extensive transmission and distribution regulated business.

How do you reconcile having regulated and unregulated assets in your portfolio and how have the capital markets responded to this?

Our business is capital intensive. We are an integrated company that focuses on the wholesale side, which provides the higher growth some investors want. This is complemented by a robust regulated business that has predictable cash flows. Our capital allocation favors the wholesale side. The balanced business portfolio is attractive to investors, particularly now after the telecom, dot-com and Enron experiences. We try to educate financial institutions as to what this means. They think of wholesale as trading, and equating it with risks. Trading really comes at the end of it. I'm really saying that we are asset-based and involved with fuel procurement and generation, and then the delivery of power and gas. We trade around the assets to optimize value. We structure transactions that provide our wholesale customers with energy that meets their needs in a cost-effective manner.

Doesn't this investment philosophy require an innovative approach, or a fundamental restructuring of your company?

We are legally dividing our regulated and unregulated assets, hopefully beginning by mid-year. We will recapitalize about half our generation in the US ? about 18,000MW and place it in the unregulated portfolio. This means refinancing a large portion of our balance sheet, up to $4 billion. The regulated side will also consist of our wires business and the generation in states which have not introduced customer choice. But our generation assets in Ohio and Texas, which have restructured their electricity markets, will go into our unregulated portfolio. We will be looking for ways to creatively refinance these assets, but keeping in mind that it will be done in a transparent fashion for investors.

As the values of utilities that developed merchant power generation to supply electricity during peak demand periods rose to astronomical highs, were you not criticized by investors who thought AEP to be sitting on the sidelines?

We had been criticized severely by analysts and others who said we should be building new generation, because everyone else was. But we looked at the supply and demand and the price curves a few years down the road and concluded that it wasn't best for us to sink capital into new generation projects. The returns just weren't there. We've been proven right. Look at the Mirants and Calpines of the world now: They can't finance their projects. The demand for power has dropped and the fundamentals do not support such a build-out of generating capacity.

There simply was a myth about the estimation for demand. As a result, too much generation flooded the market. All of a sudden, the market's assessment of the value reflected in the forward price of a kilowatt hour came down. Investors then realized the return that builders would get on their capital invested would not be as high, or their earnings would not grow as much. If earnings aren't there, the stock price comes down. If the stock is less valuable, the currency that companies have to build these assets is not there. And on top of that, you introduce the Enron phenomenon, which has shaken a lot of investors who now understand how important the financial reporting really is. It is about cash and earnings. And if you don't have that, there is not value to follow. It's similar to the dot.com experience.

What power projects are you working on in Europe?

On 21 December 2001, we finalized a deal in which we acquired 4,000MW of coal-fired plant from Edison Mission Energy [a subsidiary of recently-troubled Edison International]. It's a deal valued at $960 million and will be immediately accretive to AEP's earnings by about $0.06 a share in 2002.

The two plants are Fiddler's Ferry, a four unit, 2,000MW station in north-west England and Ferrybridge, a four unit 2,000MW station located in north-east England. This purchase allows us to begin to replicate in Europe our North American wholesale energy strategy. We now have a link between our generation assets and our London-based energy trading and marketing organization. This is a good opportunity to add margin.

It is important to note that we bought these assets for about half of what Edison paid for them two years earlier. In other words, our patient, analytical, strategic investment approach paid off. We resisted the temptation to build facilities or to buy existing plants at a premium price. Instead, we saw the market heading down and chose to wait until the price was right.

How are the deals being financed?

We have funded those acquisitions with bank financing and are working with a group of financial institutions to implement the permanent financing arrangements. We have a bridge loan now.

Because the deal was closed in a relatively short time frame ? it started in October and concluded in December ? the easiest thing to do was to close with bank financing. The bridge financing is for 12 months and can be extended. But it is our intention that when the bank market is right, we'll replace the bridge financing with primarily non-recourse or limited-recourse project financing in the UK bank market. We expect this will be a syndicated loan underwritten by a number of banks.

Corporate bank financing is typically used until a project is nearing completion. In the case of our UK investments, this bank financing gives us plenty of time to organize project financing. We expect that to be executed this year. Of course, this is generally non-recourse debt that is tied to the success of the specific project. In other words, the project's cash flow needs to be sufficient to service the debt.

Isn't non-recourse debt, or debt financed off-balance sheet, difficult after the Enron mess because investors might be dubious?

Investors are certainly more focused on issues of borrowers' credit quality and the risks associated with financing structures.

Would lease financing be any easier or any more practical?

Sometimes, but not in this case. That's because the credit agencies impute it as debt, which might affect the credit rating. Still, if the balance sheet can absorb it and the company does not want to invest any capital in the project, it might be a good idea. The project is owned by a third party that leases it to a utility. The payments are then deductible as expenses if the lease is structured as an operating lease.

We have two such large lease deals: One is for scrubbing equipment at our Gavin Plant in Ohio, which was a $600 million project. And the second is a lease on a generating unit at our Rockport Plant in Indiana, originally a $1.7 billion transaction. These are operating leases whereby our rental payment is an operating expense. The credit agencies impute the debt. The reason we did it is because the transaction resulted in lower costs for customers subject to regulation. It would have been more difficult to recover the capital costs through rate increases if the projects were financed in a more traditional way.

What power projects are you working on in the US?

We are not building any for our own customers' requirements. We are building one for Dow Chemical at its chemical plant in Plaquemine, Louisiana, that is 900MW. We are not using our capital. We are building this because Dow needs the energy and we can structure the project to meet their needs in a cost-effective manner for them. We can sell the power that Dow does not use through our trading and marketing organization and lock in a margin for our own account.

We are also building a project for Buckeye Power in Ohio. For this one we have use of the capacity from the plant until Buckeye grows into it through their load growth. We are not using our own capital here either, but we are able to lock in margins from selling the output into the wholesale market.

We are also adding a couple of large wind farms, the 150MW Trent Mesa Wind Project near Abilene, Texas, and the 160MW Indian Mesa Wind Power Project near Iraan, Texas. The wind generation is a nice complement to our fossil-fired generation. This now makes us the second largest wind generator in the US.

How are the wind farms being financed?

We are using bank credit initially. Then it will be project financed.

What strategies are you implementing to improve your BBB+ senior debt rating from Standard & Poor's?

We have approximately $2 billion of leverage on balance sheet from two distribution companies that we acquired in the UK and Australia several years ago. They are good retail electricity companies, but they are low growth businesses that do not fit with our wholesale-focused growth strategy. At the moment, we have restrictions on significant divestitures because of the pooling accounting used in our merger with Central and South West Corp., but those restrictions end in June. It's likely we will make some strategic divestitures the second half of the year and use the money to pay down debt.

Our retained earnings are also growing at a faster pace because we have overcome a major outage at the Cook Nuclear Plant in Bridgman, Mich., that had depressed earnings. We are focused on keeping our operating expenses down and improving cash flow. Lastly, we will be issuing common equity and/or mandatory convertible securities that will bolster our equity account in the balance sheet and use the proceeds initially to pay down debt.

For AEP to have BBB rating, we need to have a debt-to-equity ratio of between 47% and 57%. But a more important measure is how much cash we are generating. To maintain a BBB, we need to cover our interest obligations between 2.7 and 4 times. If, for example, our annual interest expense is $100 million, then we need to generate $400 million in cash every year before interest and dividends to be at the high end of the BBB range. A company that operates solely in a regulated environment could get by with having more debt and one that operates purely in an unregulated environment would need more equity.

Could you describe your capital allocation process and how the company decides on whether an investment fits the overall strategy?

The project must first fit the company strategy. The project is reviewed by a project development team, business unit management, the treasurer and the risk management team. Then, if the investment warrants, it goes to the board for final approval. From a purely financial angle, we look at the cash and earnings that it contributes. Our internal rate of return (IRR) measures the cash return on cash invested. Then we look at the various risks associated with the project. The risks might include the construction permitting process, technology used, environmental situations, financing viability, and market for the project's output. These risks are quantified to determine the minimum cash return required as measured by the IRR. The approval process considers earnings accretion (particularly in early years), IRR, risks and risk mitigation plans.