Talking Shop
New Jersey is great place to locate a power company. The PJM power
region is widely acknowledged to be the best functioning and most
liquid power pool in the United States, and over the Hudson River
lies New York City, a power-hungry and supply-constrained
metropolis where Orion Power and Dynegy, amongst others, have been
able to make a killing. PSEG, New Jersey's principal utility, has
survived the rigours of deregulation more or less intact and is
still on speaking terms with the state's utilities' board.
But earnings growth now has to come from the unregulated side, and PSEG needs to unlock the value of its generating assets without upsetting the delicate regulatory compromise agreed over the last two years. PSEG was not asked to sell off any of its generating assets, largely because outside generators had been operating in the region for some time, simply to transfer them to an unregulated subsidiary in 1999.
PSEG's Global operations were also separated from its domestic assets, with the latter forming PSEG Power. Some US assets, particularly some developments in California and the Texas Independent Energy (TIE) plants, Odessa and Guadelupe were retained by Global. The TIE deals, arranged by ING Barings over 1999-2000, totalled $640 million and were early greenfield merchant templates. Future US development will now come through the Power division.
Nevertheless, Global continues to enjoy success in Poland, India, Latin America and Oman. The $270 million Elcho deal in Poland, of which PSEG was 93% sponsor, won Project Finance's European Independent Power deal of the year. And it has expanded its control of the Chilean electricity market with the takeover of distributor Saesa, as well as a recent $320 million non-recourse bond issue led by JP Morgan Chase and Salomon Smith Barney for Chilquinta, which it controls along with Sempra.
Nevertheless, it is the US market where PSEG is gearing up for expansion, and the developer clearly shares the ambitions of Calpine, Mirant, Duke, NRG and others to grab as large a slice of the available action as possible. It recently mandated the CSFB project finance team to put together an $850 million deal to finance the construction of its MidWest assets, one of a number of high-profile scoops this year for CSFB. This deal is expected in the market at some point over the next quarter.
The other trend of the moment has been a market increase in the issuance of corporate genco bonds, ones free of restrictive covenants on indebtedness and distributions. NRG Energy and Edison Mission Energy have both issued senior notes recently, and Mirant Americas Generating and PG&E's National Energy Group both priced issues in May. One of the earliest ones, along with other issues from Ameren Energy and Allegheny Energy Supply, was the April 9, 2001 issue from PSEG Power.
This $1.8 billion deal, lead managed by Morgan Stanley Dean Witter (which also acted as financial advisor) was one of the largest genco financings to date, at a moment this year when merchant power was not perceived as the most stable of credits. As a source close to the transaction says, ?the day before we were set to price the issue, Pacific Gas & Electric filed for bankruptcy, but we only postponed for one day. It's a testament to PSEG that we were successful in that sort of environment?.
The notes received ratings of Baa1/BBB/BBB+ (Moody's/ S&P/Fitch) and came in three tranches. A $500 million tranche of five-year notes came with a coupon of 6.875%, an $800 million tranche of ten-year notes carried a 7.75% coupon and a final series of 2031 notes came in with an 8.625% coupon. The spreads over treasuries, at 252-312bp, were comfortably within existing merchant paper spreads. The issue took orders of $6 billion and was 3.3x oversubscribed, attracting $500 million from European institutions alone, although this sum was scaled back on a pro rata basis.
There were two significant aspects to the deal ? the sizeable nuclear component of the assets portfolio and the unprecedented merchant risk to which PSEG power is exposed. The first issue was dealt with by ensuring that decommissioning funds were topped up to adequate levels, and that further additions are passed on to ratepayers, although liability still rests at the Power level. Still, if vice-president Cheney's wish for nuclear to take up more of the load is to be fulfilled then PSEG should find itself well positioned to exploit any expansion plans.
Merchant risk, however, remains an integral part of the credit. Power's PPA with PSE&G extends only for another year, after which the utility will be free to shop elsewhere. However, the assets are 36% baseload, 36% load following and 28% peaking, and, at least in terms of capacity, diversified in terms of fuel ? although nuclear and coal account for a disproportionate share of revenues because of their load profile. Equivalent transactions, such as Allegheny or Ameren, had five- to eight-year PPAs.
The transaction was tranched to create a strong yield curve and stagger the maturities along the life of the Power assets. It was also necessary to have at least $500 million in each class to create the necessary liquidity for a secondary market. That has already happened since the PSEG Power bonds, along with NRG's recent issue, now act as the benchmarks for US generation paper. Co-managers on the deal were Salomon Smith Barney, JP Morgan Chase, First Union, UBS Warburg and Bank One. Several of the names that appear there are believed to be corporate lenders to PSEG and have been partially paid off as a result of the deal.
Nevertheless, PSEG, despite its attractive position in the PJM market, will have to struggle with a few issues as deregulated markets form. The first of these is how the stock market will view PSEG's nuanced and careful approach, and whether it will come under pressure to realise surging earnings growth. The next is whether it ends up at the top of banks' business priorities ? the handful of credits that can expect a following whatever they demand. The final one, perversely, is whether a reasonably competitive market emerges so that in New Jersey, unlike in California, deregulation does not become a dirty word.
Tom Nelthorpe spoke to Robert Busch, president and COO of PSEG Energy Services Corporation, and architect of PSEG's restructuring, about the recent developments at PSEG and how he views the changes in the US power market.
Project Finance: Was the rationale for hiving off your US generation assets strategic, or forced by the regulators in New Jersey?
Busch: It was both part of the energy master plan and a strategic imperative for the firm. In New Jersey we accomplished a very delicate balance between the demands of the larger customers, who had argued for years that they needed access to power markets at a retail level in a competitive non-regulated way, and at the same time the needs of small business and residential customers.
We created a set of compromises around three basic features of deregulation. The first ? a shopping credit, giving people the ability to choose suppliers. You could take your power from PSE&G at a known set of prices or go to a third party supplier.
Second, we provided in that shopping credit, over a multi-year period, a string of discounts totalling 15 percent. This gave automatic benefits to the little guys, those that wouldn't necessarily be able gain the benefits of going to the free market early. It takes time for aggregators to come into being and for a market to develop, so if you were a residential customer, you saw the benefit of deregulation by simply doing nothing ? your prices went down.
Third, to achieve those reductions, we could not, as some companies had, sell all our generation to third parties. So, we transferred the generation into a new unregulated subsidiary, which allowed us to have the capacity to supply, in assured ways, the basic shopping credit, or what we call the basic generation service. That avoided pitfalls like California's, where prices went out of control, because we understood what the prices to supply were as long as we had our own generation.
Compared to other regions of the United States, New Jersey got it right. A tremendous amount of credit goes to some of my predecessors at this company, and the professionals at the BPU in New Jersey, headed up by president Herb Tate, who did a masterful job of bringing lots of people together to create the compromises necessary to enact and implement this.
On the generation side, two big trends have been apparent. One of them is to put all of the global generation business into one company, and the other one, part of the dictates of the stock market, is to try to unlock part of that value and partially spin it off. You haven't announced plans to do either.
We believe that it's too soon in the evolution of the deregulated power business to make such substantial structural decisions about where a company that has the broad range of assets that we enjoy, should go. We think that it's very valuable for our shareholders to own a very large, integrated gas and electric distribution company, with reasonable regulation in the state of New Jersey, and a track record of delivering reasonable returns. Rate-regulated distribution companies cannot be expected to have the kind of returns that rapidly growing unregulated power companies have. On the other hand they can be expected to contribute relatively stable returns to a larger business.
The question of the hour almost always is, why don't you spin off the generation, or some ask why don't you spin off the utility? Our answer is that we think we've got a nice portfolio of assets that we provide our investors. They have synergies, and we think that for now, that's the best ? long-term ? for our shareholders. It may not be in the future, but we don't have a crystal ball and we like the idea of preserving our options for the future.
And the second part of the wisdom, your split between global and domestic generation. Have you found that there's a marked difference in the disciplines that you need to develop plants in the US as opposed to elsewhere?
Absolutely. The longer we do business on both the domestic and international basis, the more convinced we are that these are different businesses. Yes, they have some skill-sets that are common, an understanding of the way power is distributed and sold, but the international overlay creates some very different imperatives. Working in lesser developed countries and working in very high growth markets is a different business proposition. You need to have partnering skills and a worldwide infrastructure. And therefore I think it's a good choice to have our global operation separate from our domestic operation.
Do you feel that the financial engineering that you have to do in the US is that much more sophisticated, given the suite of tax and accounting efficient and genco structures that have emerged? Do you tend to find that your plant financing options are different?
In some respects we're on the opposite side of that spectrum. We believe that the long-term value proposition for our generation company is best served by having a solid corporate-financed entity. That's the lowest cost of capital that provides us with the manoeuvring room that we think will be necessary in an industry that's still changing very rapidly. That does not mean that we don't continuously evaluate leading-edge financial techniques ? from synthetic leasing approaches to credit-enhanced individual project finance. And, on occasion, I think you'll see us take advantage of that for particular reasons. But our long-term strategy is to have a solid, investment corporate credit, in the triple-B range. It provides the effective credit support that we need for expanding trading operations and gives us an advantage in cost of capital and flexibility.
You recently issued $1.6 billion in senior notes...
It was increased to $1.8 billion after we had very substantial investor demand. We were able to upsize the transaction as a consequence. We had planned to do some retail preferred ? which we may still do, depending on our growth requirements. But the pricing was quite attractive, so we upsized to $1.8 billion.
Were you looking at any particular models or templates for that financing? There have been a few structured corporate deals that have gone through recently, often with leasing bolted on. Did you have to go out and find a new set of covenants or organisational structure?
It was a little of both. We started from scratch, together with Morgan Stanley. We started out saying ?we're going to have a brand new unregulated, multi-billion dollar power company. What's the best way to financially structure this business?? We looked at lots of very complicated approaches, but came back to the concept that this was intended to be one of the first generation corporations, not a project financed portfolio. In the project finance alternatives, the interlocking covenants that take place in more highly leveraged, more isolated types of project finance, didn't give us the flexibility we thought we need to manoeuvre as a very large generation company in the future.
Your trading division will be a far more integral part of your activities. How has this been going and what sort of risk profile are you looking at for the entity?
Our trading operation is pretty much in the top 15 in the United States. We are going to continue to expand that. However, our strategy is quite clear: we trade around our assets. We are not pure speculators, so if you looked at our book of business you would find that there's always a physical hedge, whether in specific terms or more conceptually, behind the trades that we do. We always have the ability, in general, to take physical delivery of gas and use it ourselves; we have the ability to store gas, to sell gas, to turn it into electricity. We have the ability to supply electricity in very large quantities ? we have close to 12000MW of existing operating generation. So we use that to leverage our trading capability and enhance the generation value. We don't think of our trading operation as a standalone, Wall Street, speculative commodities operation.
A lot of developers and financiers have been making noises about wanting to have a stronger trading counter-party, possibly even in the A range. Are you concerned with maintaining a high rating for your trading arm or do you think it will stay at the same level as PSEG Power?
Trading is a subsidiary of PSEG Power. Power's ratings were BBB+, Baa1 from Moody's and BBB from S&P. So we're pushing Triple-B plus overall for the company. I think we'll definitely maintain at least a sold triple-B. I doubt that we would go higher than that ? we've looked at the value and don't see the economic benefit.
Triple-B gives trading plenty of credit support, and the counterparty requirements are modest as a consequence ? we don't have to post any credit enhanced transactions.
One of the things that raised eyebrows was the solid nuclear component of the business. Other companies have decided to keep that portfolio separate at the corporate level, because of decommissioning costs and so on. Was there any thought on your part of keeping them separate?
We wanted to keep the nuclear assets as a strategic component of the business. The nuclear assets provide very substantial cashflows. If you look at the industry, people are operating at the mid-to-high 80's in capacity factors. These are wonderful assets to own and the industry has really matured. We met dozens of investors both in Europe and the US and nuclear was one of the very minor issues that we tended to deal with. People recognised the overall improved environment for nuclear.
Would you expect in the long-term a change in the fuel mix that you have in PSEG Power? Will combined-cycle gas stations assume a greater role?
Expect a balanced approach to fuels. I don't think you're going to see us employ a strategy of, for example, like Calpine's, where they have one very specific style of plant, running natural gas. We're always going to want to have, to the extent we can, a balanced portfolio of fuels. We're pretty evenly distributed and you'll see us stay that way. Highly efficient combined-cycle natural gas plants in certain markets make sense. But I don't think a company our size can use only one strategy.
If you look at your geographical diversity, you have a natural concentration on the PJM region and some new capacity in the Midwest. Are these regions the focus of your development activities?
We view our market as what we call the super-region, which is basically PJM plus other pools, including NEPOOL, ECAR, VACAR. That region constitutes close to one-third of the load in the US. We think that for right now that's more than big enough for us to operate in. And it's part and parcel of why you have not seen this company running off to California. PSEG Global is working on some developing projects in California because they're on some existing sites that PSEG Global was a financial participant in. But we would not be able to trade around those assets. Individual assets in California would not give us the trading basis that we're looking for.
It may not be as exciting, but we are going to expand into areas in this super region. We have also got permits to build in the New York ISO, and that's a goods example of where we've got real opportunities. Without going into detail, we're clearly looking at New York City as a very attractive potential market.
Do you find working in New York frustrating? Things appear to move slightly more slowly there.
We haven't viewed New York as a place to install power plants. We view New York as a place to provide and sell power to.
You've said that your ultimate strategy is for a corporate financed generation company. But we understand you're looking at a mini-perm portfolio deal for the Midwest plants. Is that how you imagine all of your development activity will be financed?
At the time it was an attractive way to finance the construction phase of the plants in the Midwest. We are in the process of closing on a construction-financing vehicle with a syndicate of banks and we'll roll that into the portfolio when those plants go into service. I do not expect we would take advantage of the bank financing when the plants are in commercial operation.
Will that be the last time you'll look at a deal like that?
No. We'll continue to look at lots of alternatives. But our fundamental approach to financing the growth and development of this business is going to be corporate debt, with plain vanilla covenants.
How receptive have the bank market to your plans? There have been a number of generation companies out there with very big facilities. Are you confident that you'll be a good enough credit to stand out?
Absolutely. The company that we've just underwritten gives the banks tremendous comfort, because of its fuel diversity, because of its plant type diversity ? in other words we have almost an even mix of baseload, intermediate and peaking capacity. Those are all the things that a credit analysis looks at, and I think they derive a lot of comfort from that. Obviously a non-recourse financed project stands on it's own base, but anyone in this business that's even doing a non-recourse financed project is going to recognise that you want very healthy parent relationships for the equity, and we clearly provide that. At the end of the day the banks want to be taken out and to the extent that they look towards the corporation as a healthy, viable solid credit I think that makes them more comfortable on the non-recourse nature of the debt that they're issuing.
Are there any particular banks that you go back to again and again, or do you tend to maintain a fairly broad group of institutions that you hand out arranging roles to?
There is no set group. We've been very pleased with our relationship on project finance with CSFB, but we have major relationships with Chase and Citi, and we work with a pretty substantial number of the major money centre banks in the US. We like to think that we're good buyers and that we're quite careful about making sure that we arrange these kinds of transactions very economically for our shareholders.
In terms of your international activities, have you found yourselves concentrating more on the developed end of the scale? Or will you still go to places where there is a developing electricity market?
We're concentrating on three regions in particular ? India, South America and generally the European area. We have a project being built in Poland right now. We want to do business in areas where we can develop strong partners and understand the risks. It doesn't necessarily mean that the risks have to be tiny. People would argue that the risks in California are greater than a lot of developing countries.
As the international power development sector sorts itself out, you've seen companies like ours go through three phases. In the early days, US utilities trying to get their feet wet in other countries used developers very specifically to go out into new countries and try and build a power plant. Many of those were not very successful, for a variety of reasons, not the least of which was that developers took pretty substantial fees, and a lot of the power markets weren't particularly ready to have unregulated generation facilities inserted into them.
The people who stuck with it tended to form partnerships with larger organisations to spread the risk of being in these countries ? currency, political and economic risk. We did it as well, forming partnerships with AES, Sithe and others.
Our company, along with a few others, is now in the final phase. We now develop plants where we have controlling interests ? that didn't used to be a requirement. When we develop plants now we want operational responsibility ? that didn't used to be a requirement. We look at the surrounding infrastructure to see whether or not we can combine investments in distribution with generation so there are synergistic effects of being in the overall energy business. That's what people who have stayed in it and managed to stay out of real trouble have developed into ? and that takes infrastructure. If you look at this company on the Global side, we now have a substantial accounting operation that can deal with international issues. We have a substantial financial organisation that knows how to deal with all of the currency issues. We have an IT organisation that's typically able to communicate worldwide, and management that are quite confident in their ability to move around the world, not just go to some new country and see whether or not you build a power plant.
What's the status of your alliance in Latin America with AES? Has that become looser, and do you think you'll still be doing things as joint ventures?
We would like to be the principal owner and operator of individual investments. But that does not mean that we will not have partners with minority interests in projects, and certainly I can see us on occasion working with AES.
What are your thoughts on the emerging tax and accounting efficient structures ? turbine warehouses and so on. Do you tend to find that the fees and manpower are worth the time?
They can be used in very specific cases. But you have to very careful that you don't spend a great deal of money on fees only to find that you need a transition to some other approach in the future ? and those fees have made that short period of time very uneconomic, compared to other alternatives.
Although another part of the company, PSEG Resources, that does a significant amount of lease transactions for other entities, in the form of leveraged and cross border leases.
My own inclination is that sophistication is expensive and it should only be used when there's a very particular need. Often people get caught up in the allure of off balance-sheet types of transactions, to their economic detriment. My conclusion from discussions with the major rating agencies is that ?off balance-sheet? is becoming a transparent approach. The ratings agencies are very able to look at the ?off-balance sheet? obligations that are created. The credit that people are accruing by going off balance-sheet with sophisticated accounting structures is not what it used to be.
You haven't ever felt the urge to provide a little boost to your earnings under GAAP?
There may come a time when we'll desire some earnings enhancement, but it's always at an economic cost. You pay for that enhancement by taking some of the long-run economic value inherent in that underlying investment and using it to bias earning towards the front end. If you have a sufficient need then it's worth it, and you've made your decision about how your shareholders view that. But its important to take the long view about these things.
Over all of these moves hangs the California situation. What steps have you had to take when dealing with regulators and roadshowing to investors to address specific issues from the California crisis?
We did a fair amount of educating. PJM is probably the best functioning control area ISO in the US. There's no reason to believe we're going to have the problems that existed in California. We often kidded people on the Power roadshow that we were going to wear T-shirts that said ?we are not California?. Investors generally, particularly institutional investors are more than sophisticated enough to understand those differences, and they voted with their feet. We were over three times oversubscribed on that financing. It's clear to me that they were able to discriminate the issues. On the securitization side, the fact that the California securitization bonds are holding their Triple-A is an indication that the structures work and investors relied on those structures for that credit and they are highly secure entities.
But earnings growth now has to come from the unregulated side, and PSEG needs to unlock the value of its generating assets without upsetting the delicate regulatory compromise agreed over the last two years. PSEG was not asked to sell off any of its generating assets, largely because outside generators had been operating in the region for some time, simply to transfer them to an unregulated subsidiary in 1999.
PSEG's Global operations were also separated from its domestic assets, with the latter forming PSEG Power. Some US assets, particularly some developments in California and the Texas Independent Energy (TIE) plants, Odessa and Guadelupe were retained by Global. The TIE deals, arranged by ING Barings over 1999-2000, totalled $640 million and were early greenfield merchant templates. Future US development will now come through the Power division.
Nevertheless, Global continues to enjoy success in Poland, India, Latin America and Oman. The $270 million Elcho deal in Poland, of which PSEG was 93% sponsor, won Project Finance's European Independent Power deal of the year. And it has expanded its control of the Chilean electricity market with the takeover of distributor Saesa, as well as a recent $320 million non-recourse bond issue led by JP Morgan Chase and Salomon Smith Barney for Chilquinta, which it controls along with Sempra.
Nevertheless, it is the US market where PSEG is gearing up for expansion, and the developer clearly shares the ambitions of Calpine, Mirant, Duke, NRG and others to grab as large a slice of the available action as possible. It recently mandated the CSFB project finance team to put together an $850 million deal to finance the construction of its MidWest assets, one of a number of high-profile scoops this year for CSFB. This deal is expected in the market at some point over the next quarter.
The other trend of the moment has been a market increase in the issuance of corporate genco bonds, ones free of restrictive covenants on indebtedness and distributions. NRG Energy and Edison Mission Energy have both issued senior notes recently, and Mirant Americas Generating and PG&E's National Energy Group both priced issues in May. One of the earliest ones, along with other issues from Ameren Energy and Allegheny Energy Supply, was the April 9, 2001 issue from PSEG Power.
This $1.8 billion deal, lead managed by Morgan Stanley Dean Witter (which also acted as financial advisor) was one of the largest genco financings to date, at a moment this year when merchant power was not perceived as the most stable of credits. As a source close to the transaction says, ?the day before we were set to price the issue, Pacific Gas & Electric filed for bankruptcy, but we only postponed for one day. It's a testament to PSEG that we were successful in that sort of environment?.
The notes received ratings of Baa1/BBB/BBB+ (Moody's/ S&P/Fitch) and came in three tranches. A $500 million tranche of five-year notes came with a coupon of 6.875%, an $800 million tranche of ten-year notes carried a 7.75% coupon and a final series of 2031 notes came in with an 8.625% coupon. The spreads over treasuries, at 252-312bp, were comfortably within existing merchant paper spreads. The issue took orders of $6 billion and was 3.3x oversubscribed, attracting $500 million from European institutions alone, although this sum was scaled back on a pro rata basis.
There were two significant aspects to the deal ? the sizeable nuclear component of the assets portfolio and the unprecedented merchant risk to which PSEG power is exposed. The first issue was dealt with by ensuring that decommissioning funds were topped up to adequate levels, and that further additions are passed on to ratepayers, although liability still rests at the Power level. Still, if vice-president Cheney's wish for nuclear to take up more of the load is to be fulfilled then PSEG should find itself well positioned to exploit any expansion plans.
Merchant risk, however, remains an integral part of the credit. Power's PPA with PSE&G extends only for another year, after which the utility will be free to shop elsewhere. However, the assets are 36% baseload, 36% load following and 28% peaking, and, at least in terms of capacity, diversified in terms of fuel ? although nuclear and coal account for a disproportionate share of revenues because of their load profile. Equivalent transactions, such as Allegheny or Ameren, had five- to eight-year PPAs.
The transaction was tranched to create a strong yield curve and stagger the maturities along the life of the Power assets. It was also necessary to have at least $500 million in each class to create the necessary liquidity for a secondary market. That has already happened since the PSEG Power bonds, along with NRG's recent issue, now act as the benchmarks for US generation paper. Co-managers on the deal were Salomon Smith Barney, JP Morgan Chase, First Union, UBS Warburg and Bank One. Several of the names that appear there are believed to be corporate lenders to PSEG and have been partially paid off as a result of the deal.
Nevertheless, PSEG, despite its attractive position in the PJM market, will have to struggle with a few issues as deregulated markets form. The first of these is how the stock market will view PSEG's nuanced and careful approach, and whether it will come under pressure to realise surging earnings growth. The next is whether it ends up at the top of banks' business priorities ? the handful of credits that can expect a following whatever they demand. The final one, perversely, is whether a reasonably competitive market emerges so that in New Jersey, unlike in California, deregulation does not become a dirty word.
Tom Nelthorpe spoke to Robert Busch, president and COO of PSEG Energy Services Corporation, and architect of PSEG's restructuring, about the recent developments at PSEG and how he views the changes in the US power market.
Project Finance: Was the rationale for hiving off your US generation assets strategic, or forced by the regulators in New Jersey?
Busch: It was both part of the energy master plan and a strategic imperative for the firm. In New Jersey we accomplished a very delicate balance between the demands of the larger customers, who had argued for years that they needed access to power markets at a retail level in a competitive non-regulated way, and at the same time the needs of small business and residential customers.
We created a set of compromises around three basic features of deregulation. The first ? a shopping credit, giving people the ability to choose suppliers. You could take your power from PSE&G at a known set of prices or go to a third party supplier.
Second, we provided in that shopping credit, over a multi-year period, a string of discounts totalling 15 percent. This gave automatic benefits to the little guys, those that wouldn't necessarily be able gain the benefits of going to the free market early. It takes time for aggregators to come into being and for a market to develop, so if you were a residential customer, you saw the benefit of deregulation by simply doing nothing ? your prices went down.
Third, to achieve those reductions, we could not, as some companies had, sell all our generation to third parties. So, we transferred the generation into a new unregulated subsidiary, which allowed us to have the capacity to supply, in assured ways, the basic shopping credit, or what we call the basic generation service. That avoided pitfalls like California's, where prices went out of control, because we understood what the prices to supply were as long as we had our own generation.
Compared to other regions of the United States, New Jersey got it right. A tremendous amount of credit goes to some of my predecessors at this company, and the professionals at the BPU in New Jersey, headed up by president Herb Tate, who did a masterful job of bringing lots of people together to create the compromises necessary to enact and implement this.
On the generation side, two big trends have been apparent. One of them is to put all of the global generation business into one company, and the other one, part of the dictates of the stock market, is to try to unlock part of that value and partially spin it off. You haven't announced plans to do either.
We believe that it's too soon in the evolution of the deregulated power business to make such substantial structural decisions about where a company that has the broad range of assets that we enjoy, should go. We think that it's very valuable for our shareholders to own a very large, integrated gas and electric distribution company, with reasonable regulation in the state of New Jersey, and a track record of delivering reasonable returns. Rate-regulated distribution companies cannot be expected to have the kind of returns that rapidly growing unregulated power companies have. On the other hand they can be expected to contribute relatively stable returns to a larger business.
The question of the hour almost always is, why don't you spin off the generation, or some ask why don't you spin off the utility? Our answer is that we think we've got a nice portfolio of assets that we provide our investors. They have synergies, and we think that for now, that's the best ? long-term ? for our shareholders. It may not be in the future, but we don't have a crystal ball and we like the idea of preserving our options for the future.
And the second part of the wisdom, your split between global and domestic generation. Have you found that there's a marked difference in the disciplines that you need to develop plants in the US as opposed to elsewhere?
Absolutely. The longer we do business on both the domestic and international basis, the more convinced we are that these are different businesses. Yes, they have some skill-sets that are common, an understanding of the way power is distributed and sold, but the international overlay creates some very different imperatives. Working in lesser developed countries and working in very high growth markets is a different business proposition. You need to have partnering skills and a worldwide infrastructure. And therefore I think it's a good choice to have our global operation separate from our domestic operation.
Do you feel that the financial engineering that you have to do in the US is that much more sophisticated, given the suite of tax and accounting efficient and genco structures that have emerged? Do you tend to find that your plant financing options are different?
In some respects we're on the opposite side of that spectrum. We believe that the long-term value proposition for our generation company is best served by having a solid corporate-financed entity. That's the lowest cost of capital that provides us with the manoeuvring room that we think will be necessary in an industry that's still changing very rapidly. That does not mean that we don't continuously evaluate leading-edge financial techniques ? from synthetic leasing approaches to credit-enhanced individual project finance. And, on occasion, I think you'll see us take advantage of that for particular reasons. But our long-term strategy is to have a solid, investment corporate credit, in the triple-B range. It provides the effective credit support that we need for expanding trading operations and gives us an advantage in cost of capital and flexibility.
You recently issued $1.6 billion in senior notes...
It was increased to $1.8 billion after we had very substantial investor demand. We were able to upsize the transaction as a consequence. We had planned to do some retail preferred ? which we may still do, depending on our growth requirements. But the pricing was quite attractive, so we upsized to $1.8 billion.
Were you looking at any particular models or templates for that financing? There have been a few structured corporate deals that have gone through recently, often with leasing bolted on. Did you have to go out and find a new set of covenants or organisational structure?
It was a little of both. We started from scratch, together with Morgan Stanley. We started out saying ?we're going to have a brand new unregulated, multi-billion dollar power company. What's the best way to financially structure this business?? We looked at lots of very complicated approaches, but came back to the concept that this was intended to be one of the first generation corporations, not a project financed portfolio. In the project finance alternatives, the interlocking covenants that take place in more highly leveraged, more isolated types of project finance, didn't give us the flexibility we thought we need to manoeuvre as a very large generation company in the future.
Your trading division will be a far more integral part of your activities. How has this been going and what sort of risk profile are you looking at for the entity?
Our trading operation is pretty much in the top 15 in the United States. We are going to continue to expand that. However, our strategy is quite clear: we trade around our assets. We are not pure speculators, so if you looked at our book of business you would find that there's always a physical hedge, whether in specific terms or more conceptually, behind the trades that we do. We always have the ability, in general, to take physical delivery of gas and use it ourselves; we have the ability to store gas, to sell gas, to turn it into electricity. We have the ability to supply electricity in very large quantities ? we have close to 12000MW of existing operating generation. So we use that to leverage our trading capability and enhance the generation value. We don't think of our trading operation as a standalone, Wall Street, speculative commodities operation.
A lot of developers and financiers have been making noises about wanting to have a stronger trading counter-party, possibly even in the A range. Are you concerned with maintaining a high rating for your trading arm or do you think it will stay at the same level as PSEG Power?
Trading is a subsidiary of PSEG Power. Power's ratings were BBB+, Baa1 from Moody's and BBB from S&P. So we're pushing Triple-B plus overall for the company. I think we'll definitely maintain at least a sold triple-B. I doubt that we would go higher than that ? we've looked at the value and don't see the economic benefit.
Triple-B gives trading plenty of credit support, and the counterparty requirements are modest as a consequence ? we don't have to post any credit enhanced transactions.
One of the things that raised eyebrows was the solid nuclear component of the business. Other companies have decided to keep that portfolio separate at the corporate level, because of decommissioning costs and so on. Was there any thought on your part of keeping them separate?
We wanted to keep the nuclear assets as a strategic component of the business. The nuclear assets provide very substantial cashflows. If you look at the industry, people are operating at the mid-to-high 80's in capacity factors. These are wonderful assets to own and the industry has really matured. We met dozens of investors both in Europe and the US and nuclear was one of the very minor issues that we tended to deal with. People recognised the overall improved environment for nuclear.
Would you expect in the long-term a change in the fuel mix that you have in PSEG Power? Will combined-cycle gas stations assume a greater role?
Expect a balanced approach to fuels. I don't think you're going to see us employ a strategy of, for example, like Calpine's, where they have one very specific style of plant, running natural gas. We're always going to want to have, to the extent we can, a balanced portfolio of fuels. We're pretty evenly distributed and you'll see us stay that way. Highly efficient combined-cycle natural gas plants in certain markets make sense. But I don't think a company our size can use only one strategy.
If you look at your geographical diversity, you have a natural concentration on the PJM region and some new capacity in the Midwest. Are these regions the focus of your development activities?
We view our market as what we call the super-region, which is basically PJM plus other pools, including NEPOOL, ECAR, VACAR. That region constitutes close to one-third of the load in the US. We think that for right now that's more than big enough for us to operate in. And it's part and parcel of why you have not seen this company running off to California. PSEG Global is working on some developing projects in California because they're on some existing sites that PSEG Global was a financial participant in. But we would not be able to trade around those assets. Individual assets in California would not give us the trading basis that we're looking for.
It may not be as exciting, but we are going to expand into areas in this super region. We have also got permits to build in the New York ISO, and that's a goods example of where we've got real opportunities. Without going into detail, we're clearly looking at New York City as a very attractive potential market.
Do you find working in New York frustrating? Things appear to move slightly more slowly there.
We haven't viewed New York as a place to install power plants. We view New York as a place to provide and sell power to.
You've said that your ultimate strategy is for a corporate financed generation company. But we understand you're looking at a mini-perm portfolio deal for the Midwest plants. Is that how you imagine all of your development activity will be financed?
At the time it was an attractive way to finance the construction phase of the plants in the Midwest. We are in the process of closing on a construction-financing vehicle with a syndicate of banks and we'll roll that into the portfolio when those plants go into service. I do not expect we would take advantage of the bank financing when the plants are in commercial operation.
Will that be the last time you'll look at a deal like that?
No. We'll continue to look at lots of alternatives. But our fundamental approach to financing the growth and development of this business is going to be corporate debt, with plain vanilla covenants.
How receptive have the bank market to your plans? There have been a number of generation companies out there with very big facilities. Are you confident that you'll be a good enough credit to stand out?
Absolutely. The company that we've just underwritten gives the banks tremendous comfort, because of its fuel diversity, because of its plant type diversity ? in other words we have almost an even mix of baseload, intermediate and peaking capacity. Those are all the things that a credit analysis looks at, and I think they derive a lot of comfort from that. Obviously a non-recourse financed project stands on it's own base, but anyone in this business that's even doing a non-recourse financed project is going to recognise that you want very healthy parent relationships for the equity, and we clearly provide that. At the end of the day the banks want to be taken out and to the extent that they look towards the corporation as a healthy, viable solid credit I think that makes them more comfortable on the non-recourse nature of the debt that they're issuing.
Are there any particular banks that you go back to again and again, or do you tend to maintain a fairly broad group of institutions that you hand out arranging roles to?
There is no set group. We've been very pleased with our relationship on project finance with CSFB, but we have major relationships with Chase and Citi, and we work with a pretty substantial number of the major money centre banks in the US. We like to think that we're good buyers and that we're quite careful about making sure that we arrange these kinds of transactions very economically for our shareholders.
In terms of your international activities, have you found yourselves concentrating more on the developed end of the scale? Or will you still go to places where there is a developing electricity market?
We're concentrating on three regions in particular ? India, South America and generally the European area. We have a project being built in Poland right now. We want to do business in areas where we can develop strong partners and understand the risks. It doesn't necessarily mean that the risks have to be tiny. People would argue that the risks in California are greater than a lot of developing countries.
As the international power development sector sorts itself out, you've seen companies like ours go through three phases. In the early days, US utilities trying to get their feet wet in other countries used developers very specifically to go out into new countries and try and build a power plant. Many of those were not very successful, for a variety of reasons, not the least of which was that developers took pretty substantial fees, and a lot of the power markets weren't particularly ready to have unregulated generation facilities inserted into them.
The people who stuck with it tended to form partnerships with larger organisations to spread the risk of being in these countries ? currency, political and economic risk. We did it as well, forming partnerships with AES, Sithe and others.
Our company, along with a few others, is now in the final phase. We now develop plants where we have controlling interests ? that didn't used to be a requirement. When we develop plants now we want operational responsibility ? that didn't used to be a requirement. We look at the surrounding infrastructure to see whether or not we can combine investments in distribution with generation so there are synergistic effects of being in the overall energy business. That's what people who have stayed in it and managed to stay out of real trouble have developed into ? and that takes infrastructure. If you look at this company on the Global side, we now have a substantial accounting operation that can deal with international issues. We have a substantial financial organisation that knows how to deal with all of the currency issues. We have an IT organisation that's typically able to communicate worldwide, and management that are quite confident in their ability to move around the world, not just go to some new country and see whether or not you build a power plant.
What's the status of your alliance in Latin America with AES? Has that become looser, and do you think you'll still be doing things as joint ventures?
We would like to be the principal owner and operator of individual investments. But that does not mean that we will not have partners with minority interests in projects, and certainly I can see us on occasion working with AES.
What are your thoughts on the emerging tax and accounting efficient structures ? turbine warehouses and so on. Do you tend to find that the fees and manpower are worth the time?
They can be used in very specific cases. But you have to very careful that you don't spend a great deal of money on fees only to find that you need a transition to some other approach in the future ? and those fees have made that short period of time very uneconomic, compared to other alternatives.
Although another part of the company, PSEG Resources, that does a significant amount of lease transactions for other entities, in the form of leveraged and cross border leases.
My own inclination is that sophistication is expensive and it should only be used when there's a very particular need. Often people get caught up in the allure of off balance-sheet types of transactions, to their economic detriment. My conclusion from discussions with the major rating agencies is that ?off balance-sheet? is becoming a transparent approach. The ratings agencies are very able to look at the ?off-balance sheet? obligations that are created. The credit that people are accruing by going off balance-sheet with sophisticated accounting structures is not what it used to be.
You haven't ever felt the urge to provide a little boost to your earnings under GAAP?
There may come a time when we'll desire some earnings enhancement, but it's always at an economic cost. You pay for that enhancement by taking some of the long-run economic value inherent in that underlying investment and using it to bias earning towards the front end. If you have a sufficient need then it's worth it, and you've made your decision about how your shareholders view that. But its important to take the long view about these things.
Over all of these moves hangs the California situation. What steps have you had to take when dealing with regulators and roadshowing to investors to address specific issues from the California crisis?
We did a fair amount of educating. PJM is probably the best functioning control area ISO in the US. There's no reason to believe we're going to have the problems that existed in California. We often kidded people on the Power roadshow that we were going to wear T-shirts that said ?we are not California?. Investors generally, particularly institutional investors are more than sophisticated enough to understand those differences, and they voted with their feet. We were over three times oversubscribed on that financing. It's clear to me that they were able to discriminate the issues. On the securitization side, the fact that the California securitization bonds are holding their Triple-A is an indication that the structures work and investors relied on those structures for that credit and they are highly secure entities.
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