# Black Thursday

## blackout

Many were without power for at least 14 hours and some had to endure up to 35 hours without electricity in what became the largest ever blackout in US history.

The power outage halted subways, airports, closed Michigan car plants, and shut down 100 power generating plants. Press estimates have set the cost to the economy anywhere between $6 billion and$10 billion, with New York alone estimating losses of over half a billion dollars in lost income and tax revenues.

A joint US-Canadian investigation is under way, headed by the US Secretary of Energy, Spencer Abraham, and the Canadian Minister of Natural Resources, Herb Dhaliwal. But at present the exact course of events remain shrouded in mystery and the joint investigation is not expected to release any findings for months.

In the immediate aftermath of the blackout there were, unsurprisingly, calls for someone to be held accountable. And more importantly for someone to be responsible for picking up the tab. On this matter there is some confusion: Fox-Pitt Kelton, an investment bank in New York, estimates that the cost to insurance companies could be $2 billion to$3 billion, whereas Standard & Poor’s does not view the impact on credit quality to be of much concern.

According to John Iten, an analyst at S&P: “If [the cause of the blackout turns out to be] an ‘Act of God’, then insurance companies could potentially be liable. But even then, the amount probably would not be enough to affect a rating or influence an outlook revision.” Iten adds: “If officials determine that the blackout was caused by a person’s mistake or a breakdown in equipment, insurance companies usually have no liability.”

Pointing fingers
As a result the electricity industry has lost no time in taking up the game of ‘find the culprit’. Five electricity organizations – American Electric Power, Consolidated Edison, FirstEnergy, National Grid Transco, and International Transmission – sent letters to Billy Tauzin, chairman of the House Energy and Commerce Committee, at the start of last month seeking to implicate one another to varying degrees.

After the bout of mud slinging, FirstEnergy, provider of electricity to 1.4 million customers in Ohio, appears to have emerged with most stuck to it. According to Dot Matthews, senior utilities analyst at CreditSights in New York, “FirstEnergy suffers from a perception and credibility problem. The company has a string of unfortunate events behind them, and people are all turning round and pointing at them. That may or may not be justified, we don’t know yet.”

In July, the company was at fault for an outage over the July 4 weekend and has had to shut down its nuclear plant, Davis-Besse, due to boric acid eating away at the lining of the reactor vessel head. And the company said in a statement that some of its lines failed before the July 4 blackout and that an alarm system did not signal a problem.

A lawsuit was also filed against the company on August 18 for damages caused by the recent blackout by a consortium of lawyers – the first so far.

The implications of these incidents, combined with the re-audit of FirstEnergy’s financial information and the filing of its 10-Q, became so serious that Standard & Poor’s put FirstEnergy (Baa2/BBB-) on “CreditWatch with negative implications” because of the “additional stress that management faces as it copes with even more negative publicity”. Moody’s had taken a similar action just before the blackout hit.

The company is burdened with $15 billion in debt, although it did alleviate some financial pressure by raising$975 million in equity last month. Nevertheless, S&P decided to keep its rating action in place until more clarity emerges over FirstEnergy’s role in the August blackout and the potential impact from regulators.

“Litigation could drag on for a number of years before the cloud gets lifted,” says CreditSights’ Matthews. “If FirstEnergy is exonerated by the findings of the joint US-Canadian commission, it would be hard to go through with the lawsuits. But no matter what happens, the company still has that credibility problem.”

Responsibility for the blackout hasn’t been officially pinned on FirstEnergy. But it is the company with the most to lose with regards to its credit quality. “We believe that it will be very difficult to prove that FirstEnergy or any other utility company is guilty of gross negligence with intent to cause this blackout,” says Faith Klaus, utilities analyst at Banc of America Securities. “So it will be very difficult to successfully hold the company financially liable for the blackout in the long run.”

She adds: “However, that does not mean that parties will not bring numerous and costly lawsuits against FirstEnergy resulting in a huge distraction for the company and continued overhang.”

Despite all the headline risk associated with the blackout, Barclays Capital’s utilities analyst Robert Petrosino believes that the utility industry will not bear any significant financial burdens in the form of lawsuits due to certain safety mechanisms. “Utilities typically have language in their licenses that limit their liability for loss of service, unless gross negligence is proved,” he says.

Infrastructure
While the short-term costs for the operators of America’s electricity network may be nominal, the long-term costs will not be. The blackout highlighted the parlous state that the US electricity grid has reached and there will now be huge political pressure to improve it; Energy Secretary Bill Richardson has remarked, possibly too harshly, that America has a Third World grid. And according to the Electric Power Research Institute, the cost of rebuilding the network could be between $50 billion and$100 billion.

The reason the network has reached such a state of under-investment is that the companies have been given few incentives to invest. As utilities incurred a greater potential for return on their investment in other parts of their business, transmission became a less attractive proposition for them.

This means “as more generation supply has been added to the system to keep up with growing demand, the investment in the transmission and distribution segment of the industry has not kept pace,” says Jim Asselstine, Lehman’s utilities analyst. “This has created strains on the reliability of the system,” he adds.

What’s more, piecemeal deregulation has new transmission challenges; now the system is expected to be able to handle power being shunted from where power prices are lowest to where they are highest in an attempt to enhance the efficiency. “The system is doing things it was not designed to accomplish, and this is without making the necessary investment to accommodate those differing loads and demands,” says Asselstine.

The neglect of the transmission system can be put into perspective by comparing the amount spent on the grid versus the amount of debt raised by the transmission companies in the bond markets. According to the Edison Electric Institute, a trade association for US shareholder-owned electric companies based in Washington, DC, $2.4 billion was spent on transmission in 1995, just 14% of the$17 billion the energy sector raised in the bond markets. This percentage dropped to a meager 4%: $3.7 billion out of the$88 billion energy funding from bonds in 2001.

Furthermore, BoA’s Klaus says: “The difficulty in siting transmission lines due to the not-in-my-backyard mentality and the fact there is no real centralized regulatory force with control over the transmission grid are the two main reasons for lack of investment.”

Peter Rigby, utilities analyst at S&P, believes that addressing the problems of the nation’s grid and the regulation of the entire US electricity industry is no simple matter. He warns investors that political and regulatory credit risk could linger. “Credit risk could actually intensify if the politically charged debate over reform continues for years, as it might very well do. And the regulatory treatment of the costs needed to upgrade the infrastructure remains uncertain,” he says.

Moody’s sees the primary credit driver for the industry arising out of the financial implications of improving network reliability. The rating agency also highlights credit quality pressures in the long term coming from potential changes in public policy and increases in capital expenditure programs and debt financing.

Under existing cost recovery arrangements, utilities would be eventually compensated for any transmission enhancements mandated by state or federal authorities, says ABN Amro’s utilities analyst Peggy Jones. While regulated entities will be expected to obtain a return on their investment through rates, Moody’s warns that higher debt levels could reduce financial flexibility for some utilities, be they government-owned or investor-owned firms.

“If capital expenditure doubles, it could put pressure on credit quality, but this would be dependent on how any upgrade is financed. If this is done entirely with debt, then we would certainly see some pressures,” says BarCap’s Petrosino.

Credit quality is a current issue for many utilities. Leverage continues to hover in the high 50% to low 60% level for most investor-owned acquisitions and many operating utilities are continuing to find it hard to make any money. Terran Miller, utilities analyst at UBS, says that one of the likely results of this debate is that more money will be spent on transmission.

“The important issue is which entities are going to be coordinating those spending efforts and financing the resultant capital requirements,” he says. “Also, if this becomes an issue of national importance, will the federal government participate in the process from an expenditure standpoint or even at the coordination level?”

Beneficiaries
The asset-backed securities market could be set to profit from the blackout, as industry participants look to ways to pay for upgrading the nation’s electrical grid. And with estimates of the cost of upgrading the transmission infrastructure stretching to $100 billion, funding this through securitization could grow the market by$30 billion, say analysts.

The sector has used ABS transactions before, to finance restructuring or transition costs as the market has moved from a regulated to unregulated business. “Previous ABS deals have been successful and provided an excellent source of funding for utilities,” says Lehman Brothers’ Asselstine.

The structure of transmission financings will be similar to stranded cost securitization. Stranded costs refer to the portion of the costs of a utility which is not recoverable from consumers due to the transition from a regulated to a competitive environment. The option of securitization of such stranded costs recovery has been used by several US state utilities, as it allows the utility to borrow at lower rates.

Volumes of such products have grown to \$27 billion from the market’s inception in 1997. And a similar pattern is expected to emerge with transmission-related ABS. According to Asselstine: “The underpinning of those transactions has been regulatory or statutory approvals for recovery of any costs over a predictable course of time, by passing those debt service costs on to rate payers.”

Companies could use the right to recover as a legal basis for selling these bonds, which would probably be triple-A rated, to investors. So consumers will end up footing the bill for an upgrade through rates. Whether they are higher or not will depend on the cost of capital to initially fund the upgrade, if this is either through equity, straight corporate debt or securitized debt, says Joseph Fichera, CEO of financial advisory firm Saber Partners. As companies look to carve out a portion of those rates and securitize them to fund the modernization of the system, this could actually lower pressure on rates.

“This avenue will drive down the cost of capital for utilities dramatically,” says Fichera, “but securitization is done under state laws and state rate orders. Laws are already in place for stranded costs, but they will have to be amended on a state-by-state basis for this type of financing and this could be a long process.”

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