European Infrastructure Finance Yearbook - Investing In Bonds ...

UTILITIES
28 ■ NOVEMBER 2007
pressure on market prices. However, new plants
can’t be built quickly, so it will take some time to
ease this capacity constraint.
Higher profitability from increased power prices
will underpin generators’ business profile
As seen in Western Europe, moving from
regulated cost-plus regimes to a deregulated spot
electricity market typically increases generators’
business risk and can often dilute credit quality.
Standard & Poor’s believes that the new path to
deregulation might support improved credit
quality in the sector through higher transparency
and price growth, while capacity payments and
hedging will smooth the impact of volatile
spot prices.
The deregulated market will translate rising gas
prices into higher electricity prices, reflecting the
costs of the least efficient (marginal) gas-fired
generators for all market players.
Generators using other fuels such as coal,
nuclear, hydropower would consequently reap
higher margins, as would more efficient
gas-fired producers.
We expect the higher profitability to mitigate
increased price volatility because stronger margins
will cushion the impact on cash flow. This will
somewhat offset price deregulation’s negative
impact on cash flow stability. Generation
companies’ profitability is currently low, with an
average 10% EBITDA margin for UES and a tiny
1%-2% for some thermal generators. Despite
most electricity being sold at regulated tariffs,
relatively small changes in price or fuel costs-together
with weak margins--result in substantial
cash flow fluctuation. That implies high
business risk.
Political risk remains key to power price
deregulation and growth
Political risk, however, overshadows the rosy
prospects for power generators in the new market
deregulation plan. Customers will bear substantial
price increases and could face soaring electricity
bills in the next three to four years, potentially
leading to a political backlash. In addition, most
of the market deregulation and corresponding
price increases are scheduled for 2009-2010. But
this comes after the 2008 presidential elections,
when Russia will have a new president who may
have different views on electricity price policy and
perhaps even on the sector’s overall strategy.
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK
Generators’ active hedging strategies could
provide further cash flow stability
After the wholesale market is fully deregulated,
each generator’s decision on how to balance
potentially profitable but volatile opportunities
from spot sales in order to lock in a more certain
level of profits will determine its spot-market
exposure. More forward electricity sales at a fixed
price that allows the generator to earn sufficient
profits to support its credit quality (assuming that
generation costs are also fixed) would imply a
lower business risk. Generators currently can
hedge price volatility through nonregulated
forward contracts at a fixed price. Power
exchanges plan to introduce other instruments,
such as power futures, to expand hedging
opportunities. Thus, a conservative hedging
strategy would limit the impact of changes in spot
prices on cash flow volatility in the coming one to
two years.
How capacity market contracts could help
The proposed capacity market, a system of
payments to generators that cover fixed costs, will
also mitigate the impact of spot price volatility on
cash flow stability.
Standard & Poor’s believes that recovering
fixed costs through the capacity market will
underpin generation companies’ credit quality.
Capacity payments, now accounting for about
one-half of wholesale generation revenues,
substantially reduce the operational ‘gearing’ (the
level of fixed operating costs that determines the
dependence of operating income variability on
sales variability) of generators. These payments
aren’t common in other European generation
markets. The still-to-be-determined capacity
pricing mechanism will heavily influence the level
of market-based capacity payments and
generators’ profitability and cash flow. The final
mechanism expected in 2007-2008 will reduce
this uncertainty.
Who will benefit from market deregulation?
The competitiveness and profitability of gencos in
the deregulated market depend heavily on their
marginal cost position. The main factor for
gencos is fuel costs and for hydro generators,
water tax charges.
Deregulation of the electricity market will result
in a gradual transition of the average electricity
price from regulated tariffs that reflect costs to a