Susan Abbott is malzagincp director

in the Energy Communications and

Speculatizw Grade Group at Moody’s lnzjestors Seraice, iuaHaging a group

ofatlalysts zol~ofollozu electric and

water utilities globally. She joined

Moody’s in ]me of 1982 as a senior arlalyst and has held several different

positions thcrc. She received arl M.B.A.from the Unioersity of

Corznecticut.

This article dramfrom a “Special

Commellt” published February 28, 1997 by Moody’s Investors Service.

Stranded Cost Securitization: Analytical Considerations

Securitization is a promising financing approach by which utilities may YecoveY their stranded costs while lowering their cost of capital, permitting them to ofleT rate reductions to customers. However, there are important issues to analyze before determining that securitization will be an attractive option for bondholders.

Susan Abbott

T o facilitate the transition to a

competitive electric market,

numerous state legislatures have

passed or are considering legisla-

tion that, while mandating compe-

tition, allows utilities to recover

their stranded costs through the

imposition of a competitive transi-

tion fee. To accommodate securiti-

zation of revenues from the fees,

statutes typically designate as a

property right the future revenues

from these fees and the utility

may sell, assign, or transfer the

rights to a financing vehicle. Secu-

rities may be issued by a trust or

other special purpose vehicle sup-

ported by future revenues from

these fees.

Only three stranded cost trans-

actions have been completed to

date. They include:

Puget Power Conservation Gran- tor Trust 1995, rated Aa2, which was a $202.25 million securitiza- tion of a tariff designed to recoup Puget Power’s expenditures relat- ing to its energy conservation program;

The Nuclear Moratorium Asset Securitization Fund, rated Aaa based on a guarantee from the Spanish government, securitized a 3.45 percent fee assessed utility customers in Spain to finance the costs of closing three nuclear power plants; and

Orchid Securities, a $355 million securitization of fees used to de-

14 T/le Electricity ]owrlal

fray costs from the closure of Ital- ian nuclear power plants in 1996.

This asset class has received con- siderable attention, however, due to recent passage of stranded cost legislation in California, Pennsyl- vania, Rhode Island, Montana and proposed legislation in New York. In light of the recent legisla- tive developments, Moody’s ex- pects total stranded cost securiti- zation volume of $50 billion to $75 billion over the next four years, out of the $132 million esti- mated total stranded investments

(see Table 1). Because of the unique charac-

teristics of the highly regulated

utility industry and the “asset” that is securitized, the credit analy- sis of stranded cost securities dif- fers from that of most other as- sets. For example, underwriting and servicing issues, which are

key items of interest in other seg- ments of the ABS market, are less of a concern in a stranded cost context.

I nstead, credit analysis of stranded cost securitization

focuses on the legislation that created the fees and on the de- gree of certainty of future fee generation. l Legislative Issues: An under-

standing of the legislation that cre- ated the fees is vital in assessing the credit risk of stranded cost se- curitizations. Salient legal con- cerns include the property right

characteristics of the fee revenue stream; the transfer and assign-

ability of these rights; security in- terest issues; and provisions for a true-up mechanism. Importantly the laws typically state that the

sale of the fee revenue by a utility to a financing entity will be

treated as a true sale rather than a pledge or other means of financ- ing. l Political Risk: Because inves-

tors rely on fees authorized by a legislative act, investors should fo- cus on provisions for rescinding or altering the legislation/rate or- der that authorizes the tariff. The

irrevocability of the statute is a key consideration because sub- stantial economic downturns for a

region may lead to efforts to alter the law/rate order to the detri-

ment of the securitization. The po- litical environment must also be examined because the likelihood of attempts to repeal, alter, or chal- lenge the statute are enhanced if electric utility costs are a conten- tious political issue. This issue has received heightened attention as a

result of actions taken in Pennsyl-

_

Table 1: Stranded Investments by Utility Rating, 1996

vania and statements made in New York and elsewhere by oppo- nents of the securitization of

stranded assets. l Future Fee Generation:

Stranded cost securitizations in- volve an analysis of many ele- ments found in securitizations of future receivables because the se- curities are supported by revenue from fees not assessed or billed to

the obligors at the date of the secu- ritization closing. The ability to

amortize the securities depends on future fee generation, which is primarily a function of future

population in the area serviced by the utility and energy consump-

tion. Factors that influence these items, such as the economic

health of the region, the stability and diversification of the cus- tomer base, and the elasticity of demand for energy are important to understand.

Utilitv Stranded Investment

Rating Category Amount ($ Million) Percentage of Total .~_~_______.___.~~_ _~

Aal

Aa

Aa

Al

A2

A3

Baa1

Baa2

Baa3

Bal

Ba2

Ba3

N/R

Total Surce: Momifs In\e.tors Senwe

33.30 0.03

612.18 0.46

6,568.56 4.97

4,416.85 3.35

32,818.35 24.86

12,115.44 9.18

14,088.35 10.67

24J45.18 18.43

12,963.99 9.82

9,733.19 7.37

6,648.Ol 5.04

6,478.26 4.91

1,195.71 0.91

132,017.37 100.0

October 1997 2.5

B ecause the viability of the utility is not essential to the

assessment and collection of the fee, 0 st~0&eli cost sec~~itiz&~~ ca~l nchieve n credit rating substantially

higher than the rating of the debt of

the utility. The securitization stat- utes enacted to date mandate that

the competitive transition fees are

“non-bypassable,” meaning that they must be paid by all custom-

ers regardless of the utility com- pany used as supplier of electric-

ity In addition, the fees are required to be collected by the en-

ergy distributor or any successor servicing the customer. These fea- tures differentiate stranded cost structures from other future re- ceivables transactions.

I. Evaluating the Risks of Securities Backed by Transition Fees

Because of the unique charac- teristics of the highly regulated utility industry and the “asset” that is securitized, the credit analy- sis of stranded cost securities dif- fers from that of commodity as- sets such as credit cards and auto loans. Key credit concems revolve

around the legislation that created the

fees and the prospects foY collecting

ji&ire merules from tl7e fees.

A. Legal and Structural

Considerations

In a stranded cost securitization the asset is the irrevocable prop- erty right to collect cash flow from a tariff or fee on utility customers imposed by a utility with the ap- proval of appropriate regulatory authorities. Legislation typically allows the utility to sell, assign, or

transfer the property right to a fi- nancing vehicle. Furthermore, leg- islation sets forth specific require- ments that, if satisfied, will accomplish a “true sale.”

T hese requirements elimi- nate a source of legal un-

certainty encountered in many

asset-backed transactions. A sig- nificant legal issue in securitiza- tions is whether the assets sup-

porting securities have actually

Inves tars should deter- mine lf the legislation designates as a prop-

erty right the right to the cashflowf;iom the transition charge fees.

been sold by the seller. If not, the assets will be part of the bank- ruptcy estate of the originator and anypaymentswithrespectto them could be delayed due to the automatic stay provision of the Bankruptcy Code. To avoid this risk, many transactions are struc-

tured as a true sale. The fact that strandedcostlegislationspecifies the requirements for a true sale simplifies the usual review of the facts and circumstances of the transaction required in other asset sales.

However, there are certain legal risks particular to stranded cost securitizations, primarily relating

to the authorizing statute and how the rate order is accom- plished. A primary concern for holders of these securities is altera- tions in the legislation/rate order that authorized the stranded cost fee revenue. Items of concern in- clude the following:

l Regulatory Process: Typically, a utility applies to a regulatory agency for permission to issue se- curities backed by fee revenue to recover costs that it believes are stranded. The application usually contains detailed information on (1) the utility’s stranded costs, (2) the utility’s proposal for the sale of the fees and the issuance of se- curities, (3) the benefits to con- sumers and (4) its planned use of the proceeds. Within a specified time after the application, the util- ity commission issues a final rate order for all or a portion of the amount of stranded costs the util- ity may recover that, in the com- mission’s opinion, are just, reason- able, and in the public interest. The rate order may require that the proceeds from the sale of the securities be used to reduce debt and equity associated with the utility’s stranded costs. l Definition of fees as a prop-

erty right: Investors should deter- mine if the legislation designates as a property right the right to the

cash flow from the fees. This is an important factor because if legisla- tion defines the fees as a property right, the cash flow from the fees can be sold by the utility to a spe- cial purpose vehicle for the pur- poses of a securitization. Provi- sions for security interests in the property can also be developed.

l Assignment and true sale is-

sues: Legislation typically pro- vides that revenues from the fees

may be sold. Furthermore, the laws typically state that the sale of the transition property by a utility to a financing entity will be treated as a true sale rather than a pledge or other means of financ- ing. Such statutory language sim- plifies the legal analysis regarding the ownership of the asset, an is- sue which requires substantial le- gal analysis in other securitiza-

tions. l Bankruptcy remoteness of is-

suer: Evaluating the bankruptcy remoteness of the issuer is a con-

sideration in all asset backed secu- ritization transactions. In a

stranded asset context, it is impor- tant that the cash flows intended for the securitization bonds be protected from a potential bank- ruptcy of the utility. Within a legal structure such as a bankruptcy re- mote trust, cash flows from the transition charge that services the securitization will not become en- tangled in the bankruptcy estate of the utility If a state agency is the issuer of securities, the exist- ing debt of the agency, restrictions on future debt issuance, and the linkage to the state must be ana- lyzed.

0 Provisions for a true-up

mechanism: Most statutes call for a true-up mechanism, in which the fee levied on customers is ad- justed at regular intervals based on the projected amortization of the securities. The true-up mecha- nism is an important considera- tion in assessing the certainty of payments to investors and can be

thought of as a correction mecha- nism if cash flow from the assets

does not meet expectations. Un- derstanding the correction mecha- nism is crucial to analyzing the credit risk of stranded cost securi- tizations. l Indenture issues: The utility’s

indenture is examined to deter-

mine whether revenue from the fees could be considered the prop- erty of first mortgage bond hold- ers. The underlying noncompeti-

Most securitization statutes call for a true- up mechanism, in which the fee levied on cus tamers is adjusted at regular intervals.

tive assets, excluding purchased power contracts with inde- pendent power producers, most likely have been pledged to se- cure the issuance of first mortgage bonds, the traditional utility fi- nancing method. It is uncertain whether the securitization fee

revenue stream would be subject to the first mortgage bond inden-

ture lien, since many were written in the 1920s and 30s when stranded asset securitization was

not contemplated. l Transaction structure: Struc-

tural issues for securities backed by other assets, such as auto loans

and credit cards, are common to stranded cost securitizations. Im-

portant considerations include credit support such as overcollat- eralization available to investors to absorb losses, and structural considerations about how cash flows are allocated.

Credit support for previous stranded cost transactions has been low compared to credit sup- port for other asset types. The

low support is due to the pro- jected stability of fee revenue and the presence of a true-up mechanism which would adjust fees to retire outstanding securi- ties.

Securities may be issued from a grantor trust, owner trust, or

other special purpose vehicle. Grantor trusts are pass-through

entities which can support single or senior/subordinated class structures. Each holder of a cer- tificate is treated as an owner of

the underlying assets. Thus, prin- cipal and interest allocations in the collateral are proportional to the respective interests of each class. In an owner trust or other special purpose vehicle, “fast- pay” or turbo structures are per- mitted, in which the allocation

of principal from the entire pool is paid to designated tranche(s) until paid in full. Future

stranded cost structures are an- ticipated to have multiple classes issued from an owner trust structure or other special purpose vehicle, which allows more creativity in distributing cash flows to various tranches which may be needed to meet in- vestors’ needs.

October 1997 17

B. Irrevocability: A Regulatory

and Political Issue

Because investors rely on fees authorized by a legislative act, in- vestors should focus on provi-

sions for rescinding or altering the legislation or rate order that

authorizes the tariff. The likeli-

hood of attempts to repeal, alter, or challenge the statute are en- hanced if electric utility costs are a political issue and constituents view the various legislative and rate orders of the non-bypassable fee as a bailout. Even if the legisla- tion and/or rate order is irrevoca- ble, investors must consider the

history of the legislation and /or rate order, the type of support it receives from the various parties involved in the rate making proc-

ess, and the type of opposition it faces, if any. This analysis sheds

light on the likelihood that the leg- islation and/or rate order could subsequently be undermined. If the bill has broad political and consumer advocate support and there are perceived economic benefits to rate payers, the prob- ability that the bill can withstand challenges is enhanced.

Th e size of the surcharge rela-

tive to a customer’s overall bill is a consideration. Low fees are

not likely to be noticed by consum- ers. If cash flow necessary to pay off the securities does not material- ize, the resulting increase in the fees due to the true-up mechanism would likely not be noticed by con-

sumers. On the other hand, a high tariff would leave little room for fu- ture increases and such increases could lead to political action.

C. Evaluating Future Fee

Generation and Collections

Future receivables are receiv- ables that do not exist today but which may exist in the future. Fu-

ture receivables securities, which have become popular recently, particularly in emerging markets,

can achieve a rating higher than the rating of the debt of the origi- nator of the future receivables if

certain conditions are met-e.g., if the product or service that gener- ates the receivables is essential and not easily replaced, and if the business or industry in which the receivables are generated is consis- tent and stable over sustained pe- riods of time. Furthermore, the re- ceivables would continue to be generated if the originating entity becomes subject to a bankruptcy proceeding due to the importance of the product or service. These

conditions are easily met in the electric utility industry.

Because electricity is an essen- tial service, and even utilities in

stressed financial situations have

continued to produce energy con- sistently, securities backed by stranded costs can achieve a high level of credit quality, even sub- stantially higher than the rating of the originating utility.

II. Considerations in Projecting Future Fee Revenue

If the tariff is a fixed charge

per customer, as in the Puget Power transaction, the cash flow supporting a stranded cost securitization is primarily determined by the future num- ber of customers in a utility area. Other cash flow consid- erations include the utility’s collections ability and the rela- tive mix of residential, commer-

cial, and industrial customers. The latter consideration is im- portant . . because large com- mercial and industrial custom- ers typically consume more energy and therefore cover a larger percentage of the util- ity’s fixed generating costs. Key variables in the credit

analysis of stranded cost securi- tizations are the projected

population and possibly en- ergy consumption. Factors that influence these items and the resulting cash flow (and vari- ability) supporting stranded cost securities include: l Economic health of the re-

gion: A key component in the ,

analysis of the credit quality of stranded cost transactions is the

18

economic health of the region.

Economic climate influences

population and aggregate spend-

ing. For broad customer areas, projecting economic activity is es-

sentially a macroeconomic en- deavor. Systemic factors such as the region’s aggregate economic

growth, employment, tax climate, and political considerations are key variables. l Stability and diversification

of customer base: Also consid- ered is the residential/commer- cial/industrial mix. A utility juris- diction with a large residential

base relative to the commercial base will likely experience lower volatility in energy consumption. The residential base will also be more diversified with no obligor concentration. In contrast, energy consumption by a few major com- panies comprises a significant per- centage of revenue for some utili- ties.

l Technological advances: His- torical data can identify trends in energy consumption and can be used to project energy utilization. l Elasticity of demand: Con-

sumer reactions to a substantial in- crease in the tariff from the true- up mechanism must be understood. The elasticity of de- mand for energy measures the sensitivity of energy consumption relative to a change in price. Elas-

ticity of demand varies by type of customer, with residential custom- ers the least responsive to price changes. l Evaluation of utility’s histori-

cal projections: Because the tariff is based on predictions of cus- tomer base and possibly electric-

October 1997

ity usage, the forecasting ability of

the utility must be evaluated.

l Underwriting/Servicing: The

underwriting and servicing stand- ards of the servicer are key consid- erations in many transactions backed by consumer obligations

such as subprime auto and credit card receivables transactions. However, these items are less of a concern for stranded cost transac-

tions, because: (1) very little un- derwriting activity exists as utili- ties must provide service to all prospective customers, (2) the pro- cedures for handling of delin-

quent accounts are determined by utility commissions, and (3) few remedies exist for utilities in the case of customer nonpayment of obligations. Although reposses- sion of delinquent vehicles is com- mon for subprime auto lenders, turning off a customer’s electric-

ity is generally not a utility’s first

alternative due to possible politi-

cal repercussions.

III. Conclusion

The securitization of stranded as-

sets should help enable utilities to compete more effectively. Securiti-

zations must be carefully conceived in order to meet the various tests re- quired to achieve a rating substan- tially higher than the utility’s rat- ing, or else the economic benefits to

the utility will be diminished. In ad- dition, how the utility uses the pro-

ceeds from the securitization could impact the remaining utility bond- holders, impacting the level of risk they must endure.

0 ne of the greatest risks for utilities regarding

stranded asset securitizations is a political one: the longer custom- ers see a transition charge on their

bills, the more likely they are to become dissatisfied with the no-

tion of continuing to pay for un- competitive utility assets. And the larger the charge, the more likely the customer will be to agitate for additional change. While it is diffi- cult to overturn legislation, it is not impossible. Therefore, utilities with smaller transition charges over a shorter period of time will face less risk than those with larger transition charges that re-

main for a longer period of time. Despite the risks outlined above,

securitization of stranded assets is an imaginative and useful tool that, combined with other financial and business strategies, will enable many utilities to compete effec- tively in a deregulated electric util- ity industry. n

19