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<td width="75%" valign="top"><strong><big><big><big><font face="Arial">ESCU ANALYSIS: AN
APPROACH TO ENERGY SERVICE FINANCE</font></big></big></big><strong><p ALIGN="JUSTIFY"></strong><font face="Arial" color="#000000">by Roger D. Feldman, P.C., Partner<br>
<em>Head, Energy Project Finance Group</em><br>
McDermott, Will & Emery, Washington, DC</font><br>
<font face="Arial" size="2">(<em>originally published by PMA OnLine Magazine: 04/98</em>)</font><strong></p>
</strong></strong><p align="left"> </p>
<p align="left"><font color="#000000"><strong>Introduction</strong></font><br>
<br>
Power market wares will be one choice available to future energy consumers. Financial
techniques and factors will influence their choice to an increasing extent. The question I
am here to address is: how can they be taken into account? It is a key question whether
you are a buyer or a seller of power marketing.</p>
<p>Deregulation has unleashed on the partially liberated consumer community a series of
providers of energy alternatives. "Power marketing" presently is the perceived
leader; followed by energy service companies; and consultants on cost reduction. A
definite role still also exists for developers of inside-the-fence facilities with excess
usage marketing capability. Companies in these businesses have always known about their
overlaps, and now are beginning to form new strategic alliances to better compete for end
user business.</p>
<p>For end users, this has created a new generation of timing of service purchase and
financial structuring analysis questions. Those questions traditionally faced were of
course:</p>
<p>� make or buy<br>
� operate or outsource<br>
� own separately or joint venture</p>
<p>The essence of the new generation of questions is: if it is determined to buy,
outsource or joint venture, does financing make one or another option or combination of
new economic alternative options more attractive?</p>
<p>To answer the question, it is useful to</p>
<p>(1) Identify the characteristics of the energy options from a financing perspective.<br>
(2) Consider the available financing structuring alternatives for them; and <br>
(3) Develop a methodology for the comparison of these different energy alternatives.</p>
<p>Power marketers should anticipate this development in their strategies and their
proposals to customers.</p>
<hr>
<p align="left"><font color="#000000"><strong>1. Characteristics of Energy Services from a
Financing Standpoint</strong></font></p>
<p align="left">From a finance point of view, it is useful to classify alternative
services in terms of</p>
<p>(a) intensity of asset use, <br>
(b) regulatory requirements and<br>
(c) type of contractual support.</p>
<p>Asset intensity provides one basis for secured financing. "Power marketing",
has, of course, come to embrace a variety of activities: alternative supply at attractive
prices; development of future risk management products to soften the impact of
deregulation; development of multi-fuel alternate purchasing programs; and arrangements
for outlets for customer-based excess generation or undesired supply. Its roots are in the
fuel supply and energy trading business. Power marketing is not traditionally viewed as
asset intensive, although it presents financing possibilities. Power marketing has also
become a tool in the kit of many utility services companies.</p>
<p>The retail energy services company (RESCO) model has its genesis not in the trading
environment, but in the energy management/equipment supplier/conservation environment.
Inevitably it has had to branch into tele-communications and information related
activities such as AMR and interactive communication, capital improvements, facility
management and what has variously been called "chauffage" and "bundled
energy services". It has more of a traditional asset value base.</p>
<p>Third, within the new context of these developments, new interest has been generated in
the development of self service facilities, by traditional IPP developers (now frequently
aligned with power marketers); and by firms or consortia engaged in provision of multiple
alternative energy supplies to facilities, or using such capacity for firming purposes.
Its asset backing is even higher.</p>
<p>By a final sharp contrast are institutional arrangements to provide energy savings for
industrial companies. Overlapping with the other two activities, it focuses on cost
reduction as a result of aggregation of customers and through cooperative arrangements
with utilities and possibly even power marketers. Firms not necessarily equipped to engage
in their own provision of supply options may be effective intermediaries in either of
these regards. The asset base for financing purposes is minimal.</p>
<hr>
<p align="left"><font color="#000000"><strong>(b) Impact of Regulation on Energy Services</strong></font></p>
<p align="left">From a financing standpoint the energy alternatives also are distinguished
by the impact on them of regulation changes. The shift in regulation over the past several
years has begun to favor energy marketing activities over conventional demand side
management, imposed by state regulatory commissions on utilities. However, even with the
promulgation of FERC Order No. 888 , significant barriers to realization of optimal
savings from power and energy marketers still remain. The most important, as you well
know, include the following:</p>
<p>� Retail wheeling is still confined to several particular states. The meaning of
FERC's extension of its jurisdiction to "retail interstate commerce" remains to
be established. More states are committing themselves to the retail wheeling objective,
but frequently are tying it to the disaggregation of existing utility companies, which is
resulting in delays in its implementation reflecting stranded cost recovery policy.</p>
<p>� The impact of consumer backlash on retail wheeling and the assignment by state
commissions of non-bypassable stranded investment charges has yet to be experienced.</p>
<p>� Order No. 888's stranded investment formulation of imposition of utility lost
revenues costs on withdrawing firms seems likely to be a deterrent to modification of
existing contracts and conversions to power marketer transactions</p>
<p>� Order No. 888's narrowing of the options of customer conversion from retail to
wholesale status (sometimes known as municipalization) should impede the development of
power marketing in this direction. Utility opponents of municipalization have had some
local successes, although more arrangements for wheeling through existing wholesale
purchasers have gone through</p>
<p>� The prospects for utility disaggregation have increased, but the likelihood is that
it will take place over a period of time, linked to recapture of stranded costs.
Disaggregated utilities should broaden the potential market to realize end use
opportunities, but also will have the consequence of increasing competition for end user
customers.</p>
<p>These regulatory developments must be considered along with asset intensity in
evaluating financeability of energy service options.<br>
The most clear cut implication of the current regulatory status quo is that while power
marketing arrangements already can be structured today, it is not prudent for its
customers to rely on retail wheeling (unless arrangements are made for the necessary
retail distribution, and the payment of related charges). Contracts which promise future
retail wheeling are, in effect, valuable acquisition options, and are beginning to be seen
as such.</p>
<p>� Particularly because a second implication is that over time, it is likely there will
be opportunities for better power sales deals and increased shared savings from energy
arrangement than currently are available.</p>
<p>� By contrast with power marketing, for RESCOs, more regulatory shifts may be
required. Many power marketing supporters as well as the proponents of the retail energy
services company model feel that further regulatory reform is necessary to achieve broad
market acceptance of their product. Among the additional criteria which RESCO supporters
have suggested are necessary are the following:</p>
<p>� Development of an independently managed, open bidding process to select providers of
optional bundled retail energy services packages for customers which are not interested in
choosing energy services suppliers for themselves.</p>
<p>� Use of a similar process for any acquisition of increased energy efficiency
measures, renewable energy sources or emission reductions.</p>
<p>� Allowance of bilateral electricity trading of energy among end user customers, with
reporting only of physical transactions to the system operator.</p>
<p>� Collection of distribution access fees from all users to fund bidding programs for
acquisition of increased energy efficiency measures, renewable energy sources and emission
reduction and low-income programs.</p>
<p>From a financing perspective this shift in focus to the requirements end users - as
opposed to intermediaries between them and sources of supply and conservation - means that
more radical regulatory reform may be required to put transactions in place.</p>
<hr>
<p align="left"><font color="#000000"><strong>(c) Contract Security</strong></font></p>
<p align="left">Alternative energy alternatives also can be by the amount of contract
security for financing which they provide:</p>
<p>� Power marketing generally offers short term purchase contract arrangements, perhaps
linked to operating contract arrangements as well (although there have been some longer
term arrangements entered into and that certainly could be a trend.) The power contracts
can represent a type of financing security - a recognition only now being developed.</p>
<p>� RESCO activity is based upon contract obligations, but frequently looks to savings
generated from operations as the source of financing security. Satisfactory performance
warranties may thus be a critical element of the overall financing package. In the new
market-based energy environment, it may be that price protective arrangements are
necessary as well to support financing.</p>
<p>� IPP projects historically provided such firm contracts, accompanied by strong
performance warranties but now may require price market support as well. They bring
apparent strong asset protection, although the asset value of such protection in a
competitive market may be diminished.</p>
<p>� Institutionally structured arrangements may result in a potential stream of savings,
but its value as collateral for a financing may have to be backed by the credit of the
energy recipient.</p>
<p>To date, from a financing standpoint, most of what we have seen are variations on the
traditional IPP theme and on the traditional shared-savings theme. It is important to
recognize that the former has principally - though not always - been backed by utility -
not industrial - offtake arrangements. The latter has usually been confined to the
financing of discrete capital improvement packages, where equipment supplier support for
shared savings achievement through performance - not provision of industrial credit - has
been the primary arrangement.</p>
<p>Asset backing, regulatory vulnerability, contract backing - in the new energy choice
market environment, the challenge is to mesh, for these financing security characteristics
of the energy service in question - with (2) the types of financing transactions which are
available for energy service deals.</p>
<hr>
<p align="left"><font color="#000000"><strong>2. Financing Alternatives: Commonalities</strong></font></p>
<p align="left">Essentially financial transactions fall into one of the following types:
direct operating leases; capital leases and vendor financing programs; securitization;
project finance. Each type has some suitability to the industrial alternative energy
acquisition alternatives. Superficially these alternatives sound very different:</p>
<p>� a direct lease entails payment for equipment usage not ownership, in a manner with
direct income statement impact;</p>
<p>� a capital lease essentially is asset acquisition through the pledge as security to
an industrial project lender of purchase price plus financed cost "lease"
payments over time; <br>
� securitization involves equipment supplier financing for funds advanced (probably using
a trust mechanism) in consideration for the pledge of one or more revenue streams arising
from industrials' purchase contracts as collateral </p>
<p>� project finance entails third party energy or conservation supplier borrowing
typically through a single special purpose entity from a capital source secured by project
assets and the contracts on which revenue stream payment will be made (whether power
purchase or realization of net savings)</p>
<hr>
<p align="left"><font size="3" color="#000000"><strong>Similarities Between Transactions</strong></font></p>
<p align="left">They sound so different. It is useful to focus on the fundamental
similarities among these arrangements, which are qualified more by accounting than
inherent economic differences:<br>
� In each case, the end user customer - not an intervening utility purchaser or
distributor - is the underlying credit</p>
<p>� In each instance, there is also a credit risk associated with the supplier's
performance -- whether it is (as it has been traditionally) performance by the power
purchaser; proper calculation and acquisition at specified prices from suppliers; actual
realization of savings, as a result of both efficient equipment operation and
actualization of projected power prices, as specified in agreements; realization of
revenues from sales of energy or energy management services</p>
<p>� Consequently, in each case there is a risk allocation between project development
sponsor, project credit (notably, but not exclusively the lender), and the host.</p>
<p>In the deregulated environment, with power prices susceptible of fluctuation, the
importance of this risk allocation is greater because the pricing and sustainability of
contract arrangements serving as credit represents a greater uncertainty than in the past.</p>
<p>It is also important because of its impact on accounting issues.</p>
<hr>
<p align="left"><font color="#000000"><strong>Accounting Issues</strong></font></p>
<p align="left">There are certain differences, from the user's side, from an accounting
and related financial point of view. Boiled down to basics, they relate to answers to the
following questions, which, in turn, are driven by the fact situation:</p>
<p>� Will the nature of the obligation of the end user (which essentially is a contract)
be treated as a deductible expense or a capital cost? Specifically, will the obligation of
the end user to make payments be treated as a capitalized debt obligation, a footnoted
contractual obligation, or only an off balance contractual obligation in the ordinary
course?</p>
<p>� If there are physical assets, fixtures, or contracts associated with the project,
are they deemed to be assets belonging to the end user (with possible attendant
depreciation and cash flow benefit). What are the respective remedies of lender and
industrial host with respect to the assets in the event of non-performance?</p>
<p>� If a special purpose entity is used by the project sponsor (which might even be the
host industrial) as a conduit for financing of the supply or service savings, will its
obligations be reflected on the books of its parent, e.g. in the event the nature of its
contractual undertakings are deemed to be too long or if its parent's contingent credit
obligations are too strong.</p>
<p>The answers to each of these questions tends to be in some degree of flux, and vary
from energy service to energy service, reflecting factors we have discussed: asset
intensity, uncertain impacts of regulation, and strength of contract collateral - all as
reflected in contractual terms.</p>
<hr>
<p align="left"><font color="#000000"><strong>3. Methodology of Financial Analysis</strong></font></p>
<p align="left">Given the diversity of energy options and possible financing techniques -
which is at the root of the financial complexity of the decision making consumers of power
marketing and other end user services face; it would be highly desirable if a single
framework for analysis of transactions could be developed which took into account the
regulatory and accounting aspects of alternative transactions. Because energy is becoming
an end user choice game; notwithstanding that the regulatory road is full of unpredictable
bumps, the role of finance as a differentiating factor is changing. Finance in the energy
field historically has been about leveraging end user credit to pay for the users
purchases. It is getting harder to do that. Users are fine tuning the scope of their
financial exposure. It is useful to come up with a unifying approach focused on that
exposure - and its financial implications, so that more transactions can get done.</p>
<p>As a starting point, it is possible to hypothesize the standardized finance of Energy
Service Commodity Units ("ESCUs"). The products of power marketers and RESCOs
are, after all, not so different in energy substance, in the requisites for what it takes
to finance them - and need not be that different in the way in which regulators and
accounting authorities choose to perceive them. Since power marketing and RESCO services
are coming together in actuality this is useful perception which leads us to the
development of a definition of an ESCU and its potential application by energy arbiters
and consumers.</p>
<p>An ESCU is the cost of a risk adjusted cost of a physical unit of energy production or
savings, which may be actually available to serve a site-specific user function at the
time designated by the user. The cost is "all in" including financing, hedging
and asset purchase. It also includes overall shift in cost of capital to a company as a
consequence of the characterization of the obligations incurred by an end user in a
transaction. Actual availability refers to probable life cycle requirements (and "all
in" cost must be adjusted if probable life cycle necessitates replacements). Risk
relates not only to pricing shifts, but also the danger that there will be a
recharacterization of balance sheet treatment of contractual or debt obligations; and
flexibility - lost benefits because of inability to take advantage of the market as well.</p>
<p>In sum, development of the ESCU concept requires consideration of:</p>
<p>a) The characteristics of different types of energy service, the perspective of the
energy user on its reliability, and from a financing standpoint, the impact of the still
bumpy regulatory road ahead.</p>
<p>b) The alternative approaches to financing available with respect to the different
types of energy service.</p>
<p>c) The commonalities in financing these types of energy services, and the uncertainties
which affect the respective risk in doing so.</p>
<p>Thinking in terms of ESCUs focuses on those commonalities. It provides a context for
sellers to highlight the attractiveness of their approach and buyers to evaluate
critically what they are receiving. It is a type of analysis power marketers should
anticipate.</p>
<hr>
<p align="left"><font color="#000000"><strong>Difficulties in ESCU Calculation</strong></font></p>
<p align="left">This will be more difficult than it would appear for the following
reasons:</p>
<p>� ESCUs represent fungible energy value to end users, but, depending on the
contractual arrangement under which the particular service under which they are being
delivered, the nature of commitment to purchase may vary.</p>
<p>� ESCU supplier obligations are subject to market variance, and different suppliers
may have different obligations or capacity to make up "differences". A
methodology for taking this into account on a consistent basis, acceptable to lenders need
to be established.</p>
<p>Consequently, the most difficult issues in establishing ESCU comparability may arise
out of differences on these issues reflected in contract clauses. Users crave their own
flexibility; suppliers seek firmness of asset-like credit collateral. For ESCU evaluation
purposes, it is necessary to consider the impact of an ESCU service contract on, e.g. user
control; profit sharing; upside rights. Remember we are dealing with clauses in different
types of energy services contracts. Clauses affecting ESCU calculation which energy
customers may seek, which may in turn have financing ramifications, include the following:
</p>
<p>a) Preservation of existing rights, e.g. backup power, in the event of change,
modification, or equitable adjustments of the terms of the contract. </p>
<p>b) Flexibility clauses, such as</p>
<p>� Market reopeners - e.g. "most favored nation clause"</p>
<p>� Market out - right to either renegotiate or leave the system in the event of shifts
in regulatory development</p>
<p>� Indexing of prices to certain changes in overall prices in a market territory<br>
� Relief from special charges arising from the introduction of new regulatory systems,
e.g. retail wheeling, and/or new charges for old services.</p>
<p>� Rights either to put generating assets or securities derivative from such assets to
the utility in the event of regulatory change adverse to self generation</p>
<p>� Rights to call on less expensive power potentially available - or made available to
third parties - as a result of regulatory change favorable to market fluidity</p>
<p>� Right to restructure the extent of obligations in contracts in the event of retail
wheeling introduction, e.g. right to compare prices with those offered by power marketers
aggregators and switch if appropriate; or to walk from first refusal situations.</p>
<p>� Swap-type arrangements with power suppliers triggered by the occurrence of
regulatory events, i.e. contingent risk sharing arrangements.</p>
<hr>
<p align="left"><font color="#000000"><strong>(c) Institutional Change Clauses</strong></font></p>
<p align="left">� Negative covenants obtained from utilities to preclude their
interference with regulatory flexibility which otherwise might be available, as a result
of regulatory evolution, e.g. right to aggregate; right to use municipalization, right to
engage in power sales to third parties; as well as not themselves to modify their
obligations as a result of change.</p>
<p>� Affirmative covenants by utilities to enter certain types of regulatory arrangements
beneficial to end users as they become available, e.g. regional power exchanges run by
ISOs which meet stated fairness standards; OASEs.</p>
<p>� Consent to renegotiate existing power sales special pricing arrangements in the
event of regulatory evolution - or at least to require consumer consent to modifications
of such arrangements as a result of regulatory chance.</p>
<p>� Provide automatic rights to contract participants to participate in any new RTGs,
ISOs or other institutional arrangements which may be established by the utility, or in
which it may participate.</p>
<hr>
<p align="left"><font color="#000000"><strong>Program for ESCU Clarification</strong></font></p>
<p align="left">Regulators and financial arbitrators must decide how to treat such
contract provisions from asset and financing characterization standpoints. Address of
these issues is worthwhile - worth pursuing by the power marketing community - because it
will facilitate ESCU analysis by end users of the choice of different energy service
options or combinations of them. It will facilitate acceptance of various types of power
marketing.</p>
<p>Most aspects of ESCU financial value are governed, as we have seen, not only by utility
regulatory pronouncements, but by their characterizations for financing and accounting
purposes. The terms of specific energy agreements will reflect the commercial realities
which regulation imposes.</p>
<p>The regulatory and accounting communities would be doing power marketers and energy
users a great service if they treated comparable ESCU energy situations, the blend of
energy and asset collateral risk, in a comparable manner for financing purposes. Steps
they might take include the following:</p>
<p>First, establishing criteria when any ESCU contracts are deemed to represent
"assets", which may be leased or financed, or represent merely operating service
contracts.</p>
<p>Second, establishing the criteria for security interest by lenders in ESCU contracts
and what performance will be required to honor that security, by institution that hold it.</p>
<p>Third, highlighting what effect end user risk may have on contract and financial
characterization.</p>
<p>This is the type of project where an organization like The Power Marketing Association
could make an important input to clarifying the decisions which energy managers face.</p>
<hr>
<p align="left"><font color="#000000"><strong>4. Summary</strong></font></p>
<p align="left">In sum,</p>
<p>� From a financing standpoint, energy intermediaries are offering different products;</p>
<p>� From a financing standpoint, there are a series of coherent questions which
integrate the character of these products.</p>
<p>� From an end user standpoint, it is desirable that such translation into ESCUs, or
comparable equivalents are possible, so that they can compare them from a cost, payback
and/or ROI standpoint.</p>
<p>� From a legal standpoint, it is important to have these multiple perspectives on
arrangements with energy suppliers - it is not just words we are dealing with.</p>
<p>� Finally, from a power marketers standpoint, it will help to clarify what options
realistically will be available.</p>
<p>As power marketing, energy service management, inside the fence merchant energy options
and energy cost containment merge, it will be important for this type of analysis to
occur. The sooner it does, the sooner traditional arbiters of the energy transactional
environment: regulators; commodity exchanges; equipment suppliers will change their mode
of thinking to be user friendly to the new energy/customer service environment. The ESCU
comprehending market, will be the power marketing friendly market.</p>
<hr>
<p align="left"><br>
<font color="#000080"><strong>ROGER D. FELDMAN</strong></font></p>
<p>As head of the Energy Project Finance Group of the 600 lawyer international law firm of
McDermott, Will & Emery, Roger Feldman considers ESCU finance issues on behalf of
energy users, power marketers, RESCOs, utilities and financial institutions. </p>
<p>He is Washington Editor of The Cogeneration & Power Marketing Letter, past Chair of
the Energy Law Committee of the American Bar Association; and former Deputy Administrator
for Finance and Environment of the Federal Energy Administration. </p>
<p>Mr. Feldman is a graduate of Brown University, Yale Law School and Harvard Business
School.</p>
<p>Mr. Feldman may be contacted by telephone at (202) 887-8000. </p>
<p align="left"> </p>
<p align="center"><font size="2" color="#000000"><em>� 1996, McDermott, Will & Emery.
This material may be quoted and/or reproduced, if credit is given to the source.</em></font></td>
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