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<title>June 2002: "Lot"</title>
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<p align="left"><font face="Arial"><strong><small>About The Author:<br>
<br>
</small></strong><span lang="X-NONE" style="color: black"><font size="2">
ROGER FELDMAN, Co-Chair of Andrews Kurth LLP Climate Change and Carbon
Markets Group has practiced law related to the finance of environmental and
energy projects and companies for 40 years. In particular, he has analyzed
and executed a wide variety and substantial value of project financings. He
chairs the American Bar Association’s Committee on Carbon Trading and
Finance, serves on the Board of the American Council for Renewable Energy,
and has been a senior official in the Federal Energy Administration. He is
a graduate of Brown University, Yale Law School and Harvard Business School.</font></span></font></p>
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<img src="../images/feldman.gif" alt="Washington Viewpoint by Roger Feldman" border="0" width="375" height="75"><p><b><u><br>
June 2002</u><br>
</b></p>
<p><font size="6">"Lot"</font></p>
<p><strong>by Roger Feldman -- Bingham, Dana L.L.P.<br>
</strong><font face="Arial" size="2">(<em>originally published by PMA OnLine Magazine:
2002</em>/11/27)<br>
</font><span style="font-size: 10.0pt; font-family: Palatino; color: black">
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<p ALIGN="JUSTIFY">Anxious proponents of power industry restructuring
received an important Special Comment from Moody’s in May. But it was hard
to tell if it was a warning from the Board of Health, a prescription from a
physician, an autopsy from the coroner, a Delphic utterance from a
fortuneteller, or a biblical injunction. The headlines on it that caught the
general public’s eye were certainly ominous and bear repeating, but do not
begin to communicate its underlying implications:</p>
<p ALIGN="JUSTIFY">"Moody’s believes that energy trading, as presently
configured, may lack investment grade characteristics unless it is ancillary
to a more... sustainable cash flow... </p>
<p ALIGN="JUSTIFY">We believe that fundamental restructuring will need to
occur in the near term for this sector to regain investor confidence.
Options include: a) sector consolidation... b) the establishment of a
[functional] clearing system... or c) creation of... [independently ratable]
derivative products companies..."</p>
<p ALIGN="JUSTIFY">Here’s what this may well mean: the energy trading
companies that have sprung up must be replaced and (probably not or) a whole
new creditworthy energy trading market must be set up. Note, also, what the
Special Comment does not say: if only FERC would hurry up with its RTO/market
design restructuring initiative and get a handle on those market power
problems that caused California, all will be well. The private sector must
save itself.</p>
<p ALIGN="JUSTIFY">With that frame of reference, one turns to the Special
Comment’s analytic text and the following biblical analogy leaps up: Lot’s
wife has looked back, seen the financial Sodom we have all observed in the
newspaper headlines, and turned into a salty pillar. Moody’s ratings (if
any) of many energy marketing players will limit their ability to be able to
draw soothing liquidity from the capital market wells. They may find
themselves pounding. . . salt. Major players have experienced this result
already, and seen their appeal of Moody’s decisions rejected.</p>
<p ALIGN="JUSTIFY">The Special Comment also is a biblical jeremiad: fix the
following matters, merchant power players, and you may be saved. Fail to,
and you will succumb to the second great principle of capitalism, viz., pigs
get fat, hogs get slaughtered. (The first principle is, "That tulip can’t
live forever.")</p>
<p ALIGN="JUSTIFY">Three matters needing repair stand out in the Special
Comment:</p>
<ul>
<li>
<p ALIGN="JUSTIFY"><b>Lack of Credible Earnings Measures</b>. The meaning
of the financial statements of energy marketing companies in the same
basic business is obscured, not just because they may follow different
risk strategies but because GAAP allows them to use different accounting
methodologies. Specifically, accounting guidance on how to mark-to-market
("MTM") commodity-derivative transactions leave significant flexibility to
individual power marketers, with the result that ". . .management has wide
latitude as to how it chooses to treat a hedge, and thereby affect
earnings recognition." ". . .While MTM makes sense for accounting for
trading in a liquid environment, it can create significant discrepancies
between book profit and cash flows on the longer dated contracts in which
many energy merchants engage. . . As a matter of fact: "inappropriate MTM
procedures can produce revenues that are inflated by the amount of trading
activity and operation income that includes changes in the current market
value of trading assets and liabilities." (In other words: Houston, we
have a problem.) Truly segmented, transparent accounting and a tracking of
income versus cash flow must be installed to forestall the problem.<br>
</li>
<li>
<p ALIGN="JUSTIFY"><b>Excessive Leverage</b>. The Special Comment lumps
together investments by power companies in physical assets with those in
trading assets and infrastructure in assessing the extent of trading
company leverage. It condemns the obscuration of this leverage through the
use of off-balance sheet or off-credit debt and pronounces a serious curse
on the future of project finance. "We assess off-balance sheet,
non-recourse debt to determine whether it is truly non-recourse or whether
the company is likely to support such obligations – regardless of whether
or not it has a true legal obligation to do so." Consequently, it views
positively the desperate efforts of the trading companies to enhance their
financial position since the end of 2001. Unfortunately for the traders,
the markets are not similarly bemused.<br>
</li>
<li>
<p ALIGN="JUSTIFY"><b>Cash Flow Focus</b>. As far as the Special Comment
is concerned, the "CFO" of the future for power companies is "Cash from
Operations," to be measured against a variety of corporate financial
exposure measures. Those metrics represent the beacon on which Moody’s
relies to help see it past the high volatility it perceives as endemic to
energy trading. It is this perceived need for credit quality that suggests
to Moody’s that consolidation, master netting and collateralization
agreements, and emergence of en hanced creditworthy market counterparties
are the necessary developments in the future of the industry.</li>
</ul>
<p ALIGN="JUSTIFY">Of course, each of these three matters in need of repair
is larger than the power industry. They are revealed sores on the entire
body of U.S. corporate governance and operation structure. The resolution of
them has become a political foothill in Congress already, but unless the
power trading industry that grew up under the stimulus of deregulation can
itself institutionally overcome the national systemic accounting system
flaws broadly exploited in our recent gilded age (and exacerbated by certain
practices of our financial institutions), it may prove not to be a business
that continues to attract serious investors. It must deal with these issues
now and by itself, even while the larger question of corporate governance
remains the subject of ongoing national hullabaloo. There can be no
nostalgic looking back, like Lot’s wife, to how a great deal of money was
made briefly. The types of recommendations for restructuring suggested by
the Special Comment must be a take-off point for industry action, especially
since, as a practical matter, government implementation of those
recommendations most likely will be unfeasible. That way lies salinization.
</p>
<p ALIGN="JUSTIFY">Perhaps the industry will heed the message of the Special
Comment, in which case, as it says in 18 Proverbs, verse 18, "…Lot puts an
end to disputes and decides between men of power." </p>
<p>Thanks a lot, Special Comment. </p>
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<p class="MsoBodyText" align="left" style="margin-bottom:0in;margin-bottom:.0001pt;
text-align:left"><font face="Arial" size="2">
<span lang="X-NONE" style="color: black">ROGER FELDMAN, Co-Chair of Andrews
Kurth LLP Climate Change and Carbon Markets Group has practiced law related
to the finance of environmental and energy projects and companies for 40
years. In particular, he has analyzed and executed a wide variety and
substantial value of project financings. He chairs the American Bar
Association’s Committee on Carbon Trading and Finance, serves on the Board
of the American Council for Renewable Energy, and has been a senior official
in the Federal Energy Administration. He is a graduate of Brown University,
Yale Law School and Harvard Business School.</span></font></p>
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