With so much to learn and so little time to act, we're excited to debut a new series.
Get ready for a year of "explainers" from our student writers, to define and set in context the energy transition's key parts.
In this one, securitization of dirty coal plants comes out as a viable strategy for utility investors, policymakers and ratepayers.
This topic will drive a discussion at the inaugural Yale Clean Energy Conference, happening April 1 and April 2. Please learn more and register here for the conference, forward this article to teammates and partners with whom you grapple with this stuff, and bring your (clean-) burning questions to the session!
Imagine that you are a utility owner. You could be one of many, or you could own a small local utility. Either way, you invested in high-performing coal plants 25 years ago that you anticipated would have an average life of 40 years. Not only that, you have invested hundreds of millions more in repairs, maintenance, and upgrades over that period. You took out a sizable loan, and then another, and then another. Now you go to the market and see that the value of the plants is in sharp decline. Coal might be uneconomical, but you can’t walk away and strand your assets. Your bank expects to recoup its returns and you are on the hook for paying back. You wonder whether there is a way to financially engineer the utility out of the morass. What do you do when you have a lot of debt and not a lot of value? What does your bank do?
This is the reality faced by independent power producers with coal assets today. Coal plants are shutting down at faster rates than ever before, and nearly half of the US coal fleet is currently operating at a loss. In response, utilities have primarily passed on costs to ratepayers, who don’t have much of a say in the matter. Over 70 percent of the electricity market is serviced by investor-owned utilities, which simply aren’t willing to accept significant losses. Nevertheless, billions of dollars in coal plant investment could still be unrecoverable under the status quo. In search of a way out, utilities have begun turning to securitization as a way to stay afloat and potentially transition to cleaner energy assets.
What is securitization?
is the process of packaging different assets into a single security. The original purpose of securitization was to enable sellers to bundle assets into a marketable bond, thereby removing them from their balance sheets and creating the possibility for a return while potentially reducing the cost of debt. The tool has long been used by utilities, including 66 issuances for a total of $51 billion since 1997. More recently, securitization became infamous for playing an (inconclusive) role in the global financial crisis. Like any tool, it is vulnerable to abuse when taken to extreme limits.
Now, securitization may be making a comeback. For utilities, securitization can effectively lower the cost of debt for the coal plant. Here’s how it works.
First, the utility packages the assets it wants to sell into a securitized, private bond with a lower cost of capital (the rate of return needed to justify the project) compared to its original financing. This means that another group of investors stands ready to cover any losses, because that group feels so confident of losses being less likely than gains.
The utility uses that new capital to pay off the existing debt. Not only is the utility made whole, but the additional stream of revenue tied to the bond can be used to support communities struggling to manage the clean energy transition, as has been done in New Mexico. For buyers of the bonds, it is an opportunity to reduce emissions by purchasing the assets at a discount and encouraging responsible retirement. For owners and operators, especially vertically-integrated utilities, it is a way to manage the energy transition without cannibalizing investors at a time of industry-wide stress.
Two different types of securitization have emerged as viable.
Ratepayer-backed securitization is a model where utilities issue long-term bonds to investors with a pledge to pass on a surcharge to the ratepayer to cover interest payments. That sounds like it would raise costs on the ratepayer, yet that is actually unlikely. The cost of the securitized debt could be significantly lower than the utility’s current cost of debt because it is backed by the near certainty that customers will pay their bills (a utility’s average interest rate is 6-8 percent, but ratepayer backed bonds are priced at 3-4 percent). That savings means that utilities don’t need to raise costs for ratepayers. With this model, the risk of retirement is low since the new utility-owned debt is backed by ratepayers, not by the depreciating plant. There is no credit risk tied to the physical assets owned by the utility. Instead, the utility simply procures energy from other, likely cleaner sources.
Through asset-portfolio securitization, an independent power producer could issue securitized bonds that are backed by revenues from investments in new renewable power-purchase agreements. By using the higher returns on renewable power projects as a form of repayment for the new debt, the utility could retire existing coal assets in favor of developing and operating clean energy projects. The catch with an asset-portfolio securitization is that this requires an agreement with the offtaker (the buyer of energy) to restructure the power purchase agreement (PPA) such that the payments to the offtaker under the new PPA come from the new projects.
The trend is clearly catching on, yet challenges remain.
In 2019, several states passed laws enabling the practice, approving rating agencies the authority to issue AAA ratings for securitized bonds. 21 states currently have legislation enabling securitization of utility assets. 18 others are pursuing some type of regulatory or legislative action to do the same.
The fact that the regulatory change must occur at the state level nonetheless limits the ability to scale the securitization model across state lines. For regional or national utilities with several uncompetitive coal plants, that means large transaction costs for regulatory compliance for retiring assets across different states. Larger utilities may be able to bear those costs of doing business. What about the smaller ones? Some have proposed a national approach instead. A recent report suggested that the Department of Energy Loan Program Office create a financing facility for ratepayer-backed bond securitization that included transition assistance for coal communities, bypassing the need to wait for the states to act.
By using the higher returns on renewable power projects as a form of repayment for the new debt, the utility could retire existing coal assets in favor of developing and operating clean energy projects.
Moreover, what is to prevent investor-owned utilities from negotiating the terms of ratepayer securitization in favor of the investors? Investment banks, after all, are the ones structuring the bond, lining up the buyers of the debt, and getting the fees. Moreover, in the ratepayer model, ratepayers bear the liabilities. The key is for ratepayers to be at the table. Aspects like loan terms, loan amounts, and larger economic factors make a huge difference in terms of how much costs are passed onto ratepayers. So do the transaction costs that ratepayers could get billed for if consumer advocates aren’t present. Financial advisors have successfully negotiated on behalf of ratepayers prior to utilities’ issuances of securitized bonds and procured large customer savings, but it requires a concerted effort by ratepayers to use their leverage in the negotiations.
Utilities are fighting to stay financially viable while they overhaul their business to tackle the climate crisis. This leaves them with only tough choices as they weigh what to do with their current coal assets: fight to delay the acknowledgment of the loss of value by passing on charges to ratepayers, or embrace the possibility of plant retirement.
While the second option sounds daunting, securitization makes it possible that ratepayers, utilities, investors, and the communities negatively impacted by the decline of coal can all gain. Yet, regulatory challenges remain and ratepayers could emerge worse off depending on the balance of power in negotiations. Securitization’s effect on the clean energy and utility transition will depend on how the tool is used, to what end, and whose interests are represented.