To increase the capital availability for energy markets and restore investor confidence, the Federal Energy Regulatory Commission must finish with the California refund claims, western contract disputes, the El Paso Corp. complaint case, standard market design (SMD) and investigations into trading irregularities — and most of all, provide a climate of regulatory certainty, said energy analysts, rating agencies and capital investors Thursday.

Regulators need to decide “what was illegal and what wasn’t, and let’s get on [with it],” Christine Tezak of Schwab Capital Markets WRG told the Commission during a day-long technical conference exploring ways to increase the energy industry’s access to capital to build natural gas and electricity infrastructure [AD03-3]. Affordable capital has largely dried up for the industry over the past year in the wake of allegations of corporate wrongdoing and depressed market conditions.

In addition to the actions of federal and state regulators, Tezak said she believes energy companies must do their part to win back the confidence of investors. “If there’s a perception that this industry is still a [bunch] of black hats from Houston,” Tezak noted, it will never get out of the “morass” in which it currently finds itself.

Short of “setting up a confessional on the 11th floor” at FERC for companies to admit their sins, Commissioner Nora M. Brownell agreed industry “could make their own contributions here by getting the issues behind them.” Regulators “have obligations and responsibilities, but I think the industry could help us out” in clearing away the damage, part of which she said was “self-created.”

The Wall Street representatives appeared optimistic that investors would return to the energy industry eventually, but several said they don’t expect to see a recovery until 2004 or 2005 at the earliest. Investors are “tight…they’re very risk averse right now,” said Evan Silverstein of SILCAP LLC, but he added that “the cash will be there over time.” Also, the “pullback in lending from the banks” has made available capital to energy “scarce and too costly,” he noted.

For example, capital for the merchant generation business presently is “largely unavailable,” said Suzanne Smith of Standard & Poor’s (S&P).

To give an idea of how much energy investors have been hurt, Merrill Lynch analyst Steve Fleishman said the market capitalization of the top 25 energy companies fell 43% from $370 billion at the start of 2001 to $212 billion by the end of 2002. He noted the decline was even more severe if the new equity issued by the energy sector over that period ($38 billion) is included.

Fleishman estimated that the top 20 utilities had negative cash flow of $10 billion last year, after accounting for capital expenditures and dividends. Those same companies paid out approximately $9 billion in dividends in 2002, which he said had to be financed externally sometimes at interest rates as high as 12%. He projects that the same group of companies will be generating excess cash flow by 2004, most of which he said will come from reduced capital spending.

The bottom line is the “industry will [have to] start living within its means,” Fleishman noted. Others agreed that mending “weakened balance sheets” should be a top priority of energy corporations.

In the meantime, financial analysts predicted there would be more bankruptcies, and more energy companies exiting from the troubled trading and overbuilt merchant generation sectors.

“I’m confident and optimistic too” that investment in the energy sector will return, said FERC Chairman Pat Wood, but he noted he wanted to achieve this in the near-term, not 2010. He asked the Wall Street representatives to provide him with a “shopping list of things” that need to happen to bring the cost of capital down for energy companies, “other than behave.”

While a number of companies are fleeing trading in the wake of multiple federal investigations into this business, Prudential Securities’ Carol Coale said she believes trading remains a “viable” business. “Marketers are still needed to aggregate supply and deliver [it] to customers, and to create liquidity.” Without trading aggregation, she predicted that “gas prices could rise even further from their current levels.”

Coale blames much of the financial plight of the industry on the relentless downgrades of the credit agencies. She accused them of “overreacting to the situation,” and said the “abrupt shift in posture last year [was] largely to blame for the horrendous stock performance” of energy companies. Coale said she expects the rating agencies to maintain their “negative look to the group” in 2003, citing heightened liquidity risks and refinancing risks.

On the issue of companies’ cash flows, she noted she viewed as “contradictory” that firms were being required to sell off cash-producing assets to raise liquidity. “I see [this as] a disconnect here.” Moreover, Coale observed that companies are divesting critical assets now that they may need to pledge to secure future financing.

John Diaz of Moody’s Rating Service said he’d like to see more conservative financial strategies from energy companies in the future. He noted that 80% of the energy company downgrades were tied to merchant trading activities. He pointed to the current overcapacity of merchant generation, much of which was funded with debt.

On the regulatory front, Prudential’s Coale called on FERC to propose a global settlement to resolve the California refund claims, in the event that individual refund settlements are not reached soon. She agreed with other analysts that the refund proceedings have dragged on much too long at FERC. She further noted she opposed any kind of price caps or mitigation for electricity, saying it discouraged investment in utilities.

While Coale favored a more hands-off approach from the Commission, SILCAP’s Silverstein and Kara Silva of MBIA Insurance Corp. supported FERC intervention in some market areas. By using market monitors, FERC can “start correcting the problems of the ’90s,” said Silverstein, but he cautioned the agency not to “overcorrect.”

Silva called on the agency to implement a stronger Section 204 policy. “When you look at the financial requests [of energy companies], you [should] understand where those monies will be used within the corporate family and what it will do to the existing lenders,” she said.

“I like both of those messages, but I’m surprised to get them from Wall Street,” said Commissioner William Massey. “I must say that you’re preaching to the choir.”

While FERC policies have favored investment in electric generation, to the point of oversupply, several agreed they have not encouraged similar investor spending for transmission. The agency’s policies “make it easier to build in one area [generation] than the other,” said Morgan Stanley analyst Kit Konolige. He noted that greater transmission investment was needed to make the market more efficient.

SILCAP’s Silverstein believes the problems with California’s energy market were “magnified” because the state did not have an adequate, competitive transmission system.

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