Standard & Poor’s issued a warning Thursday that more credit rating declines and possible defaults “loom on the horizon” even though the industry already has experienced its sharpest credit slide in decades.

The reasons ranged from excessive debt to surplus power generation capacity, S&P said in a special report titled “U.S. Power and Energy Sector Credit Slide to Continue.”

“In January of last year we asked ourselves if things can get any worse for the industry,” said S&P Managing Director Ronald Barone. “Well, things have gotten a lot worse. It’s been a torturous path to deregulation, companies have failed miserably and it has been a credit Armageddon for some. You can’t pick up the morning paper without reading about federal and state investigations, accounting irregularities and market manipulation.”

A big part of the problem has been the “bizarre energy policies, price caps and interference in the markets,” he noted. This haphazard approach to deregulation has left 65% of generation capacity still regulated.

There were nearly 300 credit downgrades in the last three years and through the first three quarters of this year there have been 135 with only 14 credit upgrades. During the first three quarters of last year there were 81 credit downgrades and 29 upgrades. In all of 2000, there were 65 downgrades and 20 upgrades.

“The credit downgrade to upgrade ratio was about three-to-one from 1999 to 2001,” Barone said. The ratio in 2002 is 10-to-one with 40% of all power companies on negative outlook or negative CreditWatch. More than 13% of firms are non-investment grade.”

S&P Managing Director William Chew said he doesn’t see much improvement on the horizon. “Defaults haven’t been in the headlines but they will be soon,” he said. “The problem that we see in the power and energy sector is not solely a U.S. one; it includes the rest of the world. As we aggregate the numbers, we are talking about over $30 billion in total defaults.”

The reasons include a “collision of business and financial risk,” liquidity problems, the “expansion of the capital investment cycle,” the return of regulatory uncertainty, and the “rise of post default recovery.”

Deep structural problems may be inherent in the merchant energy sector, suggested S&P Director Suzanne Smith. “I don’t know if it’s a cyclical low in the commodity business or structural issues that need to be fixed — probably a combination of both — but it’s clear that we have not yet seen the bottom of a very negative trend in creditworthiness.”

She noted that about 80% of the diversified energy companies have investment grade ratings but only about 30% of merchant energy companies have investment grade ratings. “This demonstrates the benefits of diversification in this industry as well as the heightened business risk of the energy merchants,” said Smith. “And given industry conditions, adequate liquidity may mean the key to survival over the next two years.”

Merchant energy companies have about $90 billion in medium term debt to refinance over the next four years. However, refinancing will be extremely difficult for the companies and the banks that will be asked to refinance the debt because of weakening market fundamentals, poor short-term liquidity and lack of capital market access, S&P noted.

“When it comes to refinancing, companies most at risk are those that are highly leveraged, have large bullet maturities or highly volatile cash flow or have invested heavily in construction programs,” said Smith. “Many of these companies fall on the energy merchant list.”

Another current and future problem for the energy merchants is cash flow because of low power prices and excess generation capacity. “This could continue as the conditions of low spark spreads have its roots in overcapacity slower demand growth and considerable capacity still in regulated hands. In some cases we are beginning to look at merchants’ assets not only with net revenue assumptions but also using current forward prices. We are likely to look at cash flows both ways, especially for companies with merchant assets in certain markets, such as [The Electric Reliability Council of Texas].”

Maintaining credit ratings will be achieved by multi-year commitments to debt reduction, probably including difficult decisions regarding equity issues, dividend policy and capital spending cuts, said Smith.

S&P Director Peter Rigby said a record number of defaults are expected in the industry. “Already lenders have suffered defaults of bank loans and capital market bonds. Still billions of dollars more of loans have become problem loans — a signal that likely portends more defaults,” he said.

However, many energy companies have remained highly regulated and can rely on the strength of their predictable cash flow and ready access to capital markets. While the focus has been on the financial troubles of the dozen or so large energy merchants, many forget that 26 or 27 states remain untouched by deregulation. S&P sees a solid investment-grade picture for utilities operating in these jurisdictions.

“The average rating for the power and energy sector as a whole has slipped out of the ‘A’ category and into the high ‘BBB’ area,” said S&P Director Richard Cortright Jr. “Companies that continue to emphasize a more traditional regulated structure, vertically integrated or not, remain firmly ensconced at an ‘A-‘ average.”

Cortright suggested that state regulators pay closer attention to the relationship between energy companies regulated and nonregulated operations. “There is a general absence of regulatory insulation of the utility from nonregulated operations,” and that creates a significant area of concern for credit rating agencies.

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