INFRASTRUCTURE AND PROJECT FINANCE SECTOR IN-DEPTH US Unregulated Power and Project Finance 23 March 2016 ERCOT: Renewables To Hold Down Power Prices in the Lone Star State TABLE OF CONTENTS Renewable generation moves front and center in Texas Upward creep in the reserve margin continues Power prices remain under pressure GDP growth still likely to outpace electricity growth Financing challenges, supply shocks or weather could drive up prices Appendix A - About ERCOT Appendix B - At Risk Coal Plants Moody's Related Research » Renewables front and center in Texas. US Congressional approval in December 2015 to extend the federal renewable electricity production tax credit (PTC)1 and business energy investment tax credit (ITC)2 will further accelerate wind and solar development, respectively. We expect the additional renewable generation capacity in an abundantly supplied ERCOT market will hold down already low prices. 6 » 7 10 10 11 Reserve margin creeping up. Generation supply remains robust in ERCOT with current forecasts indicating the target planning reserve margin of 13.75% is not expected to be reached until a decade from now. The extension of renewable generation subsidies will compound this situation. » Power prices remain under pressure despite some demand gains. Downward pressure on power prices from sustained natural gas prices below $3/MMBtu contributed to negative rating actions in 2015 and 2016 on ExGen Texas Power, LLC (B2, negative), Lonestar Generation LLC (B1, negative) and Sandy Creek Energy Associates, LP (B2, negative). We expect natural gas prices will remain low, averaging $2.25/MMBtu in 2016 and $2.50/MMbtu in 2017. Financial pressure on project issuers remains, but large, diversified merchant generators with meaningful ERCOT exposure like NRG Energy, Inc. (Ba3, stable) and Calpine Corporation (Ba3, stable) are better positioned to manage these trends. » GDP growth still likely to outpace electricity demand. GDP growth in Texas has outpaced electricity consumption in recent years, most notably since 2011. Strategies adopted by industrials and large utilities to better manage their power use and load, together with better integration and changing residential consumption habits continues to reduce demand. These factors extend the time frame that excess supply will exist, which keeps power prices down. » Financing challenges, weather or supply shocks could drive up prices. A sustained environment of low commodity prices and higher borrowing costs should slow the pace of new natural gas-fired generation, leading eventually to an uptick in power prices. The pace of coal retirements will also play a role, but timing remains uncertain. An extremely hot summer accompanied with scarcity pricing could also lift prices. 2 4 5 Contacts Charles Berckmann 212-553-2811 AVP-Analyst charles.berckmann@moodys.com Alexander Liu Associate Analyst alexander.liu@moodys.com 212-553-1183 Clifford J Kim VP-Senior Analyst clifford.kim@moodys.com 212-553-7880 Richard E. Donner 212-553-7226 VP-Sr Credit Officer richard.donner@moodys.com Scott Solomon 212-553-4358 VP-Sr Credit Officer scott.solomon@moodys.com Jennifer Chang 212-553-3842 AVP-Analyst jennifer.chang@moodys.com A.J. Sabatelle 212-553-4136 Associate Managing Director angelo.sabatelle@moodys.com INFRASTRUCTURE AND PROJECT FINANCE MOODY'S INVESTORS SERVICE Renewable generation moves front and center in Texas The US Congress's approval in December 2015 to extend the federal production tax credit (PTC) to December 31, 2019 is expected to accelerate the development of new wind projects over the next several years. The PTC provides wind project owners a credit of $0.023/ kilowatt-hour (kWh) for electricity generated to the power grid.3 The resulting impact of additional renewable generation will be the continuation of low power prices in line with prices experienced in 2015, as ERCOT already has an ample supply of existing power generation. Installed wind power generation in Texas has been the fastest growing new resource on an absolute megawatt (MW)-basis over the past several years (see Exhibit 1 below). Exhibit 1 Year-over-Year change in capacity additions Source: SNL Financial, Moody's Investors Service The jump in wind power growth in 2015 is largely attributable to developers seeking to get their projects on-line, in order to qualify for the PTC credit that was originally slated to expire in December 2015. The last-minute US government approval in late December 2015 to extend the tax credits, will foster continued development as the PTC extension includes step-downs in increments of 20% each year starting in 2017, as part of a gradual phase-out. This step-down mechanism is a reasonable catalyst to spur continued rapid growth of wind generation in Texas in the short-term, in order for developers to qualify for the maximum subsidy before the step down begins. According to ERCOT, wind power growth in Texas over the next several years is indeed poised to accelerate. As evidenced in Exhibit 2 below, a substantial number of wind projects are pending and the PTC extension should ensure a higher completion rate for projects in the queue that have posted financial security. This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on www.moodys.com for the most updated credit rating action information and rating history. 2 23 March 2016 US Unregulated Power and Project Finance: ERCOT: Renewables To Hold Down Power Prices in the Lone Star State INFRASTRUCTURE AND PROJECT FINANCE MOODY'S INVESTORS SERVICE Exhibit 2 Up and away Installed commercial wind (2016 and 2017 projected) Source: ERCOT 2015 State of the Grid Report, ERCOT Generator Interconnection Status Report (February 2016) The prospect of substantial new wind generation bodes ill for the merchant generators for several reasons. First, wind farms are generally easy to build quickly and Texas’ topography, wind resource, and historical pace of development has borne this out. Second, the “fuel” cost for wind farms is zero, therefore a wind farm can tolerate negative pricing, to a degree, given their $23/MWh subsidy and typically contracted revenues. Negative prices have occurred in the evening and generally off-peak since that is when the wind is strongest but power demand is at its lowest level, resulting in some generators effectively paying customers to take their product. Conventional generators cannot financially compete against this. Even utilities have recognized the potential costs as evidenced by TXU Energy offering customers the option of free electricity from 9pm until 6am in exchange for higher daytime rates.4. Like the PTC, the energy investment tax credit (or ITC) mainly provides solar project owners a tax credit of 30% for commercial and residential property installations5. The ITC is set at 30% until 2019 after which the credit slowly ratchets down to 10% by 2022. While solar installations are growing from a very small base, the impact of solar-derived electricity generally impacts peak, day-time useage more than wind. In Exhibit 3 below we show the near-term growth potential in solar installations. Though the projections are only through 2017, further cost reduction and technology advancement over the term of the ITC could result in greater solar power penetration in the state than projected below. Exhibit 3 Small but budding solar installation Installed utility scale solar (2016 and 2017 projected) Source: ERCOT 2015 State of the Grid Report, ERCOT Generator Interconnection Status Report (February 2016) 3 23 March 2016 US Unregulated Power and Project Finance: ERCOT: Renewables To Hold Down Power Prices in the Lone Star State INFRASTRUCTURE AND PROJECT FINANCE MOODY'S INVESTORS SERVICE The combination of substantial new wind farms and solar build-out, however modest, would lower night-time and mid-day peaks, and further reduce wholesale prices as well as the on-peak/off-peak price disparity. While solar currently remains a negligible factor in ERCOT supply, it functions to shave peak-load, similar to California. Thus incremental growth need not be significant to impact power prices. While we caution that not all projects with signed interconnection agreements will ultimately get developed due to the ability to obtain attractive financing in the current market cycle, among other factors, substantial growth in renewable generating capacity (solar and wind) would occur even if one third of the potential new build was completed. Upward creep in the reserve margin continues The supply situation remains robust in ERCOT with current reserves meaningfully exceeding peak load forecasts and the recent PTC and ITC credit extension extends the life of this healthy reserve margin. ERCOT's planning reserve margin is targeted at 13.75%, which is calculated as total available resources less firm peak demand, divided by total firm demand and is published twice annually in May and December as the Capacity, Demand and Reserve (CDR) report. This reflects a long-term view of supply and demand. Exhibit 4 below highlights the changing picture of ERCOT’s reserve margin projection. Exhibit 4 Onward and upward Source: ERCOT We believe many developers, though not all, rely on ERCOT’s reserve margin forecast as a signal for development opportunities. A developer using the December 2011 CDR report (light blue line in Exhibit 4) as a basis for investment decisions would have expected reserve margins to fall below the 13.75% target (black dotted line) in 2012 and continue downward to below 5% by 2015, suggesting an opportune time to enter the interconnection queue. Strikingly, reserve margins for 2015 and beyond are now forecast to remain comfortably above the 13.75% target for the next decade, which is contributing to the downward pressure on prices. ERCOT does not conduct look-backs and publish actual reserve margins, but the graph suggests that an excess supply situation is likely through 2025 if projections hold. Separately, we note that ERCOT’s latest CDR report was issued in early December 2015, prior to the PTC and ITC extension; therefore future reserve margins may well remain higher than the most recent projections reflected above, especially if new renewable generation develops as expected. In our previous report on ERCOT published in May 20, 2015 we highlighted this upward trend.6 4 23 March 2016 US Unregulated Power and Project Finance: ERCOT: Renewables To Hold Down Power Prices in the Lone Star State INFRASTRUCTURE AND PROJECT FINANCE MOODY'S INVESTORS SERVICE Exhibit 5 ERCOT's Seasonal Assessment of Resource Adequacy (SARA) report for summer 2016,7 indicates that reserve capacity will be nearly 10% higher than in 2015. While 2015 had some record demand days, power prices generally stayed low. Given today’s current low natural gas prices and increased reserve margins, power prices are unlikely to climb out of their doldrums. Adequate summer reserve capacity, year-over-year Note: Scale starts at 5,000 MWs Source: ERCOT Seasonal Assessment of Resource Adequacy reports, Preliminary Summer 2015 and Preliminary Summer 2016 Power prices remain under pressure Natural gas prices drive on-peak power prices in ERCOT. We believe that natural gas prices will remain under pressure as evidenced by our average natural gas price forecast for 2016 and 2017 of $2.25/MMBtu and $2.50/MMBtu, respectively8. We further anticipate continued pressure on the ratings for stand-alone power project financings in this market, as these issuers rely solely on energy markets for cash flow generation, and unlike their peers in other power markets, do not earn incremental revenue and cash flow from forward capacity auctions. In Exhibit 6 below the downward trend in prices is visible, notwithstanding that power prices are generally higher in certain summer months. Winter 2014 was an aberration, owing to extremely cold temperatures and nearly 900MW loss of load9 with reserves falling below 1,750 MWs10 resulting in high prices, albeit during short periods of time. Exhibit 6 Power prices trending down Source: Moody's Investors Service, SNL Financial Given the steady downward trend in prices, energy margins have been negatively affected, resulting in several rating actions taking place within the last year for project issuers and shown in Exhibit 7 below. 5 23 March 2016 US Unregulated Power and Project Finance: ERCOT: Renewables To Hold Down Power Prices in the Lone Star State INFRASTRUCTURE AND PROJECT FINANCE MOODY'S INVESTORS SERVICE Exhibit 7 A bleak outlook for project issuers Source: Moody's Investors Service For merchant generators with diversified activities like NRG and Calpine, the current trends are more manageable. Other operators with some exposure to ERCOT include Talen Energy Supply, LLC (Ba3 stable) and potentially Dynegy Inc. (B2 stable) 11 though all of these unregulated power companies have a number of material resources outside of ERCOT to help manage the negative business and electricity market trends. For power project financings exposed to coal-fired generation, such as Sandy Creek and to a lesser extent, Lonestar Generation, and who are expected to run as a baseload plant with capacity factors in excess of 75%, around-the-clock (ATC) pricing is more relevant than on-peak prices. The picture is equally bleak with ATC prices in 2015 being much lower than recorded in 2014. We see 2016 to be a similar story to 2015 given the current excess supply. Exhibits 8 and 9 below highlight year-on-year around-the-clock (ATC) price change on a real time basis for two of the zones near large population centers, ERCOT North (near Dallas) and Houston. Exhibit 8 Exhibit 9 Power prices fell in 2015 Power prices fell in 2015 Around-the-clock prices, year-over-year Around-the-clock prices, year-over-year Source: SNL Financial Source: SNL Financial GDP growth still likely to outpace electricity growth GDP growth in Texas has outpaced electricity consumption in recent years, most notably since 2011. However, were it not for record breaking drought and extreme temperatures in 2011, the disparity between GDP growth and electricity use would likely have been greater than illustrated in Exhibit 10 below. We believe that strategies adopted by industrial users and large utilities to manage their power use and load, together with better integration and changing residential consumption habits are capping demand, which ultimately help keep power prices down. Below in Exhibit 10 we highlight diverging trends since 2011. 6 23 March 2016 US Unregulated Power and Project Finance: ERCOT: Renewables To Hold Down Power Prices in the Lone Star State INFRASTRUCTURE AND PROJECT FINANCE MOODY'S INVESTORS SERVICE Exhibit 10 Modest electricity demand even as Texas’s economy grows Source: Moody's Analytics, ERCOT Demand and Energy Reports While industrial users are altering their own consumption behavior, we also observe that industrial and manufacturing activity in general has recently declined, which alone will lead to less power consumption. In Exhibit 11, we show the Texas Manufacturing Index since 2004. Levels in January and February 2016 are at their lowest since the 2008 recession. With electricity use expected to be most intense in this sector, the picture highlights a more pessimistic view of the business activity, which directly translates into lower power consumption. Exhibit 11 Declining manufacturing will lessen power demand Texas Manufacturing Outlook Survey, Diffusion Index; >0 is Expansionary U.S. Board of Governors of the Federal Reserve System (FRB):Bank of Dallas Source: Moody's Analytics Financing challenges, supply shocks or weather could drive up prices Balancing this view, we recognize that several factors exist that could give a positive jolt to power prices and benefit unregulated power generators. These factor include the ability to access financing for new development projects, the potential for coal plant retirements and weather. Current sector-wide credit concerns and rising credit spreads may present a challenge to obtaining financing for new merchant project development. Some of the newest natural gas fired generation that have come-on line in the past two years in Texas benefitted greatly from a very low interest rate environment and an issuer friendly high yield capital market. 7 23 March 2016 US Unregulated Power and Project Finance: ERCOT: Renewables To Hold Down Power Prices in the Lone Star State MOODY'S INVESTORS SERVICE Exhibit 12 Financing getting costlier Seven-year spread over treasury INFRASTRUCTURE AND PROJECT FINANCE Credit spreads have jumped over the past year, particularly in recent months. The majority of non-contracted, project financings with a meaningful degree of merchant exposure tend to fall between the “Ba” and “B” rating categories. For example, spreads in the “B” rating category have increased by as much as 200 bps in the past five to six months. Higher interest rates and the more selective credit environment could delay potential new merchant additions for some period. Source: Moody's Investors Service Coal retirements remain the x-factor in ERCOT and an unexpected level of base-load coal retirements would boost power prices, notwithstanding expectations for increasing levels of renewable generation and sustained low natural gas prices. In Exhibit 13 below we derived a list of plants “on the fence” owing to their cash-flow profile on a merchant, unhedged basis. Our analysis is based on variable cost and forward price for the next 12 months and a roughly estimated cash fixed cost of $70/kW-year. We utilized a blended power price calculation based on on-peak prices up to a 50% capacity factor and off-peak prices for capacity factors above 50%. We caution that this data is preliminary and some plants, while cash-flow negative now, are not planning to be retired, especially as some benefit from the presence of hedges or contracts for a sizeable portion of the plant capacity, such as Sandy Creek. Nevertheless, we find this instructive in highlighting the number of plants that could come off line due to poor economics if power prices persist at their current low levels, which would benefit merchant gas-fired generators. Exhibit 13 Coal plants at risk Source: SNL Financial, Moody's Investors Service The plants with negative un-levered cash-flow total (red columns) over 12,000 MWs as compared to the 19,900 MWs in total coalfired capacity of all the plants listed below. In the extreme case, should the plants that are free cash flow negative end up being mothballed, the power price forecast would be significantly altered. However, that scenario is unlikely in 2016 as ERCOT does not forecast any capacity reductions for this summer based on its preliminary summer 2016 SARA report. Furthermore, the decision to 8 23 March 2016 US Unregulated Power and Project Finance: ERCOT: Renewables To Hold Down Power Prices in the Lone Star State MOODY'S INVESTORS SERVICE INFRASTRUCTURE AND PROJECT FINANCE mothball will be driven by each owner's cash flow expectations which will vary and is highly unpredictable. Please see Appendix B for plant size, capacity factors and zonal location in ERCOT. Finally, weather is always a wildcard in ERCOT and an extremely hot summer could put rapid upward pressure on prices that currently have a ceiling of up to $9,000/MWh. Several hours at this pricing level for several days could result in sizeable gains for generators. As illustrated below, scarcity pricing has occurred at very few intervals and only notably in August 2015 when new peak demand records were set. Prices lasted not even for a full hour and were well below $9,000/MWh. Exhibit 14 Not so scarce Real-time pricing, ERCOT North, Hourly Source: SNL Financial, Moody's Investors Service As illustrated in Exhibit 15 below, based on cooling degree days (the number of degrees that a day's average temperature is above 65 degrees Fahrenheit), the last several years experienced less intense temperatures compared to the average, with only 2011 seeing well above average temperatures. In Dallas in 2011, temperatures exceeded 100 degrees for a record 71 days12 and even in 2015 when cooling degree days exceeded the prior three years and temperatures were above average, power prices in ERCOT remained below average. Exhibit 15 Exceedance of Average Temperature in Houston Source: www.weatherdatadepot.com, Moody's 9 23 March 2016 US Unregulated Power and Project Finance: ERCOT: Renewables To Hold Down Power Prices in the Lone Star State INFRASTRUCTURE AND PROJECT FINANCE MOODY'S INVESTORS SERVICE Appendix A - About ERCOT Exhibit 16 The Electric Reliability Council of Texas (ERCOT) manages the flow of electric power to 24 million Texas customers -representing about 90 percent of the state’s electric load (as shown in blue). As the independent system operator for the region, ERCOT schedules power on an electric grid that connects more than 43,000 miles of transmission lines and 550 generation units. ERCOT also performs financial settlement for the competitive wholesale bulk-power market and administers retail switching for 6.7 million premises in competitive choice areas. ERCOT is a membership-based 501(c)(4) nonprofit corporation, governed by a board of directors and subject to oversight by the Public Utility Commission of Texas and the Texas Legislature. ERCOT's members include consumers, cooperatives, generators, power marketers, retail electric providers, investor-owned electric utilities (transmission and distribution providers), and municipal-owned electric utilities. Source: ERCOT Appendix B - At Risk Coal Plants Exhibit 17 Source: SNL Financial; Moody's Investors Service 10 23 March 2016 US Unregulated Power and Project Finance: ERCOT: Renewables To Hold Down Power Prices in the Lone Star State INFRASTRUCTURE AND PROJECT FINANCE MOODY'S INVESTORS SERVICE Moody's Related Research Unregulated Power » North American Project Finance Issuers Are Vulnerable to Weak Commodity Cycle, February 2016 (1017147) » Gas and Power Prices Could Be Lower For Longer; Outlook Shifts to Negative, November 2015 (1009149) » ERCOT: Power Market Doldrums in the Lone Star State, May 2015 (1003428) » EPA Carbon Rule Hurts Coal, Boosts Renewables, August 2015 (1007366) » US Supreme Court’s Stay of Clean Power Plan May Swing Merchant Coal Plant Closure Decisions, February 2016 (187595) » US Supreme Court MATS Ruling is Positive for Coal-Dependent Public Power, Negative for Unregulated Midwest Generators, July 2015 (182792) Other Energy Sectors » Increased Supply and Concerns About Demand Growth Drive Prices Yet Lower, January 2016 (1014345) » Persistent Weak Prices in 2016 Rein in Capital Spending, Heighten Financing Risk, January 2016 (1011164) » Oil and Gas Industry Will Wrestle With “Lower for Longer” Conditions in 2016, November 2015 (1009544) » Oil and Gas Price Assumptions: Continued Oversupply Compounds Weakening Demand, October 2015 (1009269) To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report and that more recent reports may be available. All research may not be available to all clients. 11 23 March 2016 US Unregulated Power and Project Finance: ERCOT: Renewables To Hold Down Power Prices in the Lone Star State INFRASTRUCTURE AND PROJECT FINANCE MOODY'S INVESTORS SERVICE Endnotes 1 https://www.gpo.gov/fdsys/pkg/BILLS-114hr2029enr/pdf/BILLS-114hr2029enr.pdf 2 https://www.gpo.gov/fdsys/pkg/BILLS-114hr2029enr/pdf/BILLS-114hr2029enr.pdf 3 Consolidated Appropriations Act, 2016 (the Act). The PTC starts at $0.023/kWh and is reduced by 20% for projects commencing construction in 2017, by 40% for projects commencing construction in 2018 and by 60% for projects commencing construction in 2019. 4 http://www.nytimes.com/2015/11/09/business/energy-environment/a-texas-utility-offers-a-nighttime-special-free-electricity.html?_r=0 5 http://www.seia.org/research-resources/solar-investment-tax-credit-itc-101 6 Power Market Doldrums in the Lone Star State 7 http://www.ercot.com/gridinfo/resource/index.html) 8 https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1014345 9 http://www.climatecentral.org/news/wind-may-have-kept-lights-on-in-texas-during-cold-snap-17101 10 http://www.ercot.com/services/comm/mkt_notices/opsmessages/2014/01 11 Dynegy acquired the ENGIE portfolio with an expected close end of 2015. The ENGIE assets are 4,400 MW in ERCOT but collectively represent less than 10% of Dynegy's cashflow. 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REPORT NUMBER 1013808 13 23 March 2016 US Unregulated Power and Project Finance: ERCOT: Renewables To Hold Down Power Prices in the Lone Star State INFRASTRUCTURE AND PROJECT FINANCE MOODY'S INVESTORS SERVICE Contacts 14 CLIENT SERVICES Charles Berckmann AVP-Analyst charles.berckmann@moodys.com 212-553-2811 Toby Shea VP-Sr Credit Officer toby.shea@moodys.com 212-553-1779 Chee Mee Hu MD-Project Finance cheemee.hu@moodys.com 212-553-3665 23 March 2016 Swami Venkataraman, CFA VP-Sr Credit Officer swami.venkat@moodys.com 212-553-7950 Laura Schumacher VP-Sr Credit Officer laura.schumacher@moodys.com 212-553-3853 Americas 1-212-553-1653 Asia Pacific 852-3551-3077 Japan 81-3-5408-4100 EMEA 44-20-7772-5454 US Unregulated Power and Project Finance: ERCOT: Renewables To Hold Down Power Prices in the Lone Star State