According to global rating agency Standard & Poors (S&P) the past ten years has seen the number of independent power producers (IPPs) slowly dwindle.
It’s not set to change anytime soon, says the agency, thanks in part to the largest fuel switch in the electric industry's history—from coal to natural gas, which has led to changing consumer preferences, new technologies, weaker commodity prices, and greater distributed generation.
The changes have put tremendous pressure on the traditional IPP model.
Taken together, these disruptions make conventional IPP generation difficult to predict, and the agency believes that these uncertainties will continue for some time. Also interesting is the increasing availability and use of renewable power sources, which have often performed well when conventional power runs short, and a more robust power system with limited fuel interruptions is perhaps permanently affecting electricity demand.
IPPs have no choice but to evolve and adapt to a rapidly changing marketplace and join the trend towards deleveraging, and aggressively transform their portfolios and entire business strategies in ways that favourably affecting many companies' credit profiles.
With the future unclear for the IPPs, S&P Global Ratings is updating its credit views on the sector, with an emphasis on how the IPP business model has changed over the past two years. Although credit profiles are generally improving, the agency notes a need to see certain improvements before higher ratings are considered for these companies, and investors.
- IPPs are under intense pressure as renewable energy sources and distributed generation have increased, and commodity prices have fallen
- Although the ultimate effects of these disruptions on IPPs remain uncertain, we believe these changes are continuing to result in unsustainably volatile or declining cash flow
- We believe that the IPPs will respond to the new industry dynamics by substantially reducing leverage, pursuing a new business model that strongly integrates wholesale and retail power sales, or even deciding to go private
- While we have already seen some credit quality improvement that reflects deleveraging, we think that to achieve an investment-grade rating IPPs will have to overhaul their current business model to better balance wholesale and retail power sales
- We will, however, monitor cash flow volatility at the IPPs, as we will need to see a satisfactory cash flow history before we assess any company's efforts to change its business model
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Can they achieve an investment-grade rating?
Over the past two years, even as IPP's began cutting debt, none had publicly and clearly stated a desire for investment-grade ratings. However, given the volatility of commodity prices, S&P sees an investment-grade rating bringing significant benefits as IPP's have slowly shown increasing desire to achieve that status.
An investment-grade rating has consistently shown some clear advantages such lower cost of capital, lower collateral postings with counterparties, a better ability to transact with counterparties—especially industrial customers that prefer investment-grade counterparties—and reduced liquidity needs, but now additional advantages are also becoming apparent.
Benefits could include better access to capital and alignment with public equity investors looking for simpler and less risky capital structures, with the agency noting that public equity investors, showing that investment-grade ratings appear to have relevance for shareholder value, and maximising stakeholder value propositions.
The truth, says S&P, is that ultimately IPPs are not there yet.
Until fully-engaged and sustainable transformation strategies, which deleverage dependence on, and reduce risk to, wholesale power markets become more common-place and apparent, IPP’s aren’t likely to get the rating.
Says S&P, companies with an integrated model have not yet been tested in either a competitive market, where the fight for market share may become fiercer, or under adverse conditions such as extreme, or very mild weather, where the efficiency and efficacy of integration can be tested, but they’ll be watching the market for the next two years, where consistency, and delivering on commitments will go a long way to proving the case for the rating so many believe is already late.