Natural disasters spark rate reduction bond supply

IFR 2371 - 20 Feb 2021 - 26 Feb 2021
4 min read
Richard Leong

Extreme natural events are acting as a catalyst for more US utilities to return to the ABS market to raise financing to recover costs and protect their power equipment as the first such deal in more than a year was priced last week.

Wildfires that damaged California's power grid last summer and the deadly cold snap in Texas that caused millions of residents to lose power last week could convince state lawmakers and regulators to allow utilities to assess special fees from customers to back debt – via so-called rate reduction bonds – to recoup costs and to prevent damages from such events.

"The amount of utility securitisations that will be coming out over the next couple of years versus the last couple years could increase," a senior ABS banker said.

Rate reduction bonds began life as a financing mechanism that allowed utilities to recover past investments after their states deregulated local power markets. Their use has expanded to fund upgrading of existing plants with pollution controls and to recoup expenses on shuttered nuclear power plants.

More than two decades since their debut, they could become a critical vehicle for utilities to help address natural disasters.

For investors, a new generation of such deals would be welcome as they hunt for high-quality long-dated bonds in the current rock-bottom yield climate.

"People will gravitate toward them. You have a lot of cash on the sidelines right now," Merganser Capital portfolio manager Peter Kaplan said.

Market observers warned, though, that the pace of increase of issuance of such bonds may be modest. Not every major incident has led lawmakers to approve new sets of rate reduction bonds for recovery costs, they said.

Given the recent dearth of issuance, the outstanding balance of rate reduction bonds has fallen to US$11.5bn across 35 deals, as a majority of the 80 issues, whose original balance had totalled US$63bn, have been repaid, said Moody's senior credit officer Tracy Rice.

Out of the gate

On Wednesday, Southern California Edison, an Edison International unit, recharged this sluggish corner of the ABS market. Its US$337.78m SCE Senior Secured Recovery Bonds Series 2021, jointly led by Barclays and RBC, saw huge orders that resulted in some of the lowest yields for this type of ABS. The yield on SoCal Edison's 20-year Triple A note came in at 2.51%, which was 60bp above 20-year Treasuries.

It was the first deal in the rate reduction market since a US$235m issue from American Electric Power in September 2019 that recouped repair costs from Hurricane Harvey in 2017.

In 2019, the California legislature enacted a statute that allows large electric utilities to recover up to a combined US$5bn of their expenditures on fire mitigation efforts in the securitisation market. SCE's share of the US$5bn is US$1.575bn, Fitch Ratings said in a pre-sale report on the SoCal Edison deal.

By letting utilities borrow from the ABS market, regulators and lawmakers hope to lower the cost for electric customers on a present value basis. In SCE's case, it is estimated the net-present value benefits for customers from the ABS financing are around US$173.5m, Fitch said.

Outside of California, two other states have allowed utilities to tap the ABS market on a smaller scale.

In November, state lawmakers approved Wisconsin Electric Power to refinance US$100m in costs linked to environmental controls installed at its now retired Pleasant Prairie coal-fired power plant, while North Carolina passed a law in late 2019 that permits utilities to issue bonds to fund storm recovery with the goal to save customers 15%–20% on storm costs.