Restructuring PREPAs Debt Part II: What Replaces the RSA?
Founding Director, Fundación Borincana
Good news for Puerto Rico.
It may be counterintuitive for those outside Puerto Rico, but it looks increasingly like the Restructuring Support Agreement (RSA) between bondholders and PREPA to restructure its debt is dead on arrival in the Puerto Rico legislature. Despite pressure from bondholders and the Financial Oversight & Management Board (FOMB – the federally mandated group overseeing the bankruptcy) to approve the deal, the governor and the legislature of Puerto Rico seem to have responded to widespread public opposition and reports have AAFAF (Fiscal Agency and Financial Advisory Authority of Puerto Rico, think Treasury Department), who signed the deal, stating that the terms of the deal are in fact “subject to change“.
The RSA was the product of a FOMB and Governor in a hurry to get PREPA out of bankruptcy on the basis of a minimally viable deal. The Puerto Rico Energy Bureau (PREB – the energy industry regulatory body) was inexplicably by-passed and undermined in the process. Ms. Jaresko, Head of the FOMB, was correct when she publicly emphasized that PREPA’s emergence from bankruptcy is critical and that speed and a less than perfect deal have greater value than is publicly appreciated. Nevertheless, the RSA as it finally emerged was a “blunt” and “dumb” instrument that threatened not only the transformation of PREPA and the energy system but the future economic recovery of Puerto Rico. In a multi-dimensional environment, it demonstrated shockingly two-dimensional thinking. After months and months and tens of millions of dollars in legal and advisory fees, Puerto Rico deserves better.
So, what do you put in place of the Restructuring Support Agreement? In all of the outrage and protest no one seems to have genuinely focused on what comes next.
I have a few ideas.
In August 2018 in Restructuring PREPA’s Debt: Thoughts on the PRSA, I wrote “The structural concept is sound: term out significantly to lower the immediate burden on the defaulting party while writing off less from face value - pleasing creditors and offering the prospect that at some future point they may trade at or over new face value as the utility or its successor recovers. Moreover, the security of the Transition Charges and the operational tax they place on the utility increases the likelihood of a refinancing when the capital markets are accessible once more. Meanwhile, it is unclear from the document but from the context of commentary it appears bondholders will be giving up any general claim on the utility for a specific one on the account into which the Transition Charges are paid. This provides visibility and certainty on the costs to the utility and customers.”
I also added, “Lest it become ‘the tail that wags the dog,’ the ultimate deal must not in any way infringe upon the utility or the energy infrastructure system to evolve or the government or regulator (PREB) to act in full discretion for the benefit of Puerto Rico.”
The problem with the RSA is not the bankruptcy-remote Special Purpose Vehicle (SPV) structure or the fact of a transition charge that improves the credit quality of the new bonds. Transition charges are simply specified, mandatory charges most commonly used in situations where asset security is unavailable - like sovereign debt workouts or utility stranded cost recovery. Puerto Rico’s sales tax bond structure is an example. PREPA’s situation is similar but has some differences.
The problem here is the crippling mandatory amount of the transition charge in the RSA, the inability of that charge to respond dynamically to changes in circumstance of PREPA both positive and negative, and an agreement that dictates policy – disempowering the government and PREB and disincentivizing the transformation and modernization of Puerto Rico’s energy infrastructure.
So, we can keep the basic structure - which is good because speed to an agreement is still important. Here are my suggestions of the types of modifications needed to make the “new” RSA one that works for PREPA, the people, and the economic future of Puerto Rico:
Additional Cuts to the Debt. Eighteen months ago, I was indifferent to greater reductions to the face value of the debt noting that “Much or more can be accomplished by pushing out maturity, lowering interest rates, and reducing the Transition Charges.” After the earthquakes and the prolonged loss of 20% of the island’s generating capacity, this needs to move closer to 50%.
Extend the Repayment Period and Create an Interest-only Period. Move final maturity out by 5 years and create a 5 year interest only period at the front end. This will not materially change the value of the bonds to their holders but will create additional room to moderate the transition charge in the critical early period.
Enhance the new RSA Credit Structure to Lower the Interest Rate. Interest Rates on exchanged debt are punitive and this case is no exception. There is risk and perhaps more important there is a high perception of risk which damages liquidity value. Nevertheless, if for example all revenues of PREPA where to go into a lockbox account administered by a trustee and if the transition charge was paid to the SPV near the top of the waterfall of funds flowing from the account, this would lower payment risk and justify a lower interest rate. The draft laws talk about the SPV being the “sole and exclusive” owner of transition revenues, but make no mention of any structural risk reduction. Lowering interest rates in response to lower risk will increase the likelihood of recovery, materially reduce the cash flow burden and create significant room to moderate the transition charge.
Litigation/Settlements and Proceeds of Privatization. There would appear to be a case for recovery against the Underwriters of the bonds, and the privatization/concession agreements contemplated by the law could result in cash flows to PREPA. There is no tangible guarantee that these actions will result in any payments whatsoever, but pledging any net recoveries to a prepayment or cash collateralization of the new bonds would be a benefit to the bondholders that might support a more favorable view of changes elsewhere.
Lower the Minimum Transition Charge but Make It Dynamic. Structure the charge so that the minimum mandatory payment is for example $.01 to start but increases as a percentage of PREPA operational cost savings so that bondholders interests are aligned and vested with PREPA’s successful transformation and recovery (and so customers do not see their bills increase - this would be a result consistent with the stated aims of the legislative branch who must approve any new deal).
That is the carrot, but to make it viable there has to be a stick. PREPA, the government, and/or the PREB will be required to take steps and achieve agreed objective goals (chosen to support enhanced performance, reliability, and resiliency of the system, to promote third party capital investment in distributed electric infrastructure, and to facilitate economic recovery and growth across the island). Failure to take those steps and reach those goals will result in an increase of the minimum transition charge (so customers WILL see their electric bills increase and take steps to hold the utility and government accountable for getting back on track).
I will not speculate here about what these steps and goals should be. That is a longer discussion. But this approach would empower and reinforce the PREB where the former RSA undermined it.
Who Pays? This is perhaps the most important and difficult question for which an answer must be provided. As “owners” of PREPA the people of Puerto Rico are ultimately responsible for its debts. However, it is not productive to think about transferring repayment to the public at large and so the burden falls entirely on the customers. This tends strongly to be more regressive – disproportionately affecting those at the lower end of the income scale. This is one of the hidden risks of publicly owned utilities.
In structuring the policy around payment, care must be taken to avoid items that would disincentivize private investment in resilient, distributed infrastructure or unduly bind the ability of the PREB and the energy sector to carry out reforms. These are crucial to the economic redevelopment and growth of Puerto Rico. It was short-sighted and contrary to their own interests for bondholders to insist on the types of detailed controls and charges that they did in the RSA. Economic growth drives energy consumption which drives transition charge revenues. Even where a growing proportion of power is distributed and self-generated, much of it will still rely on the grid and should generate higher revenues to the SPV.
In principle, I believe EVERY kWh taken off the grid should be subject to payment of the transition charge – no exceptions. In relation to overburdening the poor, PREPA and PREB are perfectly capable of negating the effect through its own tariff making. Those with solar systems that use the grid as their storage system through net metering would see their benefit eroded slightly but it is fair that they share in the cost associated with the benefit they receive. Those deploying storage systems would avoid most of this cost as they rely less on the grid and this will incentivize more investment in the resiliency afforded by distributed storage.
There should not be a so-called “solar tax“ that transfers an undue burden on those very people investing their time and resources to lead the transformation and economic recovery of Puerto Rico. On the other hand, it is not wrong that PREPA should require some form of modest exit charge for those leaving the system and significant stand-by charges for large consumers who self-generate to cover the cost of “spinning reserves” it must maintain for system stability. Smaller systems less than 25kW should probably be exempt with gradations for larger systems depending upon the risk posed to the system. Those larger consumers who self-generate and install storage and demand response might limit this and even see revenues if their assets are made available to strengthen and balance the grid. In this manner the grid will be strengthened organically without the deliberate intervention of PREPA, materially reducing the operational and capital burdens on a utility that can use all the help it can get.
PREPA and Puerto Rico need a more creative and thoughtful resolution to its debt that aligns with and supports energy infrastructure transformation and economic development and recovery. The better the deal, the more likely PREPA and Puerto Rico are to succeed and the less likely we will be back into another restructuring discussion in a few years’ time.