For a case study in how to run a company into the ground, look no further than the Puerto Rico Electric Power Authority.
The island’s government-owned electric utility has $9 billion in debt, falling sales and rising costs. Its electricity rates for consumers run 2
All that money has purchased precious little. The utility’s power plants, with a median age of 44 years, lack pollution controls and violate Environmental Protection Agency mercury limits. The plants burn dirty residual fuel oil and diesel to generate about two-thirds of the island’s power. And thanks to aging infrastructure, frequent and costly power failures plague customers. The calls of customers bold enough to phone the utility to complain about service are dropped more than 50 percent of the time.
Now, however, PREPA is running out of cash and its creditors — including the major bond funds Oppenheimer and Franklin Templeton — can’t be put on hold.
The utility lies at the epicenter of a mounting financial crisis in Puerto Rico, frequently called “America’s Greece.” The territory’s governor recently called the island’s $73 billion of debts “unpayable.” With hundreds of millions of dollars of payments looming and little cash on hand, PREPA has been thrust to the forefront of a fight over whether the Puerto Rican commonwealth should be able to resort to U.S. bankruptcy courts for protection while it restructures its debts.
That in turn is part of a larger debate over the status of Puerto Rico — tethered to the United States ever since it was seized in the Spanish-American War of 1898, yet treated neither as a state nor as a country. Bankruptcy rules are part of that. In 1984, Congress passed legislation barring municipalities, agencies and government-owned utilities in Puerto Rico from declaring bankruptcy, while allowing those located on the mainland to do so.
Amid all this, PREPA stands out as what Puerto Rican Gov. Alejandro Garcia Padilla in an interview called “the biggest mess.”
A report issued by three veteran International Monetary Fund economists said the utility’s poor performance not only ruined its own balance sheet but also undermined the Puerto Rican economy’s competitiveness because of needlessly high electricity rates.
“As a key input cost, this cascades down to locally produced goods and services and stunts potential growth sectors such as tourism,” the report said.
The cost and availability of energy “is probably the most serious issue we face today,” said Eric Spackey, chief executive officer of Bluewater Defense, a manufacturer of uniforms and protective clothing for the military. “My largest fixed cost is energy, and sadly service in the area of my plant is intermittent.”
Spackey said that every time there is a power failure, more than 450 machines in his complex just west of San Juan “turn off and production stops until the generator kicks in and the machines can reboot — disrupting the production flow, machine circuit boards and ultimately morale.” He said that while the government is aware of the problems, he fears the liquidity crisis will only make things worse.
Fixing the mess at PREPA — whose chief executive and several other top officials resigned in June — will be no small task.
“This is not something where a few tweaks will do,” said Anne O. Krueger, former chief economist at the World Bank and former No. 2 official at the International Monetary Fund. She helped write the report on Puerto Rico’s finances.
One of the main problems is PREPA’s overwhelming dependence on oil for power generation, a function of poor planning. Moreover, its antiquated power plants burn the oil inefficiently. As a result, high oil prices over the past 10 years have helped strangle the utility and at one point drove electricity rates over 30 cents a kilowatt hour.
But PREPA’s problems run deeper than that and are rooted in the island’s political culture.
The Krueger-led report called PREPA “an inefficient and over-staffed public enterprise using technologies decades out of date.” Three-quarters of the utilities service trucks are “obsolete” and frequently out of service, said a presentation by Lisa J. Donahue, a managing director of New York-based Alix Partners who is now acting as the utility’s restructuring officer.
Donahue has vowed to fix the trucks and shrink the bloated payroll, which is twice as big as the average utility payroll on the mainland, according to a June 2010 report by the Center for a New Economy.
Both of the island’s political parties have been complicit; they have padded the payrolls with loyalists in equal number as part of an unwritten pact to feed off the utility’s revenues. More than a thousand of these “trust employees” work more — and earn more — when their party is in power.
“So when your party is in the majority, you might be given more responsibilities, and if it is out of power then you are sent to the basement for four years,” said former Puerto Rico secretary of state Kenneth McClintock, who tried in vain to reform PREPA when he was in office. He said that the political parties also raised money by pressing the utility’s suppliers to buy tickets to utility raffles or social events whose earnings go to the parties.
The EPA’s experience with PREPA suggests not just political meddling but a pattern of disregard of laws and regulations. In 1993, the utility was found to have committed multiple violations of air, water and storage-tank regulations. In 1997, it was fined for failing to fix those. In 1999, the EPA won a criminal case under the Clean Water Act to force the utility to comply with orders after a sulfuric acid spill. In 2004, PREPA was fined again for failing to meet terms of an earlier consent decree.
Not all of PREPA’s woes are of its own making. The Puerto Rican government, no matter what party was in power, has in the past used its ownership of public utilities to extend subsidies to lure new investors or keep businesses from leaving, Eugenio J. Alemán, senior economist of Wells Fargo, wrote in a May 24, 2012, note to investors.
“In the past, some of the hotels that have gone bankrupt over the years on the island had been delinquent in their public utility bill payments and phone bills for years before the bankruptcy, but state-owned public utilities never enforced the collection of their bills from those hotel chains,” Alemán said.
“This meant that public utilities would have to recoup the costs of these subsidies either by not investing or by charging a higher rate to other businesses or individuals or a combination of both strategies,” he wrote. “For many decades, they did not do either. This is one of the reasons why public utilities are in such dismal conditions today.”
As the commonwealth’s finances have crumbled, PREPA also has had trouble collecting money owed by the government itself. According to the last report, from 2013, the government owed the utility $250 million.
Stealing electricity has grown more prevalent too, by some estimates draining as much as 15 to 25 percent of output.
Many investors have put forth a different vision of PREPA, offering to build a variety of solar, wind, hydro and natural-gas-powered plants to make the utility’s electricity cheaper and greener.
Yet PREPA, reluctant to relinquish its grip on power supplies, has turned away many of those investors. Although sunlight is plentiful and breezes steady, the island has only about 150 megawatts of wind and solar installed — barely 1 percent of total consumption. Although many wind and solar developers have signed contracts with PREPA, virtually all of them have shelved the projects for now.
In late 2012, Robert Sternthal, president of CohnReznick Capital Markets Securities, predicted that Puerto Rico would become “the next hot development spot in the U.S. solar market.” After all, with nationwide tax incentives and the high cost of oil-fired electricity, solar would be significantly cheaper than business as usual.
Today, a frustrated Sternthal admits he was wrong. PREPA demanded that independent solar power developers meet “minimum technical requirements” or PREPA would close off the solar project’s access to the grid for an unspecified amount of time, with no clear guidance on when a project could come back online, Sternthal wrote in a November 2013 online solar industry publication.
Complying with PREPA’s requirements “is a near impossibility” and “would make nearly all of the projects uneconomic to build,” wrote Sternthal, whose firm has arranged financing for more than $4 billion in renewable energy projects. By the time PREPA’s finances are sorted out, the federal tax incentives for solar will probably have expired.
“To me it’s astounding that you look at the world and the creation of renewables, at how many megawatts are built every day, and these guys cannot get out of their own way,” Sternthal said in an interview. “They would save millions, if not hundreds of millions of dollars, a year.”
Now PREPA is attracting conventional firms and financiers who see the potential for big savings and profits.
York Capital, a New York-based investment firm, and NRG, one of the country’s largest electric utilities, teamed with ITC Holdings, a transmission company, and recently came up with a grand vision for Puerto Rico’s electricity sector. The three firms said they would invest $3.5 billion to install a natural-gas-fired plant, about 400 megawatts of solar, and transmission lines to take power from the gas plant in the south of the island to the north.
The group would sell electricity to PREPA — without getting involved in the utility’s debt headaches, its four trade unions or its aging power plants.
Within a couple of years, the group says, the island would save $1.5 billion annually, or 9 cents a kilowatt hour, more than 40 percent of retail rates — enough to pay creditors and still slash consumers’ bills.
“Our interest in the project comes from being distress investors and restructuring experts,” said William Vrattos, partner and head of global credit at York. “At PREPA, we felt that not only would more value be created for the PREPA bankruptcy estate or the company but also for the island and all the stakeholders.”
For now, PREPA is at the mercy of its creditors while a team hired by the Puerto Rican government scrambles to restructure — and get some financial relief.
On July 13 at Citigroup’s midtown Manhattan headquarters, advisers to PREPA spelled out to a room crowded with creditors how dire the island’s situation is.
Jim Millstein, former head of restructuring at the Treasury during the financial crisis, warned at the meeting that “if this turns into a donnybrook, with creditors litigating against one another and litigating with the commonwealth,” it would hurt the economy and tax revenues needed to meet payments. Millstein’s firm has been working with Puerto Rico’s Government Development Bank.
PREPA proposed deferring principal payments and most interest payments for five years, delaying more than $600 million a year in payments and providing the utility with enough capital to build more efficient power plants that would be cheaper to operate because they wouldn’t burn petroleum.
The biggest creditors initially insisted that the utility could cover interest costs by raising electricity rates about 4 cents a kilowatt hour. The utility’s advisers replied that higher rates would only accelerate the fall in demand, which has sliding about 2.5 percent a year for the past decade.
Franklin Templeton and Oppenheimer have about $10 billion in Puerto Rican bonds, valued by investors because interest on such bonds is exempt from federal, state and local taxes. Together with Blue Mountain, a hedge fund, Franklin Templeton and Oppenheimer won an appeals court ruling that threw out Puerto Rican legislation that would have allowed government entities there to use bankruptcy, saying that power belonged to Congress.
But on Thursday, a group representing holders of 40 percent of PREPA’s bonds — including Franklin, Oppenheimer, Blue Mountain and Knighthead, another hedge fund — made a counterproposal, offering to exchange old bonds for new ones with lower average interest rates and a mixture of deferred payments.
For PREPA, it would be a mixed bag. It would still pay $1.6 billion in the first five years but would save $2.5 billion in interest and principal payments over 10 years. Electricity rates would be lower than Hawaii’s but would remain high compared with rates on the mainland.
A big obstacle to a compromise could be the two companies that insured much of PREPA’s bonds — National, formerly known as MBIA, and Assured. They have guaranteed $10 billion of Puerto Rican debt; about $3 billion of that was issued by PREPA. If PREPA and its bondholders agree on terms, National and Assured, which also guaranteed mortgage securities caught in the housing collapse of 2008, would still have to pay investors in insured bonds the shortfall.
To Wolfe, co-author of the Krueger report, the PREPA crisis echoes the earlier U.S. financial crisis.
“To me, this is second example of where financial markets have completely failed because of bad information,” Wolfe said. Just as ratings agencies rated sub-prime mortgages without any idea what they were rating, he said, “here investors were lending to a governmental agency, and no one knew what its financial situation was.”