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Electricity securitization in China
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Energy 32 (2007) 1886–1895 www.elsevier.com/locate/energy
Electricity securitization in China Wei Liua, J.H. Wangb,, Jun Xiec, Chang Songa a
School of Business, Renmin University of China, Beijing 100872, China Department of Electrical and Computer Engineering, Illinois Institute of Technology, Chicago 60616, USA c School of Management, Wuhan University of Technology, 430070, China
b
Received 10 August 2006
Abstract This paper discusses the past and the status quo of electricity securitization in China. First, the stranded cost securitization in American electricity industry and the ongoing securitization progress in emerging market countries are investigated, which enlightens the way of electricity securitization in China. Through analysis of electricity industry in China, the paper proposes constructive policy suggestions for regulators who intend to prompt securitization to develop electricity infrastructure, and detailed recommendations for companies who plan to raise money at reduced cost. It is concluded that even though it is at the very beginning stage in China, securitization not only provides financing for investment projects, but also speeds up the reform by stranded cost securitization, a novel idea for electricity industry in China. r 2007 Elsevier Ltd. All rights reserved. Keywords: Securitization; Electricity policy; Electricity industry; Electricity restructuring; China
1. Introduction China is experiencing a boom in economy, in which electricity infrastructure development is playing a vital role for prompting and maintaining her momentum. International Energy Agency (IEA) forecasted that the demand of electricity in China will increase by 4.5% through 2030 and the corresponding investment in the electricity industry will amount to two billion US dollars [1]. In the mean time, the electricity industry reform has made a substantial step towards an ultimate competitive market. Several pilot market operations have demonstrated the bright future for further restructuring. To meet the fast increasing demand of electricity and address the stranded cost recovery in the ongoing reform, this paper aims to explore securitization as a potential way to finance electricity-related projects and recover the stranded cost. Previous domestic and overseas experience has illustrated the workable application of securitization to the electricity industry. In 2004, Huaneng Lancangjiang Corresponding author. Tel.: +1 224 217 2342; fax: +1 312 567 8976.
E-mail address: [email protected] (J.H. Wang). 0360-5442/$ - see front matter r 2007 Elsevier Ltd. All rights reserved. doi:10.1016/j.energy.2007.02.001
Hydropower Return Special-purposed Asset Management Scheme (Lancangjiang Scheme) as the first electricity securitization case in China was successfully applied, which gave a good example of project financing by securitization. Experiences from the electricity asset backed securitization in US and future flow backed securitization of emerging markets also offer valuable reference to China. However, even though securitization has been proven to be a feasible and effective tool for financing in China and recovering stranded cost overseas, there are no mature regulatory and legal conditions to guarantee the broad application of securitization in China yet. Many challenges for regulation, legistration and utilities themselves still exist. Previous research has shown that no uniform reform template can be applied to different countries and the specific reform must be built based on the thorough consideration of connections between economic ideals and political reality [2]. A broad set of accommodation including legitimacy, regulation and public benefits must be realized [3]. To analyze these challenges and promote the securitization in China’s unique case, our discussion proceeds as follows. Section 2 reviews the general concept of electricity asset backed securitization in America and future flow
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securitization in emerging markets. Section 3 analyzes the successful application of Huaneng Scheme. Section 4 investigates the current status of securitization in China and lists the obstacles to securitization. Section 5 gives thorough suggestions for government, legistration and utilities to advance securitization. Section 6 concludes the discussion. 2. Electricity securitization in other countries The general incentive of securitization is to enable companies to isolate funding activity from credit rating. Asset Backed Securitization (ABS) is the separation of favorable assets from a corporation or financial institution, which will render the intended assets independent of and higher than the creditworthiness of the originator. In a typical securitization, the originator that owns the financial asset must transfer and convey the asset to a specialpurpose vehicle (SPV) that should be a bankruptcy remote company or trust. The transfer and conveyance must lead to such an outcome that the transferred financial asset will no longer be considered to be an asset of the originator or part of its estate even when it becomes subject to a bankruptcy proceeding. This kind of transfer is generally referred to as a ‘‘true sale.’’ 2.1. Electricity asset backed securitization in America In the United States, stranded cost securitization was first designed to deal with utilities’ stranded cost and lower electricity rates when electricity industry restructuring legislation was adopted by California, Pennsylvania and Montana in 1996. Stranded cost is well discussed and defined as ‘‘the difference between the present value of a utility’s return on and of the assets under the extant regulatory regime and the market value of those assets under a competitive market environment newly created by the market reform. These assets are considered stranded when their expected return are lowered by the reform’’ in [4]. Under a representative stranded cost securitization, utility companies submit an application for securitization to a regulatory agency that is usually the state’s public utility commission. Within a certain period afterward, the utility commission issues a final financing order for all or a specified portion of the amount of stranded costs the utility may recover. And these costs are required to be reasonable and in the public interest [5]. By this order the utility commissions allow the utility to collect from their captive customers a non-bypassable surcharge (also ‘‘transition charges’’ or ‘‘competitive transition charges’’) that is based on the amount of electricity purchased by the customers, regardless of whom they purchase electricity from. Besides, the financing order includes a ‘‘mechanism’’ for the periodic adjustment of the surcharge. Subsequently, the utility sells this separate transition property right collecting the stranded cost recovery surcharge to a third party,
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usually a SPV. The SPV is in charge of issuing the bonds, selling them into the securities markets and transferring the proceeds on the bonds to the utility in turn. Because the interest and principal on the bonds are guaranteed by irrevocable regulations, the bonds are ensured to be paid off. Additionally, since the future revenue on surcharges has been isolated from the utility, the bonds are likely to gain a higher rating than the normal debt of the utility. Therefore, the utility is enabled to bear interest at rates lower than other borrowings like loans from banks or corporation bonds. When filing for securitization, the utility often alleges that such a reduced capital cost is partly or wholly passed to the customers. In other words, the utility will transfer this benefit through a reduced rate to its customer (free customers, not necessarily the consumers who have to pay the transition charge). For this reason, sometimes the securities backed by stranded cost are called ‘‘transition bonds’’ or ‘‘rate reduction bonds’’. Such a process is outlined in Fig. 1. More recently, utilities are allowed to expand the use of tariff-based securitization as a new financing tool whether or not it is related to stranded costs in US. For example, bonds like ‘‘storm recovery bonds’’ and ‘‘environmental cleanup bonds’’ have emerged as new ABS products. In fact, the biggest difference between the stranded cost securitization and other tariff-based securitization is whether the competitive transition fees are mandated to be paid by the captive customers.
2.2. Future flow securitization in emerging markets In emerging markets most of the future flow securitizations are initialized by originators, whose offshore borrowing abilities are often stymied by the sovereign rating of the country where the originator is located [6]. Securitizing future receivables can enable emerging market countries to surpass the sovereign credit ceilings, borrow with better credit and fulfill financing in international capital markets [7]. With a higher rating and lower risk for the securities supported by future flow, these developing countries can assume lower risk premiums and lower corresponding interest expense. For instance, in late 1998, Pemex Finance Ltd. issued oil export backed securities rated BBB by Standard and Poor’s, three notches above Mexican sovereign and Pemex unsecured debt. In a typical future flow securitization, the originator pledges the future revenues from export of a product as collateral and sells the right to collect future receivables to the off-shore SPV. The SPV issues securities backed by the future products to the off-shore investors, passes the money collected on to the originator and transfers designed products to the off-shore customers or obligors. The obligors’ payments are directly deposited in an off-shore collection account managed by a trustee. The payments of interest and principal to investors are serviced from this account and excess collections are forwarded to the
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Fig. 1. Stranded cost securitization.
Fig. 2. Future flow securitization.
originator. The following Fig. 2 illustrates the framework of future flow securitization: 3. The Lancangjiang Scheme On February 2, 2004, the State Council of the People’s Republic of China released /Some Opinions on Promoting the Reform, Opening and Steady Growth of the Capital MarketS. It was composed of nine items on how to develop China’s domestic capital market, one of which brought forward a goal to widen direct financing channels and expand investment instruments. Under such a background, securitization is explicitly supported by government and is drawing more and more attention from regulators, banks, corporations and investors. Securitization is viewed as a potential tool that can enable the
corporations to raise money in a cheaper way and improve their financial structure. In a sense, securitization is an activator for China’s capital system reform and strengthened by the reform itself. In May of 2006, Yunnan Huaneng Lancang River Hydropower Company, 56% of which held by China Huaneng Group, became the first electricity company to get approval from China Securities Regulatory Commission (CSRC) to implement its securitization program, the so-called ‘‘Lancangjiang Scheme’’. Lancangjiang Scheme is supported by the sales of certain periods (38 months) within the future five years since the day the scheme is effective. All of the power is generated by Manwan hydroelectric power plant. The total issue amounts to 2 billion benefit vouchers, including 1.98 billion RMB for priority benefit vouchers, an assigned sale
ARTICLE IN PRESS W. Liu et al. / Energy 32 (2007) 1886–1895 Table 1 Comparison of interest rates between bank loans and Lancangjiang Scheme Maturity period
PBOCa Benchmark lending rate
Lancangjiang Schemeb
3 years 4 years 5 years
6.30% 6.48% 6.84%
3.57% 3.77% B_2wc+180BP
a
The People’s Bank of China (PBOC). China Structured Finance Internet. Available at http://www.csfrc.org/. c It is a weighted rate for seven-day repurchase and is daily released by Inter-bank Lending Center. Lancangjiang Scheme adopts the B_2w for the last ten trading days before payments date. ‘‘B_2w’’ means ‘‘before 2 weeks’’in financial terms. In addition, BP is the abbreviation of ‘‘Basis Point (0.01%)’’. b
by domestic qualified investors, and secondary benefit vouchers for 0.02 billion RMB purchased by Yunnan Huaneng Lancang River Hydrodropower Co. Ltd. In contrast to long-term bank loan, Lancangjiang Scheme has a significantly smaller interest rate (see Table 1). For example, the three-year bank loan charges an interest rate of 6.30% while Lancangjiang Scheme’s is only 3.70%. The excess collateral, cash reserves, priority/ secondary level and so on are adopted by Lancangjiang Scheme as the internal credit enhancements. Also, it utilizes external credit guarantees by the Agricultural Bank of China. Dagong Global Credit Rating assigned a triple A rating to this Scheme and all the benefit vouchers will be traded in the bulk trading system of Shenzhen Stock Exchange. 4. The barriers for securitization in China Generally speaking, securitization in China started late and is still in its infancy in contrast to securitization in America, even to other emerging market countries. But different from the ABS market in America, which is dominated by home equity and credit card and has fewer future flow securitizations, credit asset and future flow securitizations in China are evenly distributed. Also unlike the prevailing ABS products backed by hard-currency receivables in emerging market countries, securitization in China started as a domestic ABS market with no foreign obligors involved. Several factors are attributed to the slow uptake of securitization in China. 4.1. The administrative system In China’s present regulatory structure, there are at least nine departments involved in supervising securitization deals. The People’s Bank of China (PBOC) and China Banking Regulatory Commission (CBRC) assume the regulation of credit asset backed securities issued by financial institutes and banks. CSRC is in charge of Special-purposed Asset Management Scheme, which is in
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general backed by future inflows and issued by non-bank companies. The central enterprises have to get the approval from State-owned Assets Supervision and Administration Commission of the State Council (SASAC) before they dispose of or transfer the state-owned assets in the process of securitization. Specially, on condition that the off-shore SPV participates in sales of asset, the originator also has to file to Ministry of Commerce of the People’s Republic of China (MCPR). Because the product of securitization is a kind of debt bonds or debt instruments, National Development and Reform Commission (NDRC) is on duty of controlling the size and scope of debts. In the case that the securitization is backed by future receivables paid in foreign currency, State Administration of Foreign Exchange (SAFE) will be involved. Whether insurance companies can set foot in securitization is decided by China Insurance Regulatory Commission (CIRC). Besides, Ministry of Finance People’s Republic of China (MFPC) is responsible for enacting how to reflect the securitization in financial reports and State Administration of Taxation is entitled to release the policy of taxation in securitization (SAT). Such a complicated regulatory system greatly aggravates the cost for the companies who intend to reduce capital cost via securitization. The functions of departments involved in securitization are outlined in Table 2.
4.2. The legal system Though domestic and international experts estimate the ABS market will surge in the near future, China’s securitization legislation remains limited in scope and depth. The body of investors is confined to certain qualified institutions and the originators are constricted to qualified banks and corporations. What’s more, the securities are only allowed to be traded in a particular market. These restrictions limit the benefit of securitization to a certain extent. As far as credit asset securitization is concerned, the only guidelines at present are /The Administrative Measures on Pilot Projects of Credit Assets SecuritizationS, which became effective on April 20, 2005, and /The Measures on
Table 2 Functions of departments in securitization in China Departments
Credit asset-backed
Future flows-backed
PBOC/CBRC CSRC SASAC MCPR NDRC SAFE CIRC MFPC SAT
Granting approval — — Granting approval Sales of state-owned assets Off-shore SPV as a participant Debt scale Foreign currencies Insurance company as a participant Accounting principles Taxation policies
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the Administration and Supervision of Pilot Projects for the Securitization of Credit Assets by Financial InstitutionsS, which became effective on December 1, 2005. Both the measures are designed specially for the two pilots of credit asset securitization, which are the housing mortgage securitization proposed by China Construction Bank and infrastructure loan securitization by China Development Bank. The prior was promulgated by PBOC and CBRC together and the latter was issued by PBOC. To assist in implementing these two cases, the related accounting principals were released by MFPC in May 2005, and taxations were promulgated by MFPC and SAT in February 2006. As for future flow securitization, the CSRC has issued an unpublicized notice, /The Measures on Special-purposed Asset Management SchemeS, offering the sixteen franchised securities companies a draft of universal rules on how to file a Special-purposed Asset Management Scheme. But there have not been any accounting principles and taxation policies released in correspondence with the headway of Special-purposed Asset Management Scheme, an embryo of future flow securitization. Also, the CSRC has not developed any related guidelines on who to function as SPV in the general company asset-backed securitization. Based on the practice of the Special-purposed Asset Management Scheme until now, the benefit vouchers are only traded in the bulk trading system of Shanghai or Shenzhen Stock Exchange. Furthermore, the benefit vouchers are merely allowed to be purchased by certain large groups, financial corporations, social security funds, annuities, trusts and securities companies. Insurance companies and fund companies are prohibited from investing in ABS securities. Accordingly, the restrained scope of investors and market has greatly lowered the liquidity of ABS, which will force the originators to pay back certain premium to investors. Considering that the future flow securitization is not supported by tangible financial claims and existing assets but is secured by anticipated future revenues, CSRC more closely scrutinizes the implementation of future flow securitization to control the risk of future flow and is prudent in granting approvals. It implies that the projects with a stable future flow, especially those involving the infrastructure construction, are easy to get into the securitization market. In this context, Huaneng Group, a state-owned energy company with high rating in both the domestic and international markets, drove its holding corporation to implement the first electricity asset backed securitization. Now every franchised securities company in China is engaged in at least two ongoing projects on securitization. But at the time of writing, all the projects are regarded as special cases and have not yet formed a large-scale issue. 5. Suggestions for the future steps Although securitization is an effective and novel way to help Chinese electricity companies to raise money at lower
costs, it is very difficult to establish a securitization market on a trial basis without an all-around legal framework and enough government support. All the restrictions discussed above decrease the liquidity of ABS to a great extent. Investors would not prepare to invest in securitized assets that cannot be traded freely. Reversely, the electricity corporations will be scrupulous in securitization if this program cannot attract enough investment. Also, the unclear accounting principles and taxation policies make the electricity industry hold a wait-and-see attitude toward securitization. In order to get electricity-backed securitization on a stable and speedy way, it is necessary for China to build a sound framework for securitization. Some suggestions follow. 5.1. Government support 5.1.1. Reform regulatory regime for ABS It cannot be denied that the Chinese government has provided explicit and implicit support for securitization. But it has to be admitted that validation of both the credit assets and future flow backed securitization looks like a ‘‘Byzantine’’ process of obtaining approvals from a panoply of government bodies. Sometimes the expected convenience and economy are offset by the complicated regulatory structure. Establishing a smooth filing is indispensable to turn varieties of direct financing into reality. The critical step of altering the status quo is to reduce the number of departments associated with the regulation of securitization and concentrate on distributing authorities in light of the special industry. For example, the State Electricity Regulatory Commission of the People’s Republic of China (SERC), which has been empowered to perform administrative and regulatory duties with regard to the national electric power sector, can be authorized to act as the main regulator of securitization in the electricity industry. There are reasons to believe that this restructuring will greatly simplify the relevant procedure. 5.1.2. Allow the stranded cost securitization In China, stranded cost arises largely from the past planned economic regime. In the integrated electricity industry structure, reimbursement for investment is guaranteed by the fixed electricity sale price, which leads to a big amount of over investment. And the composition of investment is rather complicated involving central government, local government, enterprise internal funds, foreign investors and so on, which leads to a huge difficulty in recovering stranded cost. For example, foreign investment accounts for 17.4% of the total funding in China’s 9th Five-Year period [8]. Renegotiating the existing contract for recovering stranded cost with foreign investors will cause political resistance and result in trouble in drawing future investments because of the unpredictable policy. On the other hand, some power plants have already finished their construction cost recovery and only have operating cost left. For these utilities, such huge
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advantages over their rivals with stranded cost will by no means render the market in a fully competitive status. A well-functioning market is aimed to increase the efficiency of the system’s operation based on a fair competition. A transition period is necessary for recovering stranded cost so that utilities with stranded cost can be competitive enough in the restructured market. In 1998, China implemented the initial restructuring step in electricity industry including ‘‘separating plants and grids’’ and ‘‘priced by market’’. During the transition from regulated system to competitive market, the price was changed to encompass two parts, one of which is capacity tariff unified by the regulator and the other is electricity tariff decided by the market. According to /National Development and Reform Commission on the Northeast Regional Power Market Access Issues Related to Tariff Reform PilotS, the stranded cost is allowed to be recovered at a high capacity tariff, which means the stranded cost recovery is guaranteed by the legislation. Securitization offers a better way to recover the stranded cost in America as discussed. And most importantly, the process of reform will be speeded up. In other words, even though the transition period is allowed, the benefit of reform can not be realized until the end of that period. But through the immediate revenue flow by securitization, the generation companies with compensated stranded cost will get on the same starting point with other utilities. They can focus on increasing operation efficiency to be more competitive in the market instead of worrying about stranded cost, which exactly meets the original goal of restructuring. So it can be envisioned that this acceleration of restructuring will generate benefit much faster than other cost recovery regimes and have a ‘‘two-win’’ consequence from the regulator and utility’s points of view. Generally, mainland China’s electricity industry is mainly state-owned and has a much higher centralized administrative system in contrast to the cases in Hong Kong and America where electricity is supplied by investor-owned utilities [9,10], which possibly helps China to behave administratively with higher efficiency and stronger power in the transitional period. Government can consider implementing securitization that is backed by regulated fees like capacity tariffs. This will not only give more financing options to electricity corporations but also provide a feasible solution to a headachy problem—how to deal with stranded cost in the transition of electricity industry. 5.1.3. Promote future flow securitization Securitization also provides a good way to finance the project just like the Lancangjiang Scheme. By future flow securitization, the companies can raise fund at a cheaper cost and break through their credit ceiling. But it should be noted that the project financing securitization is based on the certain future revenue for supplying the demand, which contradicts the purpose of electricity competition in some sense because the revenue cannot be guaranteed in the
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future market and only can be collected when the utilities are operating at lower cost than the rivals’. But in the foreseeable future, the peak demand will keep increasing in a rapid rhythm. And the market will only work well when the redundant capacity is provided. So taking into account the economic development, the guaranteed rate of return for the investment in a certain transitional period is reasonable, which provides the stage for securitization and further competition. 5.1.4. Improve electricity pricing For the development of ABS, the reasonable electricity pricing mechanism is one of the vital factors. In circumstances without a clear and stable pricing policy, investors’ passion in electricity-related securities will be depressed by uncertainty of future flow. Also originators’ financing cost will be increased when paying a high-risk premium. But the present Chinese pricing of electricity is complicated and inefficient. At the wholesale level, power plants are paid not according to short-run marginal costs but according to the dates of production, guaranteed rates of return and total costs of the plant. At the end-user level, cross subsidy is also very common [8]. Electricity cannot flow freely between different regions based on the production cost. Barriers to the inter-provincial trade of power are mainly brought about by the financial system, wherein central and regional financial operations are separated; individual provincial grids; and thriving local protectionism [11]. In the transition period to a fully competitive market, China’s government intends to emphasize price stability instead of rushing into possible price volatility in a completely competitive environment. The current two-part pricing regime is a good step to help the utilities transfer to the market circumstances by recovering the utilities’ capital cost [12] while the benefit of competition has to be held off until the transitional period ends as discussed. 5.1.5. Give more utilities access to securitization As the scope of future flows securitization has widened, so has the range of originators. Though it is plausible to give priority to high-rating electricity companies in order to minimize the state’s financial risk, the advantages of securitization are more phenomenal when it is employed by the originator who has a low rating of creditworthiness and high-quality assets. The reason is that the principal focus of securitization is on the cash flow from the assets themselves, not the utilities. The candidateship of assets for securitization does not lie so much in what they are, but in whether they are amenable to rigorous credit and statistical analysis [13]. As a whole, the electricity industry in China has a large proportion of fixed assets and high debt-to-asset ratio (an average of around 53% and the long-term debt accounting for around 38% of total assets at the end of 20051). Since 1
Data source: China Industry News, 2006.
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April 28, 2006 when the central bank increased the benchmark interest rate of loans, the corporations with higher debt ratios like Guizhou Qianyuan Power Co. Ltd, Guangxi Guiguan Electric Power Co. Ltd and Huadian Power International Corporation Ltd have been suffering from the increased interest rate. The estimated net profit gained by these corporations in 2006 will fall at around 1.5–4%.2 To fund electricity projects that are critical for national economic development, these weaker borrowers should be allowed to deploy their good assets to access capital markets that would otherwise be closed to them.
Since investors will rely pretty much on the detailed assessments and ratings assigned by the principal rating agencies such as Moody’s and Standard and Poor’s, it is necessary to involve such agencies in the risk-management process.
5.1.6. Expand the range of investors and markets for trading It is natural to confine the investors of ABS to institutional investors such as unit trusts (mutual funds), money managers, banks, pension funds and the like because they are equipped with experts and techniques to identify both financial and operational risks of the electricity industry. But diversified investors form the base of a successfully structured financing market. Unless the investors grow in harmony with the boom of securitization, the electricity corporations may waver before they invest considerable time and efforts in this kind of financing. Besides, a prosperous primary market also needs the support from an active secondary market. The secondary market is capable of providing helpful and effective information for pricing the similar securities to be issued. Once the issuance of securities has been finished, the investors will also seek liquidity of their holding securities in the vibrant secondary market. Hence, with varieties of ABS available and the market mature, the individual investors shall be allowed the chance to invest in ABS, which will make ABS actively traded in secondary markets.
5.2.1. The form of SPV In the mature securitization market, the SPV is usually structured to have no assets or business other than holding the securitized assets. When all principal payments have been made and the securities have accordingly matured, the SPV is extinguished and any remaining assets (including cash) are returned to the originator. The consensus of establishing SPV is ‘‘bankruptcy-remoteness’’: the SPV must be insulated against bankruptcy of the originator, and vice-versa. In practice, there are three forms of SPV that can be chosen by the originator: trust, company and limited partnership. If SPV takes the form of company in China, it seems that a paradox is produced because the company subject to /Company LawS in China is based on the concept of ‘‘everlasting’’, which excludes the form of ‘‘shell’’ company. To evade the limitation of /Company LawS, one of the current popular resolutions is to use the off-shore SPV, which is usually established in the Virgin or Cayman islands.
5.1.7. Protect the interest of investors The government needs to protect investors’ rights and interest and to maintain their confidence and passion. In the stranded cost securitization in the United States, the asset is the irrevocable property right to collect cash flow from a tariff or fee on the utilities’ customers. Furthermore, the regulators introduced the true-up mechanism, which has played an important role in assuring sufficient payment for the rate-reduction bonds. Such regulations are of great help for electricity companies to enhance the credit rating of securities and are also safeguards for investors to avoid or lessen credit risk. Should regulators of China adopt such policies, they have to consider the state’s risk if a future legislature changes or rescinds the law enforcing the revenue scheme [14]. While many investors may not have the means to scrutinize the electricity assets, one or more rating agencies should do so, as will a specialized and highly rated financial institution that can provide its own guarantee. 2
Data source: Guotai Junan Securities, 2006.
5.2. Legal framework In addition to developing a good regulatory regime, keeping legislation in pace with the energy of securitization is also important. To build an all-round legal framework, there are some issues to be clarified:
5.2.2. The criteria for true sale The universal criterion to identify a true sale is whether the risks and benefits of the intended asset have passed from the originator to the SPV. As for the electricity industry, a large number of long-term contracts are involved in future receivables and are constrained by /Chinese Contract LawS. According to the treaties, the customers commit to using certain amounts of power at a consentient rate for a long term. But the electricity companies may have sold some related benefits or properties by agreeing to covenants in bank loan or other financing documents. Hence, even though the assets have been transferred from the electricity company to the SPV, the essential property rights may still remain with the originator legally. At this point, the regulators have to look through possible contractual impediments according to the /Chinese Contract LawS before they release the regulation on the criterion for true sale. 5.2.3. The notice to obligors Electricity utilities’ numerous contracts result in both plenty of future receivables and lots of obligors. In practice, once the contracts are effective or the electricity has been consumed, the customers become obligors. In
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light of /Chinese Contract LawS, the creditor has to notify the obligor when the transfer of creditor’s rights occurs. Without such a notice, the transfer of the rights is invalid. Apparently, the notifying obligation to so many obligors will increase the cost of securitization for originators. In allusion to article 9 of /Uniform Commercial CodeS in America, the originator can file the ‘‘financing statement table’’ to the relevant government departments to publicize the transfer of receivables. That means, the notification to obligors can be completed in a simpler way with less cost. Also, other creditors have the opportunity to learn about the notification from public resources of the central registration system. Since China has not constituted a comprehensive central registration system at present, the English concept of declaration and acceptance of trust can work at the initial stages of securitization: if the asset transfer has been announced in two or more newspapers and also registered in the regulatory institution, the obligation is regarded as fulfilled according to the legal requirement. 5.3. Suggestions for electricity companies 5.3.1. Prepare the asset pool Nowadays, the electricity assets securitization in China is concentrated on project financing. The proposed assets are usually future flows produced by a project that does not exist on the issuing day until the fund is collected from investors in certain periods. Indeed any income-producing asset with an adequate performance record can be securitized. For the electricity industry, if historical statistics on the composition of receivables, agings, defaults, losses and dilution indicate a stable and consistent trend for one company and the assets are unencumbered and transferable, the company is qualified for starting securitization supported by these assets. For example, the capacity tariff including fees for stranded cost recovery can be a candidate for securitization as long as the tariff is guaranteed. To deal with amounts of stuck electricity receivables that are nearly impossible to withdraw, the electricity companies can also conduct a securitization. Such an action resembles factoring in which the company sells accounts receivable at a discount to a factor who then assumes the credit risk of the account debtors and receives cash. Factoring tends to be more useful for middle-market companies that have limited access to other forms of funding, while securitization is more commonly used by large investment-grade companies. 5.3.2. Pursue a better rating To pursue a better rating for the securities, the electricity companies have to be familiar with the evaluation criteria of rating agencies on given assets. Only when the selected assets are of high quality and the related information is well prepared, will the rating agency assign an investment grade to the security. The rating agencies usually focus on the ability of the company to continue its operation and
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generate the receivables. The other considerations include the nature of proposed assets, the obligor profile, sovereign risk, unique structural features and a summary of legal issues. At the present time, international rating agencies are not popular in assigning ratings to domestic issuances because China has a deep domestic market. But with the spreading of the market, the cross- border issuance is required to be assigned an international rating by companies like Fitch, Standard and Poor’s, and Moody’s in order to be directly comparable in markets such as Australia, Japan, America and most of Europe. The electricity companies also need to know the particular emphasis of certain agencies. For example, Standard and Poor’s services for rating emerging market future flow transactions are derived as three interrelated analytical assessments—the business line risk assessment, the structural risk assessment and the sovereign interference risk assessment [15]. 5.3.3. Implement credit enhancement It is well known that future flow of electricity companies is fluctuating with loads. Other factors such as the social economy development, the competition intensity and the stability and diversification of the customer base can influence the future flow of electricity companies in certain aspects. The securities issued by the electricity companies are supported by revenue from fees that are not assessed or billed to the obligors at the date of the securitization closing. Their credit risk is higher than credit asset backed securities, which are guaranteed by existing mortgage loans, credit card receivables, auto loans, manufactured-housing contracts or homeequity loans. To offset this effect, the electricity company may resort to credit enhancement. There are usually two ways for the utilities to enhance their creditworthiness: one of which is interior credit enhancement such as cash allocation and establishment of a special-purpose vehicle, and the other of which is exterior enhancement such as excess collateral, cash reserves or a third-party guarantee [16]. The operation of practical markets shows that investors particularly favor assets isolated from bankruptcy and assets with a guarantee from top-rated, specialized financial institutions who adopt prudent credit policies. 5.3.4. Issue securities in accordance with participants’ interest The risk and interest of securities: The designed securities are supposed to represent an accommodation among the legal restrictions, the future receivables, the originator’s requirement and investors’ risk-return preferences. To alleviate the requirement for professional knowledge and cater to investors with various risk tolerance, the securities are often designed to several tranches. The tranche segmentation offers flexible debt structures that make risk and profitability match properly. If one
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tranche is senior and the other is subordinated, the senior securities usually carry lower profitability and higher ratings while the subordinated class bears a higher profitability and lower rating that is typically below investment grade. The circulation area of securities: The circulation areas designed for ABS vary in different countries. The securities may be placed domestically, in a major capital market such as America or Japan, in two markets simultaneously or globally in the form of Eurobonds. They may or may not be listed on an exchange. In fact, their liquidity ranges from non-tradable private placement, tradable private placement, commercial paper and public issue to actively traded bonds as from the most illiquild to the highly liquid. In China, the electricity company’s decision on how widely the future flow backed securities are traded depends on the development of a domestic trade market, the design of transaction mechanisms, the openness for investment, the term of bilateral contracts with consumers, the creditworthiness of the company itself and the trait of future revenue. Domestic securitization or cross border: The emerging markets are usually divided into ‘‘domestic’’ and ‘‘cross border’’ issuance. Market placements backed by hardcurrency receivables can allow issuers to break through sovereign credit ceilings and gain access to cheaper financing legally and practically, which reduces the willingness-to-pay issue. Especially in countries with poor sovereign ratings, the originators are highly enthusiastic about cross border securitizations. In 2005, the major international credit rating companies such as Fitch, Standard and Poor’s and Moody’s have raised China’s sovereign credit respectively. In view of the importance of the electricity industry for the national economic security and social stability, the electricity companies are more likely to have a high level of creditworthiness. Higher sovereign credit and industry credit entitle the Chinese electricity companies that have future receivables paid by the foreign obligors in hard currencies to raise money in off-shore structured financing markets at lower cost. As a matter of fact, some southern electricity companies are planning to export power to their neighboring countries. However, the offshore securitization involves complicated steps and also assumes risk resulting from unfamiliarity with foreign legislation. 5.3.5. Continue as a servicer Once a pool of future flows has been securitized, the originator must continue to collect the payments, follow up on delinquents, maintain statistics on performance, pass on payments in a timely fashion and perform other administrative tasks. The companies may continue as a receivable servicer to retain the servicing fees, the excess of the SPV’s revenue over costs and surplus collateral once the ABS are redeemed. Nevertheless, due to political and social reasons, the Chinese electricity
companies often feel helpless when confronted with some customers who refuse to or are unable to pay electricity bills because they cannot force the obligors to pay by threatening cutoff. In this case, the electricity company may employ servicing agencies who are professionals in asset management. In a sense, the originators have transferred part of the monitoring task to the financial guarantor in a securitization, which will continue to monitor the receivables in order to minimize its risk and maintain its own rating. 6. Conclusion China’s regulatory framework for credit asset securitization has paved the way for a larger application of asset backed securitization. With increased enthusiasm in electricity securitization, this paper discusses the current Chinese regulatory and legal system for securitization thoroughly in light of some overseas experiences. While the electricity securitization is confirmed as a promising method to recover the stranded cost and to obtain financing, regulatory and legal suggestions as well as future steps for utilities are proposed to build a sound foundation for electricity securitization. Acknowledgments The authors would like to thank the editor and the anonymous reviewers for their constructive comments which greatly improve this paper’s exposition. All the errors are the sole responsibility of the authors. References [1] International Energy Agency. World energy outlook 2004. 2004. See also: /http://www.worldenergyoutlook.org/S. [2] Xu Y-C. The myth of the single solution: electricity reforms and the World Bank. Energy 2006;31:802–14. [3] Williams JH, Ghanadan R. Electricity reform in developing and transitional countries: a reappraisal. Energy 2006;31:815–44. [4] Woo CK, Lloyd D, Karimov R, Tishler A. Stranded cost recovery in electricity market reforms in the US. Energy 2003;28(1):1–14. [5] Elcon. The first states: the learning curve on stranded cost recovery policies. October 1998. [6] S. Ketkar, D. Ratha. Securitization of future flow receivables: a useful tool for developing countries. Finance Development 2001; 38(1): 46–9. [7] D. Ratha. Financing development through future-flow securitization. PREM notes, No. 69, World Bank, June 2002. [8] Yeoh Boon-Siew, Rajaraman Rajesh. Electricity in China: the latest reforms. Electricity J 2004;17(3):60–9. [9] Ngan HW, Wang JH, Engriwan W, Lo KL. A feasible reform for the electricity supply industry in Hong Kong. Energy Policy 2006; 34(17):2881–90. [10] Wang JH, Ngan HW, Engriwan W, Lo KL. Performance based regulation of the electricity supply industry in Hong Kong: an empirical efficiency analysis approach. Energy Policy 2007;35(1): 609–15. [11] Xu Shaofeng, Chen Wenying. The reform of electricity power sector in the PR of China. Energy Policy 2006;34(16):2455–65.
ARTICLE IN PRESS W. Liu et al. / Energy 32 (2007) 1886–1895 [12] Varley Caroline. China’s power sector reforms : where to next? International Energy Agency 2006. [13] V. Kulatilaka. Asset securitization, association of professional bankers, 2005. See also: /www.apbsrilanka.org/articales/15an/ artical-vajira-kulathilake.htmlS. [14] Rogers DB, Jameson JM, Yoong DKL. Legal considerations in utility stranded cost securitizations. Electricity J 1997;10(8): 54–68.
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[15] Standard and Poor’s. Unlocking the benefits of securitization in emerging Asia. Friday, 19th May 2006. [16] Oh, G, Park D, Park J, Yang DY. How to Mobilize the Asian Savings within the Region: Securitization and Credit Enhancement for the Development of East Asia’s Bond Market. Paper presented at the Ford Foundation conference on ‘‘A New Financial Market Structure for East Asia: How to Promote Regional Financial Market Integration’’, 2003.
Energy 32 (2007) 1886–1895 www.elsevier.com/locate/energy
Electricity securitization in China Wei Liua, J.H. Wangb,, Jun Xiec, Chang Songa a
School of Business, Renmin University of China, Beijing 100872, China Department of Electrical and Computer Engineering, Illinois Institute of Technology, Chicago 60616, USA c School of Management, Wuhan University of Technology, 430070, China
b
Received 10 August 2006
Abstract This paper discusses the past and the status quo of electricity securitization in China. First, the stranded cost securitization in American electricity industry and the ongoing securitization progress in emerging market countries are investigated, which enlightens the way of electricity securitization in China. Through analysis of electricity industry in China, the paper proposes constructive policy suggestions for regulators who intend to prompt securitization to develop electricity infrastructure, and detailed recommendations for companies who plan to raise money at reduced cost. It is concluded that even though it is at the very beginning stage in China, securitization not only provides financing for investment projects, but also speeds up the reform by stranded cost securitization, a novel idea for electricity industry in China. r 2007 Elsevier Ltd. All rights reserved. Keywords: Securitization; Electricity policy; Electricity industry; Electricity restructuring; China
1. Introduction China is experiencing a boom in economy, in which electricity infrastructure development is playing a vital role for prompting and maintaining her momentum. International Energy Agency (IEA) forecasted that the demand of electricity in China will increase by 4.5% through 2030 and the corresponding investment in the electricity industry will amount to two billion US dollars [1]. In the mean time, the electricity industry reform has made a substantial step towards an ultimate competitive market. Several pilot market operations have demonstrated the bright future for further restructuring. To meet the fast increasing demand of electricity and address the stranded cost recovery in the ongoing reform, this paper aims to explore securitization as a potential way to finance electricity-related projects and recover the stranded cost. Previous domestic and overseas experience has illustrated the workable application of securitization to the electricity industry. In 2004, Huaneng Lancangjiang Corresponding author. Tel.: +1 224 217 2342; fax: +1 312 567 8976.
E-mail address: [email protected] (J.H. Wang). 0360-5442/$ - see front matter r 2007 Elsevier Ltd. All rights reserved. doi:10.1016/j.energy.2007.02.001
Hydropower Return Special-purposed Asset Management Scheme (Lancangjiang Scheme) as the first electricity securitization case in China was successfully applied, which gave a good example of project financing by securitization. Experiences from the electricity asset backed securitization in US and future flow backed securitization of emerging markets also offer valuable reference to China. However, even though securitization has been proven to be a feasible and effective tool for financing in China and recovering stranded cost overseas, there are no mature regulatory and legal conditions to guarantee the broad application of securitization in China yet. Many challenges for regulation, legistration and utilities themselves still exist. Previous research has shown that no uniform reform template can be applied to different countries and the specific reform must be built based on the thorough consideration of connections between economic ideals and political reality [2]. A broad set of accommodation including legitimacy, regulation and public benefits must be realized [3]. To analyze these challenges and promote the securitization in China’s unique case, our discussion proceeds as follows. Section 2 reviews the general concept of electricity asset backed securitization in America and future flow
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securitization in emerging markets. Section 3 analyzes the successful application of Huaneng Scheme. Section 4 investigates the current status of securitization in China and lists the obstacles to securitization. Section 5 gives thorough suggestions for government, legistration and utilities to advance securitization. Section 6 concludes the discussion. 2. Electricity securitization in other countries The general incentive of securitization is to enable companies to isolate funding activity from credit rating. Asset Backed Securitization (ABS) is the separation of favorable assets from a corporation or financial institution, which will render the intended assets independent of and higher than the creditworthiness of the originator. In a typical securitization, the originator that owns the financial asset must transfer and convey the asset to a specialpurpose vehicle (SPV) that should be a bankruptcy remote company or trust. The transfer and conveyance must lead to such an outcome that the transferred financial asset will no longer be considered to be an asset of the originator or part of its estate even when it becomes subject to a bankruptcy proceeding. This kind of transfer is generally referred to as a ‘‘true sale.’’ 2.1. Electricity asset backed securitization in America In the United States, stranded cost securitization was first designed to deal with utilities’ stranded cost and lower electricity rates when electricity industry restructuring legislation was adopted by California, Pennsylvania and Montana in 1996. Stranded cost is well discussed and defined as ‘‘the difference between the present value of a utility’s return on and of the assets under the extant regulatory regime and the market value of those assets under a competitive market environment newly created by the market reform. These assets are considered stranded when their expected return are lowered by the reform’’ in [4]. Under a representative stranded cost securitization, utility companies submit an application for securitization to a regulatory agency that is usually the state’s public utility commission. Within a certain period afterward, the utility commission issues a final financing order for all or a specified portion of the amount of stranded costs the utility may recover. And these costs are required to be reasonable and in the public interest [5]. By this order the utility commissions allow the utility to collect from their captive customers a non-bypassable surcharge (also ‘‘transition charges’’ or ‘‘competitive transition charges’’) that is based on the amount of electricity purchased by the customers, regardless of whom they purchase electricity from. Besides, the financing order includes a ‘‘mechanism’’ for the periodic adjustment of the surcharge. Subsequently, the utility sells this separate transition property right collecting the stranded cost recovery surcharge to a third party,
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usually a SPV. The SPV is in charge of issuing the bonds, selling them into the securities markets and transferring the proceeds on the bonds to the utility in turn. Because the interest and principal on the bonds are guaranteed by irrevocable regulations, the bonds are ensured to be paid off. Additionally, since the future revenue on surcharges has been isolated from the utility, the bonds are likely to gain a higher rating than the normal debt of the utility. Therefore, the utility is enabled to bear interest at rates lower than other borrowings like loans from banks or corporation bonds. When filing for securitization, the utility often alleges that such a reduced capital cost is partly or wholly passed to the customers. In other words, the utility will transfer this benefit through a reduced rate to its customer (free customers, not necessarily the consumers who have to pay the transition charge). For this reason, sometimes the securities backed by stranded cost are called ‘‘transition bonds’’ or ‘‘rate reduction bonds’’. Such a process is outlined in Fig. 1. More recently, utilities are allowed to expand the use of tariff-based securitization as a new financing tool whether or not it is related to stranded costs in US. For example, bonds like ‘‘storm recovery bonds’’ and ‘‘environmental cleanup bonds’’ have emerged as new ABS products. In fact, the biggest difference between the stranded cost securitization and other tariff-based securitization is whether the competitive transition fees are mandated to be paid by the captive customers.
2.2. Future flow securitization in emerging markets In emerging markets most of the future flow securitizations are initialized by originators, whose offshore borrowing abilities are often stymied by the sovereign rating of the country where the originator is located [6]. Securitizing future receivables can enable emerging market countries to surpass the sovereign credit ceilings, borrow with better credit and fulfill financing in international capital markets [7]. With a higher rating and lower risk for the securities supported by future flow, these developing countries can assume lower risk premiums and lower corresponding interest expense. For instance, in late 1998, Pemex Finance Ltd. issued oil export backed securities rated BBB by Standard and Poor’s, three notches above Mexican sovereign and Pemex unsecured debt. In a typical future flow securitization, the originator pledges the future revenues from export of a product as collateral and sells the right to collect future receivables to the off-shore SPV. The SPV issues securities backed by the future products to the off-shore investors, passes the money collected on to the originator and transfers designed products to the off-shore customers or obligors. The obligors’ payments are directly deposited in an off-shore collection account managed by a trustee. The payments of interest and principal to investors are serviced from this account and excess collections are forwarded to the
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Fig. 1. Stranded cost securitization.
Fig. 2. Future flow securitization.
originator. The following Fig. 2 illustrates the framework of future flow securitization: 3. The Lancangjiang Scheme On February 2, 2004, the State Council of the People’s Republic of China released /Some Opinions on Promoting the Reform, Opening and Steady Growth of the Capital MarketS. It was composed of nine items on how to develop China’s domestic capital market, one of which brought forward a goal to widen direct financing channels and expand investment instruments. Under such a background, securitization is explicitly supported by government and is drawing more and more attention from regulators, banks, corporations and investors. Securitization is viewed as a potential tool that can enable the
corporations to raise money in a cheaper way and improve their financial structure. In a sense, securitization is an activator for China’s capital system reform and strengthened by the reform itself. In May of 2006, Yunnan Huaneng Lancang River Hydropower Company, 56% of which held by China Huaneng Group, became the first electricity company to get approval from China Securities Regulatory Commission (CSRC) to implement its securitization program, the so-called ‘‘Lancangjiang Scheme’’. Lancangjiang Scheme is supported by the sales of certain periods (38 months) within the future five years since the day the scheme is effective. All of the power is generated by Manwan hydroelectric power plant. The total issue amounts to 2 billion benefit vouchers, including 1.98 billion RMB for priority benefit vouchers, an assigned sale
ARTICLE IN PRESS W. Liu et al. / Energy 32 (2007) 1886–1895 Table 1 Comparison of interest rates between bank loans and Lancangjiang Scheme Maturity period
PBOCa Benchmark lending rate
Lancangjiang Schemeb
3 years 4 years 5 years
6.30% 6.48% 6.84%
3.57% 3.77% B_2wc+180BP
a
The People’s Bank of China (PBOC). China Structured Finance Internet. Available at http://www.csfrc.org/. c It is a weighted rate for seven-day repurchase and is daily released by Inter-bank Lending Center. Lancangjiang Scheme adopts the B_2w for the last ten trading days before payments date. ‘‘B_2w’’ means ‘‘before 2 weeks’’in financial terms. In addition, BP is the abbreviation of ‘‘Basis Point (0.01%)’’. b
by domestic qualified investors, and secondary benefit vouchers for 0.02 billion RMB purchased by Yunnan Huaneng Lancang River Hydrodropower Co. Ltd. In contrast to long-term bank loan, Lancangjiang Scheme has a significantly smaller interest rate (see Table 1). For example, the three-year bank loan charges an interest rate of 6.30% while Lancangjiang Scheme’s is only 3.70%. The excess collateral, cash reserves, priority/ secondary level and so on are adopted by Lancangjiang Scheme as the internal credit enhancements. Also, it utilizes external credit guarantees by the Agricultural Bank of China. Dagong Global Credit Rating assigned a triple A rating to this Scheme and all the benefit vouchers will be traded in the bulk trading system of Shenzhen Stock Exchange. 4. The barriers for securitization in China Generally speaking, securitization in China started late and is still in its infancy in contrast to securitization in America, even to other emerging market countries. But different from the ABS market in America, which is dominated by home equity and credit card and has fewer future flow securitizations, credit asset and future flow securitizations in China are evenly distributed. Also unlike the prevailing ABS products backed by hard-currency receivables in emerging market countries, securitization in China started as a domestic ABS market with no foreign obligors involved. Several factors are attributed to the slow uptake of securitization in China. 4.1. The administrative system In China’s present regulatory structure, there are at least nine departments involved in supervising securitization deals. The People’s Bank of China (PBOC) and China Banking Regulatory Commission (CBRC) assume the regulation of credit asset backed securities issued by financial institutes and banks. CSRC is in charge of Special-purposed Asset Management Scheme, which is in
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general backed by future inflows and issued by non-bank companies. The central enterprises have to get the approval from State-owned Assets Supervision and Administration Commission of the State Council (SASAC) before they dispose of or transfer the state-owned assets in the process of securitization. Specially, on condition that the off-shore SPV participates in sales of asset, the originator also has to file to Ministry of Commerce of the People’s Republic of China (MCPR). Because the product of securitization is a kind of debt bonds or debt instruments, National Development and Reform Commission (NDRC) is on duty of controlling the size and scope of debts. In the case that the securitization is backed by future receivables paid in foreign currency, State Administration of Foreign Exchange (SAFE) will be involved. Whether insurance companies can set foot in securitization is decided by China Insurance Regulatory Commission (CIRC). Besides, Ministry of Finance People’s Republic of China (MFPC) is responsible for enacting how to reflect the securitization in financial reports and State Administration of Taxation is entitled to release the policy of taxation in securitization (SAT). Such a complicated regulatory system greatly aggravates the cost for the companies who intend to reduce capital cost via securitization. The functions of departments involved in securitization are outlined in Table 2.
4.2. The legal system Though domestic and international experts estimate the ABS market will surge in the near future, China’s securitization legislation remains limited in scope and depth. The body of investors is confined to certain qualified institutions and the originators are constricted to qualified banks and corporations. What’s more, the securities are only allowed to be traded in a particular market. These restrictions limit the benefit of securitization to a certain extent. As far as credit asset securitization is concerned, the only guidelines at present are /The Administrative Measures on Pilot Projects of Credit Assets SecuritizationS, which became effective on April 20, 2005, and /The Measures on
Table 2 Functions of departments in securitization in China Departments
Credit asset-backed
Future flows-backed
PBOC/CBRC CSRC SASAC MCPR NDRC SAFE CIRC MFPC SAT
Granting approval — — Granting approval Sales of state-owned assets Off-shore SPV as a participant Debt scale Foreign currencies Insurance company as a participant Accounting principles Taxation policies
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the Administration and Supervision of Pilot Projects for the Securitization of Credit Assets by Financial InstitutionsS, which became effective on December 1, 2005. Both the measures are designed specially for the two pilots of credit asset securitization, which are the housing mortgage securitization proposed by China Construction Bank and infrastructure loan securitization by China Development Bank. The prior was promulgated by PBOC and CBRC together and the latter was issued by PBOC. To assist in implementing these two cases, the related accounting principals were released by MFPC in May 2005, and taxations were promulgated by MFPC and SAT in February 2006. As for future flow securitization, the CSRC has issued an unpublicized notice, /The Measures on Special-purposed Asset Management SchemeS, offering the sixteen franchised securities companies a draft of universal rules on how to file a Special-purposed Asset Management Scheme. But there have not been any accounting principles and taxation policies released in correspondence with the headway of Special-purposed Asset Management Scheme, an embryo of future flow securitization. Also, the CSRC has not developed any related guidelines on who to function as SPV in the general company asset-backed securitization. Based on the practice of the Special-purposed Asset Management Scheme until now, the benefit vouchers are only traded in the bulk trading system of Shanghai or Shenzhen Stock Exchange. Furthermore, the benefit vouchers are merely allowed to be purchased by certain large groups, financial corporations, social security funds, annuities, trusts and securities companies. Insurance companies and fund companies are prohibited from investing in ABS securities. Accordingly, the restrained scope of investors and market has greatly lowered the liquidity of ABS, which will force the originators to pay back certain premium to investors. Considering that the future flow securitization is not supported by tangible financial claims and existing assets but is secured by anticipated future revenues, CSRC more closely scrutinizes the implementation of future flow securitization to control the risk of future flow and is prudent in granting approvals. It implies that the projects with a stable future flow, especially those involving the infrastructure construction, are easy to get into the securitization market. In this context, Huaneng Group, a state-owned energy company with high rating in both the domestic and international markets, drove its holding corporation to implement the first electricity asset backed securitization. Now every franchised securities company in China is engaged in at least two ongoing projects on securitization. But at the time of writing, all the projects are regarded as special cases and have not yet formed a large-scale issue. 5. Suggestions for the future steps Although securitization is an effective and novel way to help Chinese electricity companies to raise money at lower
costs, it is very difficult to establish a securitization market on a trial basis without an all-around legal framework and enough government support. All the restrictions discussed above decrease the liquidity of ABS to a great extent. Investors would not prepare to invest in securitized assets that cannot be traded freely. Reversely, the electricity corporations will be scrupulous in securitization if this program cannot attract enough investment. Also, the unclear accounting principles and taxation policies make the electricity industry hold a wait-and-see attitude toward securitization. In order to get electricity-backed securitization on a stable and speedy way, it is necessary for China to build a sound framework for securitization. Some suggestions follow. 5.1. Government support 5.1.1. Reform regulatory regime for ABS It cannot be denied that the Chinese government has provided explicit and implicit support for securitization. But it has to be admitted that validation of both the credit assets and future flow backed securitization looks like a ‘‘Byzantine’’ process of obtaining approvals from a panoply of government bodies. Sometimes the expected convenience and economy are offset by the complicated regulatory structure. Establishing a smooth filing is indispensable to turn varieties of direct financing into reality. The critical step of altering the status quo is to reduce the number of departments associated with the regulation of securitization and concentrate on distributing authorities in light of the special industry. For example, the State Electricity Regulatory Commission of the People’s Republic of China (SERC), which has been empowered to perform administrative and regulatory duties with regard to the national electric power sector, can be authorized to act as the main regulator of securitization in the electricity industry. There are reasons to believe that this restructuring will greatly simplify the relevant procedure. 5.1.2. Allow the stranded cost securitization In China, stranded cost arises largely from the past planned economic regime. In the integrated electricity industry structure, reimbursement for investment is guaranteed by the fixed electricity sale price, which leads to a big amount of over investment. And the composition of investment is rather complicated involving central government, local government, enterprise internal funds, foreign investors and so on, which leads to a huge difficulty in recovering stranded cost. For example, foreign investment accounts for 17.4% of the total funding in China’s 9th Five-Year period [8]. Renegotiating the existing contract for recovering stranded cost with foreign investors will cause political resistance and result in trouble in drawing future investments because of the unpredictable policy. On the other hand, some power plants have already finished their construction cost recovery and only have operating cost left. For these utilities, such huge
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advantages over their rivals with stranded cost will by no means render the market in a fully competitive status. A well-functioning market is aimed to increase the efficiency of the system’s operation based on a fair competition. A transition period is necessary for recovering stranded cost so that utilities with stranded cost can be competitive enough in the restructured market. In 1998, China implemented the initial restructuring step in electricity industry including ‘‘separating plants and grids’’ and ‘‘priced by market’’. During the transition from regulated system to competitive market, the price was changed to encompass two parts, one of which is capacity tariff unified by the regulator and the other is electricity tariff decided by the market. According to /National Development and Reform Commission on the Northeast Regional Power Market Access Issues Related to Tariff Reform PilotS, the stranded cost is allowed to be recovered at a high capacity tariff, which means the stranded cost recovery is guaranteed by the legislation. Securitization offers a better way to recover the stranded cost in America as discussed. And most importantly, the process of reform will be speeded up. In other words, even though the transition period is allowed, the benefit of reform can not be realized until the end of that period. But through the immediate revenue flow by securitization, the generation companies with compensated stranded cost will get on the same starting point with other utilities. They can focus on increasing operation efficiency to be more competitive in the market instead of worrying about stranded cost, which exactly meets the original goal of restructuring. So it can be envisioned that this acceleration of restructuring will generate benefit much faster than other cost recovery regimes and have a ‘‘two-win’’ consequence from the regulator and utility’s points of view. Generally, mainland China’s electricity industry is mainly state-owned and has a much higher centralized administrative system in contrast to the cases in Hong Kong and America where electricity is supplied by investor-owned utilities [9,10], which possibly helps China to behave administratively with higher efficiency and stronger power in the transitional period. Government can consider implementing securitization that is backed by regulated fees like capacity tariffs. This will not only give more financing options to electricity corporations but also provide a feasible solution to a headachy problem—how to deal with stranded cost in the transition of electricity industry. 5.1.3. Promote future flow securitization Securitization also provides a good way to finance the project just like the Lancangjiang Scheme. By future flow securitization, the companies can raise fund at a cheaper cost and break through their credit ceiling. But it should be noted that the project financing securitization is based on the certain future revenue for supplying the demand, which contradicts the purpose of electricity competition in some sense because the revenue cannot be guaranteed in the
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future market and only can be collected when the utilities are operating at lower cost than the rivals’. But in the foreseeable future, the peak demand will keep increasing in a rapid rhythm. And the market will only work well when the redundant capacity is provided. So taking into account the economic development, the guaranteed rate of return for the investment in a certain transitional period is reasonable, which provides the stage for securitization and further competition. 5.1.4. Improve electricity pricing For the development of ABS, the reasonable electricity pricing mechanism is one of the vital factors. In circumstances without a clear and stable pricing policy, investors’ passion in electricity-related securities will be depressed by uncertainty of future flow. Also originators’ financing cost will be increased when paying a high-risk premium. But the present Chinese pricing of electricity is complicated and inefficient. At the wholesale level, power plants are paid not according to short-run marginal costs but according to the dates of production, guaranteed rates of return and total costs of the plant. At the end-user level, cross subsidy is also very common [8]. Electricity cannot flow freely between different regions based on the production cost. Barriers to the inter-provincial trade of power are mainly brought about by the financial system, wherein central and regional financial operations are separated; individual provincial grids; and thriving local protectionism [11]. In the transition period to a fully competitive market, China’s government intends to emphasize price stability instead of rushing into possible price volatility in a completely competitive environment. The current two-part pricing regime is a good step to help the utilities transfer to the market circumstances by recovering the utilities’ capital cost [12] while the benefit of competition has to be held off until the transitional period ends as discussed. 5.1.5. Give more utilities access to securitization As the scope of future flows securitization has widened, so has the range of originators. Though it is plausible to give priority to high-rating electricity companies in order to minimize the state’s financial risk, the advantages of securitization are more phenomenal when it is employed by the originator who has a low rating of creditworthiness and high-quality assets. The reason is that the principal focus of securitization is on the cash flow from the assets themselves, not the utilities. The candidateship of assets for securitization does not lie so much in what they are, but in whether they are amenable to rigorous credit and statistical analysis [13]. As a whole, the electricity industry in China has a large proportion of fixed assets and high debt-to-asset ratio (an average of around 53% and the long-term debt accounting for around 38% of total assets at the end of 20051). Since 1
Data source: China Industry News, 2006.
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April 28, 2006 when the central bank increased the benchmark interest rate of loans, the corporations with higher debt ratios like Guizhou Qianyuan Power Co. Ltd, Guangxi Guiguan Electric Power Co. Ltd and Huadian Power International Corporation Ltd have been suffering from the increased interest rate. The estimated net profit gained by these corporations in 2006 will fall at around 1.5–4%.2 To fund electricity projects that are critical for national economic development, these weaker borrowers should be allowed to deploy their good assets to access capital markets that would otherwise be closed to them.
Since investors will rely pretty much on the detailed assessments and ratings assigned by the principal rating agencies such as Moody’s and Standard and Poor’s, it is necessary to involve such agencies in the risk-management process.
5.1.6. Expand the range of investors and markets for trading It is natural to confine the investors of ABS to institutional investors such as unit trusts (mutual funds), money managers, banks, pension funds and the like because they are equipped with experts and techniques to identify both financial and operational risks of the electricity industry. But diversified investors form the base of a successfully structured financing market. Unless the investors grow in harmony with the boom of securitization, the electricity corporations may waver before they invest considerable time and efforts in this kind of financing. Besides, a prosperous primary market also needs the support from an active secondary market. The secondary market is capable of providing helpful and effective information for pricing the similar securities to be issued. Once the issuance of securities has been finished, the investors will also seek liquidity of their holding securities in the vibrant secondary market. Hence, with varieties of ABS available and the market mature, the individual investors shall be allowed the chance to invest in ABS, which will make ABS actively traded in secondary markets.
5.2.1. The form of SPV In the mature securitization market, the SPV is usually structured to have no assets or business other than holding the securitized assets. When all principal payments have been made and the securities have accordingly matured, the SPV is extinguished and any remaining assets (including cash) are returned to the originator. The consensus of establishing SPV is ‘‘bankruptcy-remoteness’’: the SPV must be insulated against bankruptcy of the originator, and vice-versa. In practice, there are three forms of SPV that can be chosen by the originator: trust, company and limited partnership. If SPV takes the form of company in China, it seems that a paradox is produced because the company subject to /Company LawS in China is based on the concept of ‘‘everlasting’’, which excludes the form of ‘‘shell’’ company. To evade the limitation of /Company LawS, one of the current popular resolutions is to use the off-shore SPV, which is usually established in the Virgin or Cayman islands.
5.1.7. Protect the interest of investors The government needs to protect investors’ rights and interest and to maintain their confidence and passion. In the stranded cost securitization in the United States, the asset is the irrevocable property right to collect cash flow from a tariff or fee on the utilities’ customers. Furthermore, the regulators introduced the true-up mechanism, which has played an important role in assuring sufficient payment for the rate-reduction bonds. Such regulations are of great help for electricity companies to enhance the credit rating of securities and are also safeguards for investors to avoid or lessen credit risk. Should regulators of China adopt such policies, they have to consider the state’s risk if a future legislature changes or rescinds the law enforcing the revenue scheme [14]. While many investors may not have the means to scrutinize the electricity assets, one or more rating agencies should do so, as will a specialized and highly rated financial institution that can provide its own guarantee. 2
Data source: Guotai Junan Securities, 2006.
5.2. Legal framework In addition to developing a good regulatory regime, keeping legislation in pace with the energy of securitization is also important. To build an all-round legal framework, there are some issues to be clarified:
5.2.2. The criteria for true sale The universal criterion to identify a true sale is whether the risks and benefits of the intended asset have passed from the originator to the SPV. As for the electricity industry, a large number of long-term contracts are involved in future receivables and are constrained by /Chinese Contract LawS. According to the treaties, the customers commit to using certain amounts of power at a consentient rate for a long term. But the electricity companies may have sold some related benefits or properties by agreeing to covenants in bank loan or other financing documents. Hence, even though the assets have been transferred from the electricity company to the SPV, the essential property rights may still remain with the originator legally. At this point, the regulators have to look through possible contractual impediments according to the /Chinese Contract LawS before they release the regulation on the criterion for true sale. 5.2.3. The notice to obligors Electricity utilities’ numerous contracts result in both plenty of future receivables and lots of obligors. In practice, once the contracts are effective or the electricity has been consumed, the customers become obligors. In
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light of /Chinese Contract LawS, the creditor has to notify the obligor when the transfer of creditor’s rights occurs. Without such a notice, the transfer of the rights is invalid. Apparently, the notifying obligation to so many obligors will increase the cost of securitization for originators. In allusion to article 9 of /Uniform Commercial CodeS in America, the originator can file the ‘‘financing statement table’’ to the relevant government departments to publicize the transfer of receivables. That means, the notification to obligors can be completed in a simpler way with less cost. Also, other creditors have the opportunity to learn about the notification from public resources of the central registration system. Since China has not constituted a comprehensive central registration system at present, the English concept of declaration and acceptance of trust can work at the initial stages of securitization: if the asset transfer has been announced in two or more newspapers and also registered in the regulatory institution, the obligation is regarded as fulfilled according to the legal requirement. 5.3. Suggestions for electricity companies 5.3.1. Prepare the asset pool Nowadays, the electricity assets securitization in China is concentrated on project financing. The proposed assets are usually future flows produced by a project that does not exist on the issuing day until the fund is collected from investors in certain periods. Indeed any income-producing asset with an adequate performance record can be securitized. For the electricity industry, if historical statistics on the composition of receivables, agings, defaults, losses and dilution indicate a stable and consistent trend for one company and the assets are unencumbered and transferable, the company is qualified for starting securitization supported by these assets. For example, the capacity tariff including fees for stranded cost recovery can be a candidate for securitization as long as the tariff is guaranteed. To deal with amounts of stuck electricity receivables that are nearly impossible to withdraw, the electricity companies can also conduct a securitization. Such an action resembles factoring in which the company sells accounts receivable at a discount to a factor who then assumes the credit risk of the account debtors and receives cash. Factoring tends to be more useful for middle-market companies that have limited access to other forms of funding, while securitization is more commonly used by large investment-grade companies. 5.3.2. Pursue a better rating To pursue a better rating for the securities, the electricity companies have to be familiar with the evaluation criteria of rating agencies on given assets. Only when the selected assets are of high quality and the related information is well prepared, will the rating agency assign an investment grade to the security. The rating agencies usually focus on the ability of the company to continue its operation and
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generate the receivables. The other considerations include the nature of proposed assets, the obligor profile, sovereign risk, unique structural features and a summary of legal issues. At the present time, international rating agencies are not popular in assigning ratings to domestic issuances because China has a deep domestic market. But with the spreading of the market, the cross- border issuance is required to be assigned an international rating by companies like Fitch, Standard and Poor’s, and Moody’s in order to be directly comparable in markets such as Australia, Japan, America and most of Europe. The electricity companies also need to know the particular emphasis of certain agencies. For example, Standard and Poor’s services for rating emerging market future flow transactions are derived as three interrelated analytical assessments—the business line risk assessment, the structural risk assessment and the sovereign interference risk assessment [15]. 5.3.3. Implement credit enhancement It is well known that future flow of electricity companies is fluctuating with loads. Other factors such as the social economy development, the competition intensity and the stability and diversification of the customer base can influence the future flow of electricity companies in certain aspects. The securities issued by the electricity companies are supported by revenue from fees that are not assessed or billed to the obligors at the date of the securitization closing. Their credit risk is higher than credit asset backed securities, which are guaranteed by existing mortgage loans, credit card receivables, auto loans, manufactured-housing contracts or homeequity loans. To offset this effect, the electricity company may resort to credit enhancement. There are usually two ways for the utilities to enhance their creditworthiness: one of which is interior credit enhancement such as cash allocation and establishment of a special-purpose vehicle, and the other of which is exterior enhancement such as excess collateral, cash reserves or a third-party guarantee [16]. The operation of practical markets shows that investors particularly favor assets isolated from bankruptcy and assets with a guarantee from top-rated, specialized financial institutions who adopt prudent credit policies. 5.3.4. Issue securities in accordance with participants’ interest The risk and interest of securities: The designed securities are supposed to represent an accommodation among the legal restrictions, the future receivables, the originator’s requirement and investors’ risk-return preferences. To alleviate the requirement for professional knowledge and cater to investors with various risk tolerance, the securities are often designed to several tranches. The tranche segmentation offers flexible debt structures that make risk and profitability match properly. If one
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tranche is senior and the other is subordinated, the senior securities usually carry lower profitability and higher ratings while the subordinated class bears a higher profitability and lower rating that is typically below investment grade. The circulation area of securities: The circulation areas designed for ABS vary in different countries. The securities may be placed domestically, in a major capital market such as America or Japan, in two markets simultaneously or globally in the form of Eurobonds. They may or may not be listed on an exchange. In fact, their liquidity ranges from non-tradable private placement, tradable private placement, commercial paper and public issue to actively traded bonds as from the most illiquild to the highly liquid. In China, the electricity company’s decision on how widely the future flow backed securities are traded depends on the development of a domestic trade market, the design of transaction mechanisms, the openness for investment, the term of bilateral contracts with consumers, the creditworthiness of the company itself and the trait of future revenue. Domestic securitization or cross border: The emerging markets are usually divided into ‘‘domestic’’ and ‘‘cross border’’ issuance. Market placements backed by hardcurrency receivables can allow issuers to break through sovereign credit ceilings and gain access to cheaper financing legally and practically, which reduces the willingness-to-pay issue. Especially in countries with poor sovereign ratings, the originators are highly enthusiastic about cross border securitizations. In 2005, the major international credit rating companies such as Fitch, Standard and Poor’s and Moody’s have raised China’s sovereign credit respectively. In view of the importance of the electricity industry for the national economic security and social stability, the electricity companies are more likely to have a high level of creditworthiness. Higher sovereign credit and industry credit entitle the Chinese electricity companies that have future receivables paid by the foreign obligors in hard currencies to raise money in off-shore structured financing markets at lower cost. As a matter of fact, some southern electricity companies are planning to export power to their neighboring countries. However, the offshore securitization involves complicated steps and also assumes risk resulting from unfamiliarity with foreign legislation. 5.3.5. Continue as a servicer Once a pool of future flows has been securitized, the originator must continue to collect the payments, follow up on delinquents, maintain statistics on performance, pass on payments in a timely fashion and perform other administrative tasks. The companies may continue as a receivable servicer to retain the servicing fees, the excess of the SPV’s revenue over costs and surplus collateral once the ABS are redeemed. Nevertheless, due to political and social reasons, the Chinese electricity
companies often feel helpless when confronted with some customers who refuse to or are unable to pay electricity bills because they cannot force the obligors to pay by threatening cutoff. In this case, the electricity company may employ servicing agencies who are professionals in asset management. In a sense, the originators have transferred part of the monitoring task to the financial guarantor in a securitization, which will continue to monitor the receivables in order to minimize its risk and maintain its own rating. 6. Conclusion China’s regulatory framework for credit asset securitization has paved the way for a larger application of asset backed securitization. With increased enthusiasm in electricity securitization, this paper discusses the current Chinese regulatory and legal system for securitization thoroughly in light of some overseas experiences. While the electricity securitization is confirmed as a promising method to recover the stranded cost and to obtain financing, regulatory and legal suggestions as well as future steps for utilities are proposed to build a sound foundation for electricity securitization. Acknowledgments The authors would like to thank the editor and the anonymous reviewers for their constructive comments which greatly improve this paper’s exposition. All the errors are the sole responsibility of the authors. References [1] International Energy Agency. World energy outlook 2004. 2004. See also: /http://www.worldenergyoutlook.org/S. [2] Xu Y-C. The myth of the single solution: electricity reforms and the World Bank. Energy 2006;31:802–14. [3] Williams JH, Ghanadan R. Electricity reform in developing and transitional countries: a reappraisal. Energy 2006;31:815–44. [4] Woo CK, Lloyd D, Karimov R, Tishler A. Stranded cost recovery in electricity market reforms in the US. Energy 2003;28(1):1–14. [5] Elcon. The first states: the learning curve on stranded cost recovery policies. October 1998. [6] S. Ketkar, D. Ratha. Securitization of future flow receivables: a useful tool for developing countries. Finance Development 2001; 38(1): 46–9. [7] D. Ratha. Financing development through future-flow securitization. PREM notes, No. 69, World Bank, June 2002. [8] Yeoh Boon-Siew, Rajaraman Rajesh. Electricity in China: the latest reforms. Electricity J 2004;17(3):60–9. [9] Ngan HW, Wang JH, Engriwan W, Lo KL. A feasible reform for the electricity supply industry in Hong Kong. Energy Policy 2006; 34(17):2881–90. [10] Wang JH, Ngan HW, Engriwan W, Lo KL. Performance based regulation of the electricity supply industry in Hong Kong: an empirical efficiency analysis approach. Energy Policy 2007;35(1): 609–15. [11] Xu Shaofeng, Chen Wenying. The reform of electricity power sector in the PR of China. Energy Policy 2006;34(16):2455–65.
ARTICLE IN PRESS W. Liu et al. / Energy 32 (2007) 1886–1895 [12] Varley Caroline. China’s power sector reforms : where to next? International Energy Agency 2006. [13] V. Kulatilaka. Asset securitization, association of professional bankers, 2005. See also: /www.apbsrilanka.org/articales/15an/ artical-vajira-kulathilake.htmlS. [14] Rogers DB, Jameson JM, Yoong DKL. Legal considerations in utility stranded cost securitizations. Electricity J 1997;10(8): 54–68.
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[15] Standard and Poor’s. Unlocking the benefits of securitization in emerging Asia. Friday, 19th May 2006. [16] Oh, G, Park D, Park J, Yang DY. How to Mobilize the Asian Savings within the Region: Securitization and Credit Enhancement for the Development of East Asia’s Bond Market. Paper presented at the Ford Foundation conference on ‘‘A New Financial Market Structure for East Asia: How to Promote Regional Financial Market Integration’’, 2003.