TEXT-S&P revises La Paloma Generating outlook to negative
Overview -- La Paloma Generating Co. LLC (LPGC) will be exposed to carbon taxes on its four gas-fired power generating units under California's cap-and-trade law effective January 2013. This tolling cost is not passed through to the tolling offtaker. -- We are revising the outlook to negative from stable. -- We are affirming the 'B' rating on LPGC's debt. We are also changing the recovery rating on this debt to '2' from '1', indicating our expectation of lower recovery prospects in case of payment default. -- The negative outlook reflects our conclusion that the project's debt service coverage ratios will be below 1x due to a carbon tax cost once the cap-and-trade law is implemented. Rating Action On Sept. 28, 2012, Standard & Poor's Ratings Services affirmed its 'B' rating on La Paloma Generating Co. LLC's (LPGC) senior secured first-lien debt and revised the outlook to negative from stable. In addition, we changed the recovery rating on this debt to '2' from '1' indicating our expectation for substantial (70% to 90%) recovery prospects in a payment default. Rationale The outlook revision is based on the 2013 implementation of carbon taxes under AB32 in California, which we expect will lead to significant additional costs to LPGC and materially reduce cash flows. LPGC cannot pass through these carbon taxes to offtaker Morgan Stanley Capital Group (MS, a unit of Morgan Stanley; A-/Negative/A-1) under tolling agreements. Unless adequate allowances are granted by the state regulators, we expect the project's debt service coverage ratio will be below 1x. The 'B' rating on LPGC's debt takes into account the adverse impacts on its near-term financial performance of depressed natural gas prices and the inability, under existing tolling agreements, to recover carbon costs that it will incur under requirements of California's cap-and-trade law in 2013. The project also faces refinancing risk at maturity of its large debt burden with limited amortization under our assumptions. LPGC sells power to MS from three of its four units under tolling agreements through 2012. It dispatches the fourth unit to take advantage of merchant opportunities. MS can renew the toll for one unit annually from 2013 to 2017 and has chosen to do so for 2013. The project has hedges on two other units in 2013, and one unit each in 2014 and 2015. We expect cash flow contributions from the hedged units will be somewhat constrained due to limited offsets for carbon taxes. Over the longer term, LPGC remains exposed to the volatile merchant power market. These weakness are somewhat tempered by the proven Alstom GT 24 gas turbine technology and sufficient liquidity over the near term. Once cap-and-trade compliance starts, LPGC's generating margins will come under pressure because the MS toll does not allow carbon cost pass-through, which we consider as a substantial credit negative. As per our assumption, those costs are projected to be about $7 per megawatt-hour (MWh), based on carbon at $17 per ton. LPGC is working with the California Air Resources Board (CARB) to allow it to pass through carbon costs. While the regulators have agreed to provide some relief to the generators in a recent ruling, the timing and the details of the implementation have yet to be determined. If the allowances are unfavorable, LPGC's financial profile will be under significant pressure over the next two years due to low natural gas prices and the terms of the tolling agreement. We expect the debt service coverage ratio (DSCR), assuming cap-and-trade compliance with carbon costs of $17 per ton in 2013, to be about 0.7x for 2013 and 2014 (calculated before the draw on the potential $20 million letter of credit, or debt service reserve fund). However, if carbon pass-through on the MS toll unit is granted, this coverage goes up to slightly above 1x under our pricing assumptions. If carbon costs are considerably lower, at $11 per ton, the DSCR would average about 1.1x, even without regulatory allowances. In either case, LPGC should be able to cover projected shortfall in debt service in 2013 by drawing on the cash on hand and debt service reserve. The project also has considerable refinancing risk. Although we expect higher capacity factors in a low gas environment, the hedging program and the tolling agreement should provide stable cash flows. As a result, we do not expect the cash sweep to pay down debt over and above the mandatory amortization payments. We estimate debt at maturity of about $408 million (including second lien) or debt of $399 per kilowatt (KW); resulting in considerably greater refinancing risk from our earlier expectations. To help mitigate the immediate financial impact of the cap-and-trade rule, LPGC has prefunded its major maintenance reserve with $20 million from newly issued loans. It also plans to retain $20 million contingent letters of credit to meet any shortfall in debt service in the near term. The combination of the toll and hedge program should also provide some predictability to the cash flows. However, the hedges incorporate enough liquidity for carbon only up to $10 per ton. If carbon costs are higher, as per our projections, cash flows from these units will also be constrained. In 2013, the un-contracted fourth unit should benefit from its merchant status given its dispatch characteristics, and the uplift will partly offset the drag from carbon costs that the tolled unit and the hedged units incur. As per the current hedge structure, there will be two un-contracted units starting 2014. LPGC is a 1,022-megawatt (MW) combined-cycle, gas-fired power plant near McKittrick, Calif. The plant has four equal-sized ABB GT24-B combustion turbine generation units, coupled with Alstom KA24-1 combined-cycle power units and related equipment, including natural gas and electric transmission facilities, and has been in service since March 2003. Following a foreclosure of the ownership interest of Complete Energy Holdings (CEH)/La Paloma Holding Co. in 2010, the project is owned by EIG Global Energy Partners, Morgan Stanley, private equity firm Rockland Capital, Solus, and Bank of America. After the change in ownership, Rockland replaced CEH as the project asset manager. LPGC's operating history has been inconsistent. As part of its operational improvement plan, new co-owner and asset manager Rockland Capital contracted with North American Energy Systems (NAES) to provide operating and maintenance (O&M) services and with EDF Trading North America (a unit of EDF S.A.; AA-/Stable/A-1+) to be the new energy manager, California ISO scheduling coordinator, and the counterparty on the hedges through 2015. LPGC expects to save about $2.3 million annually through various operational programs put in place by NAES and about $0.75 million from EDF's gas-procurement and dispatch capabilities, in addition to having lower collateral requirements. Liquidity The project's liquidity includes a six-month debt service reserve account for the first- and second-lien term loans, a major maintenance reserve account that covers the next 12 months maintenance requirements, and a $15 million revolver for general corporate and working capital purposes. The $30 million letter of credit in support of collateral needs under the MS toll will drop to $10 million at the end of 2012 as two units come off the tolling agreement. We expect the project to retain $20 million for greater cushion for debt service. Recovery analysis LPGC's $302 million first-lien term loan due 2017 is rated 'B' with a recovery rating of '2', indicating a substantial expectation of recovery (70% to 90%) if a default occurs. Outlook The negative outlook reflects our expectation of constrained cash flows from three of the four units following the implementation of carbon taxes under AB32 in California effective 2013. We could lower the rating if our projected DSCR remains below 1.1x on a steady basis. This would likely happen if California regulators do not grant LPGC adequate allowances to pass through its carbon costs on the MS toll unit. We could also lower the ratings if LPGC's availability goes down, its heat rate degrades, or if O&M costs increase above our expectations. An upgrade is unlikely over the next one to two years but is possible if debt/kw goes down below $200/kW and we expect DSCR to exceed 1.2x on a consistent basis. Related Criteria And Research -- "here 7041103&rev_id=2&sid=998239&sind=A&", Dec. 20, 2011 -- "here 4419919&rev_id=9&sid=998239&sind=A&", Sept. 18, 2007 Ratings List Ratings Affirmed; Outlook Revised; Recovery Rating Changed To From La Paloma Generating Co. LLC Senior Secured B/Negative B/Stable Recovery Rating 2 1 Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column.
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