Credit Calpine The following is a contributed article by Aneesh Prabhu senior director US Energy Infrastructure S P Global Ratings Americas independent power producers IPPs have long had a bitter pill to swallow around three years ago market conditions began to turn negative and things have barely improved since Not only have IPPs been caught up in the electric industrys most prominent fuel switch from coal to natural gas they have been exposed to changing consumer preferences new technologies and weakening commodity prices As a result the number of IPPs has been declining for the past decade And those remaining in the market have been forced to adapt to new market realities or else face an uncomfortable future From software to fire codes safe and optimal BESS performance requires collaboration from many stakeholders Learn how to engage them in our playbook Download The response has looked familiar across the board At considerable pace IPPs are deleveraging and aggressively transforming their portfolios and even entire business strategies by shifting to an integrated model for both wholesale and retail power sales Other choices for IPPs have emerged too including the possibility of going private as Calpine Corporation did last year But a cold truth remains While some credit improvements have appeared todays market is not one in the IPPs favor Ultimately the market fundamentals have long been problematic and for various reasons More renewable power on the grid means lower round-the-clock power prices lower commodity prices have resulted in lower spreads and increased energy efficiency and more distributed on-site off grid generation have played their part in decreasing electricity demand In turn IPPs have had little choice but to adapt Inaction could weaken IPPs investment propositions within a matter of two to three years as a result But thankfully many have responded to the alarms sounding by deleveraging adopting leaner cost structures and cutting debt Deleveraging for instance should continue through 2020 with IPPs likely to use any excess cash flow to reduce debts Another likely tactic for IPPs will be debt restructuring which will push maturity dates further down the line The integrated model heightened risks Of course management boards have some control over deleveraging strategies since they are the result of a willingness to adjust capital structures more than anything else But in some cases more fundamental measures will be required and this means relinquishing control to some extent Indeed some IPPs are pursuing an integrated business model one that incorporates both retail and wholesale or merchant power Initially this overhaul may heighten an IPPs execution risk and in turn influence our view of its business from a credit perspective Nonetheless we acknowledge that over the past two years the integrated model has gained some market credibility Its a matter of diversification with retail power activities providing a hedge for wholesale power operations when they are regionally matched Get electric utility news like this in your inbox daily Subscribe to Utility Dive As a result the integrated model lessens the financial impact of lower power prices in the futures market which incidentally has been the case in almost all independent power markets for some time But therein lies the rub It seems implausible that a capital-lite model whereby an IPP provides a consumer with a non-discretionary service such as an electricity supply can continue uncontested Rather we believe that the integrated model could come under pressure especially once IPPs operating with the integrated model are properly tested This may come for instance once competition for market share intensifies or if an extreme weather event pushes the efficiency and efficacy of the integrated business to its limits For example during a recession we expect both wholesale power prices and retail power margins to decline especially if weather patterns fail to cooperate One prominent area of uncertainty then is how IPPs manage this delicate balance between their retail and wholesale businesses going forward So what other relief exists for IPPs Beyond adopting the integrated model some market participants believe that IPPs could even decide to go private Last year saw Energy Capital Partners ECP buy Calpine Corporation Americas largest electricity generator from natural gas and geothermal resources in a 55 billion deal Contrary to market expectations the deal has been credit favorable for Calpine Indeed the new owner has followed through on the 27 billion deleveraging plan that Calpine had previously announced an important move given that the company must quickly adapt to potentially lower cash flows while it also grows its retail operations But in baseball terms this play comes in the bottom of the fifth Thats to say we are unsure what ECPs eventual exit strategy may look like but we assume it could take the form of an initial public offering in around five years Still investors seem cold on the IPP market Based on stock price valuations alone the evidence suggests that the equity markets have not appreciated IPPs efforts to transform and investors remain tentative amid this uncertain phase in the power markets development Specifically investors are asking who will be or perhaps should be the owners of power generation assets and what the expected life of conventional generation assets would be In short they are not yet convinced to make the leap In their quest for simpler and less risky capital structures investors may also consider whether IPPs can carry investment-grade ratings IPPs however are not quite there yet They must still execute fully on and sustain their transformation strategies of deleveraging and reducing exposure to wholesale power markets Since the IPP business model is fast evolving we at S P Global Ratings would typically assess key metrics such as cash flow volatility over a longer five-year scale In turn the earliest we may consider whether IPPs warrant investment-grade ratings will be in the latter half of 2020 or early 2021 For now though theres a long road ahead The bitter reality for IPPs is apparent In todays market there are very few positive catalysts and the biggest risk for IPPs remains not taking one While the silver lining is that credit profiles in this segment are improving the cloud over IPPs is yet to disperse