July 04, 2018

The Future of PREPA and Puerto Rico

Thomas King

Thomas King
Managing Partner/CrossRiver Capital

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I have followed the travails of Puerto Rico’s energy market and infrastructure for several years – contributing to a federal study in 2013 that included an analysis of the island’s energy infrastructure – and provided advice and support to a number of solar and wind projects. The challenges posed by a bankrupt state and chronic underinvestment and corruption at the Puerto Rico Electric Power Authority (PREPA) were epic even before the devastation caused by Hurricanes Irma and Maria. While the immediate emergency response has ended, the more arduous task of restoring a minimum level of island-wide energy service continues. Without it, more lives will be lost, the descent into a frontier economy will continue, migration will accelerate, and the date of Puerto Rico’s recovery will shift further and further into the future.

I am not addressing this heroic effort here but rather what comes after. The challenges are daunting, but so are the opportunities. The storms made the mountain twice as high to climb, but may also have simplified the path toward identifying, implementing, and executing on those systemic changes that can leapfrog Puerto Rico’s energy infrastructure from antiquated and expensive to efficient and leading edge.

Over the past several months I have had the benefit of directly and indirectly learning from a cross-section of parties working toward a restoration and revitalization of Puerto Rico’s energy infrastructure. Based on these conversations I believe, if approached correctly, a very substantial amount of private capital and resources may be levered for Puerto Rico (not just federal disaster relief – which will be substantial but must be applied with optimal efficiency). The opportunity (and my hope) is that capital and resources judiciously applied with the right incentives and appropriate legal and regulatory framework may see Puerto Rico become a laboratory for utility and infrastructure reform, revitalization, and resiliency, and a shining model for the entire US and beyond.

I have spent decades working around the world on the privatization of energy infrastructure, developing and financing independent power production, and driving the market for distributed, renewable and sustainable sources of energy. Since every discussion needs a point of origin and I have rarely been shy about sharing my thoughts, here is a very high-level summary of what I recommend and why.

Privatization of PREPA

The first crucial step is the re-organization, break up, and privatization of PREPA. Without first accomplishing this, the revitalization of the energy infrastructure is in jeopardy and consequently the entire future of Puerto Rico. Accomplished successfully, great outcomes are possible. Fail and Puerto Rico will continue to devolve and $Billions of disaster relief for rebuilding will be spent with little or no positive effect.

Privatization and restructuring can happen in a myriad of ways and there is no one structure that would either ensure or eliminate the possibility of success. Growing chatter about a top-down or bottom-up solution (or even a middle-out one) misses the mark and fails to recognize the political and systemic obstacles to change and/or the massive potential of new technology and business models to overcome or circumvent historical obstacles. The plan for PREPA needs to negotiate the path between the practical and the possible.

Generation. All generating assets that are not specifically used for grid stabilization should be sold to private owner/operators with transitional offtake and employment contracts coupled with specific (and limited) asset refurbishment support from federal disaster relief funds. In fact, the amount of government funded rebuilding capital provided to each asset should ideally be a consideration called out in the bid process. Proceeds from the auction of generating assets can be used in part to satisfy PREPA’s obligations to creditors. All supply contracts from existing third-party generators will continue to be honored and, along with any projects completed under PROMESA’s Title V Critical Projects Process, should be transferred into the new regime.

Distribution. The high-voltage (HV) transmission system and local distribution systems should remain quasi-public but under different operating structures.

Local Distribution Companies (LDCs). For system resiliency, there is discussion around segmenting distribution assets into eight or nine zones that could under future emergency conditions separate and perform as autonomous regional grids. The technical and organizational requirements to accomplish this and rebuild for a new and prosperous Puerto Rico will be considerable and will require the initiative, capital, and ingenuity of the private sector. However, eight or nine independent distributors are too many for a market the size of Puerto Rico.

Three to five LDC concessions can be auctioned with initial licenses granted for 10 to 20 years and perpetually renewable in five-year increments. LDC concession holders could lose their licenses for material or repeated breaches. The state and people of Puerto Rico would still have long-term control of the local distribution infrastructure as the grantor and enforcer of the concession but the for-profit LDC as concession holder would have full management control and decision-making authority subject to its concession license and regulatory oversight. The criteria for the auction of Concessions should be more focused on the qualification of the consortium, nature of and commitment to the investment plan, and quality and price of electricity delivery, and rather less on the price paid for the Concession or on-going license fees or royalties.

Grid resiliency measures would be a requirement for maintenance of the Concession. LDCs will be required to back the obligations under the transitional generation agreements, but regulation and the concession license should also provide wide latitude for each LDC to implement and organize local distributed generation, storage, and microgrids as well as an ability to experiment with new modes of doing business. We may in this way more rapidly discover and evolve low-cost, efficient, and stable models of the new provider/consumer utility business.

High Voltage Transmission. The HV grid should remain directly under state ownership and decision-making authority; however it may choose to outsource day-to-day management to a third-party. Operating revenues would come from charges to generators interconnected to or utilizing the HV grid to wheel power and LDCs. This entity might also serve as a balancing authority and system operator but perhaps only in an interim capacity. Ideally, the system operator will be independent. Keeping an active role in the high-voltage distribution network is a means for the state to retain a tool that can provide active temporary system-wide course correction as the new market develops.

Existing Creditors of PREPA

It would be natural, but unwise, to suggest that PREPA’s creditors – unsecured as they are – be wiped out: unwise because how these creditors are treated will influence how future creditors will assess new investment opportunities and because if not treated fairly, but firmly, they can cause a material delay in the implementation of the new system and time is not a luxury Puerto Rico can afford. A deal should be done expeditiously that can be made (effectively) mandatory for all creditors to clear the way for what needs to be done with PREPA. A deal might include converting a portion to new debt secured by the HV assets, a share of the proceeds from the sale of generating assets, and a very significant write-off of the balance. To sweeten the deal perhaps the federal government might allow write-offs to be retroactively allowed against 2017 earnings (before the tax rate drop).

Legal and Regulatory Framework

Much of the legal and regulatory framework envisioned is implicit in the discussion on privatization above. PREPA, as an arm of the state, has no real history of regulatory oversight and no institutional memory. A strong, independent Office of Electricity Regulation will need to be created and staffed from the ground up. It should have statutory authority over all material aspects of electricity production and distribution, set and enforce standards, and renew, enforce, and interpret (or amend as necessary) concession agreements. The Regulator will also be responsible for setting out and periodically updating the short, medium, and long-term system development goals in consultation with Generators, LDCs, HV grid Operator, and Customers.

The legal and regulatory framework established in Puerto Rico together with the credibility of the Regulator will have a critical impact on the quality and quantity of private sector participation in the renaissance of Puerto Rico’s energy infrastructure as well as the industry’s ability to attract and maintain access to required capital long-term. The framework should include explicit (but not unlimited) support for the borrowing authority of LDCs and HV grid operator.

Federal Disaster Relief

There will be some major contributions made by the federal government toward the rebuilding of Puerto Rico’s energy infrastructure. While writing big checks is important and welcome it is equally as important that the aid is spent wisely. In addition to requiring a thoughtful restructuring with a robust legal and regulatory framework there are at least three key measures that should be undertaken:

  1. Waive or repeal provisions of the Jones Act that distort the price of goods imported from the mainland and penalize Puerto Rico.
  2.  
  3. Amend or waive requirements that aid only be used to rebuild to the same standard as was damaged/destroyed. (This replacement with the old standard or lose relief funding is moronic. The criteria should be that the amount of aid limited to an amount equal to or less than rebuilding to the prior condition, but the asset may be replaced with a newer/better standard.)
  4.  
  5. Provide transitional credit support to the entities that emerge out of the restructuring.

What Now, What Next

On December 11, 2017, the Puerto Rico Energy Resiliency Working Group convened by Governor Andrew Cuomo and Governor Ricardo Roselló delivered their report “Build Back Better: Reimagining and Strengthening the Power Grid of Puerto Rico.” This is an incredibly useful document containing detailed audits of PREPA’s assets, damage from the storms, estimates of repair and hardening costs, and recommendations for repair, replacement, or abandonment. It also contains well-camouflaged hints and suggestions about what the future shape of PREPA may be but the words “privatization” and “restructuring” do not appear at all in the report. While of tremendous value, the report is in no way a plan for the future of Puerto Rico’s electricity market.

The Financial Oversight and Management Board established by PROMESA continues its efforts on Title V critical projects and earlier this week posted a notice on a 30 public comment period for its first batch of four projects. It has hired a top tier consultancy and leading bank to assist in restructuring and creditor relations and PREPA is expected to deliver its revised Fiscal Plan this week (postponed from December 22nd) including “a revised capex plan, transformational operational targets and the governance and regulatory framework to facilitate federal recovery funding and private sector investment.”

Interest is building in the private sector from a reasonably wide array of investors and technology providers both foreign and domestic. Several have been in the news and even on the ground in a limited fashion. Others have become active in the Title V critical projects process. Still, relatively little can happen until Oversight Board and the Government of Puerto Rico make clearer their vision for the future of PREPA. 

Comments? You can contact me directly via my AdvisoryCloud profile.

 

"The Future of PREPA and Puerto Rico" was originally on LinkedIn on Jan 11, 2018.

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