Some state officials believe a multi-billion dollar ratepayer bailout of Edison and PG&E is necessary. FTCR and other consumer groups are adamantly opposed to another utility bailout. (See our fact sheet). The companies created the deregulation mess, exacerbated the current crisis, and have the resources to bail themselves out. They should be required to spend their own money before ratepayers are ordered to do so.
The politicians are well aware of the devastating political repercussions of a bailout. So they are looking for a way to compensate ratepayers in exchange for keeping the utility companies afloat. If ratepayers are to be forced to invest in these companies — assuming no one else will — then ratepayers should get what a Wall Street investor would demand: repayment of the loan, plus a “rate of return” (profit) equal to the risk of the investment. Here, the risk is so huge that no one else will lend.;
One suggestion is to offer ratepayers stock warrants. These were used in the federal bailout of Chrysler.
What are “stock warrants”? They are essentially options to buy stock at a fixed price, with the ability to sell at a far higher price, and thus make a profit. Warrants assume that the utility will eventually recover financially, and that the company’s stock will appreciate in value to the point where the warrant holder will make a potentially large profit by exercising the warrants. Here’s how warrants would work in a nutshell:
First, the amount of money ratepayers or taxpayers are to be forced to give the utilities to keep them afloat is determined.
Then, stock warrants are issued under terms which, when the stock is purchased at the option price and then sold, will provide an amount of money equivalent to the bailout amount paid to the utilities, plus profit (a “fair return”) commensurate with the risk that the utilities’ stock might become worthless. There is no charge for the warrants themselves.
Presumably the warrants will be held in trust by the state for the ratepayers.
What are the risks of warrants? There are a variety of risks associated with warrants — some of which depend on the intentions of the legislators:
o The terms of the deal could limit the value of the warrants to far below the value of the bailout. This is a real danger in the plans being discussed by Sacramento officials.
o The company could later go bankrupt, destroying the value of the warrants.
o Making the state an “investor” creates a conflict of interest with ratepayers who desire to keep electricity rates low. In other words, ratepayers will want regulators to keep rates low, while those holding the warrants will want to keep rates high so the companies’ profits go up and its stock value rises.
o If profits from the exercise of warrants are returned to ratepayers through their utility bills, ratepayers run the risk that regulators will increase electricity rates, wiping out any net gains and allowing the utility companies to recapture the profits.
The Terms Are Crucial: A detailed example of how warrants must be structured to compensate ratepayers. How public officials design the bailout legislation will determine whether the deal is fair to ratepayers — or is simply a bailout with warrants as window dressing designed to fool the public. Here’s an example of how the warrants would have to work:
1. Determine the amount of the bailout. Let’s assume the amount ratepayers are going to be forced to pay to keep a utility company afloat is $2.5 billion (this is roughly the net loss Edison has experienced over the last seven months).
2. Determine the purchase price for the warrants. This amount should be equal to the depressed value of the stock — before news of a bailout encouraged Wall Street to bid up the price. A Wall Street convention is to determine the average price during the twenty business days prior to public announcement of the use of warrants. The price per share of Edison‘s stock before the legislative bailout became a serious possibility was about $10 share. (Speculation about the possibility of a bailout by the Legislature has since pushed the stock up 30-40%). This price ($10) is the purchase price for the stock (also known as the “strike” or “exercise” price).
3. Determine the anticipated price of shares once the company has recovered. This will be the price at which the warrants would be sold, subject to certain conditions discussed below. Here, it would be the price Edison was trading at before its current financial problems. One measure: its average trading price over the last three years. For purposes of this example, let’s assume that is $30 per share.
4. Determine the amount needed to repay the bailout. Subtracting the “strike” price from the post-recovery market price equals $20. That is the profit needed to recover the full amount of the bailout. Note that if the stock were to appreciate beyond $30 per share, the profit would be greater.
5. Determine how many warrants must be offered to recover the amount of the bailout. The guiding rule here is that those forced to bailout the utility should get treated as any Wall Street investor would: repayment of principal, plus a fair return equivalent to the risk of the “investment.”
Start with a simple calculation which assumes that Edison‘s net losses between June of 2000 and the present day are $2.5 billion:
Bailout amount: $2.5 billion.
Value per warrant: $20
Divide $2.5 billion by $20 = 125 million warrants.
In this simple calculation, the state would get 125 million warrants in exchange for giving Edison $2.5 billion. When the company had recovered financially to the point where its stock value returned to $30/share, the warrants could be exercised. The state would exercise its option by buy shares at the strike price of $10 per share and then sell the shares on the market.
Note that under this example, the ratepayers merely break even — there is no interest or fair rate of return. Instead, the state could refrain from exercising the warrants until the market price of Edison‘s shares exceeded $30 in order to increase the profits. Whether to do this will depend upon the judgment of the investment experts managing the state’s position.
6. Factor in a fair return for ratepayers. There is another way to ensure that ratepayers obtain a fair return for bailout out the company: increase the number of warrants. This would protect ratepayers if the stock price of Edison did not exceed $30/share.
Given that no one else is prepared to lend the utilities money at any price, a more than fair return would be 20% interest — what a consumer might have to pay a credit card company when the consumer has to borrow money. There are two ways to make sure ratepayers get repaid with interest: either provide more warrants, or lower the strike price. Let’s redo the calculation using the former approach:
Bailout amount: $2.5 billion.
Add 20% interest: $2.5 billion x 20% = $500 million.
Total bailout amount: $2.5 billion + $500 million = $3 billion
Value per warrant: $20.
Divide $3 billion by $20 = 150 million warrants.
7. Other issues that affect the value of warrants. There are typically other issues that are negotiated concerning warrants:
o To prevent flooding the market and thus undermining share value, the number of warrants that can be exercised in any given period may be limited. For example, exercise of the warrants may be restricted to not more than 20% of the total number over a two year period.
o Since the restrictions may require that warrants be exercised only after a period of years, the cost of warrants may be adjusted downward to reflect the fact that they are worth less in present dollars. (This is known as “the time value of money”).
o In an issue of this size, a market for the immediate sale of unexercised warrants to others may develop.
o Investment banking houses stand to reap enormous fees from the issuance of warrants and management of warrants held by the state.
o If the state were to obtain warrants in exchange for a bailout, it would in effect own approximately 30% of Edison. As part of any warrant arrangement, the state should insist on an equivalent number of positions on the board of directors of the utility companies. For the same reasons, the state should insist on receiving any stock dividends other shareholders will receive. Finally, the state should insist as a precondition of such an arrangement that the utilities enclose notices in its monthly bills to ratepayers inviting them to create and join a new ratepayer watchdog group.
8. How did the Chrysler warrants work? The Chrysler situation was much different:
o The federal government guaranteed private loans to Chrysler; the company gave the federal government stock warrants in exchange for the guarantee. Here, the state itself will be making the loans to the utilities rather than guaranteeing private loans.
o Chrysler repaid the private loans in full, and the government made a profit on the stock warrants.
o Chrysler gave the US Treasury authority to order management changes.
o Chrysler was required to submit an annual operating plan for federal approval.
o Chrysler put the head of the UAW on its Board.
o The company was banned from issuing stock dividends.
o Unions made labor concessions.
o Executives took huge pay cuts.