Alan Schankel of Janney Capital Markets expects "robust" retail demand to compliment strong institutional demand on Illinois GOs
Janney Capital Markets managing director Alan Schankel thinks the rapid conversion of plants to natural gas is achievable.

Puerto Rico is caught between a rock and a hard place with its public power authority.

High electricity rates are among the factors holding back its moribund economy. Yet lowering those rates might threaten the authority's already low-investment grade credit.

Nonetheless, a wide range of Puerto Rico political leaders are proposing changes for Puerto Rico's electrical system. Puerto Rico's Senate President joined them Wednesday with a major new reform proposal. Even the executive director of the Puerto Rico Electric Power Authority has called for major changes.

For residents and businesses, the central problem is an electricity rate per kilowatt-hour about 2.4 times higher than the United States average. For bondholders, the central concern is that PREPA has about $8.5 billion in bond debt rated at or near the bottom of investment grade.

PREPA is rated Baa3 by Moody's Investors Service, BBB by Standard and Poor's and BBB-minus by Fitch Ratings.

Yet some observers in and outside the bond industry say that lower electrical rates are a worthy goal to help turn around a declining economy.

"Having relatively affordable, high quality, reliable electricity service of strategic importance for the economy of Puerto Rico," said Sergio Marxuach, public policy director at the Center for a New Economy, a think tank in San Juan, Puerto Rico. "That means that without it, it would be extremely difficult to restart economic growth in the island because electricity is a key operational cost."

Reducing electrical rates is important to strengthening the island's economy, agreed Standard & Poor's director Judith Waite. Improving the economy is key to improving the commonwealth's general obligation rating. And improving the GO rating will help PREPA's bond rating, she said.

Janney Capital Markets managing director Alan Schankel and AllianceBernstein senior vice president Joseph Rosenblum said that lowering electricity rates is more important for the island economy than for PREPA.

PREPA is essentially the sole distributor of electricity in Puerto Rico and is the largest United States public power utility in customers and revenues. It owns six major generating plants and several smaller facilities. About 68% of the authority's electricity is produced by its own plants. The remaining 32% is produced by several private firms that sell their electricity to PREPA.

With electricity a hot topic in Puerto Rico, many politicians are working to change how it is being provided.

On Wednesday Puerto Rico Senate President Eduardo Bhatia threw his hat into the debate by proposing a 10 pronged approach. "The projects and resolutions I am presenting today are solely aimed at reducing the cost of electricity for all Puerto Ricans," he said.

Bhatia proposed the creation of an electrical commission to regulate PREPA and the energy marketplace.

Bhatia also called for eliminating the fuel adjustment charge, which PREPA uses to raise rates when energy costs go up. The commission would regulate prices. PREPA would be required to justify rates to the commission.

Also on Wednesday Bhatia said the senate would explore securitization of PREPA's debt. Along with about $8.5 billion in revenue bond debt, it also has about $750 million in operational line of credit debt and other loans and subordinated debt.

Bhatia is a member of the Popular Democratic Party, which controls both houses of Puerto Rico's legislature. Gov. Alejandro García Padilla is also a member of this party.

For his part, García Padilla proposed major changes to PREPA at an October 23 conference on Puerto Rico's energy. The governor also called for the creation of a regulatory board. He said that a 17% rate reduction this past May should be followed by a 3% cut in 2015. PREPA should reduce its rates by 50% in 12 years, he said.

PREPA should offer other services besides electricity, with internet service being one possibility, the governor said.

A source close to the governor said his ideas will be presented in a bill in the legislature in the next few weeks.

Puerto Rico Representatives Javier Aponte Dalmau in the governor's own party and Angel "Gary" Rodríguez Miranda in the opposition New Progressive Party have called for the privatization of PREPA. However, because of the governor's and the senate president's leading roles in the majority Popular Democratic Party, their plans may have better chance for adoption in the near future.

PREPA executive director Juan Alicea Flores is also seeking major changes for his authority in the near future. At the October conference he called for oil use to go from 53% of electrical production today to just 2% in 2017. Natural gas would go from 28% to 72% in the same period. The use of natural gas is a cheaper way to produce electricity than through the use of oil, PREPA has said.

Alicea Flores said PREPA should attempt to lower its kilowatt hour rate from its current 25 cents rate to 16 cents in June 2019. PREPA should diversify its income streams.

PREPA should reduce its use of long-term loans and strengthen its finances, he said.

Analysts have varying opinions about whether a new oversight body over PREPA would be a credit positive or negative.

In late October Moody's Investors Service said implementation of the governor's regulatory body would end PREPA's rate-setting independence and would be a credit negative. However, S&P director Waite said that it was too early to say what the credit impact of this body would be. Schankel said he was unsure at this point.

Municipal Market Advisors managing director Robert Donahue said Bhatia told him that he intends PREPA to honor all existing bondholder obligations.

It will be hard to lower rates without lowering costs, and analysts are generally optimistic about PREPA's attempt to rapidly shift from oil to liquefied natural gas. A private company is expected to build a platform for unloading the gas in Aguirre, on the southeast coast. Some of PREPA's plants are already burning natural gas.

Schankel said he thought the rapid conversion of plants to natural gas was achievable. However, the conversion may not come about quite as fast as PREPA plans.

Observers have mixed views as to the future of another PREPA goal, the reduction of its accounts receivables -- money owed to the utility. The ratings agencies have pointed to this as one of the authority's chief financial problems.

In the official statement for this summer's PREPA bond offering, PREPA identified collecting past due government accounts as one of its chief means of achieving fiscal stability. Yet this statement said that the central government and public corporations' past due balance had increased to $254 million as of June 30, 2013 from $183 million as of June 30, 2012.

Waite and Donahue were optimistic about PREPA's ability to make headway on this front.

"PREPA's account receivable has been growing because of lenient policies (with regard to overdue bills and service cutoffs) and high reliance on slow paying government agencies, who are PREPA's largest customer," Donahue said. "The utility is tackling these problems. For example, PREPA recently suspended service to one city for non-payment and is working closely with the Treasury Department to coordinate automatic payment for government agencies."

Puerto Rico passed legislation in 2011 to make sure government departments would be current in their electrical payments, Waite said. This is having a positive impact on government payments, she said.

Schankel said he is skeptical of PREPA's abilities to cut account receivables. In PREPA's September 2013 financial update, overall receivables had grown to 31% of sales from 27% at the same point in the previous year. The government sector, in particular, showed an even more serious decline.

For its part, PREPA has identified other routes to fiscal stability. It has been reducing operating costs principally through cutting labor costs. It is also working to reduce electricity theft. In fiscal 2013 PREPA collected $5 million in theft-collections. It is planning to expand this to $30 million a year each fiscal year through 2018.

A law passed in December 2011 is allowing PREPA to reduce its contribution in lieu of taxes to municipalities.

Finally, a recent small decrease in demand for electricity and completion of certain key projects is allowing PREPA to reduce the size of its capital improvement program in fiscal 2014 to 2018. It will also allow the authority to shift the focus from creating more generating capacity to, among other things, introducing cheaper and more reliable energy sources, PREPA said.

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