In the municipal credit field, analyzing waste-to-energy revenue bonds is uniquely challenging. Aside from the technical aspects of facility operations, investors must be acquainted with the economic and demographic characteristics of the host community.
With challenges to flow control laws, buyers also must understand how pending legal actions may affect bondholder security.
Finally, unlike utilities whose bonds also require multi-faceted analysis, comparatively little is known about solid waste authorities. While several new electric or water and sewer bonds are issued almost every week, only 14 long-term bonds were issued for new or existing waste-to-energy facilities between January 1992 and June 1993, ac-cording to Securities Data Corp. These factors translate into higher borrowing costs for issuers.
Of the 14 bond issues, approximately one-third were insured by a municipal bond insurer, roughly the same percentage as were insured in the whole market. Four issues carried either an explicit general obligation (G.O.) guarantee by a municipality or the unconditional guaran- tee of the company operating the plant and were rated as such by agencies such as Moody's and Stan-dard & Poor's. Of the nine bonds rated on the merits of the project, six were rated below the 'A' category. This is important because even though Baa (Moody) and BBB (Stan-dard & Poor) are considered to be "investment grade," many mutual fund investors limit themselves to bonds in the 'A' category or better, even if the bond is insured.
In pricing municipal bonds, unfamiliarity breeds contempt. The goal of issuers should be to reduce this unfamiliarity and make investments easy to understand. Not surprisingly, solid waste resource recovery bonds are often offered at yields higher than comparably rated securities, as buyers demand to be compensated for the "story" that must be told about the bond, both initially and in the secondary market.
The uninsured non-G.O. bonds initially were offered at yields that were often far higher than the market benchmark for bonds of the same maturity and rating. The difference in yield between the solid waste bond and the benchmark ranged from 0.05 percent to more than 0.5 percent above the "standard," with a median of 0.25 percent. (Each maturity was compared to a similarly rated tax-exempt benchmark published that day by Delphis Hanover Inc.)
Surprisingly, the "yield penalty" existed as much for those bonds backed wholly by tipping fees and energy sales as for those whose revenue sources were more diverse. As there are significant differences in the credit features of waste-to-energy bonds, but often little difference in the way they are priced, issuers need to educate investors to improve the reception their bonds receive and lower their borrowing costs.
Flow control is one issue in the forefront of buyers' minds, and it often is cited by bond rating agencies as an important credit strength. While no bond issues have been downgraded because of challenges to flow control laws, a Supreme Court decision invalidating flow control could potentially threaten some issuers' investment grade rating.
It is likely that the uncertainty surrounding the constitutionality of flow control will persist until at least next summer when the Supreme Court decision is expected in the case of Clarkstown, N.Y., vs. Carbone Inc. Of course, even then the issue may not be resolved. In the meantime, issuers will continue to come to market and buyers (acting either in the primary or secondary market) will have to evaluate these issues considering the uncertainties. The challenge for issuers and underwriters, therefore, is to demonstrate clearly that in many cases the ab-sence of flow control will not seriously threaten bondholder security.
While any facility that relies on flow control will be hurt if these laws become unenforceable, bondholders need to appreciate the difference between projects that would become less attractive under this circumstance and projects whose bondholders would be directly threatened. Bond buyers must determine if the revenue that is used to pay the debt depends on the amount of tonnage processed and if so, if that amount is likely to drop if the solid waste authority cannot mandate that all trash go the facility.
One popular security feature oc-curs when a municipality (or group of municipalities) commits to deliver a minimum amount of tonnage necessary to insure that the plant can operate profitably. To the extent that it is unable to deliver the requisite amount, the municipality agrees to make a shortfall payment to the solid waste authority. This shortfall payment may be a general obligation of the city or county. The risk therefore is borne by the community, not by the bondholder. Here, eliminating a flow control ordinance should not directly affect bondholder security because the amount of waste processed theoretically will not affect the amount of revenue available to service the debt.
This is more desirable than a bond backed solely by tipping fees and energy sales without a guaranteed amount of tonnage revenue from the communities. Clearly, a drop in tonnage due to invalidation of the flow control law could have a direct effect on revenues to pay the debt and consequently threaten bondholder security. None of the bonds surveyed with this type of structure received an 'A' rating. Buyers should be made aware of this type of distinction.
A shortfall payment agreement is not necessarily a panacea, however. When an authority must continually depend on shortfall payments to make up for revenue deficiencies, the community may feel that the facility has become economically unattractive to operate. Bondholders cannot overlook this danger. In at least two cases, waste-to-energy bond ratings have been placed under review or downgraded because the municipalities either resisted making shortfall payments to the authority as required, or the authority failed to impose the shortfall charge.
Will There Be Waste? Investors must consider how much a facility relies on flow control to insure revenue. For example:
* Is there a nearby facility, such as a landfill, with a lower gate fee where private haulers would prefer to go?
* Does the municipality rely primarily on private haulers who have incentive to seek the lowest tip fee?
* How much will increased recycling affect the amount of waste available for processing?
* Is the plant properly sized given area demographics? Is the community losing residents? Will significant population growth be necessary to insure an adequate supply of waste?
* Does the authority have contracts to receive waste from any surrounding communities that do not have their own facility?
An alternative is to sever the relationship between the amount of waste processed and debt service payments. A frequently used mechanism is an assessment of a user fee on residents and businesses who benefit from the facility. These fees, used to pay debt service, often are collected on regular property tax bills. This attractive credit feature can earn a waste-to-energy bond a coveted 'A' rating.
Why else do investors demand more yield from waste-to-energy bonds? For a new facility, one factor is construction risk. Bondholders assume the risk that the facility is completed on time, without significant cost overruns. In addition, there is no operating history for the facility, so buyers must rely on the authority's projections.
Investors are concerned about how the host community perceives the resource recovery plant. Com-munity resistance could lead to construction delays and additional costs, especially if the permitting process is disrupted. In addition, not only must investors be concerned with whether or not the facility is fully permitted, but also whether or not arrangements for the accompanying ash landfill are complete.
Investors also must be compensated for the extraordinary call provisions of waste-to-energy bonds. Resource recovery bonds usually contain several situations where the issuer can redeem the bond at par. As a general matter, buyers dislike extraordinary call provisions of any kind. If a buyer has paid a premium for the bond (more than $100 per $1,000 face value), then a par call ($100 per $1,000) represents a real dollar loss.
Extraordinary redemption provisions from insurance collected from plant damage and/or destruction is standard to any project-related bond. However, because of the unfamiliarity of the technology, some buyers tend to pay more attention to this risk in a waste-to-energy bond.
Bondholders also are exposed to the "worthiness" of the facility operator. Even though the company may not guarantee the debt, bonds are often callable if the company fails to meet its obligations under its performance contract with the authority.
There is often a recision period of a year or more after the plant is completed when the bonds could be called, if due to an "uncontrollable circumstance," the tipping fee rises dramatically. An uncontrollable circumstance is usually interpreted to mean a change in existing law. Theoretically, the invalidation of a flow control law could cause a large enough increase in tipping fees to trigger an uncontrollable circumstance. A change in environmental law also has the potential to trigger the uncontrollable circumstance clause. For example, the outcome of the pending Supreme Court case City of Chicago vs. Environmental Defense Fund may significantly increase municipalities' ash disposal costs. In some situations, these costs may need to be passed along in the form of a higher tipping fee.
Addressing Investors There are a myriad of issues that potential resource recovery bondholders must consider. By addressing the concerns of the investors, issuers have the opportunity to reap significant, quantifiable benefits by lowering their borrowing costs. How might issuers accomplish this?
First, institutional investor meetings might be beneficial. By providing a forum for potential buyers to pose questions directly to the authority, concerns can be alleviated and demand stimulated.
Second, issuers could conduct investor tours of the facility to in-crease understanding of the technology and increase comfort with the facility operator.
Or issuers may arrange conference calls with institutional investors.
Whatever method is chosen - investor meetings, site visits, conference calls - the issuers should:
* Emphasize the revenue structure. Some issues provide bondholders with a diverse, non-tonnage dependent revenue stream. Other things being equal, these bonds should be better received than their tipping fee-only counterparts.
* Demystify the technology by emphasizing the successful operating history of mass-burn facilities.
* Articulate clearly how much, or little, the facility depends on flow control. Because of recent media at-tention, investors are very concerned about this issue and yet, in many cases, this fear is unwarranted.
As available landfill space is re-duced by either demand or tougher Subtitle D regulations, more municipalities may look to waste-to-energy. The most successful issuers will be those that appreciate that better information equals better pricing in the primary market, and more liquidity in the secondary market.