PPA Credit Risk; no corporate too big to fail

Recently ?rsted signed a Corporate PPA with Taiwanese semiconductor company TSMC for the full output from their 920MW Changhua 2b & 4 offshore project in Taiwan. Signing such a large PPA with only one counterparty will expose ?rsted to a huge credit or counterparty risk.

I am not saying anything about the current credit standing of TSMC, as that seems to be really good. However, the PPA will first start in 2026 for a 20 year period. A lot can happen during that time and there are many examples of companies that were considered to be among the world’s best companies that still went bust. 

I have written this before, but during my career, spanning 30 years, I have learned that credit risk is prone to a pig cycle. Once a credit event happens, credit risk will become high priority again and after some time the attention will slowly die away, until the next credit event happens. 

In other words history always repeats itself due to short memories. To revive memories, I will dive into a notorious example from within the energy industry that happened around the turn of the century.

Enron

Although almost two decades have passed, the name ‘Enron’ continues to hold notoriety in the investing community.

Enron’s 2001 bankruptcy destroyed over $60 billion of shareholder value. At the time of its bankruptcy, Enron was the seventh-largest company in the United States. Additionally, Enron’s $63.4 billion in assets made it the largest bankruptcy ever (until it was surpassed by Worldcom’s bankruptcy in the following year).

Enron’s bankruptcy came directly after the dot-com bust, when overvalued Internet stocks came crashing down from peak valuations and resulted in a widespread market recession. Surprisingly, Enron was a part of this mania before the bubble popped.

In 1999 – the middle of the dot-com bubble -the company created Enron Online, an electronic commodity & commodity derivatives trading website. Amazingly, Enron was the counterparty to every transaction made on Enron Online. For obvious reasons, this presented risks if commodity prices moved against the company.

However, the markets failed to accurately perceive these risks. In fact, Fortune named Enron ‘America’s Most Innovative Company’ for six consecutive years between 1996 and 2001, partially because of the then-unheard-of commodity trading website that it had created.

In the initial years, trading volumes on Enron Online expanded exponentially; by mid-2000, Enron Online was on pace to execute $350 billion in trades per year. For context, Enron’s entire business had only ~$60 billion in assets. It is not hard to see that Enron had overextended itself.

Amid the mania of the dot-com bubble, Enron’s board of directors began investing significant sums of capital into broadband telecommunications equipment – expensive assets that never generated a dime of profit for the company’s shareholders.

It is hard to overstate the negative impact of Enron’s poor investments outside its circle of competence. In one of the company’s last quarterly earnings releases before bankruptcy, its fledgling telecommunications segment reported an operating loss of $137 million.

In 2001, everything began to fall apart for Enron executives and shareholders and Enron eventually declared bankruptcy in December of that year.

Credit Risk lessons

Enron’s shareholders were not the only ones who were significantly harmed by the Enron scandal. Many of the company’s counterparties also suffered extreme financial losses.

By and large, this is because they did not properly assess the counterparty risk that they assumed when entering agreements with Enron.

Counterparty risk is defined as:

“The risk to each party of a contract that the counterparty will not live up to its contractual obligations. Counterparty risk is a risk to both parties and should be considered when evaluating a contract.”

– Investopedia

There are many different types of counterparties that suffered financial losses after the Enron scandal.Many of them were on the other end of the many derivative contracts held by Enron at the time of its bankruptcy.

In fact, the importance of assessing counterparty risk to derivatives according to warren Buffet is:

“Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them.”

Additionally, Enron’s many creditors lost money when the company went bankrupt. Enron’s total debt of $10.3 billion and total liabilities of $54 billion means that a significant number of large investors saw their debt holdings take a haircut in December of 2001.

Important Lesson

The Enron saga tells you that no company is too big to fail and every company can go bankrupt, whether you are Google, Apple, Facebook or Ikea. Making assessing counterparty risk an important aspect of business and the risk should be properly mitigated under the PPA contract.