Covanta Holding Corp 10-K 2006
Documents found in this filing:
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Commission file number: 1-06732
COVANTA HOLDING CORPORATION
(Exact name of registrant as specified in its charter)
Registrants telephone number, including area code:
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No þ
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes o No þ
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act.
Large accelerated filer þ Accelerated filer o Non-accelerated filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
As of June 30, 2005, the aggregate market value of the registrants common stock held by non-affiliates of the registrant was $872,088,630 based on the closing sale price as reported on the American Stock Exchange (the exchange upon which the registrants common stock was listed on such date).
Indicate the number of shares outstanding of each of the issuers classes of common stock, as of the latest practicable date.
Documents Incorporated By Reference:
TABLE OF CONTENTS
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
Certain statements in the Annual Report on Form 10-K may constitute forward-looking statements as defined in Section 27A of the Securities Act of 1933 (the Securities Act), Section 21E of the Securities Exchange Act of 1934 (the Exchange Act), the Private Securities Litigation Reform Act of 1995 (the PSLRA) or in releases made by the Securities and Exchange Commission (SEC), all as may be amended from time to time. Such forward-looking statements involve known and unknown risks, uncertainties and other important factors that could cause the actual results, performance or achievements of Covanta Holding Corporation and its subsidiaries (Covanta), formerly known as Danielson Holding Corporation, or industry results, to differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements. Statements that are not historical fact are forward-looking statements. Forward-looking statements can be identified by, among other things, the use of forward-looking language, such as the words plan, believe, expect, anticipate, intend, estimate, project, may, will, would, could, should, seeks, or scheduled to, or other similar words, or the negative of these terms or other variations of these terms or comparable language, or by discussion of strategy or intentions. These cautionary statements are being made pursuant to the Securities Act, the Exchange Act and the PSLRA with the intention of obtaining the benefits of the safe harbor provisions of such laws. Covanta cautions investors that any forward-looking statements made by Covanta are not guarantees or indicative of future performance. Important assumptions and other important factors that could cause actual results to differ materially from those forward-looking statements with respect to Covanta include, but are not limited to, the risks and uncertainties affecting their businesses described in Item 1A of this Annual Report on Form 10-K for the year ended December 31, 2005 and in other securities filings by Covanta and its subsidiaries.
Although Covanta believes that its plans, intentions and expectations reflected in or suggested by such forward-looking statements are reasonable, actual results could differ materially from a projection or assumption in any of its forward-looking statements. Covantas future financial condition and results of operations, as well as any forward-looking statements, are subject to change and inherent risks and uncertainties. The forward-looking statements contained in this Annual Report on Form 10-K are made only as of the date hereof and Covanta does not have or undertake any obligation to update or revise any forward-looking statements whether as a result of new information, subsequent events or otherwise, unless otherwise required by law.
AVAILABILITY OF INFORMATION
You may read and copy any materials Covanta files with the SEC at the SECs Public Reference Room at 100 F Street, N.E., Room 1580, Washington, D.C. 20549. Copies of such material also can be obtained at the SECs website, www.sec.gov or by mail from the Public Reference Room of the SEC, at prescribed rates. Please call the SEC at 1-800-SEC-0330 for further information on the Public Reference Room. Covantas SEC filings are also available to the public, free of charge, on its corporate website, www.covantaholding.com as soon as reasonably practicable after Covanta electronically files such material with, or furnishes it to, the SEC. Covantas common stock is traded on the New York Stock Exchange. Material filed by Covanta can be inspected at the offices of the New York Stock Exchange at 20 Broad Street, New York, NY 10005.
Covanta Energy Corporation is a wholly-owned subsidiary of Covanta. As of June 30, 2005, Covanta Energy Corporation ceased to file periodic reports or other information with the SEC. Covanta Energy Corporations historical reports and other information filed by Covanta Energy Corporation with the SEC can be read and copied at the Public Reference Room of the SEC at the address set forth above. Copies of such historical material also can be obtained at the SECs website, www.sec.gov or by mail from the Public Reference Room of the SEC, at prescribed rates. Please call the SEC at the number set forth above for
further information on the Public Reference Room. Historical information on Covanta Energy Corporation is also available to the public on Covantas corporate website at www.covantaholding.com.
Covanta ARC Holdings, Inc. is a wholly-owned subsidiary of Covanta Energy Corporation and does not currently file periodic reports or other information with the SEC. However, certain of its subsidiaries MSW Energy Holdings LLC, MSW Energy Finance Co. Inc., (collectively MSW I) and MSW Energy Holdings II LLC, and MSW Energy Finance Co. II, Inc., (collectively MSW II) file periodic reports and other information with the SEC. Such reports and other information filed by these entities with the SEC can be read and copied at the Public Reference Room of the SEC at the address set forth above. Copies of such material also can be obtained at the SECs website, www.sec.gov or by mail from the Public Reference Room of the SEC, at prescribed rates. Please call the SEC at the number set forth above for further information on the Public Reference Room. These SEC filings are also available to the public on Covantas corporate website at www.covantaholding.com.
About Covanta Holding Corporation
Covanta Holding Corporation (Covanta) is a holding company incorporated in Delaware on April 16, 1992. Covanta changed its name as of September 20, 2005 from Danielson Holding Corporation to Covanta Holding Corporation. Covanta primarily operates in the waste and energy markets through Covanta Energy Corporation and its subsidiaries (Covanta Energy). Covanta acquired Covanta Energy on March 10, 2004 and acquired Covanta ARC Holdings, Inc. (formerly known as American Ref-Fuel Holdings Corp., and referred to as ARC Holdings) and its subsidiaries on June 24, 2005. Substantially all of Covantas operations were conducted in the insurance industry prior to its acquisition of Covanta Energy through its indirect subsidiaries, National American Insurance Company of California (NAICC) and related entities.
Covanta Energy develops, constructs, owns and operates for itself and others infrastructure for the conversion of waste-to-energy and independent power production in the United States and abroad. Following its acquisition of ARC Holdings, an owner and operator of six waste-to-energy projects and related businesses in the northeast United States, Covanta Energy owns or operates 55 energy generation facilities, 43 of which are in the United States and 12 of which are located outside of the United States. Covanta Energys energy generation facilities use a variety of fuels, including municipal solid waste, water (hydroelectric), natural gas, coal, wood waste, landfill gas and heavy fuel oil. Covanta Energy also owns or operates several businesses that are associated with its waste-to-energy business, including a waste procurement business, two landfills, and several waste transfer stations. Covanta Energy also operates one water treatment facility which is located in the United States.
The nature of Covantas business, the risks attendant to such business and the trends that Covanta faces have been significantly altered by the acquisitions of Covanta Energy and ARC Holdings. Accordingly, Covantas financial results prior to the acquisitions of Covanta Energy in March 2004 and ARC Holdings in June 2005 are not directly comparable to current and future financial results.
Covantas Business Strategy
With the acquisition of Covanta Energy and ARC Holdings, Covanta is focused on the Waste and Energy Services business. Covantas mission is to be the worlds leading waste-to-energy company, with a complementary network of waste disposal and energy generation assets. Covanta expects to build value for its shareholders by satisfying its clients waste disposal and energy generation needs with safe, reliable and environmentally superior solutions. In order to accomplish this mission, Covanta intends to:
Leverage its core competencies by:
Maximize long-term value of its existing portfolio by:
Capitalize on growth opportunities by:
Covanta has two business segments: Waste and Energy Services, which is comprised of Covanta Energys business, and Other Services, which includes Covantas parent company operations and insurance business. Covantas Waste and Energy Services segment is substantially larger than its Other Services segment. Each of these segments are described below.
Additional information about Covantas business segments is contained in Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations Overview Covantas Business Segments and in Note 1. Organization and Summary of Significant Accounting Policies and Note 27. Business Segments of the Notes to the Consolidated Financial Statements (Notes).
WASTE AND ENERGY SERVICES BUSINESS
Covantas strategic acquisitions of Covanta Energy and ARC Holdings have made it a leader in the waste and energy services markets.
On December 2, 2003, Covanta executed a definitive investment and purchase agreement to acquire Covanta Energy in connection with Covanta Energys emergence from Chapter 11 proceedings. On March 5, 2004, the Bankruptcy Court confirmed Covanta Energys proposed plans of reorganization and on March 10, 2004, Covanta acquired 100% of Covanta Energys equity for approximately $30 million.
Covanta, through its wholly-owned subsidiary Covanta Energy, acquired ARC Holdings on June 24, 2005 by purchasing 100% of the issued and outstanding shares of ARC Holdings capital stock. Covantas purchase price was approximately $747 million, including transaction costs, for the stock of ARC Holdings and the assumption of the consolidated net debt of ARC Holdings, which was approximately $1.3 billion ($1.5 billion of consolidated indebtedness net of $0.2 billion of cash and restricted cash). Covanta financed this transaction through a combination of debt and equity financing. The equity component of the financing was effected through a rights offering to existing Covanta shareholders (the ARC Holdings Rights Offering) that was consummated as of June 24, 2005.
See Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations Managements Discussion and Analysis of Liquidity and Capital Resources Financing Arrangements, Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations Managements Discussion of Liquidity and Capital Resources Related Party Transactions Affiliate Agreements, Note 3. Acquisitions and Dispositions and Note 18. Long-Term Debt of the Notes for a detailed description of this financing associated with this acquisition.
ARC Holdings is now a wholly-owned subsidiary of Covanta Energy, and Covanta Energy controls the management and operations of the ARC Holdings facilities.
The fundamental purpose of Covanta Energys waste-to-energy projects is to provide waste disposal services, typically to municipal clients who sponsor the projects. Generally, Covanta Energy provides these services pursuant to long-term service contracts. The electricity or steam generated is generally sold pursuant to long-term power purchase agreements with local utilities or industrial customers, and most of the resulting revenues reduce the overall cost of waste disposal services to the municipal clients. The original terms of the service contracts are each 20 or more years, with the majority now in the second half of their respective terms. Many of Covanta Energys service contracts may be renewed for varying periods of time, at the option of the municipal client. Covanta Energy receives its revenue in the form of fees pursuant to the service or waste contracts, and in some cases, energy purchase agreements, at facilities it owns or operates. TransRiver, one of Covanta Energys subsidiaries, markets waste disposal services to third parties predominantly to efficiently utilize that portion of the waste disposal capacity of Covanta Energys projects which is not dedicated to municipal clients under such long-term service contracts.
Covanta Energy currently operates waste-to-energy projects in 15 states, identified below under Domestic Project Summaries. Most of Covanta Energys operating waste-to-energy projects were developed and structured contractually as part of competitive procurement processes conducted by municipal entities. As a result, many of these projects have common features. However, each service agreement is different to reflect the specific needs and concerns of a client community, applicable regulatory requirements and other factors. The following describes features generally common to these agreements, as well as important distinctions among them:
Covanta Energys service and waste disposal agreements, as well as its energy contracts, expire at various times as noted in the table below. The extent to which any such expiration will affect Covanta Energy will depend upon a variety of factors, including whether the project itself is owned by Covanta Energy or its municipal client, market conditions then prevailing, and whether the municipal client exercises options it may have to extend the contract term. As Covanta Energys contracts expire it will become subject to greater market risk in maintaining and enhancing its revenues. As its service agreements at municipally-owned facilities expire, Covanta Energy intends to seek to enter into renewal or replacement contracts to operate several such facilities. Covanta Energy also will seek to bid competitively in the market for additional contracts to operate other facilities as similar contracts of other vendors expire. As Covanta Energys service and waste disposal agreements at facilities it owns or leases begin to expire, it intends to seek replacement or additional contracts, and because project debt on these facilities will be paid off at such time, Covanta Energy expects to be able to offer rates that will attract sufficient quantities of waste while providing acceptable revenues to Covanta Energy. At Covanta Energy-owned facilities, the expiration of existing energy contracts will require Covanta Energy to sell its output either into the local electricity grid at prevailing rates or pursuant to new contracts. There can be no assurance that Covanta Energy will be able to enter into such renewals, replacement or additional contracts, or that the terms available in the market at the time will be favorable to Covanta Energy. See Item 1A. Risk Factors Waste and Energy Services Business-Specific Risks Covanta Energy may face increased risk of market influences on its domestic revenues after its contracts expire.
Covanta Energys opportunities for growth by investing in new projects will be limited by existing non-project debt covenants, as well as by competition from other companies in the waste disposal business. For a discussion of such debt covenants, see Note 18. Long-Term Debt of the Notes. See Item 1A. Risk Factors Waste and Energy Services Business-Specific Risks Our ability to grow our Waste and Energy Services business may be limited.
Other Waste-Related Businesses
TransRiver, a wholly-owned subsidiary of Covanta Energy, provides waste procurement services to Covanta Energys waste disposal and transfer facilities which have available capacity to receive waste. In doing so, TransRiver seeks to maximize Covanta Energys revenue, and ensures that Covanta Energys facilities are being utilized most efficiently, taking into account maintenance schedules and operating restrictions that may exist from time to time at each facility. TransRiver also provides management and marketing of ferrous and non-ferrous metals recovered from waste-to-energy operations, as well as services related to non-hazardous special waste destruction and residue management for Covanta Energys waste-to-energy projects.
Covanta Energys waste-related business also include the operations of five transfer stations and two landfills in the northeast United States, which it utilizes to supplement and manage more efficiently the fuel requirements at its waste-to-energy operations.
Independent Power Projects
Covanta Energy is also engaged domestically in developing, owning and/or operating independent power production facilities utilizing a variety of energy sources including water (hydroelectric), waste wood (biomass) and landfill gas. The electrical output from each facility, with one exception, is sold to local utilities. Covanta Energys revenues from the independent power production facilities are derived primarily from the sale of energy and capacity under energy contracts. The facilities and locations are identified below under Domestic Project Summaries.
Covanta Energy owns a 50% equity interest in two run-of-river hydroelectric facilities which have a combined gross generating capacity of 17 megawatts (MW). Both facilities are located in the State of Washington and both sell energy and capacity to Puget Sound Energy under long-term energy contracts. A subsidiary of Covanta Energy provides operation and maintenance services at one of the facilities under a cost plus fixed-fee agreement.
Covanta Energy owns 100% interests in three wood-fired generation facilities and a 50% interest in a partnership which owns a fourth wood-fired generation facility, all of which are located in northern California. Fuel for the facilities is procured from local sources, primarily through short-term supply agreements. The price of the fuel varies depending on time of year, supply and price of energy. These projects have a combined gross generating capacity of 67.1 MW and sell energy and capacity to Pacific Gas & Electric Company under energy contracts which have fixed pricing through July 2006 and market pricing thereafter through 2011.
Covanta Energy has interests in and/or operates six landfill gas projects which produce electricity by burning methane gas produced in landfills. Five of these projects are located in California, and one is located in Maryland. The six projects have a total gross generating capacity of 16.1 MW. The Maryland facilitys energy contract has expired and the facility is currently selling its output into the regional utility grid. The remaining five projects sell energy to various California utilities. Upon the expiration of the energy contracts, it is expected that these projects will enter into new power off-take arrangements or the projects will be shut down.
Covanta Energy designed, built and now continues to operate and maintain a 24 million gallon per day (mgd) potable water treatment facility and associated transmission and pumping equipment in Alabama. Under a long-term contract with a public utility authority, Covanta Energy is paid a fixed-fee plus pass-through costs for delivering processed water to a municipal water distribution system.
Domestic Project Summaries
Summary information with respect to Covanta Energys domestic projects that are currently operating is provided in the following table:
International Waste and Energy Services Business
Covanta Energy conducts its international energy business through its wholly-owned subsidiary, Covanta Power International Holdings, Inc. (CPIH) and its subsidiaries. The largest element of CPIHs waste and energy services business is its 26% ownership in and operation of a 510 MW (gross) pulverized coal-fired electric generating facility in the Philippines. CPIH also has interests in other fossil fuel generating projects in
Bangladesh, China, India and the Philippines, a waste-to-energy project in Italy and two small hydroelectric projects in Costa Rica. In general, these projects provide cash returns primarily from equity distributions and, to a lesser extent, operating fees. The projects sell the electricity and steam they generate under long-term contracts or market concessions to utilities, governmental agencies providing power distribution, creditworthy industrial users, or local governmental units. In select cases, such sales of electricity and steam may be provided under short-term arrangements as well.
Covanta Energy presently has interests in international power projects with an aggregate generating capacity of approximately 1,051 MW (gross) with proportionate ownership in these facilities being approximately 461 MW. In addition to its headquarters in Fairfield, New Jersey, Covanta Energys international business is facilitated through field offices in Shanghai, China; Chennai, India; Manila, Philippines; and Bangkok, Thailand.
General Approach to International Projects
In developing its international business, Covanta Energy has employed the same general approach to projects as is described above with respect to domestic projects. While Covanta Energy intends to focus its business primarily in domestic markets, it may seek to develop or participate in additional international projects, particularly waste-to-energy projects. Covanta Energys financing arrangements place limitations on investments and borrowings it may make in connection with such projects. For information related to the revenues and identifiable assets of the international business, see Note 27. Business Segments of the Notes.
The ownership and operation of facilities in foreign countries in connection with Covanta Energys international business entails significant political and financial uncertainties that typically are not encountered in such activities in the United States as described in Item 1A. Risk Factors Waste and Energy Services Business Specific Risks Exposure to international economic and political factors may materially and adversely affect our Waste and Energy Services businesses.
Many of the countries in which Covanta Energy operates are lesser developed countries or developing countries where the political, social and economic conditions are typically less stable than in the United States. The financial condition and creditworthiness of the potential purchasers of power and services provided by Covanta Energy or of the suppliers of fuel for projects in these countries may not be as strong as those of similar entities in developed countries. The obligations of the purchaser under the energy contract, the service recipient under the related service agreement and the supplier under the fuel supply agreement generally are not guaranteed by any host country or other creditworthy governmental agency. At the time it develops a project, Covanta Energy undertakes a credit analysis of the proposed power purchaser or fuel supplier and to the extent appropriate and achievable within the commercial parameters of a project, requires such entities to provide financial instruments, such as letters of credit or arrangements regarding the escrowing of the receivables.
Covanta Energy has typically sought to negotiate long-term contracts for the supply of fuel with creditworthy and reliable suppliers. However, the reliability of fuel deliveries may be compromised by one or more of several factors that may be more acute or may occur more frequently in developing countries than in developed countries, including a lack of sufficient infrastructure to support deliveries under all circumstances; bureaucratic delays in the import, transportation and storage of fuel in the host country; customs and tariff disputes; and local or regional unrest or political instability. In most of the foreign projects in which Covanta Energy participates, it has sought, to the extent practicable, to shift the consequences of interruptions in the delivery of fuel (whether due to the fault of the fuel supplier or due to reasons beyond the fuel suppliers control) to the electricity purchaser or service recipient by securing a suspension of its operating responsibilities under the applicable agreements and an extension of its operating concession under such agreements. In some instances, Covanta Energy requires the energy purchaser or service recipient to continue to make payments in respect of fixed costs if such interruptions occur. In order to mitigate the effect of short-term interruptions in the supply of fuel, Covanta Energy has also endeavored to provide on-site storage of fuel in sufficient quantities to address such interruptions.
Payment for services that Covanta Energy provides will often be made in whole or in part in the domestic currencies of the host countries. Conversion of such currencies into U.S. dollars generally is not assured by a governmental or other creditworthy country agency and may be subject to limitations in the currency markets, as well as restrictions of the host country. In addition, fluctuations in the value of such currencies against the value of the U.S. dollar may cause Covanta Energys participation in such projects to yield less return than expected. Transfer of earnings and profits in any form beyond the borders of the host country may be subject to special taxes or limitations imposed by host country laws. Covanta Energy has sought to participate in projects in jurisdictions where limitations on the convertibility and expatriation of currency have been lifted by the host country and where such local currency is freely exchangeable on the international markets. In most cases, components of project costs incurred or funded in the currency of the United States are recovered without risk of currency fluctuation through negotiated contractual adjustments to the price charged for electricity or service provided. This contractual structure may cause the cost in local currency to the projects power purchaser or service recipient to rise from time to time in excess of local inflation, and consequently there is risk in such situations that such power purchaser or service recipient will, at least in the near-term, be less able or willing to pay for the projects power or service.
Covanta Energy has sought to manage and mitigate these risks through all means that it deems appropriate, including: political and financial analysis of the host countries and the key participants in each project; guarantees of relevant agreements with creditworthy entities; political risk and other forms of insurance; participation by United States and/or international development finance institutions in the financing of projects in which Covanta Energy participates; and joint ventures with other companies to pursue the development, financing and construction of these projects. Covanta Energy determines which mitigation measures to apply based on its balancing of the risk presented, the availability of such measures and their cost.
In addition, Covanta Energy has generally participated in projects which provide services that are treated as a matter of national or key economic importance by the laws and politics of the host country. Therefore, there is a risk that the assets constituting the facilities of these projects could be temporarily or permanently expropriated or nationalized by a host country, made subject to local or national control or be subject to unfavorable legislative action, regulatory decisions or changes in taxation.
In certain cases, Covanta Energy has issued guarantees of its operating subsidiaries contractual obligations to operate certain international power projects. The potential damages owed under such arrangements for international projects may be material if called. Depending upon the circumstances giving rise to such damages, the contractual terms of the applicable contracts, and the contract counterpartys choice of remedy at the time a claim against a guarantee is made, the amounts owed pursuant to one or more of such guarantees could be greater than Covanta Energys then-available sources of funds. To date, Covanta Energy has not incurred any material liabilities under its guarantees on international projects.
Covanta Energys international power projects are identified below under International Project Summaries. The following describes the important features of these projects, by fuel type:
Covanta Energy owns a 13% equity interest in an 18 MW mass-burn waste-to-energy project at Trezzo sullAdda in the Lombardy Region of Italy (the Trezzo project) which burns up to 500 metric tons per day of municipal solid waste. The remainder of the equity in the project is held by a subsidiary of Falck S.p.A. and the municipality of Trezzo sullAdda. The Trezzo project is operated by Ambiente 2000 S.r.l. (A2000), an Italian special purpose limited liability company of which Covanta Energy owns 40%. The solid waste supply for the project comes from municipalities and privately-owned waste haulers under long-term contracts. The electrical output from the Trezzo project is sold at governmentally established preferential rates under a long-term purchase contract to Italys state-owned grid operator, Gestore della Rete di Trasmissione Nazionale S.p.A. (GRTN).
A2000 also entered into a 15-year operations and maintenance agreement to operate and maintain a 10 MW waste-to-energy facility capable of processing up to 300 metric tons per day of refuse-derived fuel in the Municipality of San Vittore del Lazio (Frosinone), Italy (the San Vittore project). Operation and
maintenance of the plant by A2000 was scheduled to commence during 2004, but has been delayed due to a dispute as to the validity of the operations and maintenance agreement. There can be no assurance as to the outcome of this dispute, or that A2000 will operate the San Vittore project.
Covanta Energy operates two hydroelectric facilities in Costa Rica through an operating subsidiary pursuant to long-term contracts. Covanta Energy also has a nominal equity investment in each project. The electric output from both of these facilities is sold to Instituto Costarricense de Electricidad, a Costa Rica national electric utility.
A partnership, in which Covanta Energy holds a 26% equity interest, owns a 510 MW (gross) coal-fired electric power generation facility located in Mauban, Quezon Province, the Philippines, (the Quezon project). The remaining equity interests are held by an affiliate of International Generating Company, an affiliate of General Electric Capital Corporation, and an entity owned by the original project developer. The project company sells electricity to Manila Electric Company (Meralco), the largest electric distribution company in the Philippines, which serves the area surrounding and including metropolitan Manila.
Under an energy contract expiring in 2025, Meralco is obligated to take-or-pay for stated minimum annual quantities of electricity produced by the facility at an all-in tariff which consists of capacity, operating, energy, transmission and other fees adjusted to inflation, fuel cost and foreign exchange fluctuations. Project management continues to negotiate with Meralco with respect to proposed amendments to the power purchase agreement to modify certain commercial terms under the existing contract and to resolve issues relating to the projects performance during its first year of operation. The project company has entered into two coal supply contracts expiring in 2015 and 2022. Under these supply contracts, the cost of coal is determined using a base energy price adjusted to fluctuations of specified international benchmark prices. Covanta Energy is operating the project through a subsidiary under a long-term agreement with the project company. In 2005, the project lenders permitted the full release for distribution of cash previously required to be held back in excess of reserve requirements. In addition, the project lenders granted an extension of an existing waiver permitting the project to continue to forego obtaining certain project insurance coverage levels that are not available at commercially reasonable rates.
The financial condition of Meralco has been stressed by the failure of regulators to grant tariff increases to allow Meralco to achieve rates of return permitted by law. However, in late 2004, Meralco successfully refinanced $228 million (U.S.) in expiring short-term debt on a long-term seven year basis, improving Meralcos financial condition. Covanta Energy has obtained political risk insurance for its equity investment in this project.
Covanta Energy has majority equity interests in three coal-fired cogeneration facilities in three provinces in the Peoples Republic of China. Two of these projects (the Yanjiang project and the Linan project) are operated by the project entity in which Covanta Energy holds a majority interest. The third project (the Huantai project) is operated by an affiliate of that projects minority equity shareholder. Parties holding minority positions in the projects include a private company, a local government enterprise and affiliates of the local municipal government. In connection with the Linan project, the local Peoples Congress has enacted a non-binding resolution calling for the relocation of the cogeneration facility from the city center to an industrial zone. The project company continues to review its options in this matter. While the steam produced at each of the three projects is intended to be sold under long-term contracts to the industrial hosts, in practice, steam has been sold on either a short-term basis to local industries or the industrial hosts, in each case at varying rates and quantities. At the Yanjiang and Linan projects, the electric power is sold at an average grid rate to a subsidiary of the Provincial power bureau. At the Huantai project, the electric power is sold directly to the industrial host at a similar rate. In December 2005, Covanta Energy entered into a letter of intent to sell the assets of the Huantai project to an affiliate of the minority equity shareholder for a sale price of $3.5 million in cash. The potential sale of this interest is subject to satisfactory diligence by the
purchaser and execution of definitive documentation. Covanta can provide no assurance that such proposed sale will close.
Covanta Energy holds a 45% equity interest in a barge-mounted 126 MW (gross) diesel/natural gas-fired electric power generation facility located near Haripur, Bangladesh (the Haripur project). The remaining equity interests are held by an affiliate of El Paso Energy Corporation and an affiliate of Wartsila North America, Inc. Subject to consents from the project lenders and the Government of Bangladesh, El Paso Energy Corporation is in the process of transferring its 50% interest in the project to Globaleq Asia Holdings Limited. The electrical output of the project is sold to the Bangladesh Power Development Board (BPDB), pursuant to an energy contract with minimum energy off-take provisions at a tariff divided into a fuel component and an other component. The fuel component reimburses the fuel cost incurred by the project up to a specified heat rate. The other component consists of a pre-determined base rate adjusted to actual load factor and foreign exchange fluctuations. The energy contract also obligates the BPDB to supply all the natural gas requirements of the project at a pre-determined base cost adjusted to fluctuations on actual landed cost of the fuel in Bangladesh. The BPDBs obligations under the agreement are guaranteed by the Government of Bangladesh. Covanta Energy is operating the project through a subsidiary under a long-term agreement with the project company. In 2005, the project obtained the extension of an existing waiver from the project lenders permitting it to continue to forego obtaining certain project insurance coverage levels that are not available at commercially reasonable rates. Covanta Energy has obtained political risk insurance for its equity interest in this project.
Covanta Energy holds majority equity interests in two 106 MW (gross) heavy fuel-oil fired electric power generation facilities in India. The first project, where Covanta Energy holds a 60% equity interest, is located near Samalpatti, in the state of Tamil Nadu (the Samalpatti project). The remaining equity interests are held by affiliates of Shapoorji Pallonji Infrastructure Capital Co. Ltd. and by Wartsila India Power Investment, LLC. The second project, where Covanta Energy holds a 77% equity interest, is located at Samayanallur, also in the state Tamil Nadu (the Madurai project). The balance of this equity interest is held by an Indian company controlled by the original project developer. The electrical output of both projects is sold to the Tamil Nadu Electricity Board (TNEB) pursuant to long-term agreements with full pass-through tariffs at a specified heat rates, operation and maintenance costs, and equity returns. TNEBs obligations are guaranteed by the government of the State of Tamil Nadu. Indian oil companies supply the oil requirements of both projects through 15-year fuel supply agreements based on market prices. Covanta Energy operates both projects through subsidiaries under long-term agreements with the project companies.
Disputing several tariff provisions, TNEB has failed to pay the full amount due under the energy contracts for both the Samalpatti and Madurai projects. Similar to many Indian state electricity boards, TNEB has also failed to fund the escrow account or post a letter of credit required under the project energy contracts, which failure constitutes a default under the project finance documents. The project lenders for both projects have not declared an event of default due to this matter and have permitted continued distributions of project dividends. To date, TNEB has paid the undisputed portion of its payment obligations (approximately 95%) representing each projects operating costs, fuel costs, debt service and some equity return. Project lenders for both projects have either granted periodic waivers of such default or potential default and/or otherwise approved scheduled equity distributions. Neither such default nor potential default in the project financing arrangements constitutes a default under Covanta Energys recourse debt. TNEB has indicated a desire to renegotiate tariffs for both project energy contracts, and it is possible that the issue of the escrow account or letter of credit requirement will be resolved as part of any such process.
A subsidiary of Covanta Energy owns and operates a 63 MW heavy fuel-oil fired electric power generation facility located in the province of Cavite, the Philippines (the Magellan project). Due to high fuel pricing and low tariff conditions, project revenues were insufficient to cover both operating costs and debt service beyond the second quarter of 2004 and in May 2004, the Magellan project company filed a petition for
corporate rehabilitation under Philippine Law. On October 20, 2005, the Court overseeing the rehabilitation issued an order approving, with certain modifications, a rehabilitation plan. The approved rehabilitation plan, among other things, provided for debt restructuring and reduction via a debt-to-preferred equity swap. Covanta Energy will retain management control of the project, but its equity interest will be reduced from 100% to approximately 30 to 36%. The courts order has been appealed by certain creditors which could result in modifications to the rehabilitation plan. Covanta Energy wrote off its investment in this project in 2002.
Covanta Energy owns a minority interest in a 7 MW heavy fuel-oil fired electric power generation facility located in the province of Mindoro, the Philippines (the Island Power project) that has a long-term power sales contract.
International Project Summaries
Summary information with respect to Covanta Energys projects that are currently operating is provided in the following table:
Covantas opportunities for growth by investing in new domestic business will be limited by Covanta Energys debt covenants, as well as by competition from other companies in the waste disposal and energy businesses. For Covanta to achieve meaningful growth, due to the capital intensive nature of its municipal solid waste processing and energy generating projects, Covanta must be able to invest its own funds, obtain equity or debt financing, and provide support to its operating subsidiaries. Covantas domestic project development has recently concentrated on working with its client communities to expand existing waste-to-energy project capacities, and has one project in advanced stages of development and another in construction. Covanta is pursuing additional expansion opportunities, as well as opportunities in businesses ancillary to its existing business such as additional waste transfer, transportation, processing and landfill businesses. Covanta is also pursuing international waste and/or energy business opportunities, particularly in markets where the regulatory environment encourages waste-to-energy development, such as in Italy, where Covanta has an existing presence, as well as in the United Kingdom.
Covantas development efforts regarding project expansions are described below.
Covanta Energy designed, constructed and now operates and maintains this 1,200 tpd mass-burn waste-to-energy facility located in and owned by Hillsborough County. Due to the growth in the amount of municipal solid waste generated in Hillsborough County, Hillsborough County informed Covanta Energy of its desire to expand the facilitys waste processing and electricity generation capacities, a possibility contemplated by the original contract between Covanta Energy and Hillsborough County. In August 2005, Covanta Energy and Hillsborough County entered into agreements to implement this expansion, and to extend the agreement under which Covanta Energy operates the facility, which would otherwise expire in 2007, through 2027. Environmental and other project related permits will need to be secured and financing completed by Hillsborough County in order for the agreements to take effect and construction to commence.
Covanta Energy designed, constructed and now operates and maintains this 1,200 tpd mass-burn waste-to-energy facility located in and owned by Lee County. Due to the growth in the amount of solid waste generated in Lee County, Lee County informed Covanta Energy of its desire to engage Covanta Energy to manage the expansion of the facilitys waste processing and electricity generation capacities, a possibility contemplated by the original contract between Covanta Energy and Lee County. As part of the agreement to implement this expansion, Covanta Energy received a long-term operating contract extension expiring in 2024. Contracts for construction of the expansion and contracts for operation and maintenance of the expanded facility have been executed by the parties. The principal environmental permit for the expansion has been received and construction of the expansion has commenced.
This 2,160 ton per day refuse-derived fuel facility was designed and constructed by an entity not related to Covanta Energy. Subsequently, Covanta Energy purchased the rights to operate and maintain the facility on behalf of the City and County of Honolulu. Previously, the City and County of Honolulu had informed Covanta Energy of their desire to expand the facilitys waste processing capacity, a possibility contemplated by the original contract between Covanta Energy and the City and County of Honolulu. However, more recently the City and County of Honolulu may be reconsidering their desire to expand their facility and are evaluating alternatives to accommodate their waste disposal needs. At this time, there can be no assurance that any definitive agreements will be finalized or approved by the parties or that the City and County of Honolulu will, in fact, expand the facility.
OTHER SERVICES BUSINESS
Discussion of Other Services Business
Given the significance of the Covanta Energy and ARC Holdings acquisitions to Covantas business, results of operations and financial condition, Covanta decided, during the third quarter of 2005, to combine the previously separate business segments of Insurance Services and Parent-only operations into one reportable segment referred to as Other Services. Certain prior period amounts, such as parent investment income, have been reclassified in the consolidated financial statements to conform to the current period presentation.
The operations of the parent company prior to the acquisition of Covanta Energy on March 10, 2004, primarily included general and administrative expense related to officer salaries, legal and other professional fees and insurance. Subsequent to the acquisition of Covanta Energy, these expenses are reimbursed by Covanta Energy under an administrative services agreement. The parent company operations also include income earned on its investments.
Following the acquisitions of Covanta Energy and ARC Holdings, the relative contribution of Covantas insurance business to Covantas cash flow and its relative percentage of Covantas financial obligations were significantly reduced. Consequently, unlike prior years, Covantas insurance business neither contributes materially to Covantas cash flow nor imposes material financial obligations on Covanta.
Covantas insurance business continues to represent an important element of Covantas structure in that its net operating loss carryforwards (NOLs) were primarily generated through the operations of former subsidiaries of Danielson Indemnity Company (DIND). Covantas ability to utilize that portion of the NOLs will depend upon the continued inclusion of its insurance business in Covantas consolidated federal income tax return. See Note 22. Income Taxes of the Notes for more information on Covantas NOLs.
Covantas insurance operations are conducted through wholly-owned subsidiaries. NAICC, an indirect wholly-owned subsidiary of Covanta through DIND, is Covantas principal operating insurance subsidiary. References to NAICC include NAICC and its subsidiaries unless otherwise indicated. NAICC has historically managed its business across four principal lines of business: non-standard private passenger automobile; commercial automobile; workers compensation; and property and casualty. However, as of December 31, 2004, NAICC was engaged in writing exclusively non-standard private passenger automobile primarily in California.
As discussed more fully below, Covantas insurance businesses have succeeded in reducing their loss ratio by tightening underwriting criteria, exiting unprofitable lines of business and focusing on writing more profitable lines of business through its arrangements with third parties providing marketing, underwriting and administration services. Such third parties do not have rate making authority or authority to enter into reinsurance arrangements. Such third parties are paid flat commission on new and renewal policies written and they participate in an incentive compensation arrangement dictated solely by underwriting results.
Insurers admitted in California are required to obtain approval, from the California Department of Insurance, of rates and/or forms prior to being used. Many of the other states in which NAICC does business have similar requirements. Rates and policy forms are developed by NAICC and filed with the regulators in each of the relevant states, depending upon each states requirements. NAICC relies upon its own, as well as industry, experience in establishing rates.
Non-standard risks are those segments of the driving public which generally are not considered preferred business, such as drivers with a record of prior accidents or driving violations, drivers involved in particular occupations or driving certain types of vehicles, or those drivers whose policies have not been renewed or whose policies have been declined by another insurance company. Generally, in order to address the associated higher risk of non-standard private automobile insurance, their premium rates are higher than standard premium rates while policy limits are lower than typical policy limits. Policyholder selection is governed by underwriting guidelines established by NAICC. Management believes that it is able to achieve underwriting success through refinement of various risk profiles, thereby dividing the non-standard market into more defined segments which can be adequately priced. Additionally, traditional lower policy limits lend themselves to quicker claims processing allowing management to respond more quickly to changing loss trends, by revising underlying underwriting guidelines and class and rate filings accordingly.
NAICC maintains reserves with respect to net unpaid losses and loss adjustment expense (LAE), representing the estimated indemnity cost and expense necessary to cover the ultimate net cost of investigating and settling claims. Such estimates are based upon estimates for reported losses, historical company experience of losses reported by reinsured companies for insurance assumed and actuarial estimates based upon historical company and industry experience for development of reported and unreported claims (incurred but not reported). Any changes in estimates of ultimate liability are reflected in current operating results. Inflation is assumed, along with other factors, in estimating future claim costs and related liabilities. NAICC does not discount any of its loss reserves. NAICC believes its provisions for unpaid losses and LAE are adequate to cover the net cost of losses and loss expenses incurred to date, and that it satisfies all reserve based capital requirements imposed under applicable insurance regulations.
In its normal course of business, NAICC typically reinsures a portion of its exposure with other insurance companies so as to effectively limit its maximum loss arising out of any one occurrence. Contracts of reinsurance do not legally discharge the original insurer from its primary liability. Estimated reinsurance receivables arising from these contracts of reinsurance are reported separately as assets in accordance with generally accepted accounting principles in the United States.
MARKETS, COMPETITION AND BUSINESS CONDITIONS
General Business Conditions
Covanta Energys business can be adversely affected by general economic conditions, war, inflation, adverse competitive conditions, governmental restrictions and controls, changes in laws, natural disasters, energy shortages, fuel costs, weather, the adverse financial condition of customers and suppliers, various technological changes and other factors over which Covanta Energy has no control.
Covanta Energy expects in the foreseeable future that competition for new contracts and projects will be intense in all markets in which Covanta Energy conducts or intends to conduct its businesses, and its businesses will be subject to a variety of competitive and market influences.
With respect to its waste-related businesses, including its waste-to-energy and TransRiver businesses, Covanta Energy competes in the waste disposal market, which is highly competitive. While Covanta Energy currently processes for disposal over 5% of the municipal solid waste in the United States, the market for waste
disposal is almost entirely price-driven and is greatly influenced by economic factors within regional waste sheds. These factors include:
In the waste disposal market, disposal service providers seek to obtain waste supplies to their facilities by competing on disposal price (usually on a per-ton basis) with other disposal service providers. At all but 8 of its waste-to-energy facilities, Covanta Energy typically is unable to compete in this market because it does not have the contractual right to solicit waste. At these facilities, it is the client community which is responsible for obtaining the waste, if necessary by competing on price to obtain the tons of waste it has contractually promised to deliver to Covanta Energys facility. At 8 of its waste-to-energy facilities and at its TransRiver businesses, Covanta Energy is responsible for obtaining material amounts of waste supply and therefore, is actively competing in these markets to enter into spot medium- and long-term contracts. All of these waste-to-energy projects are in densely populated areas, with high waste generation rates and numerous large and small participants in the regional market. Certain of its competitors in these markets are vertically-integrated waste companies which include waste collection operations, and thus have the ability to control supplies of waste which may restrict Covanta Energys ability to offer disposal services at attractive prices. Covanta Energys business does not include waste collection operations.
Covanta Energys waste operations are largely concentrated in the northeastern United States. See Item 1A. Risk Factors Waste and Energy Services Business-Specific Risks Covanta Energys waste operations are concentrated in one region, and expose us to regional economic or market declines for additional information concerning this geographic concentration.
If a long-term contract expires and is not renewed or extended by a client community, Covanta Energys percentage of contracted disposal capacity will decrease, and it will need to compete in the regional market for waste disposal. At that point, it will compete on price with landfills, transfer stations, other waste-to-energy facilities and other waste disposal technologies that are then offering disposal service in the region. See discussion under Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations Overview Waste and Energy Service Contract Duration for additional information concerning the expiration of existing contracts.
Covanta may develop or acquire, itself or jointly with others, additional waste or energy projects or businesses. If it were to do so in a competitive procurement, Covanta would face competition in the selection process from other companies, some of which may have greater financial resources than Covanta. If it were selected, the amount of market competition it would thereafter face would depend upon the extent to which the capacity at any such project would be committed under contract. If Covanta were to develop or acquire additional projects or businesses not in the context of a competitive procurement, it would face competition in the regional market and compete on price with landfills, transfer stations, other waste-to-energy facilities, other energy producers and other waste disposal or energy generation technologies that are then offering service in the region.
With respect to its sales of electricity from its waste-to-energy projects and independent power projects, Covanta Energy primarily sells its output pursuant to long-term contracts. Accordingly, it generally does not sell its output into markets where it must compete on price. As these contracts expire, Covanta Energy will participate in such markets if it is unable to enter into new or renewed long-term contracts. See discussion under Item 1A. Risk Factors Waste and Energy Services Business-Specific Risks Covanta Energy may
face increased risk of market influences on its domestic revenues after its contracts expire for additional information concerning the expiration of existing contracts.
Once a contract is awarded or a project is financed and constructed, Covanta Energys business can be impacted by a variety of risk factors which can affect profitability over the life of a project. Some of these risks are at least partially within Covanta Energys control, such as successful operation in compliance with law and the presence or absence of labor difficulties or disturbances. Other risk factors are largely out of Covanta Energys control and may have an adverse impact on a project over a long-term operation. See Item 1A. Risk Factors Waste and Energy Services Business-Specific Risks for more information on these types of risks.
Covanta Energy has the exclusive right to market in the United States the proprietary mass-burn technology of Martin GmbH fur Umwelt und Energietechnik, referred to herein as Martin. The principal feature of the Martin technology is the reverse-reciprocating stoker grate upon which the waste is burned. The patent for the basic stoker grate technology used in the Martin technology has expired and there are various other expired and unexpired patents relating to the Martin technology. Covanta Energy believes that it is Martins know-how and worldwide reputation in the waste-to-energy field, and Covanta Energys know-how in designing, constructing and operating waste-to-energy facilities, rather than the use of patented technology, that is important to Covanta Energys competitive position in the waste-to-energy industry in the United States. Covanta Energy does not believe that the expiration of the remaining patents covering portions of the Martin technology will have a material adverse effect on Covanta Energys financial condition or competitive position.
Covanta Energy believes that mass-burn technology is now the predominant technology used for the combustion of municipal solid waste. Covanta Energy believes that the Martin technology is a proven and reliable mass-burn technology, and that its association with Martin has created significant name recognition and value for Covanta Energys domestic waste-to-energy business.
Since 1984, Covanta Energys rights to the Martin technology have been provided pursuant to a cooperation agreement with Martin which gives Covanta Energy exclusive rights to market, and distribute parts and equipment for the Martin technology in the United States, Canada, Mexico, Bermuda and certain Caribbean countries. Martin is obligated to assist Covanta Energy in installing, operating and maintaining facilities incorporating the Martin technology. The cooperation agreement renews automatically each year unless notice of termination is given, in which case the cooperation agreement would terminate ten years after such notice. Any termination would not affect the rights of Covanta Energy to design, construct, operate, maintain or repair waste-to-energy facilities for which contracts have been entered into or proposals made prior to the date of termination.
Through facility acquisitions, Covanta Energy owns and/or operates some waste-to-energy facilities which utilize additional technologies, including non-Martin mass-burn technologies, and refuse-derived fuel technologies which include pre-combustion waste processing not required with a mass-burn design.
The insurance industry is highly competitive, comprised of a large number of companies, many of which operate in more than one state, offering automobile, homeowners and commercial property insurance, as well as insurance coverage in other lines. Many of NAICCs competitors have larger volumes of business, greater financial resources and higher financial strength ratings. NAICCs competitors having greater shares of the California market sell automobile insurance either directly to consumers, through independent agents and brokers or through exclusive agency arrangements similar to those utilized by NAICC.
The principal means by which Covantas insurance business competes with other automobile insurers is by its focus on meeting the needs of the non-standard private passenger automobile market in California where it believes it has competitive pricing, underwriting and service capabilities. Covantas insurance business also competes by using niche marketing efforts of its products.
The operating results of a property and casualty insurer are influenced by a variety of factors including general economic conditions, competition, regulation of insurance rates, weather and frequency and severity of losses. The California non-standard personal automobile market in which NAICC operates has experienced a recovery of rate adequacy; however, competition is rising with a number of new entrants into the marketplace, resulting in underwriting guidelines softening. Frequency of claims remained stable from 2003 to 2004 and increased in 2005, while the average cost of settling claims has steadily improved from 2003 to 2005.
REGULATION OF BUSINESS
Covantas waste and energy services business and its insurance business are both highly regulated.
Environmental Regulatory Laws Affecting Covantas Waste and Energy Services Business
Covanta Energys business activities in the United States are pervasively regulated pursuant to federal, state and local environmental laws. Federal laws, such as the Clean Air Act and Clean Water Act, and their state counterparts, govern discharges of pollutants to air and water. Other federal, state and local laws comprehensively govern the generation, transportation, storage, treatment and disposal of solid and hazardous waste and also regulate the storage and handling of chemicals and petroleum products (such laws and regulations are referred to collectively as the Environmental Regulatory Laws).
Other federal, state and local laws, such as the Comprehensive Environmental Response Compensation and Liability Act commonly known as CERCLA and collectively referred to with such other laws as the Environmental Remediation Laws, make Covanta Energy potentially liable on a joint and several basis for any onsite or offsite environmental contamination which may be associated with Covanta Energys activities and the activities at sites. These include landfills that Covanta Energys subsidiaries have owned, operated or leased or, at which there has been disposal of residue or other waste generated, handled or processed by such subsidiaries. Some state and local laws also impose liabilities for injury to persons or property caused by site contamination. Some service agreements provide for indemnification of operating subsidiaries from certain liabilities. In addition, other subsidiaries involved in landfill gas projects have access rights to landfill sites pursuant to certain leases that permit the installation, operation and maintenance of landfill gas collection systems. A portion of these landfill sites have been federally-designated Superfund sites. Each of these leases provide for indemnification of the Covanta Energy subsidiary from some liabilities associated with these sites.
The Environmental Regulatory Laws require that many permits be obtained before the commencement of construction and operation of any waste, independent power project or water facility, and further require that permits be maintained throughout the operating life of the facility. There can be no assurance that all required permits will be issued or re-issued, and the process of obtaining such permits can often cause lengthy delays, including delays caused by third-party appeals challenging permit issuance. Failure to meet conditions of these permits or of the Environmental Regulatory Laws can subject an operating subsidiary to regulatory enforcement actions by the appropriate governmental unit, which could include fines, penalties, damages or other sanctions, such as orders requiring certain remedial actions or limiting or prohibiting operation. See Item 1A. Risk Factors Waste and Energy Services Business-Specific Risks Compliance with environmental laws could adversely affect our results of operations. To date, Covanta Energy has not incurred material penalties, been required to incur material capital costs or additional expenses, or been subjected to material restrictions on its operations as a result of violations of Environmental Regulatory Laws or permit requirements.
Although Covanta Energys operations are occasionally subject to proceedings and orders pertaining to emissions into the environment and other environmental violations, which may result in fines, penalties, damages or other sanctions, Covanta Energy believes that it is in substantial compliance with existing Environmental Regulatory Laws. Covanta Energy may be identified, along with other entities, as being among parties potentially responsible for contribution to costs associated with the correction and remediation of environmental conditions at disposal sites subject to CERCLA and/or analogous state laws. In certain instances Covanta Energy may be exposed to joint and several liabilities for remedial action or damages.
Covanta Energys ultimate liability in connection with such environmental claims will depend on many factors, including its volumetric share of waste, the total cost of remediation, and the financial viability of other companies that also sent waste to a given site and, in the case of divested operations, its contractual arrangement with the purchaser of such operations.
The Environmental Regulatory Laws are subject to revision. New technology may be required or stricter standards may be established for the control of discharges of air or water pollutants, for storage and handling of petroleum products or chemicals, or for solid or hazardous waste or ash handling and disposal. Thus, as new technology is developed and proven, it may be required to be incorporated into new facilities or major modifications to existing facilities. This new technology may often be more expensive than that used previously.
The Clean Air Act Amendments of 1990 required the Environmental Protection Agency (EPA) to issue New Source Performance Standards (NSPS) and Emission Guidelines (EG) applicable to new and existing municipal waste combustion (MWC) units. EPA issued its first NSPS and EG for large MWCs (First MACT Rule) in 1995 and 1997. Covanta Energy installed all new equipment needed to achieve the emissions limits imposed by the First MACT Rule prior to the December 19, 2000 general compliance deadline. On December 19, 2005, EPA issued for public comment its proposed revisions to the NSPS and EG for large MWCs (Proposed MACT Revisions). Although EPA does not propose to expand the list of regulated pollutants beyond those included in the First MACT Rule, its Proposed MACT Revisions would lower the emission limits for most of those pollutants.
The public comment period for the Proposed MACT Revisions closed on February 6, 2006; EPA is expected to issue the final rule (Final MACT Rule) in April 2006. The compliance deadlines for the Final MACT Rule are expected to be July 2006 for the NSPS (new MWC units), and on or before April 2009 for the EG (existing MWC units). Until the Final MACT Rule is issued, it is not possible to predict with certainty its impact on waste-to-energy facilities operated by Covanta Energy subsidiaries. However, Covanta Energy anticipates that it is unlikely existing waste-to-energy facilities will require capital improvements to comply with the EG. It is, however, likely that most existing facilities will incur increased operating and maintenance costs. The costs to Covanta Energy associated with compliance with the Final MACT Rule is not expected to be material, and at many projects such costs are expected to be shared with Covanta Energys municipal clients.
On November 1, 2005, EPA issued a proposed rule to implement the revised National Ambient Air Quality Standards for fine particulate matter, or PM2.5 (PM2.5 Rule). Unlike the MACT rules discussed above, the PM2.5 Rule is not specific to waste-to-energy facilities, but instead is a nationwide standard for ambient air quality. The primary impact of the PM2.5 Rule will be on those counties in certain states that are designated by EPA as non-attainment with respect to those standards. EPAs proposed rule to implement the PM2.5 Rule will guide how states achieve compliance with the PM2.5 Rule, and could result in more stringent regulation of certain waste-to-energy facility emissions that already are regulated by the MACT standards.
The costs to meet new rules for existing facilities owned by municipal clients generally will be borne by the municipal clients. For projects owned or leased by Covanta Energy subsidiaries, the municipal clients generally have the obligation to fund such capital improvements, and at certain of its projects Covanta Energy may be required to fund a portion of the related costs. In certain cases, the Covanta Energy subsidiary is required to fund the full cost of capital improvements.
Covanta Energy believes that most costs incurred to meet the Final MACT Rule and PM2.5 Rule at facilities it operates may be recovered from municipal clients and other users of its facilities through increased fees permitted to be charged under applicable contracts.
The Environmental Remediation Laws prohibit disposal of regulated hazardous waste at Covanta Energys municipal solid waste facilities. The service agreements recognize the potential for improper deliveries of hazardous waste and specify procedures for dealing with hazardous waste that is delivered to a facility. Although some service agreements require Covanta Energys subsidiary to be responsible for some
costs related to hazardous waste deliveries, to date no operating subsidiary has incurred material hazardous waste disposal costs.
Domestic drinking water facilities are subject to regulation of water quality by the state and federal agencies under the federal Safe Drinking Water Act and by similar state laws. These laws provide for the establishment of uniform minimum national water quality standards, as well as governmental authority to specify the type of treatment processes to be used for public drinking water. Under the federal Clean Water Act, Covanta Energy may be required to obtain and comply with National Pollutant Discharge Elimination System permits for discharges from its treatment stations. Generally, under its current contracts, Covanta Energy is not responsible for fines and penalties resulting from the delivery to Covanta Energys treatment facility of water not meeting standards set forth in those contracts.
Energy and Water Regulations Affecting Covantas Waste and Energy Services Business
Covanta Energys businesses are subject to the provisions of federal, state and local energy laws applicable to the development, ownership and operation of their domestic facilities and to similar laws applicable to their foreign operations. Federal laws and regulations applicable to many of Covanta Energys domestic energy businesses impose limitations on the types of fuel used and prescribe the degree to which these businesses are subject to federal and state utility-type regulation. State regulatory regimes govern rate approval and the other terms and conditions pursuant to which utilities purchase electricity from independent power producers, except to the extent such regulation is governed by federal law.
Pursuant to the Public Utility Regulatory Policies Act of 1978 (PURPA), the Federal Energy Regulatory Commission (FERC) has promulgated regulations that exempt qualifying facilities (facilities meeting certain size, fuel and ownership requirements, referred to as QFs) from compliance with certain provisions of the Federal Power Act (FPA), the Public Utility Holding Company Act of 1935 (PUHCA) (through February 2006), and certain state laws regulating the rates charged by, or the financial and organizational activities of, electric utilities. PURPA was enacted in 1978 to encourage the development of cogeneration facilities and other facilities making use of non-fossil fuel power sources, including waste-to-energy facilities. The exemptions afforded by PURPA to QFs from regulation under the FPA and most aspects of state electric utility regulation are of great importance to Covanta Energy and its competitors in the waste-to-energy and independent power industries. Except with respect to waste-to-energy facilities with a net power production capacity in excess of 30 MW (where rates are set by the FERC), state public utility commissions must approve the rates, and in some instances other contract terms, by which public utilities purchase electric power from QFs.
The Energy Policy Act of 2005, passed in August 2005, makes certain changes to the federal energy laws applicable to Covanta Energys businesses, the most significant of which are described below:
Regulation Affecting Covantas International Business
Covanta Energy presently has ownership and operating interests in electric generating projects outside the United States. Most countries have expansive systems for the regulation of the power business. These generally include provisions relating to ownership, licensing, rate setting and financing of generation and transmission facilities.
Covanta Energy aims to provide energy generating and other infrastructure through environmentally protective project designs, regardless of the location of a particular project. This approach is consistent with the stringent environmental requirements of multilateral financing institutions, such as the World Bank, and also with Covanta Energys experience in domestic waste-to-energy projects, where environmentally protective facility design and performance is required. Compliance with environmental standards comparable to those of the United States may be conditions to the provision of credit by multilateral banking agencies, as well as other lenders or credit providers. The laws of other countries also may require regulation of emissions into the environment, and provide governmental entities with the authority to impose sanctions for violations, although these requirements are generally different from those applicable in the United States. See Item 1A. Risk Factors Waste and Energy Services Business-Specific Risks Exposure to international economic and political factors may materially and adversely affect our Waste and Energy Services businesses and Item 1A. Risk Factors Waste and Energy Services Business-Specific Risks Compliance with environmental laws could adversely affect our results of operations. As with domestic project development, there can be no assurance that all required permits will be issued, and the process can often cause lengthy delays.
Regulation Affecting Covantas Insurance Business
Insurance companies are subject to insurance laws and regulations established by the states in which they transact business. The agencies established pursuant to these state laws have broad administrative and supervisory powers relating to the granting and revocation of licenses to transact business, regulation of trade practices, establishment of guaranty associations, licensing of agents, approval of policy forms, premium rate filing requirements, reserve requirements, the form and content of required regulatory financial statements, capital and surplus requirements and the maximum concentrations of certain classes of investments. Most states also have enacted legislation regulating insurance holding company systems, including acquisitions, extraordinary dividends, the terms of affiliate transactions and other related matters. Covanta and its insurance subsidiaries have registered as holding company systems pursuant to such legislation in California and Montana, and routinely report to other jurisdictions. The National Association of Insurance Commissioners has formed committees and appointed advisory groups to study and formulate regulatory proposals on such diverse issues as the use of surplus debentures, accounting for reinsurance transactions and the adoption of risk-based capital requirements. It is not possible to predict the impact of future state and federal regulation on the operations of Covanta or its insurance business.
NAICC is an insurance company domiciled in the State of California and is regulated by the California Department of Insurance for the benefit of policyholders. The California Insurance Code does not permit the payment of an extraordinary shareholder dividend without prior approval from the California Insurance Commissioner. Dividends are considered extraordinary if they exceed the greater of net income or 10% of statutory surplus as of the preceding December 31st. As of the date of this filing, and into the foreseeable future, NAICC does not have sufficient accumulated earned surplus to pay dividends.
A model for determining the risk-based capital requirements, referred to as RBC requirements, for property and casualty insurance companies was adopted in December 1993. The model generally assesses the
assets at risk and underwriting operations and determines policyholders surplus levels necessary to support such activity. NAICC has calculated its RBC requirement under the most recent RBC requirement model and, as of December 31, 2005, it had capital in excess of the regulatory Authorized Control level. As of December 31, 2005, the RBC requirement of NAICC improved to 589% compared to 361% in 2004.
As of December 31, 2005, Covanta employed 3,600 full-time employees worldwide, of which a majority are employed in the United States.
Of Covantas employees in the United States, approximately 11% are represented by organized labor. Currently, Covanta Energy is party to seven collective bargaining agreements: two of these agreements are scheduled to expire in 2006, four in 2007, and one in 2008.
Covanta considers relations with its employees to be good and does not anticipate any significant labor disputes in 2006.
Anthony J. Orlando was named the President and Chief Executive Officer of Covanta in October 2004 and was elected as a director of Covanta in September 2005 and is a member of the Public Policy Committee. Previously, he had been President and Chief Executive Officer of Covanta Energy since November 2003. From March 2003 to November 2003 he served as Senior Vice President, Business and Financial Management of Covanta Energy. From January 2001 until March 2003, Mr. Orlando served as Covanta Energys Senior Vice President, Waste-to-Energy. Previously, he served as executive Vice President of Covanta Energy Group, Inc. Mr. Orlando joined Covanta Energy in 1987.
Craig D. Abolt has served as the Senior Vice President and Chief Financial Officer of Covanta since October 2004. He has served as Senior Vice President and Chief Financial Officer of Covanta Energy since June 2004. Prior to joining Covanta, Mr. Abolt served as chief financial officer of DIRECTV Latin America, a majority-owned subsidiary of Hughes Electronics Corporation, from June 2001 until May 2004. From December 1991 until June 2001, he was employed by Walt Disney Company in several executive finance positions.
John M. Klett was named Senior Vice President, Operations of Covanta Energy in March 2003. Prior thereto he served as Executive Vice President of Covanta Waste to Energy, Inc. for more than five years. Mr. Klett joined Covanta Energy in 1986. Mr. Klett has been in the waste to energy business since 1977. He has been in the power business since 1965.
Timothy J. Simpson has served as the Senior Vice President, General Counsel and Secretary of Covanta since October 2004. Since March 2004 he has served as Senior Vice President, General Counsel and Secretary of Covanta Energy. From June 2001 to March 2004, Mr. Simpson served as Vice President, Associate General Counsel and Assistant Secretary of Covanta Energy. Previously, he served as Senior Vice President,
Associate General Counsel and Assistant Secretary of Covanta Energy Group, Inc. Mr. Simpson joined Covanta Energy in 1992.
Thomas E. Bucks has served as the Vice President and Chief Accounting Officer of Covanta since April 2005. Mr. Bucks served as Covantas Controller from February 2005 to April 2005. Prior to joining Covanta, Mr. Bucks served as Senior Vice President Controller of Centennial Communications Corp., a leading provider of regional wireless and integrated communications services in the United States and the Caribbean, from March 1995 through February 2005, where he was the principal accounting officer and was responsible for accounting operations and external financial reporting.
Involvement In Certain Legal Proceedings
Messrs. Orlando, Klett and Simpson were officers of Covanta Energy when it filed for bankruptcy and have continued as officers of Covanta Energy after its emergence from bankruptcy and confirmation of its plan of reorganization. As further described in the Business section above, Covanta Energys Chapter 11 proceedings commenced on April 1, 2002. Covanta Energy and most of its domestic subsidiaries filed voluntary petitions for relief under Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the Southern District of New York. All of the bankruptcy cases were jointly administered under the caption In re Ogden New York Services, Inc., et al., Case Nos. 02-40826 (CB), et al. On March 5, 2004, the Bankruptcy Court entered an order confirming the plan of reorganization and plan for liquidation for subsidiaries involved in non-core businesses and on March 10, 2004, both plans were effected.
Mr. Abolt served as the Chief Financial Officer of DirectTV Latin America, LLC, referred to a DLA, when it filed for bankruptcy in March 2003 and after its emergence from bankruptcy and confirmation of its plan of reorganization in February 2004. DLA filed a voluntary petition for reorganization under Chapter 11 of the U.S. Bankruptcy Code on March 18, 2003 in the United States Bankruptcy Court for the District of Delaware, which entered an order confirming DLAs plan of reorganization on February 13, 2004, and the plan became effective on February 24, 2004.
The terms we, our, ours, us and Company refer to Covanta Holding Corporation and its subsidiaries; the term Covanta Energy refers to Covanta Energy Corporation and its subsidiaries; the term ARC Holdings refers to Covanta ARC Holdings, Inc. and its subsidiaries; and the term NAICC refers to National American Insurance Company of California and its subsidiaries.
The following risk factors could have a material adverse effect on our business, financial condition and results of operations.
Covanta Holding Corporation-Specific Risks
As of December 31, 2005, we estimated that we had approximately $489 million of NOLs. In order to utilize the NOLs, we must generate consolidated taxable income which can offset such carryforwards. The NOLs are also utilized by income from certain grantor trusts that were established as part of the reorganization of certain of our subsidiaries engaged in the insurance business (which we refer to as the Mission Insurance entities). The NOLs will expire if not used. The availability of NOLs to offset taxable income could be substantially reduced if we were to undergo an ownership change within the meaning of Section 382(g)(1) of the Internal Revenue Code. We will be treated as having had an ownership change if there is more than a 50% increase in stock ownership during a three-year testing period by 5% stockholders.
In order to help us preserve the NOLs, our certificate of incorporation contains stock transfer restrictions designed to reduce the risk of an ownership change for purposes of Section 382 of the Internal Revenue Code. The transfer restrictions were implemented in 1990, and we expect that the restrictions will remain in force as
long as the NOLs are available. We cannot assure you, however, that these restrictions will prevent an ownership change.
The NOLs will expire in various amounts, if not used, between 2006 and 2023. The Internal Revenue Service (IRS) has not audited any of our tax returns for any of the years during the carryforward period including those returns for the years in which the losses giving rise to the NOLs were reported. We cannot assure you that we would prevail if the IRS were to challenge the availability of the NOLs. If the IRS were successful in challenging our NOLs, all or some portion of the NOLs would not be available to offset our future consolidated taxable income and we may not be able to satisfy our obligations to Covanta Energy under a tax sharing agreement described below or to pay taxes that may be due from our consolidated tax group.
Reductions in our NOLs could occur in connection with the administration of the grantor trusts associated with the Mission Insurance entities which are in state insolvency proceedings. During or at the conclusion of the administration of these grantor trusts, material taxable income could result which could utilize a substantial portion of our NOLs, which in turn could materially reduce our cash flow and ability to service our current debt. The impact of a material reduction in our NOLs could also cause an event of default under our current debt and a possible substantial reduction of our deferred tax asset, as reflected in our financial statements. For a more detailed discussion of the Mission Insurance entities and the grantor trusts, please see Note 4. California Grantor Trust Settlement and Note 22. Income Taxes of the Notes and Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations Overview.
In addition, if our existing insurance business were to require capital infusions from us in order to meet certain regulatory capital requirements and were we to fail to provide such capital, some or all of our subsidiaries comprising our insurance business could enter insurance insolvency or bankruptcy proceedings. In such event, such subsidiaries may no longer be included in our consolidated tax return, and a portion, which could constitute a significant portion, of our remaining NOLs may no longer be available to us. In such event, there may be a significant inclusion of taxable income in Covantas federal consolidated income tax return.
Although our common stock is listed on the New York Stock Exchange, there can be no assurance as to the liquidity of an investment in our common stock or as to the price an investor may realize upon the sale of our common stock. These prices are determined in the marketplace and may be influenced by many factors, including the liquidity of the market for our common stock, the market price of our common stock, investor perception and general economic and market conditions, company performance, and waste and energy market conditions.
As of March 3, 2006, SZ Investments (together with EGI Fund (05-07)), Third Avenue and Laminar, separately own or will have the right to acquire approximately 15.78%, 6.00% and 18.46%, respectively, or when aggregated, 40.24% of our outstanding common stock. Although there are no agreements among SZ Investments, Third Avenue and Laminar regarding their voting or disposition of shares of our common stock, the level of their combined ownership of shares of common stock could have the effect of discouraging or impeding an unsolicited acquisition proposal. In addition, the change in ownership limitations contained in Article Fifth of our certificate of incorporation could have the effect of discouraging or impeding an unsolicited takeover proposal.
No prediction can be made as to the effect, if any, that future sales of our common stock, or the availability of our common stock for future sales, will have on the market price of our common stock. Sales in the public market of substantial amounts of our common stock, or the perception that such sales could occur, could adversely affect prevailing market prices for our common stock. In addition, in connection with the Covanta Energy acquisition financing, we filed a registration statement on Form S-3 to register the resale of
17,711,491 shares of our common stock held by Laminar, Third Avenue and SZ Investments, which was declared effective on August 24, 2004. In connection with our acquisition of ARC Holdings, we have agreed to register upon demand, within twelve months of the June 24, 2005 closing of the ARC Holdings acquisition, the resale of certain shares held or acquired by Laminar, Third Avenue and SZ Investments in an underwritten public offering. The potential effect of these shares being sold may be to depress the price at which our common stock trades.
Our management, including our Chief Executive Officer and Chief Financial Officer, believes that any disclosure controls and procedures or internal controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, they cannot provide absolute assurance that all control issues and instances of fraud, if any, within our companies have been prevented or detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by an unauthorized override of the controls. The design of any systems of controls also is based in part upon certain assumptions about the likelihood of future events, and we cannot assure you that any design will succeed in achieving its stated goals under all potential future conditions. Accordingly, because of the inherent limitations in a cost effective control system, misstatements due to error or fraud may occur and may not be detected.
Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, and the rules and regulations promulgated by the SEC, to implement Section 404, we are required to furnish a report by our management to include in our Annual Report on Form 10-K regarding the effectiveness of our internal control over financial reporting. The report includes, among other things, an assessment of the effectiveness of our internal control over financial reporting as of the end of our fiscal year, including a statement as to whether or not our internal control over financial reporting is effective. This assessment must include disclosure of any material weaknesses in our internal control over financial reporting identified by management.
We have in the past discovered, and may potentially in the future, discover areas of our internal control over financial reporting which may require improvement. If we are unable to assert that our internal control over financial reporting is effective now or in any future period, or if our auditors are unable to express an opinion on the effectiveness of our internal controls, we could lose investor confidence in the accuracy and completeness of our financial reports, which could have an adverse effect on our stock price.
Waste and Energy Services Business-Specific Risks
Following the acquisition of ARC Holdings, Covanta Energy had corporate debt of $675 million, of which $629 million remains outstanding as of December 31, 2005, which we have guaranteed. Our ability to service this debt will depend upon:
For a more detailed discussion of Covanta Energys domestic debt covenants, see Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations Managements Discussion and Analysis of Liquidity and Capital Resources Waste and Energy Services Segment and Note 18. Long-Term Debt of the Notes.
Covantas ability to make payments on its indebtedness and to fund planned capital expenditures and other necessary expenses will depend on its ability to generate cash and receive dividends and distributions from its subsidiaries in the future. This, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. We cannot assure you that Covanta Energys business will generate sufficient cash flow from operations to pay this debt.
Much of our business is conducted through our subsidiaries. Our ability to make payments on the debt incurred by Covanta Energy is dependent on the earnings and the distribution of funds from our subsidiaries.
Certain of our subsidiaries and affiliates are already subject to project and other financing arrangements and will not guarantee our obligations on Covanta Energys debts. The debt agreements of these subsidiaries and affiliates generally restrict their ability to pay dividends, make distributions or otherwise transfer funds to us. In addition, a substantial amount of the assets of our non-guarantor subsidiaries and affiliates has been pledged as collateral under their respective project financing agreements, or financings at intermediate subsidiary levels, and will be excluded entirely from the liens in favor of Covanta Energys financing. See Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations Managements Discussion and Analysis of Liquidity and Capital Resources Waste and Energy Services Segment and Note 18. Long-Term Debt of the Notes for a more complete description of the terms of such indebtedness. We cannot assure you that certain of the agreements governing the current and future indebtedness of our subsidiaries will permit our subsidiaries to provide us with sufficient dividends, distributions or loans to fund payments on the Covanta Energy indebtedness when due.
Our ability to grow our Waste and Energy Services business by investing in new projects may be limited by debt covenants in Covanta Energys principal financing agreements, and by potentially fewer market opportunities for new waste-to-energy facilities. Our Waste and Energy Services business is based upon building and operating municipal solid waste disposal and energy generating projects, which are capital intensive businesses that require financing through direct investment and the incurrence of debt. The covenants in Covanta Energys financing agreements limit investments in new projects or acquisitions of new businesses and place restrictions on Covanta Energys ability to expand existing projects. The covenants limit borrowings to finance new construction, except in limited circumstances related to expansions of existing facilities.
The operation of our Waste and Energy Services facilities and the construction of new or expanded facilities involve many risks, including:
We cannot predict the impact of these risks on our Waste and Energy Services business or operations. These risks, if they were to occur, could prevent Covanta Energy and its subsidiaries from meeting their obligations under their operating contracts.
The development and construction of new facilities involves many risks including siting, permitting, financing and construction delays and expenses, start-up problems, the breakdown of equipment and performance below expected levels of output and efficiency. New facilities have no operating history and may employ recently developed technology and equipment. Our Waste and Energy Services businesses maintain insurance to protect against risks relating to the construction of new projects; however, such insurance may not be adequate to cover lost revenues or increased expenses. As a result, a new facility may be unable to fund principal and interest payments under its debt service obligations or may operate at a loss. In certain situations, if a facility fails to achieve commercial operation, at certain levels or at all, termination rights in the agreements governing the facilitys financing may be triggered, rendering all of the facilitys debt immediately due and payable. As a result, the facility may be rendered insolvent and we may lose our interest in the facility.
Although our Waste and Energy Services businesses maintain insurance, obtain warranties from vendors, require contractors to meet certain performance levels and, in some cases, pass risks, we cannot control to the service recipient or output purchaser, the proceeds of such insurance, warranties, performance guarantees or risk sharing arrangements may not be adequate to cover lost revenues, increased expenses or liquidated damages payments.
Most service agreements for our waste-to-energy facilities provide for limitations on damages and cross-indemnities among the parties for damages that such parties may incur in connection with their performance under the contract. In most cases, such contractual provisions excuse our Waste and Energy Services businesses from performance obligations to the extent affected by uncontrollable circumstances and provide for service fee adjustments if uncontrollable circumstances increase its costs. We cannot assure you that these provisions will prevent our Waste and Energy Services businesses from incurring losses upon the occurrence of uncontrollable circumstances or that if our Waste and Energy Services businesses were to incur such losses they would continue to be able to service their debt.
Covanta Energy and certain of its subsidiaries have issued or are party to performance guarantees and related contractual obligations associated with its waste-to-energy, independent power and water facilities. With respect to its domestic businesses, Covanta Energy and certain of its subsidiaries have issued guarantees to their municipal clients and other parties that Covanta Energys subsidiaries will perform in accordance with contractual terms, including, where required, the payment of damages or other obligations. The obligations guaranteed will depend upon the contract involved. Many of Covanta Energys subsidiaries have contracts to operate and maintain waste-to-energy facilities. In these contracts the subsidiary typically commits to operate and maintain the facility in compliance with legal requirements; to accept minimum amounts of solid waste; to generate a minimum amount of electricity per ton of waste; and to pay damages to contract counterparties under specified circumstances, including those where the operating subsidiarys contract has been terminated for default. Any contractual damages or other obligations incurred by Covanta Energy and certain of its subsidiaries could be material, and in circumstances where one or more subsidiarys contract has been terminated for its default, such damages could include amounts sufficient to repay project debt. Additionally, damages payable under such guarantees on our owned waste-to-energy facilities could expose us to recourse liability on project debt. Covanta Energy and certain of its subsidiaries may not have sufficient sources of cash to pay such damages or other obligations. We cannot assure you that Covanta Energy and such subsidiaries will be able to continue to avoid incurring material payment obligations under such guarantees or that if it did incur such obligations that they would have the cash resources to pay them.
Covanta Energys subsidiaries must satisfy performance and other obligations under contracts governing waste-to-energy facilities. These contracts typically require Covanta Energys subsidiaries to meet certain performance criteria relating to amounts of waste processed, energy generation rates per ton of waste processed, residue quantity and environmental standards. The failure of Covanta Energy subsidiaries to satisfy these criteria may subject them to termination of their respective operating contracts. If such a termination were to occur, Covanta Energys subsidiaries would lose the cash flow related to the projects and incur material termination damage liability, which may be guaranteed by Covanta Energy or certain of its subsidiaries. In circumstances where the contract of one or more subsidiaries has been terminated due to the default of the Covanta Energy subsidiary they may not have sufficient sources of cash to pay such damages. We cannot assure you that Covanta Energys subsidiaries will be able to continue to perform their respective obligations under such contracts in order to avoid such contract terminations, or damages related to any such contract termination, or that if they could not avoid such terminations that they would have the cash resources to pay amounts that may then become due.
Covanta Energy and certain of its subsidiaries are obligated to guarantee or provide financial support for its subsidiaries projects in one or more of the following forms:
Many of these contingent obligations cannot readily be quantified, but, if we were required to provide this support, it may be material to our cash flow and financial condition.
Covanta Energys contracts to operate waste-to-energy projects expire on various dates between 2008 and 2023, and its contracts to sell energy output generally expire when the projects operating contract expires. Expiration of these contracts will subject Covanta to greater market risk in maintaining and enhancing its revenues. As its operating contracts at municipally-owned projects approach expiration, Covanta Energy will seek to enter into renewal or replacement contracts to continue operating such projects. However, we cannot assure you that Covanta Energy will be able to enter into renewal or replacement contracts on terms favorable to it, or at all. Covanta Energy will seek to bid competitively for additional contracts to operate other facilities as similar contracts of other vendors expire. The expiration of existing energy sales contracts, if not renewed, will require Covanta Energy to sell project energy output either into the electricity grid or pursuant to new contracts.
At some of our facilities, market conditions may allow Covanta Energy to effect extensions of existing operating contracts along with facility expansions. Such extensions and expansions are currently being considered at a limited number of Covanta Energys facilities in conjunction with its municipal clients. If Covanta Energy is unable to reach agreement with its municipal clients on the terms under which it would implement such extensions and expansions, or if the implementation of these extensions, including renewals and replacement contracts, and expansions are materially delayed, this may adversely affect Covanta Energys cash flow and profitability. We cannot assure you that Covanta Energy will be able to enter into such contracts or that the terms available in the market at the time will be favorable to it.
Our Waste and Energy Services businesses depend on a limited number of third parties to, among other things, purchase the electric and steam energy produced by its facilities, and supply and deliver the waste and other goods and services necessary for the operation of our energy facilities. The viability of our facilities depends significantly upon the performance by third parties in accordance with long-term contracts, and such performance depends on factors which may be beyond our control. If those third parties do not perform their obligations, or are excused from performing their obligations because of nonperformance by our Waste and Energy Services businesses or other parties to the contracts, or due to force majeure events or changes in laws or regulations, our Waste and Energy Services businesses may not be able to secure alternate arrangements on substantially the same terms, if at all, for the services provided under the contracts. In addition, the
bankruptcy or insolvency of a participant or third party in our Waste and Energy Services facilities could result in nonpayment or nonperformance of that partys obligations to us.
Our Waste and Energy Services businesses often rely on single suppliers and single customers at our facilities, exposing such facilities to financial risks if any supplier or customer should fail to perform its obligations.
Our Waste and Energy Services businesses often rely on a single supplier to provide waste, fuel, water and other services required to operate a facility and on a single customer or a few customers to purchase all or a significant portion of a facilitys output. In most cases our Waste and Energy Services businesses have long-term agreements with such suppliers and customers in order to mitigate the risk of supply interruption. The financial performance of these facilities depends on such customers and suppliers continuing to perform their obligations under their long-term agreements. A facilitys financial results could be materially and adversely affected if any one customer or supplier fails to fulfill its contractual obligations and we are unable to find other customers or suppliers to produce the same level of profitability. We cannot assure you that such performance failures by third parties will not occur, or that if they do occur, such failures will not adversely affect the cash flows or profitability of our Waste and Energy Services business.
In addition, for their waste-to-energy facilities, our subsidiaries rely on their municipal clients as a source not only of waste for fuel but also of revenue from fees for disposal services our subsidiaries provide. Because contracts of our subsidiaries with their municipal clients are generally long-term, our subsidiaries may be adversely affected if the credit quality of one or more of their municipal clients were to decline materially.
While our Waste and Energy Services businesses both sell the majority of their waste disposal capacity and energy output pursuant to long-term contracts, a portion of this capacity and output representing approximately 30% of our anticipated revenue through 2009 is subject to market price fluctuation. With the acquisition of ARC Holdings, a larger percentage of our revenue is subject to market risk from fluctuations in waste market prices than has historically been the case. Consequently, short-term fluctuations in the waste and energy markets may have a greater impact on our revenues than we have previously experienced.
The majority of Covanta Energys waste disposal facilities are located in the northeastern United States, primarily along the Washington, D.C. to Boston, Massachusetts corridor. Adverse economic developments in this region could affect regional waste generation rates and demand for waste disposal services provided by Covanta Energy. Adverse market developments caused by additional waste disposal capacity in this region could adversely affect waste disposal pricing. Either of these developments could have a material adverse effect on Covanta Energys revenues and cash generation.
Eight of our 31 waste-to-energy facilities receive 100% of the energy revenues they generate. As a result, if we are unable to operate these facilities at their historical performance levels for any reason, our revenues from energy sales could materially decrease.
Achieving the anticipated benefits of the recent acquisition of ARC Holdings will depend in part upon our ability to integrate the two companies businesses in an efficient and effective manner. Our attempt to integrate two companies that have previously operated independently may result in significant challenges, and we may be unable to accomplish the integration smoothly or successfully. In particular, the necessity of coordinating organizations in additional locations and addressing possible differences in corporate cultures and management philosophies may increase the difficulties of integration. The integration will require the dedication of significant management resources, which may temporarily distract managements attention from the day-to-day operations of the businesses of the combined company. The process of integrating operations could cause an interruption of, or loss of momentum in, the activities of one or more of the combined companys businesses and the loss of key personnel. Employee uncertainty and lack of focus during the integration process may also disrupt the businesses of the combined company. Any inability of management to successfully integrate ARC Holdings operations with the operations of Covanta Energy could have a material adverse effect on our business and financial condition.
The anticipated benefits of the transaction include the elimination of duplicative costs, the strategic expansion of Covanta Energys core waste-to-energy business in the northeast region of the United States and the strengthening of Covanta Energys credit profile and lowering of our cost of capital. We may not be able to realize, in whole or in part, or within the anticipated time frames, any of these expected costs savings or improvements. The realization of the anticipated benefits of the transaction are subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control. As a result, we may not be able to achieve our expected results of operations and our actual income, cash flow or earnings available to satisfy debt obligations may be materially lower than the pro forma results we have previously filed with the SEC.
CPIH is a wholly-owned subsidiary of Covanta Energy. CPIHs operations are conducted entirely outside the United States and expose it to legal, tax, currency, inflation, convertibility and repatriation risks, as well as potential constraints on the development and operation of potential business, any of which can limit the benefits to CPIH of a foreign project.
CPIHs projected cash distributions from existing facilities come from facilities located in countries with sovereign ratings below investment grade, including Bangladesh, the Philippines and India. The financing, development and operation of projects outside the United States can entail significant political and financial risks, which vary by country, including:
The legal and financial environment in foreign countries in which CPIH currently owns assets or projects also could make it more difficult for it to enforce its rights under agreements relating to such projects.
Any or all of the risks identified above with respect to the CPIH projects could adversely affect our revenue and cash generation. As a result, these risks may have a material adverse effect on our Waste and Energy Services business, consolidated financial condition and results of operations.
CPIH participates in projects in jurisdictions where limitations on the convertibility and expatriation of currency have been lifted by the host country and where such local currency is freely exchangeable on the international markets. In most cases, components of project costs incurred or funded in the currency of the United States are recovered with limited exposure to currency fluctuations through negotiated contractual adjustments to the price charged for electricity or service provided. This contractual structure may cause the cost in local currency to the projects power purchaser or service recipient to rise from time to time in excess of local inflation. As a result, there is a risk in such situations that such power purchaser or service recipient will, at least in the near term, be less able or willing to pay for the projects power or service.
Changes in the market prices and availability of fuel supplies to generate electricity may increase CPIHs cost of producing power, which could adversely impact our energy businesses profitability and financial performance.
The market prices and availability of fuel supplies of some of CPIHs facilities fluctuate. Any price increase, delivery disruption or reduction in the availability of such supplies could affect CPIHs ability to operate its facilities and impair its cash flow and profitability. CPIH may be subject to further exposure if any of its future operations are concentrated in facilities using fuel types subject to fluctuating market prices and availability. We may not be successful in our efforts to mitigate our exposure to supply and price swings.
Our waste-to-energy facilities depend on solid waste for fuel, which provides a source of revenue. For most of our facilities, the prices they charge for disposal of solid waste are fixed under long-term contracts and the supply is guaranteed by sponsoring municipalities. However, for some of our waste-to-energy facilities, the availability of solid waste to us, as well as the tipping fee that we must charge to attract solid waste to its facilities, depends upon competition from a number of sources such as other waste-to-energy facilities, landfills and transfer stations competing for waste in the market area. In addition, we may need to obtain waste on a competitive basis as our long-term contracts expire at our owned facilities. There has been consolidation and there may be further consolidation in the solid waste industry which would reduce the number of solid waste collectors or haulers that are competing for disposal facilities or enable such collectors or haulers to use wholesale purchasing to negotiate favorable below-market disposal rates. The consolidation in the solid waste industry has resulted in companies with vertically integrated collection activities and disposal facilities. Such consolidation may result in economies of scale for those companies as well as the use of disposal capacity at facilities owned by such companies or by affiliated companies. Such activities can affect both the availability of waste to us for disposal at some of our waste-to-energy facilities and market pricing.
Our efforts to grow our waste and energy business will depend in part on how successful we are in developing new projects and expanding existing projects. The development period for each project may occur over several years, during which we incur substantial expenses relating to siting, design, permitting, community relations, financing, and professional fees associated with all of the foregoing. Not all of our development efforts will be successful, and we may decide to cease developing a project for a variety of
reasons. If the cessation of our development efforts were to occur at an advanced stage of development, we may have incurred a material amount of expenses for which we will realize no return.
Costs of compliance with federal, state and local existing and future environmental regulations could adversely affect our cash flow and profitability. Our Waste and Energy Services businesses are subject to extensive environmental regulation by federal, state and local authorities, primarily relating to air, waste (including residual ash from combustion) and water. We are required to comply with numerous environmental laws and regulations and to obtain numerous governmental permits in operating our facilities. Our Waste and Energy Services businesses may incur significant additional costs to comply with these requirements. Environmental regulations may also limit our ability to operate our facilities at maximum capacity or at all. If our Waste and Energy Services businesses fail to comply with these requirements, we could be subject to civil or criminal liability, damages and fines. Existing environmental regulations could be revised or reinterpreted and new laws and regulations could be adopted or become applicable to us or our facilities, and future changes in environmental laws and regulations could occur. This may materially increase the amount we must invest to bring our facilities into compliance. In addition, lawsuits or enforcement actions by federal and/or state regulatory agencies may materially increase our costs. Stricter environmental regulation of air emissions, solid waste handling or combustion, residual ash handling and disposal, and waste water discharge could materially affect our cash flow and profitability.
Our Waste and Energy Services businesses may not be able to obtain or maintain, from time to time, all required environmental regulatory approvals. If there is a delay in obtaining any required environmental regulatory approvals or if we fail to obtain and comply with them, the operation of our facilities could be jeopardized or become subject to additional costs.
Our Waste and Energy Services businesses are subject to extensive energy regulations by federal, state and foreign authorities. We cannot predict whether the federal, state or foreign governments will modify or adopt new legislation or regulations relating to the solid waste or energy industries. The economics, including the costs, of operating our facilities may be adversely affected by any changes in these regulations or in their interpretation or implementation or any future inability to comply with existing or future regulations or requirements.
The FPA regulates energy generating companies and their subsidiaries and places constraints on the conduct of their business. The FPA regulates wholesale sales of electricity and the transmission of electricity in interstate commerce by public utilities. Under PURPA, our domestic facilities are exempt from most provisions of the FPA and state rate regulation. Our foreign projects are also exempt from regulation under the FPA.
The Energy Policy Act of 2005 enacted comprehensive changes to the domestic energy industry which may affect our businesses. The Energy Policy Act removed certain regulatory constraints that previously limited the ability of utilities and utility holding companies to invest in certain activities and businesses, which may have the effect over time of increasing competition in energy markets in which we participate. In addition, the Energy Policy Act includes provisions that may remove some of the benefits provided to non-utility electricity generators, like Covanta Energy, after its existing energy sale contracts expire. As a result, we may face increased competition after such expirations occur.
If our Waste and Energy Services businesses become subject to either the FPA or lose the ability under PURPA to require utilities to purchase our electricity, the economics and operations of our energy projects could be adversely affected, including as a result of rate regulation by the FERC, with respect to our output of electricity, which could result in lower prices for sales of electricity. In addition, depending on the terms of the projects power purchase agreement, a loss of our exemptions could allow the power purchaser to cease taking and paying for electricity under existing contracts. Such results could cause the loss of some or all contract revenues or otherwise impair the value of a project and could trigger defaults under provisions of the
applicable project contracts and financing agreements. Defaults under such financing agreements could render the underlying debt immediately due and payable. Under such circumstances, we cannot assure you that revenues received, the costs incurred, or both, in connection with the project could be recovered through sales to other purchasers.
Our Waste and Energy Services businesses are continually in the process of obtaining or renewing federal, state and local approvals required to operate our facilities. While our Waste and Energy Services businesses currently have all necessary operating approvals, we may not always be able to obtain all required regulatory approvals, and we may not be able to obtain any necessary modifications to existing regulatory approvals or maintain all required regulatory approvals. If there is a delay in obtaining any required regulatory approvals or if we fail to obtain and comply with any required regulatory approvals, the operation of our facilities or the sale of electricity to third parties could be prevented, made subject to additional regulation or subject our Waste and Energy Services businesses to additional costs or a decrease in revenue.
We may not be able to respond in a timely or effective manner to the changes resulting in increased competition in the energy industry in both domestic and international markets. These changes may include deregulation of the electric utility industry in some markets, privatization of the electric utility industry in other markets and increasing competition in all markets. To the extent U.S. competitive pressures increase and the pricing and sale of electricity assumes more characteristics of a commodity business, the economics of our business may come under increasing pressure. Regulatory initiatives in foreign countries where our Waste and Energy Services businesses have or will have operations involve the same types of risks.
Research and development activities are ongoing to provide alternative and more efficient technologies to dispose of waste or produce power, including fuel cells, microturbines and solar cells. It is possible that advances in these or other technologies will reduce the cost of waste disposal or power production from these technologies to a level below our costs. Furthermore, increased conservation efforts could reduce the demand for power or reduce the value of our facilities. Any of these changes could have a material adverse effect on our revenues and profitability.
We expect to incur significant costs, which we currently estimate to be approximately $20 million through 2007, including costs incurred to date, associated with combining the operations of Covanta Energy and ARC Holdings. However, we cannot predict with certainty the specific size of those charges at this preliminary stage of the integration process. Although we expect the elimination of duplicative costs, as well as the realization of other efficiencies related to the integration of the businesses, we cannot give any assurance that this net benefit will be achieved as planned in the near future or at all.
Insurance Business-Specific Risks
The insurance industry is highly regulated. NAICC is subject to regulation by state and federal regulators, and a significant portion of NAICCs operations are subject to regulation by the state of California. Changes in existing insurance regulations or adoption of new regulations or laws which could affect NAICCs results of operations and financial condition may include, without limitation, proposed changes to Californias personal automobile rating regulations extension of Californias Low Cost Automobile Program beyond Los Angeles and San Francisco counties and changes to Californias workers compensation laws. We cannot
predict the impact of changes in existing insurance regulations or adoption of new regulations or laws on NAICCs results of operations and financial condition.
The insurance products sold by NAICC are subject to intense competition from many competitors, many of whom have substantially greater resources than NAICC. The California non-standard personal automobile marketplace consists of over 100 carriers.
In order to decrease rates, insurers in California must obtain prior permission for rate reductions from the California Department of Insurance. In lieu of requesting rate decreases, competitors may soften underwriting standards as an alternative means of attracting new business. Such tactics, should they occur, would introduce new levels of risk for NAICC and could limit NAICCs ability to write new policies or renew existing profitable policies. We cannot assure you that NAICC will be able to successfully compete in these markets and generate sufficient premium volume at attractive prices to be profitable. This risk is enhanced by the reduction in lines of business NAICC writes as a result of its decision to reduce underwriting operations.
Unpaid losses and loss adjustment expenses are based on estimates of reported losses, historical company experience of losses reported for reinsurance assumed and historical company experience for unreported claims. Such liability is, by necessity, based on estimates that may change in the near term. NAICC cannot assure you that the ultimate liabilities will not exceed, or even materially exceed, the amounts estimated. If the ultimate liability materially exceeds estimates, then additional capital may be required to be contributed to some of our insurance subsidiaries. NAICC and the other insurance subsidiaries received additional capital contributions from us in 2003 and 2002, and NAICC cannot provide any assurance that it and its subsidiaries will be able to obtain additional capital on commercially reasonable terms or at all.
In addition, due to the fact that NAICC and its other insurance subsidiaries are in the process of running off several significant lines of business, the risk of adverse development and the subsequent requirement to obtain additional capital is heightened.
NAICC is subject to regulatory risk-based capital requirements. Depending on its risk-based capital, NAICC could be subject to various levels of increasing regulatory intervention ranging from company action to mandatory control by insurance regulatory authorities. NAICCs capital and surplus is also one factor used to determine its ability to distribute or loan funds to us. If NAICC has insufficient capital and surplus, as determined under the risk-based capital test, it will need to obtain additional capital to establish additional reserves. NAICC cannot provide any assurance that it will be able to obtain such additional capital on commercially reasonable terms or at all.
Covantas executive offices are located at 40 Lane Road, Fairfield, New Jersey, in an office building located on a 5.4 acre site owned by a subsidiary. The following table summarizes certain information relating to the locations of the properties Covanta or its subsidiaries own or lease:
For information regarding legal proceedings, see Note 29. Commitments and Contingent Liabilities of the Notes to the Consolidated Financial Statements in Item 8, which information is incorporated herein by reference.
There were no submission of matters to a vote of the security holders of Covanta that are required to be reported on this Annual Report on Form 10-K. The results of the proposals voted on at Covantas Annual Meeting of Stockholders held on September 19, 2005 were previously reported by Covanta in its Quarterly Report on Form 10-Q for the quarter ended September 30, 2005 that was filed with the SEC on November 9, 2005.
On September 20, 2005, Danielson Holding Corporation changed its name to Covanta Holding Corporation. Covantas common stock was traded on the American Stock Exchange under the symbol DHC until close of trading on October 4, 2005. Since that date, Covantas common stock has been traded on the New York Stock Exchange under the symbol CVA. On March 3, 2006, there were approximately 1,160 holders of record of common stock. On March 3, 2006, the closing price of Covantas common stock on the New York Stock Exchange was $16.97 per share.
The following table sets forth the high, low and closing stock prices of Covantas common stock for the last two years. These prices are as reported on the American Stock Exchange Composite Tape with respect to dates through the close of business on October 4, 2005 and these prices are as reported on the New York Stock Exchange Composite Tape with respect to dates on and after October 5, 2005.
The prices above reflect the impact of a rights offering announced in December 2003 and completed on May 18, 2004 and the ARC Holdings rights offering announced in February 2005 and completed on June 24, 2005.
Covanta has not paid dividends on its common stock and does not expect to declare or pay any dividends in the foreseeable future. Under current financing arrangements there are material restrictions on the ability of Covantas subsidiaries to transfer funds to Covanta in the form of cash dividends, loans or advances that would likely materially limit the future payment of dividends on common stock. See Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations Managements Discussion and Analysis of Liquidity and Capital Resources Waste and Energy Services Segment for more detailed information on Covantas financing arrangements.
Given the significance of the Covanta Energy and ARC Holdings acquisitions to Covantas business, results of operations and financial condition, Covanta decided, during the third quarter of 2005, to combine the previously separate business segments of Insurance Services and Parent-only operations into one reportable segment referred to as Other Services. Certain prior period amounts, such as parent investment income, have been reclassified in the consolidated financial statements to conform to the current period presentation.
Covanta Holding Corporation (Covanta) is organized as a holding company with substantially all of its historic consolidated operations conducted in the insurance industry prior to the acquisition of Covanta Energy Corporation (Covanta Energy) in March 2004 and the acquisition of Covanta ARC Holdings, Inc. (formerly known as American Ref-Fuel Holdings Corp., referred to as ARC Holdings) in June 2005.
On March 10, 2004, Covanta Energy, and most of its subsidiaries engaged in waste-to-energy, water and independent power production in the United States, consummated a reorganization plan (Reorganization Plan) and emerged from proceedings under Chapter 11 of the Bankruptcy Code (Chapter 11). As a result of the consummation of the Reorganization Plan, Covanta Energy became a wholly-owned subsidiary of Covanta. The results of operations and financial condition of Covanta Energy were consolidated for financial reporting purposes commencing on March 11, 2004. Several subsidiaries of Covanta Energy did not emerge from the Chapter 11 proceedings on March 10, 2004. These subsidiaries are referred to herein as Remaining Debtors. Covanta has included Lake County and Warren County as consolidated subsidiaries in its financial statements since their respective emergence dates. Upon Tampa Bays emergence from Chapter 11, Covanta Energy did not have any operating or ownership rights in this facility.
On June 24, 2005, Covanta acquired, through Covanta Energy, 100% of the issued and outstanding shares of ARC Holdings. ARC Holdings and its subsidiaries operate six waste-to-energy facilities located in the northeastern United States and TransRiver Marketing Company, L.P. (TransRiver), a waste procurement company. Immediately upon closing of the acquisition, ARC Holdings became a wholly-owned subsidiary of Covanta Energy, and Covanta Energy assumed control of the management and operations of the ARC Holdings facilities. ARC Holdings results of operations were consolidated into Covanta beginning on June 25, 2005.
The nature of Covantas business, the risks attendant to such business and the trends that it will face have been significantly altered by these acquisitions. The consolidated performance of Covanta in 2004 and 2005
has predominantly reflected, and the continued future performance of Covanta will predominantly reflect, the performance of its waste and energy services operations which are significantly larger than its insurance operations. Accordingly, Covantas financial performance prior to 2004 will not be comparable with its future performance and its financial performance in 2005 has been materially affected by the magnitude of the ARC Holdings acquisition relative to the size of the business of Covanta prior to such acquisition. Readers are directed to Managements Discussion and Analysis of Covantas waste and energy services business below for a discussion of managements perspective on important factors of operating and financial performance.
Covantas acquisition of ARC Holdings markedly increased the size and scale of its Waste and Energy Services segment, and thus Covantas business. While Covantas consolidated assets increased to $4.7 billion at December 31, 2005 from $1.9 billion at the end of 2004, its consolidated debt increased to $2.9 billion from $1.3 billion in the same respective periods. The acquisition of ARC Holdings also provided Covanta Energy with the opportunity to achieve cost savings by combining its businesses with those of ARC Holdings and the opportunity to refinance its existing recourse debt and thereby lower its cost of capital and obtain less restrictive covenants in the credit agreements.
With the acquisition of ARC Holdings, Covantas management is focused on:
Maintaining historic facility production levels while effectively managing operating and maintenance expense is important to optimize Covanta Energys long-term cash generation. Covanta Energy does not expect to receive any cash contributions from Covanta, and is prohibited under its principal financing arrangements from using its cash to issue dividends to Covanta except in limited circumstances. For expanded discussions of liquidity, see Liquidity and Capital Resources below.
As part of the Covanta Energy acquisition, Covanta agreed to conduct a rights offering for up to 3.0 million shares of its common stock to certain holders of 9.25% debentures issued by Covanta Energy prior to its bankruptcy at a purchase price of $1.53 per share (the 9.25% Offering). Because of the possibility that the 9.25% Offering could not be completed prior to the completion of the ARC Holdings acquisition, and the commencement of the related rights offering to shareholders (the ARC Holdings Rights Offering), Covanta restructured the 9.25% Offering so that the holders that participated in the 9.25% Offering were offered the right to purchase an additional 2.7 million shares of Covantas common stock which was an equivalent number of shares of common stock that such holders would have been entitled to purchase in the ARC Holdings Rights Offering if the 9.25% Offering had been consummated on or prior to the record date for the ARC Holdings Rights Offering. The purchase price for these additional shares was $6.00 per share, the same purchase price as in the ARC Holdings Rights Offering. On February 24, 2006, Covanta completed the 9.25% Offering in which 5,696,911 shares were issued in consideration for $20.8 million in gross proceeds.
Covantas liquidity is enhanced by the existence of net operating loss carryforwards (NOLs), which predominantly arose from predecessor insurance entities of Covanta (formerly named Mission Insurance Group, Inc.). As described below, Covantas taxable income and loss relating to certain grantor trusts associated with these predecessor insurance entities continues to be included in Covantas consolidated tax group. The Internal Revenue Service (IRS) has not audited any of Covantas tax returns relating to the years during which the NOLs were generated. It is possible that the IRS could undertake an audit of Covantas tax returns for such years, as well as subsequent years during which taxable income or loss of such grantor trusts continue to be included in Covantas consolidated tax group. For additional detail relating to Covantas NOLs and risks attendant thereto, see Note 22. Income Taxes of the Notes to the Consolidated
Financial Statements (Notes) and Item 1A. Risk Factors We cannot be certain that our NOLs will continue to be available to offset our tax liability.
The ability of Covanta to utilize its NOLs to offset taxable income generated by the Waste and Energy Services operations could have a material effect on Covantas consolidated financial condition and results of operations. Covanta had NOLs estimated to be $489 million for federal income tax purposes as of December 31, 2005. The NOLs will expire in various amounts from December 31, 2006 through December 31, 2023, if not used. The amount of NOLs available to Covanta Energy will be reduced by any taxable income generated by current members of Covantas consolidated tax group, which include such grantor trusts associated with the Mission Insurance entities which have been in state insolvency proceedings in California and Missouri since the late 1980s. During or at the conclusion of the administration of these grantor trusts by state insurance regulatory agencies, material taxable income could result which could utilize a substantial portion of Covantas NOLs, which in turn could materially reduce Covantas cash flow and its ability to service current debt and achieve debt reduction goals. The impact of a material reduction in Covantas NOLs could also cause an event of default under Covanta Energys current secured credit facilities and/or a reduction of a substantial portion of Covantas deferred tax asset relating to such NOLs.
In January 2006, Covanta executed agreements with the California Commissioner of Insurance (the California Commissioner), who administers the majority of the grantor trusts, regarding the final administration and conclusion of such trusts. The agreements, which were approved by the California state court overseeing the Mission insolvency proceedings (the Mission Court), will take effect upon satisfaction of remaining conditions and settle matters that had been in dispute regarding the historic rights and obligations relating to the conclusion of the grantor trusts. The most significant of these conditions is a determination by the Mission Court of the aggregate amount of certain claims against the grantor trusts which are entitled to distributions of an aggregate of 1,572,625 shares of Covanta common stock previously issued to the California Commissioner under existing agreements entered into at the inception of the Mission Insurance entities reorganization. The distribution of such shares by the California Commissioner is among the final steps necessary to conclude the insolvency cases relating to the trusts being administered by the California Commissioner, and such arrangements would include a process by which a complete list of such claimants would be identified, and thereafter the shares to be delivered to such claimants by the California Commissioner. In connection with these agreements and in order to facilitate the orderly conclusion of the grantor trust estates, the distribution of such stock and the settlement of the related disputes, Covanta has agreed to pay an aggregate amount equal to approximately $9.14 million to the California Commissioner. While Covanta cannot predict with certainty what amounts, if any, may be includable in Covantas taxable income as a result of the final administration of the trusts, Covanta believes that these arrangements with the California Commissioner will result in no material reduction in available NOLs. For additional information regarding these arrangements (which are referred to herein as the California Grantor Trust Settlement) including its effects on Covantas deferred tax asset, see Note 4. California Grantor Trust Settlement and Note 22. Income Taxes of the Notes.
Covanta is in preliminary discussions with the Director of the Division of Insurance of the State of Missouri (the Missouri Director), who administers the balance of the grantor trusts relating to the Mission Insurance entities, regarding similar arrangements for distribution of the remaining 154,756 shares of Covanta common stock by the Missouri Director to claimants of the Missouri grantor trusts. Covanta cannot give any assurance that it will enter into similar arrangements with the Missouri Director or that the administration of such estates will not result in a material reduction in available NOLs.
Covantas Business Segments
Given the significance of the Covanta Energy and ARC Holdings acquisitions to Covantas results of operations and financial condition, Covanta decided, during the third quarter of 2005, to combine the previously separate business segments of Insurance Services and Parent-Only operations into one reportable segment called Other Services. Covanta currently has two reportable business segments Waste and Energy Services and Other Services.
Waste and Energy Services
The Waste and Energy Services segment includes Covanta Energys domestic and international businesses. Covanta Energys subsidiary Covanta Power International Holdings, Inc. (CPIH) and its subsidiaries engage in the independent power production business outside the United States.
For all waste-to-energy projects, Covanta Energy receives revenue from two primary sources: fees it charges for operating projects or processing waste received and payments for electricity and steam sales. Covanta Energy also operates, and in some cases has ownership interests in, transfer stations and landfills which generate revenue from waste disposal fees or operating fees. In addition, Covanta Energy owns and in some cases operates other renewable energy projects in the United States which generate electricity from wood waste, landfill gas, and hydroelectric resources. The electricity from these projects is sold to utilities. For these projects, Covanta Energy receives revenue from electricity sales, and in some cases cash from equity distributions.
Through CPIH, Covanta Energy also has ownership interests in, and/or operates, independent power production facilities in the Philippines, China, Bangladesh, India, and Costa Rica, and one waste-to-energy facility in Italy. The Costa Rica facilities generate electricity from hydroelectric resources while the other independent power production facilities generate electricity and steam by combusting coal, natural gas, or heavy fuel oil. For these projects, CPIH receives revenue from operating fees, electricity and steam sales, and in some cases cash from equity distributions.
Covanta Energy has 23 waste-to-energy projects at which it charges a fixed fee (which escalates over time pursuant to contractual indices Covanta Energy believes are appropriate to reflect price inflation) for its operation and maintenance services. These projects are referred to as having a Service Fee structure. Covanta Energys contracts at its Service Fee projects provide revenue that does not materially vary based on the amount of waste processed or energy generated and as such is relatively stable for the contract term. In addition, at most of Covanta Energys Service Fee projects, the operating subsidiary retains only a fraction of the energy revenues generated, with the balance used to provide a credit to the municipal client against its disposal costs. Therefore, in these projects, the municipal client derives most of the benefit and risk of energy production and changing energy prices.
Covanta Energy also has 8 waste-to-energy projects at which it receives a per-ton fee under contracts for processing waste. These projects are referred to as having a Tip Fee structure. At its Tip Fee projects, Covanta Energy generally enters into long-term waste disposal contracts for a substantial portion of project disposal capacity and retains all of the energy revenue generated. Covanta Energys waste disposal and energy revenue from these projects is more dependent upon operating performance, and as such is subject to greater revenue fluctuation to the extent performance levels fluctuate.
Under both structures, Covantas returns are expected to be stable if it does not incur material unexpected operation and maintenance costs or other expenses. In addition, most of Covanta Energys waste-to-energy project contracts are structured so that contract counterparties generally bear, or share in, the costs associated with events or circumstances not within Covanta Energys control, such as uninsured force majeure events and changes in legal requirements. The stability of Covanta Energys domestic revenues and returns could be affected by its ability to continue to enforce these obligations. Also, at some of Covanta Energys waste-to-energy facilities, commodity price risk is mitigated by passing through commodity costs to contract counterparties. With respect to its domestic and international independent power projects, such structural features generally do not exist because either Covanta Energy operates and maintains such facilities for its own account or does so on a cost-plus basis rather than a fixed-fee basis.
Certain energy contracts related to domestic projects provide for energy sales prices linked to the avoided costs of producing such energy and, therefore, energy revenues fluctuate with various economic factors. Three of Covanta Energys waste-to-energy facilities have the ability to sell electricity under either
contracts or to the regional electricity grid without a contract, and therefore are subject to energy market price fluctuations.
At some of Covanta Energys domestic and international independent power projects, Covanta Energys operating subsidiary purchases fuel in the open markets. Covanta Energy is exposed to fuel price risk at these projects. At other plants, fuel costs are contractually included in Covanta Energys electricity revenues, or fuel is provided by Covanta Energys customers. In some of Covanta Energys international projects, the project entity (which in some cases is not a subsidiary of Covanta Energy) has entered into long-term fuel purchase contracts that protect the project from changes in fuel prices, provided counterparties to such contracts perform their commitments.
Covanta Energys quarterly operating income from domestic and international operations within the same fiscal year typically differs substantially due to seasonal factors, primarily as a result of the timing of scheduled plant maintenance.
Covanta Energy typically conducts scheduled maintenance periodically each year, which requires that individual boiler units temporarily cease operations. During these scheduled maintenance periods, Covanta Energy incurs material repair and maintenance expenses and receives less revenue, until the boiler units resume operations. This scheduled maintenance typically occurs during periods of off-peak electric demand in the spring and fall. The spring scheduled maintenance period is typically more extensive than scheduled maintenance conducted during the fall. As a result Covanta Energy has typically incurred its highest maintenance expense in the first half of the year. Given these factors, Covanta Energy has typically experienced lower operating income from its projects during the first six months of each year, and higher operating income during the second six months of each year.
Covanta Energy operates its domestic waste-to-energy projects under long-term agreements. Energy sales contracts at Covanta Energy-owned waste-to-energy projects generally expire at or after the date on which that projects agreement expires. Expiration of these contracts will subject Covanta Energy to greater market risk in maintaining and enhancing its revenues. As its agreements at municipally-owned projects expire, Covanta Energy will seek to enter into renewal or replacement contracts to continue operating such projects. As its agreements at facilities it owns begin to expire, Covanta Energy intends to seek replacement or additional contracts for waste supplies. Because project debt on these facilities will be paid off at such time, Covanta Energy believes it will be able to offer disposal services at rates that will attract sufficient quantities of waste and provide acceptable revenues. Covanta Energy will seek to bid competitively in the market for additional contracts to operate other facilities as similar contracts of other vendors expire. At Covanta Energys domestic facilities, the expiration of existing energy sales contracts will require Covanta Energy to sell project energy output either into the electricity grid or pursuant to new contracts. There can be no assurance that Covanta will be able to enter into such renewals, replacement or additional contracts, or that the terms available in the market at the time will be favorable to Covanta Energy. For additional information regarding contract expiration dates, see Item 1. Business.
Covanta Energy operates many publicly-owned waste-to-energy facilities and owns and operates many other facilities. In addition, as a result of acquisitions of additional projects originally owned or operated by other vendors, Covanta Energy operates several projects under a lease structure where a third party lessor owns the project. Regardless of ownership structure, Covanta Energy provides the same service to its municipal client or customers.
Under any of these ownership structures, the municipalities typically borrow funds to pay for the facility construction by issuing bonds. In a private ownership structure, the municipal entity loans the bond proceeds to Covanta Energys project subsidiary, and the facility is recorded as an asset, and the project debt is recorded
as a liability, on Covanta Energys consolidated balance sheet. In a public ownership structure, the municipality would fund the construction costs without loaning the bond proceeds to Covanta Energy.
At all projects where a Service Fee structure exists (regardless of ownership structure), Covanta Energys municipal clients are generally responsible contractually for paying the project debt after construction is complete. At the 11 publicly-owned Service Fee projects Covanta Energy operates, the municipality pays periodic debt service directly to a trustee under an indenture. Covanta Energy owns 12 projects where a Service Fee structure exists, and at these projects the municipal client pays debt service as a component of a monthly service fee payment to Covanta Energy. The debt service payment is retained by a trustee, and is not held or available to Covanta Energy for general use. At these projects, Covanta Energy records on its consolidated financial statements revenue with respect to debt service (both principal and interest) on project debt, and interest expense on project debt. For Covanta Energy-owned projects, all cash held by trustees is recorded as restricted funds held in trust on its consolidated balance sheet.
Covanta Energy owns or leases 8 projects where a Tip Fee structure exists and neither debt service nor lease rent is expressly included in the fee Covanta Energy is paid. Accordingly, Covanta Energy does not record revenue reflecting principal on this project debt or on lease rent. Its operating subsidiaries for these projects make equal monthly deposits with their respective project trustees in amounts sufficient for the trustees to pay principal and interest, or lease rent, when due.
The term of Covanta Energys operating contracts with its municipal clients generally coincides with the term of the bonds issued to pay for the project construction. Therefore, another important difference between public and private ownership of Covanta Energys waste-to-energy projects is project ownership after these contracts expire. In many cases, the municipality has contractual rights (not obligations) to extend the contract. If a contract is not extended on a publicly-owned project, Covanta Energys role, and its revenue, with respect to that project would cease. If a contract is not extended on a Covanta Energy-owned project, it would be free to enter into new revenue generating contracts for waste supply (with the municipality, other municipalities, or private waste haulers) and for electricity or steam sales. Covanta Energy would in such cases have no remaining project debt to repay from project revenue, and would be entitled to retain 100% of energy sales revenue.
Covanta Energy has historically performed its operating obligations without experiencing material unexpected service interruptions or incurring material increases in costs. In addition, with respect to many of its contracts at domestic projects, Covanta Energy generally has limited its exposure for risks not within its control. With respect to projects acquired in the ARC Holdings acquisition, Covanta Energy has assumed contracts where there is less contractual protection against such risks and more exposure to market influences. For additional information about such risks and damages that Covanta Energy may owe for its unexcused operating performance failures, see the risk factors set forth under the sub-heading Item 1A. Risk Factors Waste and Energy Services Business. In monitoring and assessing the ongoing operating and financial performance of Covanta Energys businesses, management focuses on certain key factors: tons of waste processed, electricity and steam sold, and boiler availability.
Covanta Energys ability to meet or exceed historical levels of performance at projects, and its general financial performance, is affected by the following:
General financial performance at CPIHs international projects is affected by the following:
Covantas opportunities for growth by investing in new development opportunities will be limited by Covanta Energys debt covenants, as well as by competition from other companies in the waste disposal and energy businesses. Covanta Energys business is capital intensive since it is based upon building and operating municipal solid waste processing and energy generating projects. In order to provide meaningful growth, Covanta must be able to invest its own funds, obtain equity or debt financing, and provide support to its operating subsidiaries. Covantas domestic project development has recently concentrated on working with its client communities to expand existing waste-to-energy project capacities, and it has one project in advanced stages of development and another under construction. Covanta is pursuing additional project expansion opportunities, as well as opportunities in businesses ancillary to its existing business, such as additional waste transfer, transportation, processing and landfill businesses. Covanta is also pursuing international waste and/or energy business opportunities, particularly in markets where the regulatory environment or other factors encourage technologies such as waste-to-energy in order to reduce dependence on landfilling, such as Italy, where Covanta has an existing presence, as well as the United Kingdom.
Covantas Other Services segment is comprised of the parent company and insurance subsidiaries operations. Parent company operations prior to the acquisition of Covanta Energy on March 10, 2004, primarily included general and administrative expense related to officer salaries, legal and other professional fees and insurance. Subsequent to the acquisition of Covanta Energy, these expenses have been reimbursed by Covanta Energy under a corporate services agreement. The parent company operations also include income earned on its investments.
The operations of Covantas insurance subsidiary, National American Insurance Company of California (NAICC), and its subsidiary Valor Insurance Company, Incorporated (Valor), are primarily property and casualty insurance. Based upon the profitability of its insurance lines, NAICC has responded to expand,
contract or cease issuing certain of its insurance policies. For example, effective July 2003, the decision was made to focus exclusively on the California non-standard personal automobile insurance market. In contrast, in November, 2004 NAICC ended a self-imposed moratorium and commenced writing a new non-standard automobile program under a new rate and class plan. NAICC, from time to time, has also entered into a quota share reinsurance agreement based upon its view of underwriting risk, its reserves and internal cost structure, in order to reduce its potential exposure to outstanding policies.
As a result of declining net premium production, NAICCs investment base has steadily declined, its reserve adjustments on discontinued lines have disproportionately impacted current operating ratios and it continues to lose operating leverage. As a result of positive results in the non-standard automobile program in 2005 despite soft market conditions, NAICC cancelled the reinsurance programs effective January 1, 2006 in an attempt to retain more net premium.
RESULTS OF OPERATIONS
As discussed above, Covanta combined the previously separate business segments of its insurance operations and its parent-only operations into one reportable segment referred to as Other Services during the third quarter of 2005. Therefore, Covanta currently has two reportable business segments Waste and Energy Services and Other Services.
The results of operations for the years ended December 31, 2004 and 2005 are not representative of Covantas ongoing results since Covanta only included Covanta Energys and ARC Holdings results of operations in its consolidated results of operations from March 11, 2004 and June 25, 2005 forward, respectively.
Therefore, given the significance of the Covanta Energy and ARC Holdings acquisition to Covantas current and future results of operations and financial condition, Covanta believes that an understanding of its reported results, trends and ongoing performance is enhanced by presenting results on a pro forma basis at both the consolidated and Waste and Energy Services segment levels. Covantas consolidated and segment results of operations, as reported and where applicable, on a pro forma basis, are summarized in the tables and discussions below. The pro forma basis presentation assumes that the acquisitions of Covanta Energy and ARC Holdings both occurred on January 1, 2004. The pro forma adjustments are described on page 62.
The pro forma financial information is presented for information purposes only and is not indicative of the results of operations that would have been achieved if the acquisitions had taken place at the beginning of each period or that may result in the future. In addition, the pro forma information provided below has not been adjusted to reflect any operating efficiencies that may be realized as a result of the ARC Holdings acquisition.
The comparability of the information provided below with respect to Covantas revenue, expense and certain other items for periods during each of the years presented was affected materially by several factors in addition to the Covanta Energy and ARC Holdings acquisitions. These factors principally include:
The factors noted above must be taken into account in developing meaningful comparisons between the periods compared below.
Results of Operations Year Ended December 31, 2005 vs. Year Ended December 31, 2004
Given the significance of the Covanta Energy and ARC Holdings acquisitions to Covantas business, results of operations and financial condition, Covanta decided, during the third quarter of 2005, to combine the previously separate business segments of Insurance Services and Parent-only operations into one reportable segment referred to as Other Services. Certain prior period amounts, such as parent investment income, have been reclassified in the consolidated financial statements to conform to the current period presentation. Basic and diluted earnings per share and the average shares used in the calculation of basic and diluted earnings per share and book value per share of common stock and shares of common stock outstanding for all periods have been adjusted retroactively to reflect the bonus element contained in the rights offerings conducted in May 2004 and June 2005.
Covantas consolidated results of operations on both a reported and pro forma basis are presented in the table below (in thousands of dollars, except per share amounts):
The following general discussions should be read in conjunction with the above table, the consolidated financial statements and the notes to those statements and other financial information appearing and referred to elsewhere in this report. Additional detail on comparable revenues, costs and expenses, and operating income of Covanta Energy is provided in the pro forma Waste and Energy Services segment discussion and reported Other Services segment discussion below.
Covantas net income increased by $25.2 million for the year ended December 31, 2005, as compared to 2004. Operating income for the Waste and Energy Services segment increased by $66.5 million for the year ended December 31, 2005, as compared to 2004. The increase in operating income resulted primarily from the Covanta Energy and ARC Holdings acquisitions. Operating expenses include $10.3 million of allocated
expenses related to the California Grantor Trust Settlement. For additional information, see Note 4. California Grantor Trust Settlement of the Notes. The year ended December 31, 2005 includes the write-off of deferred financing charges of $7.0 million on Covanta Energys prior domestic and international debt, as well as $6.7 million of restructuring and acquisition-related charges. Operating loss for the Other Services segment decreased by $2.8 million for the year ended December 31, 2005, as compared to 2004, primarily due to reduced general and administrative expenses.
Total investment income increased by $3.8 million for the year ended December 31, 2005, as compared to 2004, primarily due to higher invested cash balances. Interest expense increased by $46.2 million for the year ended December 31, 2005, as compared to 2004, primarily due to the new financing arrangements put into place as part of the ARC Holdings acquisition in June 2005 and the write-off of deferred financing costs related to the debt incurred with the acquisition of Covanta Energy in 2004, which debt was refinanced in connection with the new financing arrangements. Equity in net income from unconsolidated investments increased by $8.6 million for the year ended December 31, 2005, as compared to 2004, primarily due to the acquisition of Covanta Energy, revenue adjustments which occurred in 2004 in addition to lower operating costs in 2005 at a project in the Philippines and lower project debt interest expense at projects in the Philippines and Bangladesh in 2005 as a result of project debt payments. As discussed in Note 20. Financial Instruments of the Notes, Covanta recorded a pre-tax gain on derivative instruments of $15.2 million for the year ended December 31, 2005 related to its investment in ACL warrants.
Covantas net income increased by $14.3 million for the year ended December 31, 2005, as compared to 2004. Operating income for the Waste and Energy Services segment decreased by $4.4 million for the year ended December 31, 2005, as compared to 2004, primarily due to higher operating revenues offset by $10.3 million of allocated expenses related to the California Grantor Trust Settlement. Operating loss for the Other Services segment decreased by $2.8 million for the year ended December 31, 2005, as compared to 2004, primarily due to reduced general and administrative expenses.
Total investment income increased by $2.5 million for the year ended December 31, 2005, as compared to 2004, primarily due to higher invested cash balances. Interest expense decreased $1.1 million for the year ended December 31, 2005, as compared to 2004. Equity in net income from unconsolidated investments increased by $3.7 million for the year ended December 31, 2005, as compared to 2004, primarily due to revenue adjustments which occurred in 2004 in addition to lower operating costs in 2005 at a project in the Philippines and lower project debt interest expense at projects in the Philippines and Bangladesh in 2005 as a result of project debt payments. As discussed in Note 20. Financial Instruments of the Notes, Covanta recorded a pre-tax gain on derivative instruments of $15.2 million for the year ended December 31, 2005 related to its investment in ACL warrants.
Waste and Energy Services results of operations on both a reported and pro forma basis are presented in the table below (in thousands of dollars):
The following business segment discussion is presented on a pro forma basis only. Management believes that due to the significance of the Covanta Energy and ARC Holdings acquisitions to Covantas current and future results of operations and financial condition that an understanding of Covantas reported results, trends and ongoing performance is enhanced by a discussion of the Waste and Energy Services Segment on a pro forma basis. The following general discussions should be read in conjunction with the above table, the consolidated financial statements and the Notes. Additional detail on comparable revenues, costs and expenses, and operating income, within the Waste and Energy Services segment is provided in the pro forma domestic and international business discussions below.
Operating income remained relatively unchanged for the year ended December 31, 2005, as compared to 2004, primarily due increased revenues offset by allocated expenses related to the California Grantor Trust Settlement. Revenues increased $10.7 million for the year ended December 31, 2005 compared to 2004, primarily from increases in waste and service revenues. Total operating expenses for the year ended December 31, 2005 increased by $15.1 million, as compared to 2004, as a result of higher plant operating expenses and lower project debt interest expense in both the domestic and international operations offset by an increase in domestic general and administrative expenses and the California Grantor Trust Settlement.
The domestic business results of operations on both a reported and pro forma basis are presented in the table below (in thousands of dollars):
The following discussion is presented on a pro forma basis only.
Total domestic revenue increased by $15.6 million primarily due to contract fee service escalation and higher energy prices as further described below.
Waste and service revenues for the year ended December 31, 2005 increased by $6.0 million compared to 2004.
Electricity and steam sales for the year ended December 31, 2005 increased $8.5 million compared to 2004. Revenues increased $9.9 million primarily driven by higher energy rates partially offset by a biogas project that was shut down in the fourth quarter of 2004.
Plant operating costs for the year ended December 31, 2005 were $12 million higher compared with 2004. This increase was primarily due to the normal escalation of costs such as wages and benefits, as well as
additional scheduled maintenance and a subsidiary emerging from bankruptcy partially offset by a reduction in disposal costs related to brokered waste and the impact of the termination or sale of certain of our non-core operations.
Depreciation and amortization for the year ended December 31, 2005 was comparable to 2004.
Net interest expense on project debt for the year ended December 31, 2005 decreased $4.7 million, compared to 2004, primarily as a result of lower project debt balances.
Other operating income increased by $3.5 million in 2005, compared to 2004, primarily due to a gain at a facility related to a debt refinancing in April 2005 and to third quarter insurance recoveries.
General and administrative expenses increased $7.4 million in 2005 compared with 2004. This increase was primarily due to wage escalations, additional professional and consulting fees and an increase in non-cash stock compensation expense resulting from additional grants in 2005.
During the fourth quarter of 2005, Covanta incurred $10.3 million of allocated expenses relating to the California Grantor Trust Settlement. For additional information, see Note 4. California Grantor Trust Settlement of the Notes.
The international business results of operations on both a reported and pro forma basis are presented in the table below (in thousands of dollars):
The following discussion is presented on a pro forma basis only.
Total revenues for the international business for 2005 decreased $4.9 million primarily due to elimination of revenue from marginal businesses in 2004, offset by increased tariffs due to higher fuel prices as described below. This decrease was primarily due to a $7.5 million decrease from the 2004 expiration of an energy contract in the Philippines, a $4.1 million decrease from the deconsolidation of the MCI facility in May 2004, as well as a $2.4 million decrease due to lower demand at the Huantai facility in China. These decreases were partially offset by an $8.1 million increase primarily due to increased tariffs, which resulted from higher fuel prices, at two facilities in India in 2005; as well as a $0.8 million increase in steam revenues from the Yanjiang facility in China.
Plant operating costs were lower by $5.4 million in 2005 compared to 2004. Plant operating costs decreased primarily as a result of a $4.9 million decrease in costs from the expiration of an energy contract in the Philippines, a $4.6 million reduction in costs due to the deconsolidation of the MCI facility in the
Philippines in May 2004, as well as a $2.3 million decrease due to lower generation at the Huantai facility in China. These decreases were partially offset by a $6.1 million increase in plant operating costs due primarily to higher fuel prices at two facilities in India.
Net interest expense on project debt for 2005 decreased $4.2 million compared to 2004. The decrease was primarily due to lower expenses at two Indian facilities resulting from the October 2004 refinancing and scheduled quarterly pay down of project debt, as well as the deconsolidation of the MCI facility in May 2004.
Other operating expense increased by $3.8 million in 2005 compared to 2004 primarily due to the $1.7 million write-off of the remaining assets at the Edison Bataan facility in the Philippines, and a 2005 foreign currency exchange loss of $1.0 million, compared to a $0.2 million gain recorded in 2004 on a euro-denominated note receivable from the Trezzo project in Italy and dollar-denominated debt in India.
Other Services Results
Other Services reported results of operations are presented in the table below (in thousands of dollars):
Net written premiums decreased by $2.7 million for the year ended December 31, 2005 as compared to 2004. The decrease in net written premiums for 2005 was attributable to the insurance business entering into quota share arrangements as described in the Managements Discussion and Analysis of Financial Condition and Results of Operations Overview Other Service section above.
Net earned premiums decreased by $5.3 million for the year ended December 31, 2005 as compared to 2004. The change in net earned premiums during those periods was directly related to the change in net written premiums and the run-off of the commercial automobile program.
Other operating expenses decreased by $5.4 million for the year ended December 31, 2005 as compared to 2004. Other operating expenses consists of net loss and loss adjustment expenses (LAE), and policy acquisition costs as described below.
Net loss and LAE decreased by $2.9 million for the year ended December 31, 2005 as compared to 2004. The loss and LAE ratio worsened for the year ended December 31, 2005 over the comparable period in 2004 due to the underwriting performance of the new program which was not as profitable as the renewal book. The resulting loss and LAE ratios were 78.3% and 71.5% for the years ended December 31, 2005 and 2004, respectively. For both 2005 and 2004, adverse reserve development accounted for approximately 14.0% of the net loss and LAE ratio.
Policy acquisition costs decreased by $2.5 million for the year ended December 31, 2005 as compared to 2004. As a percentage of net earned premiums, policy acquisition costs were 15.5% and 24.6% for the year ended December 31, 2005 and 2004, respectively. Policy acquisition costs decreased compared to the 2004 period due to reduced profit commissions incurred related to non-standard personal automobile and from ceding commissions earned under reinsurance agreements during 2005.
General and administrative expenses decreased by $3.5 million for the year ended December 31, 2005 as compared to 2004. Reductions in administrative personnel and rent in the insurance business contributed to the decrease in general and administrative expenses. Decreases in parent company expenses were primarily the result of the corporate services agreement, entered into between Covanta and Covanta Energy on March 10, 2004, pursuant to which Covanta provided to Covanta Energy, at Covanta Energys expense, certain administrative and professional services.
Pro Forma Reconciliations
The following tables provides a reconciliation from the as reported results to the pro forma results presented above for Covanta and its Waste and Energy Services segment where applicable (in thousands of dollars, except per share amounts). Notes to the pro forma reconciliations begin directly after the tables.
CONSOLIDATED PRO FORMA RECONCILIATIONS
WASTE AND ENERGY SERVICES PRO FORMA RECONCILIATIONS
Notes To Pro Forma Reconciliations
The unaudited pro forma combined financial statements reflect the following assumptions:
The following are a summary of the pro forma adjustments made:
Results of Operations Year Ended December 31, 2004 vs. Year Ended December 31, 2003
For the year ended December 31, 2004, Covanta Energys results of operations are included in Covantas consolidated results since March 11, 2004. Covanta Energys operations are significantly larger than Covantas insurance business, which had constituted substantially all of its ongoing operations during 2003 and prior to March 11, 2004. As a result of the consummation of the Covanta Energy acquisition on March 10, 2004, the future performance of Covanta will predominantly reflect the performance of Covanta Energys operations.
Covantas parent-only operations prior to the acquisition of Covanta Energy on March 10, 2004, primarily included general and administrative expense related to officer salaries, legal and other professional fees and insurance. Subsequent to the acquisition of Covanta Energy, these expenses are reimbursed by Covanta Energy under a corporate services agreement. Covantas parent-only operations also include income earned on its investments.
Covantas consolidated results of operations are presented in the table below (in thousands of dollars, except per share amounts):
The following general discussions should be read in conjunction with the above table, the consolidated financial statements and the Notes and other financial information appearing and referred to elsewhere in this report.
Covantas net income increased by $103.3 million for the year ended December 31, 2004, as compared to 2003 primarily due to the inclusion of income earned by Covanta Energy in 2004 on a consolidated basis and the loss incurred in 2003 as a result of Covantas $54.9 million write-down of its investment in ACL. Operating income was $76.9 million in 2004, comprised of the Waste and Energy Services operating income of $80.2 million and Other Services operating loss of $3.3 million.
As a result of the Covanta Energy acquisition and the related addition of the Waste and Energy Services segment:
Equity in net income from unconsolidated investments increased by $71.9 million for the year ended December 31, 2004, as compared to 2003. In 2004, equity in net income from unconsolidated investments from the Waste and Energy Services segment was $17.0 million and in 2003, equity in net loss from unconsolidated investments of $54.9 million primarily related to Covantas subsidiaries engaged in the marine services industry which, beginning in 2003, were accounted for under the equity method following ACLs bankruptcy filing in January 2003.
Due to the significance of the acquisition of ARC Holdings in June 2005 and Covanta Energy in March 2004, and Covanta Energys restructuring upon emergence from Chapter 11 proceedings in 2004, Covanta has elected to provide only a tabular presentation of its Waste and Energy Services segments actual results of operations from March 11, 2004 to December 31, 2004, in lieu of a discussion of Covanta Energys results of operations comparing December 31, 2004 to December 31, 2003. Since Covanta did not have any waste and energy operations in 2003, Covanta believes that a discussion of the Waste and Energy Services segment that compared 2004 to 2003 would not enhance a readers analysis or understanding of Covantas current business. Therefore, the reader is further directed to Covantas pro forma Management Discussion and Analysis of Financial Condition and Results of Operations for the periods December 31, 2005 compared to 2004 for a comprehensive analysis and discussion of its Waste and Energy Services segment. The following table presents the Waste and Energy Services segments domestic and international actual consolidated results of operations for the period since the acquisition (in thousands of dollars):
Other Services reported results of operations are presented below (in thousands of dollars):
Net earned premiums were $18.0 million and $35.9 million for the years ended 2004 and 2003. The significant decrease in earned premiums was a direct result of Covantas insurance business exiting the commercial automobile market in 2003. Net written premiums were $15.2 million for 2004 consisting entirely of non-standard personal automobile policies.
Net investment income was $2.4 million and $4.0 million for 2004 and 2003, respectively. The decrease was primarily due to a decrease in the fixed income portfolio basis, as well as a reduction in the portfolio yield. The fixed income invested assets portfolio decreased by only $12.1 million in 2004 despite net loss and LAE reserves declining by $18.9 million. The differential was a result of managements use of cash and short-term investments to satisfy the payment obligations. Due to the decrease in net written premiums on business placed in run-off noted above, NAICC also experienced negative underwriting cash flows. For the years ended 2004 and 2003, the weighted average yield on the bond portfolio was 3.8% and 4.9%, respectively. The effective duration of the portfolio at December 31, 2004 was 2.3 years which management believed was appropriate given the relative short-tail nature of the auto programs and projected run-off of all other lines of business.
Net realized investment gains of $0.2 million were recognized in 2004 compared to $1.0 million in 2003. The difference in activity was attributed to management engaging new investment advisors in June 2003 to rebalance the portfolio to address extension, credit and reinvestment risk exposures. Concurrently, an improvement in equity investment returns and realizations in 2003 provided for improved gains. For 2004, although interest rates remained at relatively low historical levels, thereby limiting returns, improved matching of portfolio asset maturity to claims payment requirements reduced the amount of disposition activity.
The net loss and LAE ratios were 71.5% in 2004 and 102.3% in 2003. The decrease in the loss and LAE ratio during 2004 was attributable to much more stable development activity on prior accident years. Although commercial automobile, assumed property and casualty, and Valor workers compensation reserves continued to generate unfavorable claim development, the non-standard personal automobile and California workers compensation lines performed better than anticipated.
The non-standard personal automobile loss and allocated LAE (ALAE) ratio was 49.3% for accident year 2004 versus 60.4% for accident year 2003 recorded in calendar year 2003. The accident year 2003 loss and ALAE ratio declined to 53.7% by 2004 year-end. Non-standard personal automobile claim frequency was 7.7 and 7.9 per 1000 vehicle months for accident years 2004 and 2003, respectively. Claim severity in 2004 trended favorably for the non-standard personal automobile policies decreasing by 5.6% from the prior year. Meanwhile average premiums per vehicle on the non-standard personal automobile remained constant, despite a shift in the mix of business moving towards non-owner policies (37% in 2004 versus 28% in 2003). Historically, the non-owner policies loss and ALAE provided 10% to 30% lower yields than owner policies.
Workers compensation reforms were enacted in California in late 2003 and again in April 2004. The reforms were designed to curb medical cost spending and resulted in more favorable settlement activity. Although the reforms did not eliminate systemic abuse, they did appear to have modified the behavior of claimants, providers and applicant attorneys. As such, management was able to recognize favorable development within the workers compensation line in the amount of $1.6 million in 2004.
Policy acquisition costs as a percentage of net earned premiums were 24.6% in 2004 and 22.2% in 2003. Policy acquisition costs include expenses which are directly related to premium volume (i.e., commissions, premium taxes and state assessments), as well as certain underwriting expenses which vary with and are directly related to policy issuance. The increase in policy acquisition costs was a result of profit commissions earned by the agent responsible for the marketing, underwriting and policy administration of the non-standard personal automobile program. The recognition of the profit commission was a direct result of favorable reserve development recognized on accident year 2003 and slightly improved results for accident year 2004.
For the insurance business, general and administrative expenses were $4.4 million in 2004 compared to $6.7 million in 2003. In 2004, management recognized additional pension expense of $0.8 million related to participants electing to receive lump sum distributions of the pension plan and severance costs of $0.1 million related to the outsourcing of its workers compensation claims. In 2003, additional allowance for uncollectible
reinsurance recoverable of $1.3 million and $0.2 million in employee severance expenses related to business contraction inflated normal expenses. Normalizing both years for items noted, general and administrative expenses decreased by $1.6 million. Management continues to examine its expense structure; however, given the decreases in premium production and its obligation to run-off several lines of business, a core amount of fixed governance costs is required and consequently its expense ratio will run higher than industry averages until it can increase premium production.
For the parent company, Covantas expenses were primarily the result of the corporate services agreement between Covanta and Covanta Energy, pursuant to which Covanta provided to Covanta Energy, at Covanta Energys expense, certain administrative and professional services and Covanta Energy pays most of Covantas expenses. Such expenses totaled $3.5 million for the period March 11, 2004 through December 31, 2004. In addition, Covanta and Covanta Energy entered into an agreement pursuant to which Covanta Energy provided, at Covantas expense, payroll and benefit services for Covanta employees, which totaled $0.5 million for the period March 11, 2004 through December 31, 2004.
MANAGEMENTS DISCUSSION AND ANALYSIS OF LIQUIDITY AND CAPITAL RESOURCES
The information set forth below regarding liquidity and capital resources is presented according to Covantas consolidated operations and Covantas current business segments of Waste and Energy Services and Other Services.
Capital Resources and Commitments
As part of the ARC Holdings acquisition, Covanta Energy entered into new credit arrangements which totaled approximately $1.1 billion and are guaranteed by Covanta and certain domestic subsidiaries of Covanta Energy. The proceeds of the new financing arrangements were used to fund the acquisition of ARC Holdings, to refinance approximately $479 million of Covanta Energys and CPIHs recourse debt and letter of credit facilities, and to pay the related fees and expenses. The new credit facilities are further available for ongoing permitted expenditures and for general corporate purposes. The following chart summarizes the various components and amounts of Covanta Energys project and intermediate debt and Credit Facilities as of December 31, 2005 (in millions of dollars):
Cash Flow and Liquidity
Covantas sources of funds are its investments and financing activities, as well as dividends, if any, and other payments received from Covanta Energy and NAICC. Various state insurance requirements restrict the amounts that may be transferred to Covanta in the form of dividends or loans from Covantas insurance subsidiaries without prior regulatory approval. Currently, NAICC cannot pay dividends or make loans to Covanta. Under its new financing arrangements, Covanta Energys ability to pay dividends to Covanta is limited, except in certain circumstances.
The following summarizes the actual inflows and outflows relating to the ARC Holdings rights offering (in millions of dollars):
Summarized cash flow information for Covantas current business segments reconciled to the consolidated statements of cash flows is as follows (in thousands of dollars):
Cash provided by operating activities was $230 million and $134 million for the year ended December 31, 2005 and 2004, respectively. The increase in cash flow from operating activities was primarily due to the ARC Holdings acquisition. Net cash used in investing activities was $707.5 million in the year ended December 31, 2005 and was primarily due to the purchase of ARC Holdings, net of acquired cash. Net cash provided by financing activities was $493.9 million for the year ended December 31, 2005 and was primarily driven by the
capital contribution from Covanta, the net impact of the refinancing of the prior long-term debt and for the acquisition of ARC Holdings offset partially by the payment and future funding of project debt.
Restricted funds held in trust were $447.4 million as of December 31, 2005. Restricted funds held in trust are primarily amounts received and held by third party trustees relating to projects owned by Covanta Energy, and which may be used only for specified purposes. These payments are made directly to the trustee primarily for related project debt and are held by it until paid to project debt holders. Covanta does not have access to these funds. In addition, as of December 31, 2005, Covanta had $19.6 million in cash held in restricted accounts to pay for additional bankruptcy emergence expenses that are estimated to be paid in the future. Cash held in such reserve accounts is not available for general corporate purposes.
Generating sufficient cash to meet Covanta Energys liquidity needs, pay down its debt and invest in its business remains an important objective of management. Maintaining historic facility production levels while effectively managing operating and maintenance expenses is important to optimize Covanta Energys long-term cash generation. Covanta Energy does not expect to receive any cash contributions from Covanta and is prohibited under its principal financing arrangements from using its cash to issue dividends to Covanta except in limited circumstances.
Covanta Energy derives its cash flow principally from its domestic and international project operations and businesses. The frequency and predictability of Covanta Energys receipt of cash from projects differs, depending upon various factors, including whether restrictions on distributions exist in applicable project debt arrangements or in debt arrangements at Covanta Energys intermediate-level subsidiaries, whether a project is domestic or international, and whether a project has been able to operate at historical levels of production.
A material portion of Covanta Energys domestic cash flows are expected to be derived from projects where financial tests and other covenants contained in respective debt arrangements must be satisfied in order for project subsidiaries to make cash distributions to intermediate Covanta Energy subsidiaries, and for such intermediate-level subsidiaries to make cash distributions to Covanta Energy. Distributions from these intermediate-level subsidiaries may only be made quarterly, if such financial tests and other covenants are satisfied. Historically all such financial tests and covenants have been satisfied. Covanta Energys remaining domestic projects generally are not restricted in making cash distributions, and no restrictions exist at intermediate Covanta Energy subsidiary levels. As a result, Covanta Energy generally receives cash from these projects on a monthly basis.
Covanta Energys receipt of cash from its international projects is also subject to satisfaction of financial tests and other covenants contained in applicable project debt arrangements. A material portion of cash distributions from Covanta Energys international projects are received semi-annually, during the second and fourth quarters. In addition, risks inherent in international operations can affect the reliability of such cash distributions.
Covanta believes that when combined with its other sources of liquidity, Covanta Energys operations generate sufficient cash to meet operational needs, capital expenditures, and service debt due prior to maturity. Management will also seek to enhance Covanta Energys cash flow from renewals or replacement of existing contracts, from new contracts to expand existing facilities or operate additional facilities and by investing in new projects. Covanta Energys new financing arrangements place certain restrictions on its ability to make investments in new projects or expansions of existing projects.
As previously announced, Covanta agreed as part of the Covanta Energy acquisition to conduct the 9.25% Offering. Also as previously announced, because of the possibility that the 9.25% Offering could not be completed prior to the completion of the ARC Holdings Rights Offering, Covanta restructured the 9.25% Offering to offer an additional 2.7 million shares of Covantas common stock at the same purchase price as in the ARC Holdings Rights Offering. On February 24, 2006, Covanta completed the 9.25% Offering in which 5,696,911 shares were issued for $20.8 million in gross proceeds.
Covanta does not have any outstanding debt for borrowed money. Covanta Energy and several of its subsidiaries have outstanding debt obligations, which are described below. Covanta has guaranteed Covanta Energys debt obligations described below.
On June 24, 2005, Covantas subsidiary, Covanta Energy, entered into two credit and guaranty agreements with syndicates of lenders led by Goldman Sachs Credit Partners, L.P. and Credit Suisse, respectively. The financing provided Covanta with available credit for the working capital and general corporate needs of Covanta Energy and its subsidiaries.
The two credit agreements consist of (1) the Credit and Guaranty Agreement, dated as of June 24, 2005, among Covanta Energy, Covanta, as a guarantor, certain subsidiaries of Covanta Energy, as guarantors, and various lenders, arrangers and agents (First Lien Credit Agreement); and (2) the Second Lien Credit and Guaranty Agreement, dated as of June 24, 2005, among Covanta Energy, Covanta, as a guarantor, certain subsidiaries of Covanta Energy, as guarantors, and various lenders, arrangers and agents (Second Lien Credit Agreement). Under these credit agreements, the lenders agreed to provide secured revolving credit, letter of credit and term loan facilities in the amount of up to $1.115 billion as described below. The following is a description of the general terms of these senior secured credit facilities.
The senior secured credit facilities are comprised of the following:
Letters of credit that may in the future be issued under the Revolving Credit Facility will accrue fees at the then effective borrowing margins on eurodollar rate loans (described below), plus a fee on each issued letter of credit payable to the issuing bank. Letter of credit availability under the Funded L/ C Facility accrues fees (whether or not letters of credit are issued thereunder) at the then-effective borrowing margin for eurodollar rate loans times the total availability under letters of credit (whether or not then utilized), plus a fee on each issued letter of credit payable to the issuing bank. In addition, Covanta Energy has agreed to pay to the participants under the Funded L/ C Facility any shortfall between the eurodollar rate applicable to the relevant Funded L/ C Facility interest period and the investment income earned on the pre-agreed investments made by the relevant issuing banks with the purchase price paid by such participants for their participations under the Funded L/ C Facility.
As of December 31, 2005, Covanta Energy had neither drawn on the Revolving Credit Facility nor caused to be issued any letters of credit under the Revolving Credit Facility. As of December 31, 2005, Covanta Energy had $307.5 million outstanding letters of credit under the Funded L/ C Facility.
Covanta Energy also entered into an intercreditor agreement with the respective lenders under the Revolving Credit Facility, the Funded L/ C Facility, and the First Lien Term Loan Facility and the Second Lien Term Loan Facility described under Capital Resources and Commitments. This agreement includes certain provisions regarding the application of payments made by Covanta Energy among the respective creditors and certain matters relating to priorities upon the exercise of remedies with respect to the collateral.
Under these agreements Covanta Energy is obligated to apply 50% of excess cash from operations (calculated pursuant to the new credit agreements), as well as specified other sources, to repay borrowing under the First Lien Term Loan Facility and reduce commitments under the financing arrangements, and in some circumstances to collateralize its reimbursement obligations with respect to outstanding letters of credit and/or repay borrowings under the Second Lien Term Loan Facility.
The new debt issued in the refinancing transaction is outlined in the following table:
In December 2005, Covanta Energy voluntarily prepaid $45 million under the First Lien Term Loan. The mandatory annual amortization was reset and will be paid in quarterly installments beginning December 31, 2006, through the date of maturity as follows (in thousands of dollars):
The Second Lien Term Loan Facility has no mandatory amortization requirements and is required to be repaid in full on its maturity date.
Loans under the senior secured credit facilities are designated, at Covantas election, as Eurodollar rate loans or base rate loans. Eurodollar loans bear interest at a reserve adjusted British Bankers Association Interest Settlement Rate, commonly referred to as LIBOR, for deposits in dollars plus a borrowing margin as described below. Interest on Eurodollar rate loans is payable at the end of the applicable interest period of one, two, three or six months (and at the end of every three months in the case of six month eurodollar loans). Base rate loans bear interest at (a) a rate per annum equal to the greater of (1) the prime rate designated in the relevant facility or (2) the federal funds rate plus 0.50% per annum, plus (b) a borrowing margin as described below.
The borrowing margins referred to above for the Revolving Credit Facility are as follows:
The borrowing margins for First Lien Term Loan Facility and the Funded Letter of Credit Facility are 3.00% for Eurodollar rate loans and 2.00% for base rate loans. The borrowing margins under the Second Lien Term Loan Facility are 5.50% for Eurodollar rate loans and 4.50% for base rate loans.
The Credit Facilities provide that Covanta Energy and its subsidiaries must comply with certain affirmative and negative covenants. See Note 18. Long-Term Debt to the Notes for a description of such covenants, as well as other material terms and conditions of such agreements.
As of December 31, 2005, Covanta Energy was not in default under the Credit Facilities.
Covanta Energys obligations under the First Lien Facilities and certain interest rate or other hedging arrangements entered into with any of the lenders and their affiliates and Covantas subsidiary guarantors guaranty obligation are secured by a first priority security interest in substantially all assets, including substantially all of the personal, real and mixed property of Covanta Energy and the subsidiary guarantors pursuant to the terms of the First Lien Facilities documentation including the First Lien Pledge and Security Agreement between each of Covanta Energy and the other grantors party to the agreement and a collateral agent acting on behalf of lenders (First Lien Security Agreement).
In addition, the First Lien Facilities are secured by a first priority perfected lien or pledge on 100% of the capital stock of Covanta Energy and certain direct subsidiaries of Covanta Energy and the subsidiary guarantors, up to 65% of the capital stock of certain first tier foreign subsidiaries of Covanta Energy and the subsidiary guarantors, and all intercompany debt owed to Covanta Energy or the subsidiary guarantors, pursuant to the terms of the First Lien Facilities documentation including the First Lien Security Agreement and the First Lien Pledge Agreement between Covanta and a collateral agent acting on behalf of lenders. Other subsidiaries of ours are not subject to any guaranty.
The Second Lien Term Loan Facility is secured by a second priority security interest in the same collateral as secures the First Lien Facilities pursuant to the terms of the Second Lien Term Loan Facility documentation including the Parity Lien Pledge and Security Agreement and a Parity Pledge Agreement between the same Covanta entities and collateral agents acting on behalf of lenders (the Parity Lien Security Agreement).
The priority of the security interests and related creditor rights between the First Lien Facilities (the First Lien Obligations) and those of the Second Lien Term Loan Facility (the Second Lien Obligations) are set forth in the Intercreditor Agreement among Covanta Energy and various lender parties (the Intercreditor Agreement). Under the terms of the Intercreditor Agreement, for as long as any of the First Lien Obligations are outstanding:
The loan documentation under the Credit Facilities contains customary affirmative and negative covenants and financial covenants. During the term of the Credit Facilities, Covanta expects that the negative covenants will restrict the ability of Covanta Energy and its subsidiaries to take specified actions, subject to exceptions, including but not limited to: