The agreement by Dallas-based TXU Corp. and backers of a $45 billion buyout of the Texas utility to drop plans for eight coal-fired power plants and cut consumer rates isn't quite the giveback it seems when one considers what the plants' absence from TXU's portfolio would do to heat rates.
The deal would include a 10% price cut resulting in more than $300 million of annual savings for residential customers and "price protection" through September 2008, the company said. However, the dropping of the coal plants likely would mean a boost to revenues in the long run, according to Merrill Lynch analysts who looked at the deal.
"Looking to the longer term we would see a retail price cut as broadly offset by heat rate benefits on existing baseload production from scaling back the coal-fired new-build," wrote Merrill Lynch analysts in a Monday note.
Baseload power production from existing units is forecast to be about 64 TWh, Merrill Lynch said. Embedded in forward pricing estimates is a heat rate reduction of 1 MMBtu/MWh due to the addition of the previously planned coal-fired generation through 2011.
"At forward gas pricing in the $7.30/MMBtu range for 2011, absence of this heat rate reduction would add $7.30/MWh to the power price -- and more than $450 million of baseload revenues given TXU's 64 TWh output."
Some of the new coal plants could still be built, but assuming a heat rate improvement of only 0.6 MMBtu/MWh yields an uplift to power prices of about $4.40/MWh. "This translates to about $280 million of revenues and 40 cents/share of EPS [earnings per share] based on the current share count (i.e., sufficient to offset the near-term impact of a 10-15% retail price cut)," Merrill Lynch said.
Texas relies more heavily on natural gas to fuel power generation than most states. So a curtailment in other types of generation almost certainly would mean higher electric rates for residents of the state, which has some of the highest electric rates in the country already.
The massive buyout could also mark a sea change in private equity's so far unsuccessful pursuit of utility assets. Also, it would herald the further "greening" of Wall Street and the energy patch in an era when global warming is on the minds of politicians, regulators, business leaders and consumers.
TXU and private equity funds Kohlberg Kravis Roberts & Co. (KKR) and Texas Pacific Group (TPG) and investment bank Goldman Sachs & Co. Monday announced the biggest leveraged buyout ever: $45 billion (including $13 billion in debt) to take TXU private. The package includes substantial concessions to ratepayers and environmentalists.
TXU shares closed up $7.91 (13.18%) at $67.93, besting the 52-week high of $67.21, following Monday trading in which volume was nearly 16 times average. Other utilities got a substantial boost from the deal as well. For instance, NRG Energy Inc. was up 6.66%, and Reliant Energy Inc. was up 6.33%. Both Standard & Poor's Ratings Services and Moody's Investors Service warned of significant downgrades for TXU and/or subsidiaries.
"There is a reasonable possibility that a multi-notch downgrade may occur at one or more of TXU's rated entities," said Jim Hempstead, a Moody's vice president.
If the deal goes through, it would mean a major detour for TXU's ambitious coal-fired generation buildout plans in Texas, cutting the number of planned coal plants to three from 11. This is in step with the tenor of the times. As Merrill Lynch analysts noted Monday, "Currently there is broad opposition to the new plants, such that it is difficult to see them being built by TXU or any other developer" (see Power Market Today, Feb. 22). The privatized company would also strengthen environmental policies, invest in alternative energy and institute policies on climate change, deal backers said in their Monday announcement. Some but not all environmental groups, which are bitterly opposed to the coal-fired plants, quickly endorsed the deal.
"This turnaround marks the beginning of a new, competitive focus on clean, efficient, renewable energy strategies to deliver the power we need while cutting global warming emissions," said Natural Resources Defense Council (NRDC) President Frances Beinecke. "It is a big step forward for the State of Texas and for the American energy economy as a whole."
Worth noting, though, is the fact that the eight plants that would be scrapped had a long and perilous permitting process in front of them, so they might not have been built regardless. Further, their ultimate absence from the TXU generation portfolio will raise heat rates and, consequently, TXU revenue, some analysts said.
An investor group led by KKR and TPG will acquire TXU, and GS Capital Partners, Lehman Brothers, Citigroup and Morgan Stanley will be equity investors at closing. The offer to shareholders is $69.25/share, a 25% premium to recent prices. The company would be reorganized into three independently operated businesses: generation, transmission/distribution and retail. Headquarters would remain in the Dallas-Fort Worth area. The deal is expected to close in the second half of 2007.
"[W]e have developed a new vision with management of how we can turn TXU into a more innovative, customer-centric, environmentally friendly company, and we plan to work with management to implement it," said Henry Kravis, founding partner of KKR. "We intend to hold this as a long-term asset, and we recognize the need to balance growth with environmental considerations."
The promise -- or at least the appearance -- of a long-term commitment will likely be key to regulatory blessing of the deal. Private equity has gone after utility assets before and gotten its fingers burned. In April TPG was forced by Oregon state regulatory resistance to drop its bid to buy Portland General Electric from Enron Corp. (see Power Market Today, April 8, 2005). In January 2005 a trio of private equity firms was thwarted by Arizona regulators in its attempt to buy UniSource Energy Corp. (see Power Market Today, Jan. 4, 2005).
In a Monday note, Merrill Lynch analysts said that other merchant generation owners could be targets of leveraged buyouts. "Two of the best candidates in our view are buy-rated NRG and EXC [Exelon Corp.]," they said. "The ongoing political uncertainties surrounding higher electricity rates in Illinois [see Power Market Today, Jan. 11] suggest that a deal involving EXC would necessarily be some way off. That said, we would have made similar comments on TXU, where it appears that the private equity bidders may be turning political uncertainty to their advantage in creating an entry opportunity."
Former U.S. Secretary of State James A. Baker III will serve as advisory chairman to the investment group of new owners. William Reilly, chairman emeritus of the World Wildlife Fund and former EPA administrator, will join the board of directors and lead efforts to make climate stewardship central to corporate policies. Donald L. Evans, former U.S. secretary of commerce; James R. Huffines, chairman of the University of Texas board of regents; and Lyndon L. Olson Jr., former Texas state representative and former U.S. ambassador to Sweden, also will join the board of directors.
TXU will create an independent sustainable energy advisory board composed of members representing the environment, customers, Texas economic development and Electric Reliability Council of Texas (ERCOT) reliability standards.
The investors said a new environmental focus will make TXU a leader in conservation and energy efficiency, creating a fundamental change in the Texas electric market. In addition, the company's new strategic direction will seek to achieve top environmental performance in the industry and greater involvement and dialogue with environmental, government and community leaders.
"KKR, TPG and the rest of the investor group are all world-class investors who bring valuable experience in the industry. With these long-term and very informed investors, we can execute a new strategy that will allow us to reshape TXU's program to build new electric generation units," said TXU CEO C. John Wilder. "Our new strategy will meet two important objectives: addressing Texas' immediate and future energy and reliability needs; and doing so in a manner that responds to the desires of policymakers and other key stakeholders to incorporate new technology advancements and conservation."
TXU Energy will provide more than $300 million in annual savings through a 10% price reduction for residential customers that have not already switched electric suppliers. Customers will begin receiving a 6% reduction in approximately 30 days and an additional 4% reduction at the close of the transaction.
The scale-back of the controversial coal buildout represents a 75% reduction in new coal capacity. The company said it seeks to join the United States Climate Action Partnership (USCAP), which is engaged in developing a climate-change program. TXU also is supporting a mandatory cap-and-trade program for carbon emissions. TXU expects to build two coal units at the Oak Grove site and one coal unit at the Sandow site. TXU will immediately seek to suspend the permit application process for the other eight units and withdraw them once the transaction closes. TXU said it does not intend to apply or reapply for permits to build additional coal units utilizing current pulverized coal-fueled technology.
On the demand side, TXU said it will implement an aggressive demand reduction program through a $400 million investment in conservation and energy efficiency activities over the next five years.
"Environmental Defense commends KKR and TPG for not only dropping TXU's applications for eight proposed coal plants in Texas, but also for the many other commitments they have made to reduce air pollution and global warming emissions, including their support for a mandatory federal cap-and-trade program to regulate carbon emissions, doubling TXU's expenditures on efficiency measures and their overall desire to rebuild TXU as a leader in the clean energy economy," said Fred Krupp, president of Environmental Defense, which, along with NRDC, endorsed the deal.
Not all of the environmentalists are appeased by TXU's proposed concessions. "The commitments by TXU's new owners should be binding, not voluntary, and the three Texas coal plants TXU still intends to build are three plants too many," said Rainforest Action Network Executive Director Michael Brune in a press release.
However, during a Monday conference call, representatives from the National Environmental Trust, Public Citizen and NRDC were quick to claim the TXU coal plant cancellation as a victory that will imperil the coal-fired generation development plans of other companies such as LS Power, Dynegy and Xcel Energy.
David Hawkins, director of the NRDC climate change center, said TXU's proposed cancellation of the eight coal plants is "an earthquake that happened in Texas, but the shockwaves are going to be felt from Wall Street to Washington." Tom Smith, director of Public Citizen's Texas office, did concede that TXU's three remaining proposed coal plants are the "dirtiest" of the 11 previously proposed.
TXU said it is committed to exploring integrated gasification combined-cycle (IGCC) generation potential to meet Texas' reliability requirements. The company said it is evaluating sites for the exploration of clean coal technologies. This is a 180-degree turn from the company's prior anti-IGCC stance (see Power Market Today, Feb. 20; Jan. 25; Jan. 12; Jan. 10). TXU also said it will reduce emissions of mercury (Hg), sulfur dioxide (SO2) and nitrogen oxide (NOx) by 20% from 2005 levels, as previously committed, through reductions at existing units and installation of emission controls on the new Oak Grove and Sandow units.
TXU said it will reduce its own carbon emissions by increasing efficiency of its generating facilities by up to 2% and will become a leader in providing electricity from renewable sources by more than doubling its purchase of wind power to more than 1,500 MW, maintaining its status as the largest buyer of wind power in Texas. TXU will also promote solar power through solar/photovoltaic rebates. The company also intends to join the FutureGen Alliance, the U.S. Department of Energy project intended to create the world's first near-zero-emissions fossil-fuel power plant.
Two of the three reorganized businesses of TXU will get new names. Generation will be called Luminant Energy. Transmission and distribution will be called Oncor Electric Delivery, and retail will retain the name TXU Energy. Separation of its wires business is something TXU has considered, and there is a bill pending in the Texas Legislature that would do the same (see Power Market Today, Feb. 9). Merrill Lynch said TXU's new owners likely would not own the company's "delivery" operation long term. "[W]e could imagine some accommodation being reached where they committed [to the Public Utility Commission of Texas] to sell within a given time frame," Merrill Lynch said.
Merrill Lynch said the buyout had positive implications for the shares of other "merchant-exposed" companies, such as NRG Energy, Exelon, Edison International, FirstEnergy Corp. and PPL Corp. "We would also mention D [Dominion Resources Inc.], which is pursuing the sale of its E&P business and will then become proportionally more merchant-exposed as the largest generation owner in the attractive New England market." Also mentioned by Merrill Lynch: Mirant Corp., Dynegy Inc., Reliant, Entergy Corp., Constellation Energy Group Inc. and FPL Group Inc.
The funding of the transaction will not result in new debt incurred at the regulated utility business. TXU may solicit alternative proposals through April 16. TXU, KKR, TPG and the rest of the investor group expect to close the transaction in the second half of 2007, subject to receipt of shareholder approval and required federal regulatory approvals, as well as satisfaction of other customary closing conditions. There is no financing contingency to the transaction.
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