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NRG's bankruptcy is challenging creditors' resolve to back merchants until power prices rebound.
Fortnightly Magazine - June 15 2003

current environment and how earnings and thus valuations are being crushed.

"NRG Energy evaluates property, plant, and equipment and intangible assets for impairment whenever indicators of impairment exist. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of the assets to the future net cash flows expected to be generated by the asset, through considering project specific assumptions for long-term power pool prices, escalated future project operating costs, and expected plant operations.

"As of Dec. 31, 2002, net income from continuing operations was reduced by $2.5 billion due to impairments recorded in 2002. Asset impairment evaluations are, by nature highly subjective."

Ironically, NRG highlights how subjective asset impairment valuations are, but arguably it is those highly subjective valuations that are keeping some merchants in business. Certainly there is nothing subjective about the fact that NRG Energy's Eastern region revenues decreased by approximately 20.9 percent.

"The Eastern region revenues were significantly affected by a combination of lower capacity revenues and a decline in megawatt-hour generation compared with 2001. This decline in generation is attributable to an unseasonably warm winter and cooler spring and a slowing economy which reduced demand for electricity, together with new regulation which reduced price volatility, particularly in New York City," NRG says in its annual report.

Furthermore, the cost of fuel burned a hole into NRG's margins. "As a percent of revenue from majority owned operations, cost of energy was 44.3 percent and 43 percent for the years ended Dec. 31, 2001 and 2000, respectively. Approximately 69.3 percent of the increase in operating costs and expenses for 2001 compared to 2000 of $369.9 million is primarily due to increased cost of energy," the company says.

Meanwhile, the speculation over the fate of the merchant sector had people at the Infocast conference speculating whether the merchant experiment can be regarded as a failure. William D. Rockford, president and COO at Private Power LLC, said the merchant experiment did not fail. "If you have 70 percent of the market regulated, it's hard to be the merchant. Merchant generation was built with the expectation that more generation would come out of the rate base."

But a utility executive at the conference said large reserve margins established by the merchant sector is its contribution, even if, as another pointed out, retail customers have not benefited from the drop in wholesale prices.

Moreover, the merchant model didn't work because they didn't have people paying the capacity costs, said James E. Rogers, CEO, Cinergy Corp. "The lesson from California is that regulators are not going to allow you to recover capacity costs on the margin," he said. "[If] push comes to shove and prices come up, regulators will demand a lower market or lower cost," Rogers said.

Many will say that hindsight is 20/20. Whatever the reasons for the current merchant predicament, merchants' best options are either to be brought into the rate base by a utility, bought by a merchant bank like Goldman, Sachs or Morgan Stanley, or emerge from bankruptcy as a recapitalized, leaner-and-meaner IPP,