USGEN IS THE NATURAL CANDIDATE TO PURCHASE NEES' generation assets. We have a well-established commitment to the region; we have strong power plant operating experience; and we have been a leader in promoting competition and customer choice in gas and electric industries."

(em USGen President and CEO Joseph P. Kearney

In August 1997, U.S. Generating Co., an affiliate of PG&E Corp., successfully bid $1.59 billion in a competitive auction for all of New England Electric System's non-nuclear generating business (18 power plants, plus power purchase contracts and other assets). The transaction marked the first major sale of electric generating assets in preparation for U.S. deregulation; following close behind came the sale of three PG&E plants for $501 million and 10 Southern California Edison plants for $1.12 billion. More will follow, as states encourage utilities to divest their generating assets to prepare for competition.

One detail merits a closer look: USGen's bid price offered a substantial premium over book value, listed by NEES at $1.1 billion. Many observers blamed USGen's apparent high bid price on its over-eagerness to position itself early in a market that is rapidly growing competitive. This explanation appears short-sighted, however. It assumes that PG&E stockholders are indifferent to how the company invests its dollars or whether it receives an adequate return. It fails to explain the value that comes from being the "first mover" in a market.

Instead, assume USGen's bid reflected sound financial analysis (em that it recognized how the assets will contribute to positive cash flows. The challenge then is to grasp how a company like USGen can boost the apparent value of the NEES assets by combining them with its own operations. Commodity-producing assets, in this case, should not be viewed on a stand-alone basis. Instead, identify how the NEES assets, as operated by USGen, will now fit within a strategy for minimizing risk and maximizing value for an entire integrated portfolio of assets.

The Regional Market: Assumptions and Variables

As a regional power market, New England tends to be isolated and high-priced. At approximately 10.2 cents per kilowatt-hour, New England's electric power rates are 44 percent greater than the national retail average. Three reasons stand out for the region's high rates: high capacity costs, a high-cost fuel mix and transmission constraints. However, these transmission constraints likely enhance the value of the NEES production assets.

About a quarter of the region's estimated 27,195 megawatts of capacity comes from nuclear plants; some 3,600 MW of this capacity is more than 20 years old. Many of these plants have either been closed or are undergoing lengthy maintenance, including Connecticut Yankee and Millstone, making supply uncertain.

The region has limited tie capability to adjacent power systems. Major interties include lines to Quebec, New York, and New Brunswick, Canada. These ties are fully subscribed under existing power purchase agreements. Significantly, there is no direct tie to the Pennsylvania-New Jersey-Maryland power pool. This weakness (plus the limited extent of ties through New York) severely constrains imports of low-cost power from the Midwest.

Attracted by deregulation and the region's high capacity costs, an estimated 3,600 MW of new merchant power plant capacity may enter the market (see Table 1). These plants will compete in wholesale spot markets and will be financed without long-term contracts.

Meanwhile, certain NEES production assets are strategically located in key load centers. For example, Salem Harbor units serve eastern Massachusetts, which at times is a transmission-constrained area. Also, the availability of NEES hydroelectric assets along the Connecticut River and Bear Swamp pump storage provide important system support and operating reserve capacity during contingencies, an ancillary benefit that a buyer of the assets would gain.

In fact, after Northeast Utilities, NEES is the region's second-largest utility, serving 1.3 million customers. With 4,000 MW of generating capacity and contracts to receive another 1,100 MW, NEES provides 20 percent of the region's electric generating capacity. Note the fuel diversity of the NEES plants. Table 2 shows the non-nuclear generating resources NEES offered for sale.

As the buyer of the physical assets auctioned by NEES, USGen also assumes the utility's contractual entitlements to approximately 1,100 MW of generating capacity under 23 multi-year power purchase agreements. To compensate USGen for the above-market portion of these contracts, New England Power Co. agreed to pay USGen approximately $150 million to 170 million annually over 10 years. These payments may offset some of the $1.59-billion purchase price, if USGen can reduce the differential between the contract prices and the competitive market price.

Then comes deregulation. The pace and direction of New England's electric restructuring certainly marked an important variable in any potential valuation of the NEES assets.

On that score, the CEO of PG&E noted that the success of the venture would depend in part on deregulation of the local electric industry, so that USGen could sell its power to utilities and other buyers. In Massachusetts, at least, legislation was passed in November to open the state's retail market by March 1, 1998. But what about progress in the other states? To address that uncertainty, the parties structured the sale to make the full price contingent on whether customer choice was in place. PG&E is not required to pay $225 million of the purchase price until choice is broadly available in New England. The rebate will decline on a prorated schedule if retail choice is implemented by Jan. 1, 1999.

Of course, deregulation in neighboring states raises the prospect of more plant sales by other utilities that sell power into the New England power pool. For example, as shown in Table 3, of the large New England utilities, Boston Edison, Central Maine Power, Commonwealth Electric, Consolidated Edison, and Northeast Utilities have announced asset sale programs.

Asset Value: The Plant as Commodity Producer

Most bidders of the NEES assets probably began their valuation analysis from the same point: They developed a model to estimate future cash flows for the asset and then discounted this figure by an appropriate cost of capital. Among the key parameters examined are plant capacity factors, new capital investment requirements, wholesale market-clearing prices, transmission constraints, and the discount rate, which is based on the effective weighted-average cost of capital.

This analysis yields wholesale bulk power prices ranging from 3 cents to 4 cents per kilowatt-hour, with a nominal escalation factor. Capacity values are estimated to begin in 2003 at $15 kW and increase to $50 kW by 2011, if the New England power exchange should put in place equivalent capacity payments for infrastructure, such as spinning reserves and voltage support.

Under the standard discounted cash-flow analysis, the value of the assets runs between $800-$900 million, about 77 percent of the $1.1 billion book value and 53 percent of the $1.59 billion sale price. On a stand-alone financial basis, that approximates the worth of the assets as "commodity producers." But can the assets create additional value? Can a strategic buyer leverage the value of individual assets beyond their discounted future cash flows? Here, however, the ability of any individual bidder to create greater value from the NEES assets will depend on the bidder's mix of tangible and intangible resources and capabilities. In this case, that prospect will depend upon the specific resources and capabilities of USGen, and how it might integrate these with the NEES assets.

Operational Value: Labor and Productivity

As an affiliate of PG&E, one of the largest investor-owned utilities in the country, USGen maintains ownership, management or operational interest in 17 generating plants, accounting for nearly 3,400 MW and represent a capital investment of more than $5 billion. This portfolio includes six operating electric generation facilities in the Northeast with an installed capacity of 1,400 MW, most of which is committed to several utilities under long-term contracts. Three of these plants lie in Massachusetts and Rhode Island, and produce about 4 percent of the region's electricity. Consequently, the company has both knowledge of the regional market and existing capacity on which to build.

This track record (em a reputation for operating "lean and mean" (em suggests that USGen can probably create additional operating savings from the NEES assets. According to the Wall Street Journal, before the sale NEES expected to cut 700 to 800 employees from a work force of 4,900. To be conservative, if USGen can eliminate 600 positions, at an average annual salary of $50,000, it can save $30 million per year over 20 years, for a net present value (10-percent discount rate) of about $255 million. This figure should be adjusted by the $85 million USGen is required to pay NEES beyond purchase price for retraining and early retirement.

With increased labor productivity as but one source of value enhancement, we estimate that USGen can increase the net present value of NEES' non-nuclear assets by at least $125 million to $175 million above the baseline estimate.

Options Value:

Merchant Plant Experience

USGen has considerable experience developing new power generation facilities that sell electricity competitively.

As shown in Table 1, of the 3,600 MW of merchant capacity planned for New England, USGen is responsible for about 1,500 MW, or more than 40 percent. The company is developing new facilities in Albany, N.Y., (1,080 MW) and Charlton, Mass., (400 MW).

USGen's merchant-plant experience and capability, especially in the New England region, give it important insight into how the wholesale and retail markets will evolve. The company's ability to defer capital investment suggests the decision of when to build is associated with an options value. Because it enables USGen to reduce risk (uncertainties about the future market conditions) at low cost, the value is positive and probably significant.

While difficult to quantify the full potential of USGen's merchant capability and the options value of future plants, we nonetheless estimate an additional $150 million to $200 million as the potential value above the baseline estimate.

Retail marketing will prove critical. With its existing generating assets and its potential merchant capacity in the region, USGen can be expected to offer attractive terms to new power customers. New, lower-cost capacity can leverage the value of contracts and customer relationships tied to existing NEES generating assets. We conservatively estimate that USGen will enter new contracts with a net present value of $175 million to $225 million.

Portfolio Value:

Integrating Fuel, Power and Risk

The ability to manage fuel and power supply risks simultaneously will be the linchpin to operating in a competitive power market. Key requirements are commodity procurement, management and trading skills. In addition, access to gas supply, the future marginal fuel, and gas transportation services will figure prominently. PG&E Energy Trading and USGen's Natural Gas Services operations cover all these areas. USGen manages approximately 935 million cubic feet of Canadian natural gas imports per day, has an ownership interest in Iroquois Gas Pipeline, a major northeast interstate pipeline, and is a lead sponsor of a new gas storage facility under construction in New York. Before the sale, PG&E was already one of the largest importers of natural gas into New England.

Combining NEES' 18 generating plants and power contracts representing about 5,000 MW with PG&E/USGen's existing assets and trading capabilities can provide three important benefits:

PORTFOLIO SIZE. By managing an aggregate 9,000 MW, PG&E will become the fifth largest natural gas trader and the 14th largest electricity trader in the U.S. With 20 percent of the generating capacity in the region, the new combined entity will have much greater trading opportunities;

PORTFOLIO FUEL MIX. The fuel diversity of the NEES assets (em coal, gas, oil and hydro (em can provide an important hedge against price volatility in any one fuel. In addition, USGen is protected on the downside of the power purchase contracts it assumed because of the New England Power's payment for the above-market value of these contracts; and

FUEL STABILITY/POWER TRADING. The increased assurance of stable fuel supplies provided by USGen's natural gas pipeline and energy trading capabilities significantly increases the company's ability to minimize market risks and take advantage of arbitrage opportunities.

Stable fuel supply, diversified electric generating portfolio and experienced energy trading operations provide a solid foundation for operating in the deregulated New England power market. Several ancillary benefits may flow to USGen/PG&E's operations as well, such as increased gas sales. We conservatively estimate that these capabilities have the potential to enhance the value of the NEES assets about $125 million to $150 million on a net present value basis.

Closing the Deal

Taken separately, none of the capabilities identified are sufficient to raise the NEES asset values above the base-case estimates significantly. Because of their unpredictable nature in a competitive marketplace, fuel and power supply prices represent key risks to manage. Consequentially, trading instruments and institutions like integrated companies will be important in managing risks and providing information on future prices of real commodities. In a competitive market, owning generation assets is also an important form of risk management for maintaining customer value.

So how did USGen/PG&E arrive at $1.59 billion? The potential sources of value enhancements discussed above are summarized in Table 4. The estimates represent the most significant sources of value enhancement. Not included in the table are several other potential ancillary sources of value. For example, it is difficult to assign a dollar value to increases in gas sales, repowering of plants and taking advantage of transmission constraints and plant siting. PG&E's financial engineering capabilities and cash position may also allow the company to decrease its weighted average cost of capital and so increase the value of the NEES assets as an addition to its portfolio. At the end of the day, the only test whether PG&E overpaid or underpaid will be the market test: Is it successful in efficiently meeting consumer demand and thus raising the value of shareholder equity?

David Haarmeyer is an executive consultant at Stone & Webster Management Consultants Inc., a subsidiary of Stone & Webster Inc., a full-service engineering, construction and consulting company. Robert T. McWhinney Jr., president and CEO, has provided clients in the U.S., Asia, Eastern Europe, and Latin American with advice on corporate and industry restructuring. Ronald Moe is a vice president and specializes in providing utility clients quantitative analysis of competitive power markets.

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