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

NRG's bankruptcy is challenging creditors' resolve to back merchants until power prices rebound.

A common complaint in the last few months by would-be buyers of merchant assets has been that all the choice power plants have been pledged as collateral to commercial banks in order to stave off bankruptcy. That's why not many transactions have taken place, merchant asset buyers say, as everything else in the market isn't worth the price being offered.

In fact, it has been commercial bankers' willingness to religiously believe power prices will rebound that has saved the merchant industry from total collapse. But that blind faith is now starting to be shaken. Some say billions in assets could hit the block this summer as bankers panic and call in merchant loans. Why?

At Infocast's 10th Annual Power Industry Forum (in association with King & Spalding), Goldman, Sachs & Co. Managing Director Larry Kellerman explained that many commercial bankers have not been able to quantify their losses because few of the more valuable assets have been bought and sold to establish a benchmark. Lenders can't foresee how much they will gain or lose on loans

Kellerman says, "Once the first merchant combined-cycle [turbine] is marked down, banks' reserves drop. They [the banks] are exposed to the merchant industry for $80 [billion] to $90 billion in loans to the merchant sector. If they get two-thirds of that, great; if they get 50 percent of that, they jump off bridges."

The bankruptcy announcement of merchant power developer NRG Energy Inc. has many wondering whether this is the first domino in the stack. While NRG in its March 2003 annual report suggested it wants reorganization, some say liquidation is just as likely, and assets are almost assuredly going to sell at marked-down prices.

"[Commercial] banks have to get into the reality business. They believe that despite forward curves in 2008 life gets a lot better. That's the religion business. Once banks reconcile that prices aren't there … they'll see that their religion won't disintermediate them," Kellerman says.

Kellerman believes it could take a few summers for bankers to come around to reality. Meanwhile, the NRG bankruptcy continues to splash cold water on lenders' expectations.

Power Plants: Like the Real Estate Market?

Bernays T. (Buz) Barclay, a partner in the law firm of King & Spalding, said at the Infocast conference that he did not believe commercial bankers would panic if assets more actively began to change hands. Having been a commercial banker, he believes bankers will look at assets with an eye to their individual, economic, and location-specific attributes.

Naturally, the real-estate approach doesn't deny that housing busts happen, experts say. Those who get squeezed in a housing bust are simply those who can no longer afford to keep paying their mortgages and so lose their homes to the bank. The question in the merchant sector is whether merchants will be able to make their principal and interest payments on corporate debt. NRG, in its annual report, provides a view on the trials and tribulations of being a merchant in this 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, said one.

But for the first time in history, the decision may not be up to the regulators, politicians, or even the utilities. Instead, bank examiners may decide the survival of the merchant sector this summer. Perhaps that is as it should be, given how blindly the banks loaned out billions to the merchants.

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