What Passes for Logic in Utility Finance

Lynne Kiesling

NRG is purchasing Texas Genco, a generator largely serving Texas markets:

Houston-based Texas Genco is owned in equal parts by affiliates of the Blackstone Group, Hellman & Friedman LLC, Kohlberg Kravis Roberts & Co L.P. and Texas Pacific Group.

Texas Genco has a portfolio with more than 13,000 megawatts of generation capacity. It owns and operates 11 power stations, selling power to wholesale purchasers in Texas’ largest power market, the Electric Reliability Council of Texas.

So what? Seems like a normal transaction. But listen to the back story from this WSJ article on the transaction (subscription required):

The deal also gives the private investors, Texas Pacific Group, Blackstone Group LP, Kohlberg Kravis Roberts & Co. and Hellman & Friedman LLC, a profit of about six times their original investment of nearly $900 million, including the value of the investors’ new 25% stake in NRG. But the rich price could raise criticism among power customers in Texas, who may soon pay higher bills because the assets once were initially valued by state regulators at far less.

Huh? I had to read this through a couple of times, and not because the article is poorly written, because it’s not. When the private investors bought the power plants (mostly coal and nuclear) from CenterPoint Energy, the distribution/wires company serving the Houston area, these assets were worth less (April 2004). Why? Because then, as now, demand for electric power in most hours is high enough that the market-clearing price is determined by the marginal cost of running a natural gas-fired unit. Since then, the price of natural gas has doubled, and that increased input cost gets reflected in the market-clearing price in most hours. It also looks like natural gas prices are going to stay this high for several years. That means that if you own plants fueled by other stuff, like coal or nuclear, if you can sell in those hours you can earn that price. The technical way of saying it is that the inframarginal suppliers earn the market-clearing price determined by the marginal unit in a uniform-price market.

And you know what? In most markets where there are different technologies with different production costs, this is common. Furthermore, in normal transactions if the seller makes a bad deal it’s their shareholders who take the hit, and as shareholders they are in the right position to discipline them before the transaction occurs. But when the production assets are part of the political negotiation to move away from regulation, then there is a mismatch between principal and agent, and it causes friction:

But customers of CenterPoint Energy Inc., the Houston utility that originally sold the power plants, are slated to pay more than $2 billion to make up the difference between what state regulators last year said the generating assets and generation-related contracts were worth and the higher book value carried by CenterPoint.

Consumer groups may now ask how those assets could have appreciated so much in so little time. It’s due in part to the run-up in natural-gas prices. About half the assets being purchased consist of nuclear and coal-fired power plants, which have low operating costs but can sell electricity at the sky-high prices commanded by gas-fired plants, because Texas allows power to be sold at the price commanded by the most expensive source.

At the time the assets were valued, consumer groups said CenterPoint lacked motivation to get the highest price. State utility regulators said last year that the utility hadn’t run the plants to maximize their value, such as by hedging fuel costs and selling power under long-term contracts. The interim private-equity owners enhanced the value by entering into long-term arrangements. They also mothballed money-losing plants.

Critics said that CenterPoint had lacked the motivation to do likewise because it wasn’t allowed to keep any sales profits in excess of book value, under the terms of the state’s utility deregulation law from 1999. Since CenterPoint sold the plants for less than book value, customers are required to make up the difference through so called “stranded-cost” payments that will last 10 years.

CenterPoint also had no incentive to get a selling price greater than book, because they knew the could make up the difference as a “stranded cost”. Yet another instance where having that “stranded cost” net underneath your financial highwire creates perverse incentives.

Stories like this just make my head spin.


6 thoughts on “What Passes for Logic in Utility Finance

  1. I agree with everything but the implications of your title. It isn’t utility finance that is the problem here, it is rather the flawed logic of regulators in setting up this disastrous stranded-cost mechanism. As you’ve explained here, all of the purchases and sales made sense, given the governing rules. Of course, the writer of the article was a bit confused as well.

  2. Yep, I think you are right. And reading Smith’s two articles in today’s WSJ, I think she just has something stuck in her craw about the Texas model. Her article about Exelon was pretty good, but her article about Reliant has thinly-disguised invective about the fuel cost pass-through in Texas.

  3. Another oddity about the article is this sentence: “But the rich price could raise criticism among power customers in Texas, who may soon pay higher bills because the assets once were initially valued by state regulators at far less.” The sentence implies that Texas Genco is charging less than the profit maximizing price simply because it paid less for the plants than NRG is paying. Somehow I don’t see a firm controlled by KKR and company leaving money on the table.

  4. I find it interesting that state regulators placed themselves in the position of valuing generation assets, particularly valuing them below their depreciated ratebase value.

    One of the restrictive aspects of the utility regulatory model is the requirement that the “value” of a utility asset is the depreciated book value reflected in the ratebase. The depreciated book value of its assets is the utility’s ratebase; and, thus, the basis for its regulated allowable rate of return. This is true even if the regulators, in their infinite wisdom, believe that the value of the asset is less than the book value. It is also the case if the market values the asset above its book value, as long as the asset is owned and used by the utility.

    Once the asset is removed from the utility’s ratebase, its market value need not bear any fixed relationship to its previous depreciated book value in the utility’s ratebase. This situation demonstrates clearly that not all of the stranded costs booked by utilities which have sold generation assets were the result of the “fact” that the assets were stranded. Only in a regulated utility environment is it a “given” that a fully depreciated asset has no earning power.

  5. I find it interesting that state regulators placed themselves in the position of valuing generation assets, particularly valuing them below their depreciated ratebase value.

    One of the restrictive aspects of the utility regulatory model is the requirement that the “value” of a utility asset is the depreciated book value reflected in the ratebase. The depreciated book value of its assets is the utility’s ratebase; and, thus, the basis for its regulated allowable rate of return. This is true even if the regulators, in their infinite wisdom, believe that the value of the asset is less than the book value. It is also the case if the market values the asset above its book value, as long as the asset is owned and used by the utility.

    Once the asset is removed from the utility’s ratebase, its market value need not bear any fixed relationship to its previous depreciated book value in the utility’s ratebase. This situation demonstrates clearly that not all of the stranded costs booked by utilities which have sold generation assets were the result of the “fact” that the assets were stranded. Only in a regulated utility environment is it a “given” that a fully depreciated asset has no earning power.

  6. You’re right, Ed. One thing that many people don’t think about is that the book value of an asset is essentally the net present value of revenue requirements minus taxes for the remainder of the plant life. The future revenue requirement stream, however, declines over time even in nominal terms. And as a regulated asset, that is all that the plant can and will recover. [Neglect continuing capital investments] However, in a market, especially one where prices are driven by modern-day gas prices, the same asset can possibly achieve a revenue stream that increases over time. Even if the asset is almost completely depreciated away, it may have 5-10 years of market-based revenues before it is rendered obsolete by increasing environmental restrictions. In short, there is (and always was) little reason to expect the market value of a plant to relate to historical book value. But if you think about it, if customers of the utility have paid down this asset to zero book value, then the premium to book should belong to them. That is, the premium should be used to reduce the revenue requirements [or stranded cost, if you will] of the selling utility. Texas regulators should realize now that they gave that value away.

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