Sunday, June 24, 2007
Editor's note: This story is the first in a three-part series examining the possible impact of the proposed TXU buyout.Electricity customers won't gain if TXU Corp. sells itself to private equity investors, and they could eventually see higher bills, according to an independent study commissioned by The Dallas Morning News.
All those promises that investors Kohlberg Kravis Roberts & Co. and TPG touted as benefits to customers – cutting prices until 2008, shelving plans to build polluting coal plants – would have been offered by the old TXU anyhow, the report concludes.
The lead author of the report, energy strategist Roger W. Gale, says unless the Public Utility Commission requires more long-term customer protections as part of the $45 billion buyout deal, the electricity supply could become tight, prices could eventually rise, and employee benefits may shrink.
TXU disputes the idea that the PUC could, or even should, require concessions for a company to change hands in a deregulated industry.
Mike McCall, head of TXU Wholesale, said in an e-mail to Mr. Gale that such action would "undermine the fundamental competitive market design."
But Mr. Gale, long a proponent of competition, counters that deregulation of the wholesale and retail electricity markets doesn't necessarily breed competition. An electric utility is a "vital public asset," necessary for healthy, prosperous human life.
"Customers have expectations and rights which include reasonable and explicable prices, reliability and sufficient control of the regulatory process, especially for the delivery business, which remains a monopoly," states the report prepared by Mr. Gale's company, GF Energy LLC of Washington, D.C.
The report highlights a fundamental debate in utility circles these days: How can regulators ensure benefits to customers in a deregulated market, which relies on competition to improve customers' lot?
And can private equity investors ever convince consumers that they'll benefit if out-of-state investors take on massive debt to buy a utility, and then sell it at a profit?
No net benefit
"Our conclusion is that the buyout of TXU provides no inherent benefits to the customer. All of the commitments being made by the buyers could be offered by TXU today – if it had the incentive to do so."
Mr. Gale concluded that the PUC should require investors to make bigger commitments to consumer welfare and create a "net benefit" for customers before allowing the buyout to proceed. "Net benefit" is the standard that regulators in some other states use to decide whether to allow a utility to change hands. Showing that customers aren't harmed isn't enough, according to the report.
Mr. McCall wrote in the e-mail to Mr. Gale – whose consulting firm has over 20 years of experience in the energy industry, working for six of the 10 biggest global electricity companies – that the old-fashioned standard no longer works in Texas.
"The assertion that customers will not benefit from the transaction seems to be based on a regulated market paradigm and a narrow definition of 'benefit,' " Mr. McCall wrote after reading the report.
On Monday, The News gave a copy of the report to TXU and the buyers, as well as the PUC, Jim Marston of Environmental Defense, and two state legislators who have worked on electricity issues, Sen. Troy Fraser, R-Horseshoe Bay, and Rep. Phil King, R-Weatherford. Reporters asked each to comment on the conclusions.
The buyers, who created a holding company called Texas Energy Future Holdings, responded in an e-mail that no one can doubt customers benefit from the promises the buyers have made.
"The report commissioned by the publisher of the Dallas Morning News, when read in its entirety, endorses our planned changes and the benefits customers can expect from the New TXU," the e-mail states.
Still, analysts have said for some time that adding billions of dollars in debt to a utility could, eventually, lead to higher prices.
And the buyers' promise to stop plans to build eight of the 11 traditional coal-fired power plants, without replacing them with newer, cleaner technology, could throttle Texas' power supply and cause prices to rise.
"It wasn't pure altruism" to shelve the plants, said Phil Adams, an analyst with independent bond research firm Gimme Credit.
"The buyers are offering the customer what TXU may have been forced to offer by regulators due to concerns over market manipulation and global warming or compelled to offer by the business imperative of stemming customer attrition and repairing reputation. Therefore, there is no net gain for the customer as the deal is currently described."
When the buyers announced in February their offer for TXU, they made a slew of promises meant to please the public and gain regulatory approval of the deal. Since that time, the buyout group has represented itself as a beneficent investor ready to shield the public from the old, dirty, greedy TXU.
"We have listened to the various TXU constituencies, including customers, ... members of the Texas Legislature and those expressing environmental concerns. As a result, we have developed a new vision with management of how we can turn TXU into a more innovative, customer-centric, environmentally friendly company,"Henry Kravis said in a prepared statement on the day TXU announced the deal.
The buyers promised to eliminate eight out of 11 proposed coal-fired power plants and to cut electricity rates by 15 percent for about 1 million North Texas customers.
With the proposed rate-cut, TXU's standard rate would drop to 12.75 cents per kilowatt hour, from 15 cents.
But TXU was already lowering rates before the buyers came along, just to keep customers. In the first quarter, the company lost 6.4 percent of its retail customers compared with the year-earlier quarter.
And 12.75 cents still isn't the lowest rate going.
Then, there's the wholesale market. TXU owns nine coal and two nuclear plants that produce cheap power. TXU can sell that power on the wholesale market, which tends to follow higher natural gas prices, and enjoy a fat margin while Texans pay more for electricity than the average American.
All told, TXU Corp.'s profit margin last year hit 24 percent, up from 16 percent in 2005.
Ehud Ronn, a finance professor at the University of Texas at Austin, said he worries that the buyout could boost electricity bills because of market forces.
Texas doesn't have enough power plants to handle growth, and there aren't enough companies vying to build plants here, he said.
"My concern is that prices will be pushed higher because of the twin effects of lack of competition and lack of sufficient generation capacity," said Dr. Ronn, who's also the director for the university's Center for Energy Finance Education and Research.
Utility experts have long debated whether Texas' deregulated wholesale and retail markets are competitive enough. Some say the fact that so many consumers have switched to new electricity companies proves competition is working. As of March, 38 percent of Texans in deregulated areas had switched to competitive providers, according to PUC data.
But some observers give the wholesale market lower marks. In some regions of the state, the former monopolies still dominate. TXU generates about 45 percent of the power used in North Texas. And TXU stands accused by PUC staff of manipulating the market, though the company denies any wrongdoing. The commission hasn't decided the case yet.
Mr. McCall pointed out in his e-mail that regulators aren't technically supposed to intervene in the deregulated wholesale market.
And, he said, "no single generator is responsible for ensuring reliability of supply," a turnaround from his position last year that TXU should build 11 coal-fired plants to keep the lights on in Texas.
"The buyer commitment to terminate eight of the 11 planned TXU coal-fired plants was the public relations angle used to launch the buyout."
A couple of days before TXU even announced the buyout, the investors began touting to the news media an unusual agreement they'd made with some national environmental groups. In exchange for endorsing the buyout, the investors would shelve plans to build eight new coal-fired power plants.
TXU had wanted to build 11 coal plants but ran into fierce opposition from environmental groups, politicians and business leaders, all worried about the toll pollution would take on Texans' health and the state's ability to meet federal clean air standards.
By the time the buyers came along, it was becoming increasingly clear that TXU wouldn't build all those plants. The prospect of more relatively dirty coal plants had begun to tarnish the company's image. Regulators had slowed down the permitting process for the plants.
Plus there were financial considerations.
According to the preliminary proxy TXU filed this month with the Securities Exchange Commission, one of TXU's financial advisers told the board that building only five plants would result in a higher value for the company than building either all of the plants or none of the plants.
TXU couldn't explain how the adviser came to those conclusions.
The proxy doesn't include an assessment for building only three plants, and the buyers declined to say whether they assessed the financial impact of shrinking the coal plan before making the three-plant promise.
"There is reason to believe that TXU's high retail customer electricity prices, alleged price manipulation, poor handling of its proposed coal projects, negative environmental positions, flagging reputation, retail customer attrition and apparent CEO excesses would have forced the company to offer most of the same 'concessions' as the buyers are touting."
On the day of the buyout announcement, Feb. 26, TXU chief executive John Wilder told analysts on a conference call that he was already considering doing a number of things the buyers had committed to, such as slashing his plan to build 11 coal-fired plants.
When a Wall Street analyst asked Mr. Wilder whether he would have split the company into three companies – generation, retail and power line – without the buyout, Mr. Wilder said yes.
"We were certainly heading in the direction operationally to separate these businesses because we think they are very different. They have different customer needs, and they have different strategies that they need to win over the long term," Mr. Wilder said, explaining that private investors can act more aggressively to split operations.
"Eight of the eleven coal plants were ultimately scrapped as part of the buyout package, although the public, the regulators, and several environmental groups had practically assured their suspension."
The private equity investors' environmental deal threw some local advocacy groups into a conundrum: optimistically support the buyout and settle for little gain, or complain about the deal and risk getting stuck with the old TXU if the buyers walk.
Founders of Texas Business for Clean Air, a group that formed late last year to oppose TXU coal-plant pollution, say they're neutral on who owns TXU. They just want cleaner air. And on that point, they say, customers benefit from the buyout.
"We can be optimistic about some of the things they promised. We are, because those will be better things than, frankly, doing nothing," said Garrett Boone, a founder of the group and of the Container Store.
Other environmental and consumer advocates have said they're very suspicious of the buyers' intentions, and called on regulators and lawmakers to block the deal.
"On the whole, it appears that the acquirers have done their homework in establishing commitments upfront that were similar to those ultimately demanded in other private buyouts of utilities. The remaining challenge will be for the PUCT to monitor and enforce those commitments."
Some other proposed private equity takeovers of electric companies have crashed because of public reactions. Two of those involved the same main actors in the TXU buyout.
In 2003, TPG tried to buy Portland General Electric, a big power company that serves 750,000 retail customers in Oregon. PGE was a leftover from the Enron debacle.
The Oregon Public Utility Commission killed the $2.35 billion deal. For a utility to change hands in that state, the transaction must be shown to yield an actual benefit to the public, not just do it no harm. The Oregon commission said the public would be better off with a utility "as a separate, stand-alone company" than as part of a private equity company not committed to long-term ownership.
A deal announced just six days after the TPG-Enron proposal also went aground on similar shoals. Kohlberg Kravis Roberts said it planned to acquire UniSource, with about 550,000 electric customers in Arizona, for $3 billion.
Again, state regulators said no, contending that the public risks, including high debt loads, outweighed any benefits. Mostly, the Arizona Corporation Commission said, the benefits would accrue to the investors.
There have been some successful utility deals in which state regulators found clear public benefits. One was the takeover in 2006 of PacificCorp by MidAmerican, a holding company that is part of Berkshire Hathaway, Warren Buffett's firm. That deal, worth $9.4 billion, involved 1.6 million customers in six Western states.
Despite its complexity and the myriad state agencies, interveners and other parties, the deal went through, in large part because MidAmerican emphasized its dedication to long-term investment and because the states secured scores of special commitments from the investors.
"The public interest test applicable to this transaction based on Texas precedent is that there needs to be net benefit to the customer. In short, if the buyers are winners, customers need to be winners, too."
In Texas, utility law says a major merger or buyout has to be reported to the PUC, which then decides whether the deal is "consistent with the public interest." The law specifies a few things the PUC must check, but it doesn't define what "the public interest" means.
Even if the agency decides a deal isn't in the public interest, it has no explicit power to block the transaction. Regulators technically have authority only over the regulated power-line industry.
All the PUC can do is forbid the company to pass along certain costs to customers in the regulated rates for the use of power lines – a small portion of customers' bills. Such action by the PUC limits the profit a company makes from delivering electricity, a key factor in utility economics.
The PUC set the stage for such an action in March, when it initiated a rate case based on "excess revenues" earned by TXU's power line company, Oncor. Last year, the same allegedly excess revenues weren't enough to make the PUC move against TXU. This year was different: The proposed buyout made it "advantageous" for the state to open a review of delivery rates, the agency staff wrote.
The buyers have pledged not to include costs associated with the buyout transaction in the rate cases. They also promised that if the cost of Oncor's capital increases, through higher interest rates, the buyers won't include such costs in rate cases this year or next.
A half-dozen other parties, from big industrial power customers to the electric workers union, have intervened so they can protect their interests in the rate case. Oncor, formerly known as TXU Electric Delivery, is under a PUC order to file papers related to its delivery rates by Aug. 28.
One group is on TXU's side when it comes to regulators blocking the buyout. Texas Business for Clean Air won't take sides on whether the buyout is a good idea or not, but "because we're in a deregulated environment, we felt the PUC shouldn't have the power to kill a deal," said Mr. Boone, one of the group's founders.
"With a legislature that seems to have stalled in creating the laws that would have tuned-up deregulation and provided further protection against global warming, against high rates and against market power abuses, Texas customers must now rely upon the good faith of the buyers, a belief in market forces, and the ability of the PUCT to monitor and enforce existing laws."
With the public reaction to the TXU buyout in mind, Texas legislators talked a lot during the recent session about boosting state oversight of power company deals. They also considered restricting the way companies may operate in deregulated markets. Months of careful lobbying by TXU and the buyers resulted in no big changes. Mr. Fraser filed bills designed to give the PUC greater authority to review utility takeovers, along with other bills designed to promote competition in the deregulated markets.
"The issues addressed in the GF Energy report on the proposed buyout are the same as those raised by the Senate. This legislation would have given the state the essential tools to ensure this transaction is in the public interest," Mr. Fraser said in an e-mail.
That legislation passed the Senate but died in conference committee, leaving the PUC, which regulates the state's electric and telecommunications industries, in the same spot it was before the session: with broad responsibility but fuzzy authority for protecting the public interest in utility mergers.
"Based on what has happened in other states when a commission opposes a merger, even without explicit merger approve-reject authority, the PUCT could kill the acquisition if it chose to do so by imposing unacceptable rate reductions, market power requirements, and through the power of delay. GF Energy's discussions with Commission staff suggest the staff believes that, lacking explicit authority to kill the acquisition, it has the power to impose tough public interest requirements and the ability to initiate a stakeholder engagement process."
The agency, headed by three full-time commissioners appointed by the governor, has indirect ways of putting its stamp on electric buyouts, but it lacks a firm mandate to do so. The PUC's ability to set conditions for the TXU deal, above those the buyers have offered, is untested.
Two modest rule-making proposals by the PUC staff to facilitate merger investigations haven't gone before the commissioners for action, PUC spokesman Terry Hadley said.
The PUC declined to comment on the consultant's report because topics that it addresses are also likely to come up in ongoing regulatory cases now before the commission, Mr. Hadley said.
If the energies expended by TXU and its buyers, customers and competitors are any sign, however, it seems that the PUC's existing powers might be greater than a first look would indicate. After the would-be buyers filed papers with the PUC in April making their voluntary commitments to consumer protection, nearly a dozen other entities intervened in the matter.
For the past 2 ½ months, the parties have aimed hundreds of pages of questions, answers and legal arguments at each other. Frequently the sparring has seen opponents trying to pry as much information out of the buyers as possible and the buyers resisting, sometimes even filing documents with large blocks of type blacked out by hand with markers.
The commissioners have agreed to hear the case themselves, rather than send it to the State Office of Administrative Hearings, which would slow down the process. Hearing dates are set for October.
More to be done
"The commitments made by Texas Energy Future Holdings, combined with pre-existing regulatory requirements, are a good start in ensuring that customers are not harmed. But in absence of specific legislation, more could be done to ensure that they benefit from the transaction."
The buyers failed to make certain promises that could benefit Texans, GF Energy concludes, and the last stop for negotiating those promises is the PUC. There's no commitment, for example, about building cleaner power plants or protecting employee benefits. The summer after TXU announced the coal plan, public concern about greenhouse gas emissions began to bubble over. It became increasingly evident that the U.S. would eventually limit such emissions.
TXU executives wouldn't explain how they might handle such limitations while operating carbon dioxide-intensive coal plants. The buyers haven't addressed that question either, other than to promise to join the lobbying effort in Washington for a market-based approach to carbon dioxide credits. If the government doles out carbon dioxide credits based on how much greenhouse gas a company already emits, TXU could get a windfall because of its existing coal plants.
The investors more recently promised to consider building plants using cleaner technology that doesn't emit greenhouse gases: coal gasification and nuclear. But they haven't decided whether to actually build them.
The consultant praised one of the buyers' commitments: the promise to spend $400 million on programs to cut electricity demand. The buyout group has agreed not to calculate any of that amount in regulated rates of the power line business.
The buyers have also said they don't intend to cut jobs or benefits, but that promise only holds until the end of 2008, according to a filing with the PUC.
TXU's defined benefit pension fund was underfunded by $367 million at the end of last year. And the company's fund to pay for retiree benefits, such as health care, was underfunded by $697 million, according to filings with the SEC. Those holes could make it attractive to change or terminate the plans.
Rick Levy, a lawyer for the International Brotherhood of Electrical Workers union, said the buyout group sent its negotiators to strike a deal with union leaders, and there was no indication that pensions would be on the table. In fact, he said, the union leaders appreciated the respectful way the buyout group approached them.
"Not that they believe in unions, necessarily, but they believe in money, and they think this is a good model," he said. "I would say, in some ways, the old management had really declared war on the unions."
The buyout group agreed to halt TXU's plans to outsource power line maintenance, a top concern for the union that represents those workers. In exchange, Mr. Levy said, the union agreed to endorse the buyout deal. And that meant to stop lobbying in support of Mr. Fraser's legislation to give the PUC explicit authority to block the deal.
Effects of debt
"Ownership of regulated and unregulated businesses by a holding company raises questions over cross-subsidization – essentially the ability to use a regulated business' stability and permission to pass costs on to customers to fund competitive businesses. This can be done by sharing propriety information, by piling costs and debt onto the regulated side, by funneling cash from the regulated to unregulated businesses, or by using regulated assets to back loans to unregulated businesses."
The buyers have made some commitments to protect consumers from the massive debt the company will take on. The investors will ring-fence the regulated power-line business, to shield it in case things go badly for the retail and wholesale units.
The buyers agreed to keep the debt-to-equity ratio for the regulated power line business at 60-to-40. And the regulated rates, which make up a tiny portion of an average household bill, won't reflect any buyout costs.
Still, changing the balance sheet for the entire company could impact costs for the regulated entity. If ratings agencies think TXU is becoming a riskier investment, they may downgrade the debt. That would likely increase the interest rate TXU must pay for loans, including loans to the regulated power-line business.
Already news of the buyout has prompted some ratings agencies to downgrade TXU debt to junk status.
The buyers have promised not to include a higher cost of borrowing in regulated rates through 2008, but there's no assurance for the long term. By 2009, if the interest rates TXU must pay on the debt rise – which seems likely given the ratings downgrades – TXU could begin passing along that extra cost to consumers.
Some private equity experts say this concern is overblown. Colin Blaydon, director of the Center for Private Equity and Entrepreneurship at Dartmouth College, said it's typically cheaper to service debt than to pay dividends on shares.
He said the notion that private equity companies are only short-term investors is "wrong-headed." Investors such as KKR and TPG must invest for the long term and improve a business if they hope to get the best possible price when they sell the company.
The consultant's report acknowledges that debt can be less expensive than equity but still calls on the PUC to protect customers from debt costs, since private equity relies more heavily on debt than healthy utilities do.
"GF Energy sees no reason to generically oppose the sale. The bottom line, however, is that there are no material advantages to the customer if the transaction proceeds. Any net benefits or protections for the customer will have to be painstakingly negotiated and monitored by the Public Utility Commission of Texas," the report states.
Read this entire series in the Dallas Morning News
or on WFFA.com
ABOUT THIS SERIES
An energy consultant hired by The Dallas Morning News was asked to assess the impact on consumers of the proposed $45 billion buyout of utility giant TXU Corp. The series explores aspects of the consultant's report.
June 24: Consumers won't benefit from the buyout and could actually see higher electricity rates.
June 25: TXU Corp. could become the first national electricity company Americans have ever seen.
June 26: Two summers from now, you may pay more for electricity.