NRG Plays the Game

 | Jun 25, 2013 | 1:45 PM EDT
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NRG Energy (NRG) recently announced the first round of incredibly strategic decisions. It looked at the power markets, it looked at its generating assets, and it realigned assets to the market. This may sound like an obvious move, but what NRG did is bold, innovative and smart.

This week NRG presented "Updating Operational Synergies," which describes some of the benefits shareholders can expect when NRG acquired GenOn Energy. Unlike Exelon (EXC), which appears surprised by the deregulated power markets and surprised shareholders with dividend cuts, NRG manages its market-based assets, finds synergies in merged operations and increases dividends.

Here is how it found synergies.

When NRG acquired GenOn Energy, it acquired old coal-fired power plants. Some of these clunkers are inefficient and uneconomic. No amount of additional investments will improve their performance enough to make them economic.

But NRG's old clunkers happened to be located in chronically constrained regions within the mid-Atlantic grid, called PJM Interconnection. It turns out that PJM not only pays power producers for energy, it also pays for capacity. Capacity payments are essentially rent and paid in terms of dollars per megawatt of capacity per day. To earn capacity payments, producers need not produce energy; they only need to be available.

One critical requirement for a facility's availability is to retain all relevant permits. Without permits, old coal plants are forced to exit energy markets, including PJM's energy and capacity markets. It is possible to retain permits for old coal plants if adequate emission controls are installed. The challenge is cost. Emission controls are expensive, make production less economical, and they usually yield low to marginal returns on investments.

Fuel is the root cause. When burned, coal emits all sorts of nasty pollutants, including high levels of carbon.

Rather than abandoning depleted assets, NRG has a better idea. It will convert its coal clunkers into natural gas and do it without spending a lot of money. NRG will keep capital costs low by retaining as much of the original plant as possible and converting as little as possible. In all likelihood, it will keep high-ticket items like turbines and generators and modify boilers to burn natural gas.

Here's the interesting part.

When a utility converts an inefficient coal plant into a gas plant, it gets an inefficient gas plant. Inefficient gas plants incur high production costs, which yield low margins. For high-cost plants to produce power, the market price has to be high enough to cover the plant's production costs. Because they are operating on the margin, the profit for any energy produced is very low. This is why most utilities decline to convert old coal-fired boilers to natural gas.

NRG has a better idea. First, it revived a dead asset with minimal expenditures by reconfiguring a boiler and connecting it to a gas line. With the modified configuration, NRG's non-complaint asset becomes compliant and is re-qualified to participate in PJM's energy and capacity markets.

With the modification, NRG's operating costs are lower. With natural gas replacing coal, NRG no longer has ash disposal costs, inventory costs or fuel handling costs. In addition, it reduced maintenance costs and headcount. Nevertheless, with higher fuel costs and persistent inefficiencies, production costs increased.

In this strategy, production costs are not the critical success factor. If NRG's revived asset never produces energy, NRG still receives capacity payments.

It gets better. When the power market enters seasons of high demand, PJM will necessarily seek additional bids for energy. With higher demand levels, PJM will be forced to buy energy at higher prices. When PJM's market prices exceed NRG's production costs, NRG's assets will be deployed and they will produce very expensive power.

The expensive deployment of the unitary asset raises the price for all assets within PJM, including NRG's regional portfolio. As such, the costly units provide NRG's portfolio an opportunity to earn higher average margins.

NRG's strategy is smart, aggressive and strategic; however, it is not foolproof. Nevertheless, at least management has the conviction to follow through with the merger, lead their company through the challenges of the emerging energy markets and find strategic synergies with their acquired assets.



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