Two interesting events this week that suggest that NRG Energy (NRG) owns valuable assets. The first event was about its Encina Power Station, which is located north of San Diego. NRG would like to replace the 60-year old gas boilers with a modern combined cycle gas turbine. The proposed facility would be renamed Carlsbad Energy Center.
On the surface, this looks like a traditional power plant deal. The state approves construction of a combined cycle gas turbine, and the generator earns guaranteed returns.
This deal, however, is a little more sophisticated. It is about a long-term vision that leads a management team to buy distressed assets on the cheap, monetizing them and waiting to make solid returns for shareholders. Let me explain.
In 1998, NRG and Dynegy (DYN) bought an old power plant from San Diego Gas & Electric, which is now a subsidiary of Sempra Energy (SRE). The Encina facility began operations in 1954; it was old and inefficient. It consists of five steam-generating units. To create a megawatt-hour, the facility burns lots of gas. It also pumps tons of emissions in an environmentally sensitive area.
Dynegy and NRG paid $356 million to acquire the old plant and a lot more. Included in the deal was approximately 400 acres of prime land, including the Agua Hedionda Lagoon, an offshore marine terminal, a 1.7 million barrel petroleum storage facility and 18 combustion turbines.
In 2006, NRG bought out Dynegy's interests for under $150,000 per megawatt, which included all other assets. In contrast, a new coal unit costs over $3 million per megawatt.
What was not listed was the old plant's air permits. In Southern California, air permits are worth a fortune. It is because the state cannot issue new air permits in a nonattainment region. To acquire necessary permits to build a new power plant, developers must buy permits from existing holders or not build their plant.
It is the air permits that allows NRG to build and operate a modern gas turbine. The permits define the framework for the new plant. Here is how it works.
NRG plans to tear down an inefficient plant that produces 965-megawatts on a part-time basis with an efficient plant that produces 558-megawatts full time. The round-the-clock air emissions should be about the same. The company's operating margins should improve.
The state is willing to approve a long-term power purchase agreement because the region desperately needs the power. Forcing the state's hand was the loss of the 2,200 megawatt San Onofre Nuclear Generating Station in an energy-constrained region. The state needed a practical solution or face rolling brownouts. One solution was converting an existing gas peaker into a base load gas turbine. The conversion increased power reliability with a minor impact on emissions. It also has a positive impact for NRG's shareholders.
The larger issue for shareholders is the discovery of NRG's highly valued air permits. NRG owns more permits than most other utilities. When it buys a fleet of old coal plants, it also buys air permits. The company can retire older plants, hang onto the air permits and retain strategic assets for the future.
The other event was the announcement that NRG acquired Dominion Resources' (D) retail energy subsidiary. This deal cements NRG's position as one of the nation's leading energy service providers. The company joins Exelon (EXC), which has been a leader in this space for over a decade.
What is interesting about this deal is that NRG is not in competition with Exelon. NRG owns the residential and small commercial space. Exelon owns the large commercial and industrial space. It turns out that they are very different businesses.
The residential and small commercial sector can be profitable. Small power users have less sophisticated needs and are less price-sensitive. Large power users demand thin margins and require sophisticated offers. Back office systems that effectively manage small power users are different from the systems needed to service large power users and vice versa.
Cost leaders win by owning assets along the value chain. By controlling generation and simultaneously owning customer load, energy service providers can arbitrage deals and lock in margins. It turns out that NRG and Exelon own large fleets of generating assets. They also own millions of customers. They need only to rent the wires in between to close the value gap.
Combining these two events paints a different picture. It is clear that NRG understands that its business environment is changing. Unlike many other utilities, the company seems to embrace change. As a result, NRG manages its business to profit from nontraditional utility operations.
