GF
ENERGY
Independent Assessment of Proposed Leveraged
Buyout of TXU:
The Impact on Consumers
Prepared for:
The Dallas Morning News
June 2007
GF Energy, LLC
1100 Connecticut Ave., NW, Suite 1250
Washington, DC 20036
LLC
Table of Contents
Purpose of This Report ........................................................... 3
Executive Summary ................................................................ 5
Overview ................................................................................ 8

Key Issues................................................................................ 8
Context .................................................................................. 16


Deregulation in Texas ................................................................ 17
Repeal of PUHCA 1935 ............................................................... 20
Precedents ............................................................................. 21




Definition of the Public Interest and Net Benefits to Customers ....... 21
Electricity M&A Decisions ............................................................ 22
Texas M&A Decisions ................................................................. 29
TXU Buyout Settlement Issues .................................................... 31
Pre-Buyout TXU ...................................................................... 44


TXU Operational Performance ..................................................... 44
TXU Financial Performance ........................................................ 47
Potential Benefits & Risks to the Buyers ............................... 49

Deal Financing and Resulting Capital Structure .............................. 51
Potential Benefits and Risks for Ratepayers ........................... 52

KKR & TPG Track Record ............................................................ 57
Potential Environmental Benefits and Risks ........................... 59
Conclusions and Recommendations ........................................ 64
Appendix ................................................................................ 70
Page 2
Purpose of This Report
The publisher of The Dallas Morning News has retained GF Energy, LLC to produce an
independent assessment of the consumer impact from the proposed private equity
buyout of TXU. Based on GF Energy’s experience in assessing major transactions in the
electricity industry, this report examines the likely impact of the transaction on customer
prices, reliability, and, most important, the extent to which the public interest is
protected, enhanced, or challenged.
The conclusions reached in this analysis are those of GF Energy and do not necessarily
reflect the views of the publisher of The Dallas Morning News or the editorial position of
the newspaper.
Page 3
About the Authors
Roger W. Gale is President and CEO of GF Energy, LLC (www.gfenergy.com), a global
energy consulting firm—6 of the 10 biggest global electricity companies have been our
clients—offering strategic analysis to senior executives. With over 20 years of global
climate, nuclear, and demand-response experience, GF Energy is positioned to help
clients develop strategies for managing these compelling issues head-on.
Roger began consulting in 1988 after working in senior positions for the US Department
of Energy, the Federal Energy Regulatory Commission and the US Environmental
Protection Agency. Since entering consulting, he has served as CEO of PHB Hagler Bailly
and headed PA Consulting's global energy practice before starting GF Energy in 2001.
Roger is well-known globally as a leading corporate strategist and is quoted in leading
business publications including Fortune, Business Week, Financial Times and appears on
CNN, PBS, etc. He has a PhD in political science from the University of California,
Berkeley. He serves on the board of directors of Adams Express, Petroleum and
Resources Corp, Ormat and the US Energy Association. He was also on the board of
Constellation Energy Group.
Abigail N. Ahearn has eleven years of market research and consulting experience
spanning the energy, financial services, and pharmaceutical industries. She has worked
collaboratively with GF Energy for over three years on projects including the annual
Electricity Outlook.
Abigail is currently an associate at HawkPartners (www.hawkpartners.com), a boutique
consulting firm that works primarily with global, market leading clients to make factbased business decisions. Prior to joining HawkPartners, Abigail served in consulting
and research roles for Allianz AG, DTE Energy and global market research firm Ipsos.
She has a B.A. from Dartmouth College and an M.B.A. from the University of Michigan’s
Ross School of Business.
Page 4
Executive Summary
The proposed buyout of TXU by Texas Energy Future Holdings Limited Partnership--a
company formed by Kohlberg Kravis Roberts & Co., Texas Pacific Group and other
investors to acquireTXU Corp.--brings to light the adequacy of state oversight to protect
the public interest, particularly the price of electricity for individual customers and
reliability as demanded by digital America. Based on our analysis, GF Energy concludes:

The buyout of TXU does not provide inherent or significant long-term advantages
to the customer.

Private equity companies are driven by fundamentally different incentives than
TXU and other utilities that have grown out of a slow-moving, low-risk,
monopoly, customer-service driven culture.

Private equity players are much less consumer-focused than TXU is today. They
are driven by achieving a single goal: Maximizing the value of the asset as quickly
and dramatically as possible.

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.
o
GF Energy’s conclusion is that the buyers are offering the customer what
TXU would have probably had to offer anyway. Therefore, there is no net
gain for the customer as the deal is currently described.

KKR, TPG and Goldman Sachs will acquire a financially healthy business that can
serve as a solid platform for hedging against many of the more speculative
investments they have already made. Unlike most of the other utility private
equity transactions so far, TXU is in good financial shape.

TXU has dramatically reduced its capital spending plans by suspending eight coal
units and not making firm commitments to IGCC and future nuclear. This cuts the
buyers exposure from capital investments and will give them much more room to
take on debt related to the purchase of the outstanding TXU shares than if there
were a major capital program underway.
o
The Texas Public Utility Commission (PUCT) should require the buyers to
commit to a capital plan that assures there will be enough clean generating
Page 5
capacity to protect customers and to be sure that the buyers don’t use that
debt capacity to secure financing for the acquisition of new businesses
unrelated to generation in Texas.

Now add to the already-high levels of debt to acquire the public shares additional
debt to build needed capacity. This could mean that the higher cost of money gets
passed through to them, and it would almost certainly mean that the owners
would try to push up rates.

This transaction could ultimately result in TXU being turned into a national
company--whether via organic growth or via acquisitions of or by non-Texas
companies. While not on the immediate horizon, such a scenario could
ultimately result in the state having less control.

Any benefits or protections for the customer will have to be painstakingly
negotiated and monitored by the Public Utility Commission of Texas. The PUCT
needs to be comfortable that it has sufficient authority and resources to manage
and control all of the separate entities now being created by TXU prior to the sale.
It is up to the PUCT to decide whether it has the power to negotiate customer
benefits and protections that it can enforce.
o
The 80th Texas Legislature passed laws granting the PUCT approval over
future electric utility mergers & acquisitions, with an effective date that
exempts the TXU deal1. In addition, H.B. 3693 sets stricter goals for
utilities to offset growth in demand with energy efficiency measures.
However, the legislature ultimately came to a stand-still in creating laws
that would have tuned-up deregulation, restricted the construction of coal
plants, and provided additional protection against wholesale market
power abuses such as those that can result in higher rates. 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.
GF Energy recommends that the PUCT consider the following actions:
1

Test the TXU transaction against public interest criteria used elsewhere in the US
to determine if this transaction offers definite net benefits to customers.

Consider negotiating commitments from the buyers that will ensure adequate
oversight. These commitments may include:
H.B. 624
Page 6

–
Safeguards involving transparency, shifting of profits, cross- market power
mitigation and financial stability
–
Operational and customer performance guarantees that allow the PUCT to
fine the companies if their performance falls below prescribed or pledged
levels such as when there are excessive power failures
–
Assurance that the new operating companies continue for significant
periods of time existing labor contracts and commitments to communityrelated support
–
Commitment to a specified investment budget, schedule and plan for
renewable energy sources–wind, solar, etc. – as well as to advanced coal
including integrated gasification combined cycle (IGCC) and nuclear
plants.
–
An effective customer-controlled demand-response program for reducing
electricity demand and the commitment to specific targets, including
consequences for not meeting them.
–
A requirement that TXU Corp. establish a global climate working group
with a six-month to one-year charter to develop specific policies and
programs for the holding company and its subsidiaries
–
Tough “change of control” provisions, including approval processes and
penalties, if the buyers decide to sell control of the businesses to others
–
Assurances that there will be no change in the cost of capital because of the
transaction that would result in higher interest costs being passed on to
customers
Launch a formal collaborative process involving a broad range of public interest
organizations representing low-income customers, retirees, labor, public power
and cooperative customers as well as environmental stewards to ensure that its
final decision on the buyout is credible and legitimized by key stakeholders
Page 7
Overview
This report assesses the impact on consumers of the proposed buyout of TXU by private
equity companies. This transaction is the largest private equity leveraged buyout (LBO)
proposal in United States history, making it an important precedent-setting transaction.
Because it would change the business incentives of a vital public asset on which
businesses and individual consumers heavily depend, the impact is of critical importance
to Texas customers.
The action on the transaction is now shifting to the Public Utility Commission of Texas
(PUCT) after the Texas Legislature, after months of debate, chose not to place barriers in
the way of the transaction. On April 25, 2007, Texas Energy Future Holdings, the
proposed buyer of TXU, filed the details of its buyout with the PUCT for review along
with a number of other major rate and market power cases already underway.
We are not analyzing “the deal” itself—the premium that the buyers are paying, how that
premium compares to other recent deals, the financial integrity of the buyers and, most
important, whether this new round of “merger mania” (more than $2 trillion worth of
private equity deals have been announced so far this year) is “out of control,” as some
suggest. Instead, in this report we look at what this deal will do to and for the customer.
What will it do to the price of electricity, its reliability, and what incentives will the
buyers have to be good corporate citizens?
We do this by recommending a stakeholder-driven review process by the PUCT that
gives consumers an active voice in reviewing the transaction. GF Energy identifies a
number of financial transparency, performance, social and environmental criteria against
which this transaction needs to be judged.
We hope this will help the consumer make his or her own decision on this transaction
and give guidance to the Public Utility Commission of Texas. It is in the best interest of
Texas for the Commission and stakeholders to work together in a collaborative process to
review the buyout and impose any conditions on it.
Key Issues
The core issue in the proposed buyout is the extent to which the transaction would
diminish state oversight. Texas has moved faster than any other state to make the
electricity business more competitive, but Texas has also retained significant state control
over the rules of the game. If the transaction proceeds, the separate companies into which
TXU would be carved, although headquartered in Texas, would be owned by companies
located outside of Texas, by privately-held companies with fewer disclosure requirements
than publicly-traded companies like the existing TXU, and by companies that usually add
extensive debt to their holding as their means of leveraging growth.
Page 8
In addition to losing local control, many observers paint an ominous picture of what can
happen to customers when private equity companies buy solid, well-performing assets.
The chairman and chief executive officer of PG&E Corp. in San Francisco, one of the
largest utilities in the United States, paints this picture:
It is no secret that private equity's leveraged buyout strategy typically follows a standard
playbook that includes heavily levering companies with debt, cutting costs and people, and
curtailing capital expenditures (i.e., investments in utility infrastructure) in order to
maximize cash flow. After holding the company for three to five years, owners usually flip
the business–or bleeding chunks of it–to another private owner or to the public market
through an initial public offering. Investors would likely walk away from the deal with a
tidy profit.
Utility customers, on the other hand, could be left with a mess: Flagging reliability and
supply problems due to underinvestment in infrastructure, poorly trained and underskilled workers hired through outsourcing firms, and increased volatility in rates as new
owners have to invest to make up lost ground. In other words, the short-term focus on
maximum returns puts private equity on a collision course with the long-term public
interests that utilities, together with their regulators, are trusted to protect.
(Source: Dallas Morning News, May 7, 2007)
Even if this picture is overblown, these “barbarians at the grid” are driven by
fundamentally different incentives than TXU and other utilities that have grown out of a
slow-moving, low-risk, customer-service-driven culture and monopolistic structure.
Utilities like TXU have not always been paradigms of customer-centric virtue, but
regulators have usually had the ability to protect customer interests when utilities erred.
Private equity players are much less consumer-focused; driven by achieving a single goal:
maximizing the value of the asset as quickly and dramatically as possible.
Opening the Texas market to competition has already transformed TXU and the other
Texas utilities and paved the way for such a buyout. TXU CEO John Wilder has already
angered customers and regulators by pushing the limits of what utilities are traditionally
“supposed” to do; for example, by charging excessively high rates and investing in
polluting technologies. And now TXU management, which stands to gain considerably in
the deal, is promoting this transaction.
It is often said, as California goes, so goes the nation. Today in electricity, that applies to
Texas, which has done far more to maximize competition than any other state—and with
great success so far. GF Energy is one of the early advocates of competitive electricity and
we admire the Texas model. To the extent that customers are freed from the bonds of the
utility that historically held them, electric power companies also need more freedom to
choose the ownership and governance structure that maximizes their return. It is not at
all surprising to us that TXU is a hot asset. And it is not surprising, therefore, that
Page 9
publicly-traded electric power companies around the world are watching this transaction
as a potential bellwether for what might be a new trend toward private ownership of
utilities.
The TXU transaction would not be the first private equity utility buyout, but it would be
the first big one. Like other, much smaller transactions by Warren Buffett, chairman and
chief executive officer of Berkshire Hathaway, Inc., and the Australian investment bank
Macquarie, utilities offer buyers two options: A steady source of earnings for players who
want to buy and hold assets, and a “strip and flip” option resulting in a potentially very
large profit. GF Energy is not able to determine the longer-term intentions of KKR, TPG
and their partners in taking on the TXU transaction. But past experience suggests a short
holding period is more likely than the buy-and-hold strategy of Warren Buffett. Berkshire
Hathaway owns the utility MidAmerican in Iowa and through it Portland, Oregon-based
PacifiCorp as well as some other smaller energy assets.
The acquirers in this case have offered up a number of significant consumer benefits to
build support for the buyout, most notably a rate reduction and the potential for cutting
costs. These benefits could be offered by TXU today just as easily, and 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, loss of retail customers, and apparent CEO excesses would have forced the
company to offer most of the same “concessions” as the buyers are touting..
Furthermore, while legal separation of the retail, wholesale, and transmission businesses
may seem to benefit customers by preventing market manipulation and increasing
accountability, such separation may ultimately be just as advantageous to the buyers as
they plan for an exit strategy that is likely to entail selling parts of the business.
GF Energy’s conclusion is that 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.
GF Energy is convinced that the proposed transaction is good for KKR, TPG and their
partners. This assessment is intended to determine whether it is good for customers.
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. As digital America expands, customers are
demanding higher reliability than before and we are on the verge of a technology
revolution in electricity that will allow customers to control their demand through the
Internet.
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10
The critical questions we endeavor to answer in this report are:
 Is this transaction is in the long-term interest of consumers?
 Does it mean lower electricity rates in the longer-term?
 Will it improve or at least sustain current levels of reliability?
 Will it encourage innovation in an otherwise conservative industry?
 What will it mean for the customer’s right to influence strategic decisions on price,
environment, etc.?
 And in the end, will the customer be better off buying electricity, having it
delivered and having it generated by private-equity owners than by a more
traditional publicly-traded utility?
GF Energy’s conclusion is: The buyout of TXU does not provide inherent or significant
long-term advantages to the customer. In the absence of a number of additional
commitments from the buyers, there is no net benefit to the customer and it would be
harder for customers and state regulators to control the actions of the new owners than
of the current owners.
As critical assets, the infrastructure owned and services provided by TXU require
significant financial and institutional transparency to assure the public interest. The shortterm benefits to the customers through lower rates do not assure that longer-term the
customer will benefit from the transaction.
If the transaction proceeds, there may be ways of requiring customer performance
guarantees and, even better, if the buyers genuinely commit to holding the assets longterm, 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 PUCT needs to be comfortable
that it has sufficient authority and resources to manage and control all of the separate
entities as well or better than it has the TXU divisions under the current structure. With
less control over a parent company, regulating the assets and assuring there are no crosssubsidies or other improprieties is possible, but will be more difficult than it is today.
Finally, if the transaction proceeds, the new owners will acquire significantly more debt,
since debt is the primary vehicle by which private equity firms finance their growth.
Some in the financial community may argue that 80% debt is not a drag on performance
in contemporary corporate America; others argue that it limits critical capital investment,
would result in declining reliability, and is inherently riskier. How much risk is the
customer exposed to by the buyers heavily leveraging the TXU assets? One of the
criticisms of private equity is the reliance on debt. Increases in interest rates, inflation and
unexpectedly low return on investments can result in serious financial problems for
holders.
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11
For customers, it could mean that the higher cost of money gets passed through to them,
and it would almost certainly mean that the owners would try to push up rates. Worst
case, there could be bankruptcy. In most such cases—the airlines being a prime
example—business continues during the bankruptcy and customers still fly. And for the
most part, there are still surplus airline seats available at reasonable prices. In the
electricity business, however, assets are fixed and, since most utilities have not made
significant new capital investment in power plants for almost 30 years, the potential for
shortages and, hence, even higher prices is real.
GF Energy’s conclusion is that the PUCT, which represents customer interests, needs to
be sure the customer will be better off if the transaction proceeds; better off in the short
term and in the long-term. Therefore, it is up to the PUCT to decide whether it has the
power to negotiate customer benefits and protections that it can enforce. In the end, if the
PUCT demands too much and deliberates too long, the deal might lose its charm for the
buyers.
At a time when Texas needs to invest very large sums into new generating plants and
other infrastructure that will inevitably push up debt levels, will the private equity
owners be willing to spend the money required for this when they already have so much
debt from the buyout? And, even if they commit to spending the money, if they plan to
sell the assets in five years, will they have the incentive to build the best, most long-term
cost- and environmentally-effective infrastructure?
GF Energy concludes that the buyers have made only wishy-washy commitments to
advanced clean coal and nuclear technology. We believe the Commission has an
obligation to Texas customers to require the buyers to make firmer longer-term
generation commitments including detailed projections of the timing, cost and financing
of both integrated gasification combined cycle (IGCC) and new nuclear units.
How much does it matter how long KKR and TPG hold the TXU assets? One of the major
criticisms of the deal is that the buyers are likely to sell the assets after only holding them
for a short period. What will it mean for consumers if the buyers repackage and sell the
assets? The two potential negatives for customers are that if the owners plan to sell the
assets, they may not invest enough in them, leading to declines in reliability, declines in
resource adequacy and, hence, substantial capital spending requirement on the part of
future owners—the cost of which would be paid for by customers. Another concern is
that the very long lead time in building new generating plants suggests that a five-year
hold period will decrease motivation for the new owners to build.
In fact, if the buyers are able to build three new coal plants in the next five years,
especially grandfathered units that don’t require advanced CO2 controls, the value of
those plants could be enormous to a potential buyer. Nuclear plants and IGCC, on the
other hand, take longer to build, introduce significant technological and political risk, and
are probably less likely to be built by the new owners than by a more traditional utility.
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12
What will the buyers get if the deal goes through?
First, KKR, TPG and Goldman Sachs will acquire a financially healthy business that can
serve as a solid platform for hedging against many of the more speculative investments
they have already made. Unlike most of the other utility private equity transactions so
far, TXU is in good financial shape. TXU’s image is not robust but its underlying
financials are very attractive. KKR, TPG and Goldman Sachs may, in fact, sell the assets as
soon as they can, but if they can’t or don’t, they will continue to own healthy assets that
are guaranteed to make money.
Not many healthy companies want to sell themselves; most would prefer to use their
capital to buy other companies. However, in TXU’s case, CEO John Wilder’s
compensation package is maximized if the company shares are acquired at a premium. In
2004 Wilder quietly put TXU’s delivery business up for sale, an early signal of what he
had in mind for the company in later years. Separating the assets, even if they aren’t sold,
is part of the plan. Selling them now at a premium only accelerates the process Wilder has
already been pursuing.
Second, not only is TXU in good overall financial shape; its generation business is a huge
profit maker. The ability to generate cheap and sell high into the wholesale markets
makes TXU one of the most profitable utilities in the US. With wholesale prices set
against the price of natural gas, lignite coal and nuclear generation costs are no more than
25% of the wholesale price TXU gets for the electricity produced. Along with Entergy,
Exelon, Constellation and a few similarly-positioned utilities, TXU has one of the most
lucrative business formulas in America.
Third, by separating the assets, the buyers get the ability to maximize the debt and equity
and to position the new companies—Luminant, Oncor and TXU Energy (see below for
organization charts before and after the transaction)—to be recapitalized, resold or rebundled. The permutation and spin options are wide-ranging and laden with upside for
the buyers.
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13
TXU Organizational Chart
Pre- and Post-Buyout
Post-Buyout TXU
Pre-Buyout TXU
Texas Energy
Future Holdings
TXU Corp
TXU Energy
Holdings
(competitive)
TXU
Energy
(retail)
TXU
Power
(generation)
TXU
Electric Delivery
(regulated)
TXU Corp
TXU Energy
Holdings
(competitive)
TXU
Wholesale
TXU
Energy
(retail)
Luminant
(generation &
wholesale)
Oncor
Electric Delivery
Holdings
Oncor
Electric Delivery
Company
*Shaded represents operating company
Fourth, by separating the assets and creating a new holding company, Texas Energy
Futures, the buyers extract themselves from the legacy TXU with all of its entanglements
with the PUCT. They create a clean holding company largely immune from state control.
The exception is the regulated transmission and delivery piece, Oncor, which will be ringfenced by regulators so that high leverage on the deregulated side does not leave Oncor
exposed to risk or failure on the part of the other TXU businesses.
Finally, while mergers between large vertically-integrated utilities like Exelon-PSEG and
FPL-Constellation having failed, the TXU transaction may be the first large horizontal
transaction—turning a vertically-integrated utility into three separate horizontal
platforms. Selling the assets piecemeal is a possibility, building a national generation
company using Luminant as a platform is another alternative. NRG, which bought Texas
Genco from KKR and TPG, could just be the Luminant model. Its Texas assets serve as
the largest platform for financing the growth of a national generating fleet.
The delivery business could also be spun off into a national business platform as Wilder
tried to do in 2004. And selling retail electricity remains just about the only business in
the US that has not been consolidated into a national platform. Constellation New
Energy, which sells retail electricity to commercial customers in Texas, is a model here
and one that the buyers may want to either merge with or compete against.
In short, the transaction has enormous upside for the buyers. In the end, much of the
judgment about it comes down to whether one believes that big national companies
owning large swathes of market share—like what we see in nearly every industry—is in
Page
14
the best interest of consumers. This transaction could ultimately result in its being turned
into a national company—whether via organic growth or via acquisitions of or by nonTexas companies—over which the state will ultimately have less control. For many
customers, this is an important value judgment.
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15
Context
In this section we set the stage for understanding the proposed buyout of TXU by KKR,
TPG, Goldman Sachs and other parties. We outline the major regulatory and economic
forces that have come together to make the transaction possible and attractive to the
buyers.
The proposed leveraged buyout of TXU occurs at a time when the repeal of the federal
Public Utility Holding Company Act makes it much easier for private equity firms to
acquire utility assets. If PUHCA had not been repealed by Congress in 2005, it is doubtful
this transaction would proceed. For, in repealing PUHCA, Congress eliminated
requirements that would turn outside buyers into regulated companies, a prospect that
KKR, TPG, and their partners would not find appealing.
The repeal and subsequent flurry of proposed private equity deals have drawn added
attention to the electric utility industry and scrutiny to the state and federal regulatory
processes. In objection to the repeal and, more recently, to the phenomenon of private
equity buyout of utilities, two of the largest trade electricity associations in the US, the
American Public Power Association and National Rural Electric Cooperative Association
conclude that “the repeal of PUHCA 1935 increases the possibility of mergers motivated
by earnings growth rather than operational efficiencies and of regulated public utilities
becoming cash cows for non-regulated utility or non-utility businesses.” APPA and
NRECA add that “the prospect of acquisitions . . . . . . by private equity firms exacerbates
those concerns. Some of these firms are well known for their financial risk-taking and
‘strip-and-flip’ strategies.”2
Another key contextual factor against which the transaction has to be weighed is that the
buyout has come at a time when today’s very high electricity rates in Texas make the rate
cut promised by the buyers particularly attractive to customers. Electricity rates are still
substantially higher for Texans than in recent years following a post-Katrina spike in
natural gas prices and a summer of record-setting temperatures. With natural gas prices
expected to remain high, Texas electricity customers will continue to pay high prices for
electricity.
Furthermore, TXU has come under public and shareholder scrutiny in the past year or
two for alleged market abuses that are currently being contestedfor its proposal to build
eleven highly-polluting coal plants and for excess generating market power in its primary
service area. In the eyes of many customers, TXU is not a customer-centric company and,
by comparison, the buyers look like white knights armed with good intentions, a robust
2
Kelly, Susan N., Richard Meyer and Randolph Lee Elliot. “Post-Technical Conference Statement of American Public
Power Association and National Rural Electric Cooperative Association.” Technical Conference on Public Utility
Holding Company Act of 2005 and Federal Power Act Section 203 Issues.” April 4, 2007
Page
16
social conscience and a hefty discount. They very well could be. In any case, they have
proven themselves to be better at the public relations game than TXU as we know it and
have positioned themselves well vis-à-vis TXU.
Taken together, these factors—repeal of PUHCA, high prices, and a tarnished TXU
reputation—have created near-perfect conditions for the buyers, who have been able to
generate good will with customers by promising rate reductions and alleviating public
concerns over clean air and global warming, all while offering a premium to TXU
shareholders.
Deregulation in Texas
Deregulation has limited the PUCT’s power in overseeing the entire electricity value
chain, but it has strengthened the PUCT’s authority over cross-subsidies and other
market power issues affecting generation. While still in transition, competition has
already produced several positive outcomes. In particular, more than 75 retail electric
providers are now providing service in the Electric Reliability Council of Texas (ERCOT),
32 of which have 500 or more customers, and 17 of which operate through the state. This
has resulted in a healthy 37% switching rate among residential customers and an 85%
switching rate among commercial and industrial customers since 2002.3,4 Switching rates
are a measure of customer choice and suggest that, since the introduction of competition,
many Texans have taken the opportunity to choose a new provider or plan – whether
driven by pricing or other factors. While some customers switched to other incumbent
providers, the overall retail customer market share of the former monopolies has
decreased significantly.5
Residential
Commercial
Industrial
Incumbent Share of Retail
Customers
Jan-02
Dec-06
98%
64%
98%
58%
95%
39%
Competition was originally promoted as a means of lowering customer prices. To give
competition and new entrants a head start, the PUCT put the Price-to-Beat (PTB)
mechanism in place until January 2007. PTB met its goal of preventing predatory pricing
by retail incumbents in that the price, based on natural gas prices, would serve as the
default for customers who did not choose to switch plans or providers.
Michaels, Robert J. “Competition in Texas Electric Markets.” Texas Public Policy Foundation, March 2007
Letter from Bret J. Slocum to Public Utility Commission of Texas, 21 Mar 2007
5 “Market Share_Number of Customers, Total Market.” Public Utility Commission of Texas,
2007:<http://www.puc.state.tx.us/electric/reports/RptCard>
3
4
Page
17
However, high retail prices cannot be separated from high wholesale prices. Although
often attributed to competition gone awry and potential collusion by powerful players,
higher wholesale, and therefore, retail prices were most likely driven more by high
natural gas prices more than other factors. Some of the increase in natural gas prices can
be attributed to the large number of new gas-turbines built in Texas and other states that
pushed up demand for natural gas as fuel, ending a 20-year old “gas bubble” that had
kept gas prices flat. This was exacerbated by a post-Katrina spike.
Ironically, while it allowed new entrants to compete with TXU on price, the natural gaspegged PTB gave TXU the ability to sustain wide margins even after natural gas prices
stabilized post-Katrina because no rate hearings were held to decrease the PTB to preKatrina levels. Because most of TXU’s generation is coal or nuclear, which is much less
expensive than natural gas-fired generation, TXU’s profits increase the more gas costs
since wholesale electricity is priced at the cost of the highest power plants generating
electricity.
A critic of competition could still argue that, since 2004, Texas prices have risen faster
than the national average, which would also be affected by gas prices. However, 71% of
Texas capacity is generated by natural gas, a far greater proportion than the national
average of 47%. Hence, Texas electricity prices are more likely to feel the impact of gas
prices, whose compound annual growth rate was 14.7% between 2002 and 2006 in
comparison to an 8% compound annual growth rate for coal between 2002 and 2005.6
Generation Capacity by Type
ERCOT v. US
ERCOT2
US1
Coal
31%
Oil & Gasl
47%
1 Energy
2 ERCOT
6
Oil & Gasl
73%
Other
4%
Nuclear
6%
Other
5%
Hydro
7%
Coal
19%
Nuclear
10%
Information Administration, 2005
2005 State of the Market Report
United States. Department of Energy: Energy Information Administration. “Annual Coal Report 2005.” Washington.
DOE, Oct 2006. <http://www.eia.doe.gov/cneaf/coal/page/acr/acr.pdf>
Page
18
In reality, despite a 126% increase in natural gas prices since 2002, the PTB offered by
TXU increased by a comparatively low 87% and the lowest-cost provider’s rates only
increased 64%.7 Since natural gas is a major component of prices and the basis for PTB,
Texas customers have felt this effect in ways that not all other states have.
The bottom line is that, because Texas has allowed electricity prices to follow the natural
gas market, it is an attractive market for firms looking to acquire companies, such as TXU,
built on lower cost coal and nuclear assets.
Average Retail and Wholesale Prices
80
30
70
25
60
$/MWh
40
15
cents/KWh
20
50
30
10
20
5
10
Natural Gas ($/MWh)
National Retail (cents/KWh)
TX Retail (Cents/KWh)
0
0
2002
2003
2004
2005
2006
U.S. Dept of Energy, Energy Information Administration, “Sale, Revenue, and Prices”, 2002-2005
Competition’s effect on overall generation capacity is harder to measure given the long
capacity planning and building time. However, the reserve margin projections made by
the Electric Reliability Council of Texas (ERCOT), which oversees the Texas grid, suggest
that Texas reserve margins will fall below the recommended 12.5% level by 2009.8 At the
same time, ERCOT’s Generation Adequacy Task Force has recently reexamined the
methodology for calculating reserve margins and the availability of mothballed capacity
and new wind generation proposals should make up for the shortfall for some period of
time.
Pointing to a market friendly to new investments, new wind generation has made Texas
the largest supplier of wind power in the country. While this should ease the public’s
mind in the short-term, the question remains whether a private equity entity proposing a
minimum five-year ownership of Texas’ second largest wholesale provider will be willing
to make the investments needed to ensure long-term supply. Since large baseload power
plants generally take more than five years to build, there is no assurance the buyers
would be able to site, permit, build and operate new generation during their ownership.
7
8
Michaels, Robert J. “Competition in Texas Electric Markets.” Texas Public Policy Foundation, March 2007
Bojorquez, Bill. “Capacity, Demand, and Reserves Report.” Update for Technical Advisory Committee. Electric Reliability
Council of Texas, 4 May 2007
Page
19
In sum, deregulation appears to be serving its purpose of introducing competition and
encouraging increased investment, even if external events have inhibited the lowering of
prices. For TXU and NRG with large low-cost generating fleets, higher gas costs are a
huge plus. It is this investor-friendly market that has partially paved the way for the TXU
buyers.
Repeal of PUHCA 1935
The repeal of the 1935 Public Utility Holding Company Act under the 2005 Energy Policy
Act also has a significant impact on the proposed transaction in that the original
legislation was specifically designed to prevent market abuses, geographically remote
ownership, and non-utility diversification that could be funded on the backs of utility
ratepayers. As told by one utility expert interviewed by GF Energy, “the TXU buyout is
the perfect example of the transaction that PUHCA was meant to prohibit—an out-ofstate company with no interest in being a utility, leveraging assets to squeeze value from
a healthy business.”
It was correctly assumed that the repeal of PUHCA would result in more investment in
the industry, diversification, and consolidation. 9, 10 Merger and acquisition activity and
investment by industry outsiders has increased since PUHCA repeal and significant
difference exists in how transactions are approved in Washington with the Federal
Energy Regulatory Commission (FERC) broadly disposed to approve almost any merger.
Rather than waiting for states to act first, as it used to, FERC now tends to set the pace by
approving mergers before states have acted. By doing so in the merger between Exelon
and PSEG without holding a public hearing, the Justice Department and the state of New
Jersey eventually delayed the deal and imposed unacceptable conditions that FERC had
not applied. This speaks to a trend: Private and public entities that have attempted to
invest are finding new, sometimes tougher barriers at the state level after they have been
endorsed at the federal level.
“Private Equity Firms Discover Electricity – And Lead the Charge for Energy Investment,” Wharton Private Equity Review.
Knowledge@Wharton,26 Apr26, 2007 <http://knowledge.wharton.upenn.edu>
10 Burns, Robert Esq. and Michael Murphy, Esq. “Repeal of PUHCA 1935: Implications and Options for StateCommissions,”
National Regulatory Research Institute, August 2006.
9
Page
20
Precedents
Defining the Public Interest and Net Benefits to Consumers
From the consumer perspective, one of the key issues is assuring that the transaction is
not harmful and, based on the mandates of many states including Texas, that the
transaction has a “net benefit” to TXU’s customers.
Most recent mergers and acquisitions have been approved or rejected by state and federal
regulators based ultimately on whether or not they are in the public interest. The “public
interest” is an ambiguous term that has been used by regulators in different states to
approve or reject mergers. By its very philosophical nature, the public interest standard
will always remain up for interpretation. However, over the years, legislators in some
states have codified “public interest” and “net benefit” standards in statutory law. In
addition, federal and state agencies have relied upon case law—law established via
precedent—to help guide their decisions on whether individual mergers and acquisitions
are in the public interest.
When reviewing proposed utility mergers and acquisitions, FERC, which will have to
approve the TXU transaction, has traditionally “examine[d] a merger’s effect on
competition, rates and regulation, and the potential for cross-subsidization,” the negative
impacts of which would tend to result in higher customer costs and often a lack of
transparency. For FERC, which is responsible for assuring the growth of wholesale
competitive markets, excessive concentration of market power—in other words, the
ability to unfairly control prices or inhibit competition due to excessive market share or
control of assets in a market--is grounds for denying. When tested against the public
interest criteria applied by FERC, the TXU transaction—which would result in a change
of ownership but not in market structure—would probably not directly harm customers
as the result of reduced competition or a change in rates and regulation.
In most other states, where deregulation has not advanced as far as it has in Texas, state
commissions often review proposed ownership changes, using individual standards to
determine the “public interest.” Despite the variation in standards, it is generally found
that, “each state commission must balance consumer protection and the possibility of
additional investment in electric utility infrastructure.”11 A number of states and
organizations have attempted to pre-define the “public interest” regarding proposed
utility mergers and acquisitions while others make a case-by-case judgment.
At the state level, many criteria apply, most of them relating to net benefits to customers.
Commissioners in these states—including Arizona, New Jersey, Pennsylvania, Oregon,
and Utah—have considered numerous factors in determining benefits and harms to
11
Ibid.
Page
21
customers, including rates, service quality standards, financing, debt load, and protection
of utility assets.
Electricity M&A Decisions
In the past few years, several transactions much smaller in scale than the TXU deal have
gone through state and federal review processes. However, because of the size of the
proposed TXU buyout and because the PUCT has never had to review a private equity
LBO of a major, vertically-integrated utility in a highly deregulated state, the outcome of
the deal will set a precedent.
While no other case replicates the proposed TXU transaction in size, we look at how other
states have treated post-PUHCA repeal mergers and acquisitions that bear similarities to
the TXU transaction, particularly because they proposed control by privately-held
holding companies. We also look at how Texas has treated mergers and acquisitions
since transition to a competitive market.
Deals That Fell Through
Examples of out-of-state deals that fell through due to regulatory rulings include the
Unisource acquisition in Arizona by a consortium of private investors that included KKR,
and the proposed buyout of Enron-owned Portland General (PGE) in Oregon by TPG.
In these failed attempts, factors in regulators’ opposition included:



Inability of regulators to see a clear benefit to new ownership that would
outweigh the risks (PGE, Unisource, Northwestern).
Leverage at levels that might lead to below investment-grade credit ratings, a
subsequent inability of the buyers to pay debtors, and the increased possibility of
bankruptcy. (Unisource)
Length of ownership; in other words, would the private equity buyers focus on
short-term objectives of paying down debt and re-selling the company or its assets
at a profit? (PGE)
In Oregon, proposed mergers must pass a net benefits test, whereby “the transaction
should not harm customers and not impose a detriment to Oregon citizens, and benefits
and harms resulting are weighed against the utility as currently configured.”12
The Oregon commission determined that PGE would be stronger on its own, “despite
being owned by bankrupt Enron.” The Oregon PUC also stated, "the potential harms or
risks to PGE customers from the deal outweigh the potential benefits . . . Based on the
evidence presented to us, we found that PGE customers would not be better off in terms
of rates and service than they would with PGE as a separate, stand-alone company” and
that “the end of Enron ownership will occur without this transaction. The question is
12
Ibid.
Page
22
whether the immediate end of Enron’s ownership is a customer benefit. Today, PGE is
not a distressed company, either financially or operationally.”13
In Arizona, the commission also applies a net benefits test whereby the benefits would
need to be sufficiently tangible, attributable to the transaction, and substantial enough to
outweigh perceived risks of the transaction.14
The Arizona Corporation Commission (ACC) rejected the Unisource buyout following an
Arizona judge’s opinion that the risks of the deal outweighed any benefits. The ACC
concurred with the judge that “the risks of the proposed Unisource reorganization
outweighed any expected benefits and that the standard of review prescribed under
Arizona law therefore requires denial of the transaction.” Arizona Commissioner Kris
Mayes added, “We know the investors have much to gain but I’m not sure the ratepayers
have much to gain . . . I believe, in the final analysis, this transaction lacked tangible
benefits.”15 Commissioner Jeff Hatch-Miller also opposed the buyout, citing high levels of
debt that would put the ratepayer at risk in the long run.
Finally, while not an example of a buyout by private owners, Exelon’s failed merger with
PSEG in New Jersey exemplifies a case in which a deal was abandoned by the utilities
themselves due to excessive conditions required by regulators. While the Exelon-PSEG
deal differs from the TXU deal in that it was a deal between two publicly-traded New
York Stock Exchange utilities, it nevertheless illustrates how a utility commission can
impose death by a thousand cuts to a deal without explicitly ruling against it.
In 2006 the New Jersey Board of Public Utilities (BPU) adopted a standard of review
whereby the BPU would not “approve a merger . . . or acquisition and/or change in
control unless it is satisfied that positive benefits will flow to customers and the State of
New Jersey and, at a minimum, that there are no adverse impacts on any of the criteria
delineated in N.J.S.A 48:2-51.1 [the change in control statute authorizing the Board to
review and approve mergers].”16 Under this statute, the BPU is required to evaluate the
impact of an acquisition on competition, rates, utility employees, and on the provision of
safe and adequate service.
Using this "positive benefits" standard rather than a "no harm" standard, the New Jersey
BPU believed that the combined entity’s market power might hinder competition and
result in higher rates, while an independent PSEG, which was strong enough to stand on
its own, would not harm the market. The New Jersey regulator was also concerned about
losing control over the merged company’s decisions since the headquarters would be in
“Oregon PUC Cites PGE Stability in Rejecting Sale to Texas Pacific.” Power Market Today, 11 Mar 2005
Melnyk, Markian. “PUHCA Repeal and the Challenges Ahead,” Harvard Electricity Policy Group 41st Plenary Session,
LeBoeuf, Lamb, Greene & MacRae llp. Atlanta, GA: 8 Dec 2005.
15 “Commission Rejects Unisource Acquisition,” Arizona Corporations Commission [Press Release,]. 23 Dec 2004.
<http://www.azcc.gov/divisions/admin/news/pr12-23-04.htm>
16 State of New Jersey. New Jersey Board of Public Utilities. “New Jersey Board of Public Utilities Petitions for Approval of
a Merger, Consolidation, Acquisition, and/or Change in Control. [N.J.A.C 14:1-5.14 (a) through (d)]. 17May 2006
13
14
Page
23
Chicago, rather than Newark. While it did not make a legal ruling against the deal, the
BPU did place enough restrictions on it as to make it unattractive to Exelon.
We have learned from recent post-PUHCA history that mergers & acquisitions between
utility partners may fail due to concerns over potential market power abuses and their
subsequent effect on rates and competition. Deals involving financial companies, most
often leveraged buyouts, more typically raise questions about the utility’s financial
stability, rates, and reliability.
 Stability may be negatively impacted by dangerously-high debt loads and shortterm ownership commitments.
 Rates may be affected not only by funds needed to cover debt payments, but in the
case of PacifiCorp and TXU, by potential market power abuses.
 Reliability might be affected by the new owner’s reticence to make capital
expenditures. Private equity funds’ principal objectives of providing returns to
their owners and investors can pose an inherent conflict with utilities’ needs for
long-term capital investment as well as innovation to ensure long term resource
adequacy.
Deals That Went Through
Many deals are judged to be in the best interest of customers and are allowed to proceed.
Examples of successful acquisitions by non-utility entities include the Macquarie Bank
acquisition of Duquesne Light and Power in Pittsburgh and the MidAmerican Energy
Holding Company (a Berkshire Hathaway Company) acquisition of PacifiCorp.
In April 2007 the Pennsylvania Public Utility Commission approved the Australian
Macquarie-led private equity takeover of Duquesne Light Company, citing that “the
settlement was in the public interest because it affirmatively promotes the service,
accommodation, convenience or safety of the public in some substantial way.”17 In
Pennsylvania, this standard has typically been achieved by the creation of synergies
between merging entities, financially healthier companies via investor attraction to larger
enterprises, sharing of best practices across merging utilities, and the reduction of rates
via economies of scale and scope.18
Lacking the typical rationale for a merger, the Macquarie-Duquesne transaction was
passed by the PUC because, despite concerns over financial structure and ownership time
horizon, the buyers agreed on several commitments that would result in “affirmative
benefits” that could not be provided by a stand-alone company that was in poor shape.
The Public Utility Commission approved the Macquarie-Duquesne deal because
Macquarie’s infrastructure fund has a long history of investing in utility assets for the
long term, because Duquesne had been beset by troubles since 2001 following a period of
17
18
York v. PA PUC, 449 Pa.136, 295 A.2d 825, 828, Pennsylvania Supreme Court, 1972
Joint Application of Peco Energy Company and Public Service Energy Company. Docket No. 2159237.1. Pennsylvania Public
Utility Commission. 4Feb 2005 <http://www.state.nj.us/bpu/wwwroot/secretary/merger_14.pdf>
Page
24
unbridled expansion and, perhaps most importantly, because Macquarie agreed to a
number of conditions.
In a statement accompanying Pennsylvania PUC approval of the deal, the Chairman
states, “there are several aspects of this Settlement that I like—namely, the protection of
competitive markets . . . and the assurance of a Pittsburgh headquarters. I note the
important financial commitments made by Duquesne in support of its infrastructure
improvement plan. Customers tend to suffer the long term consequences of excessive
capital outlays related to acquisition premiums and transaction costs, at the expense of
future capital outlays for reliability investments. Given Duquesne’s commitments for
continued investments in infrastructure, I am much more comfortable with this
transaction.”19
Besides the above-stated concessions, the Macquarie consortium alleviated Commission
concerns by agreeing to terms and conditions that would address concerns over rates, a
desire for local control and economic development, access to books and records, capital
structure, reliability and customer service, community commitment, corporate cost
allocation, and support of retail competition.
While not a private equity buyout per se, the PacifiCorp acquisition by MidAmerican
Energy Holdings, which is controlled by Warren Buffett’s Berkshire Hathaway, is
perhaps the best example of a successful private buyout due to the size and scope of the
transaction. According to Oregon law, the PUC cannot approve the sale of electricity
assets unless it finds the transaction is in the public interest and provides a net benefit to
ratepayers. The MidAmerican-PacifiCorp transaction illustrates how regulators, in order
to meet their legal mandate, were able to secure terms and conditions that would
adequately protect customers while allowing the deal to go through.
In May 2005, the board of Scottish Power, then owners of PacifiCorp, voted to sell
PacifiCorp “in light of the scale and timing of the capital investment required in
PacifiCorp and the likely profile of returns from that investment.”20 Shortly thereafter in
May, MidAmerican submitted an application to acquire all of PacifiCorp’s common stock
and debt for $9.4 billion. In its application, MEHC stated that its “focus on significant,
long-term investment in well-operated energy companies is a focus that should provide
PacifiCorp’s customers, employees, the public and regulators with valuable stability,
permitting PacifiCorp’s management and employees to apply their full attention to
exceeding customer expectations.” MEHC further advanced its case by claiming
similarities to PacifiCorp including “a track record for investment in a diverse mix of
generation technologies . . . investment in energy efficiency, demand-side management
and environmental technologies . . . [comfort] with operating in a diverse service area,
“PUC Approves Agreement for Macquarie Consortium to Acquire Duquesne Power & Light.” Pennsylvania Public
Utility Commission [Press Release]. 24 Apr 2007
<http://www.puc.state.pa.us/general/press_releases/press_releases.aspx>
20 “MidAmerican Energy to Buy PacifiCorp, Does Not Claim Synergies.” SNL Insurance Daily. 25 May 2005
19
Page
25
with states that have opted for competitive retail services as well as states that have opted
for the traditional model of regulated retail electric service.”21
While the sale to MidAmerican initially drew skepticism, it ultimately succeeded due to
extensive commitments made by the buyers at the behest of regulators, resulting in its
passing the net benefits standard. Commission Chairman Lee Beyers stated in the
decision that, “when viewed in total, this is a good deal for ratepayers due to the
combination of financial ring-fencing, certain guaranteed cost cuts, commitments for
renewable energy, and low-income energy assistance.”22
After 30 parties intervened in the approval process, 34 Oregon-specific commitments
were added to the 54 already agreed upon by other states. Many of these are outlined
later in this document. Ultimately, the commission ruled that “the potential harms
identified by parties have been mitigated by commitments agreed to in the Stipulation.
The Stipulation provides additional benefits to ratepayers in the form of rate credits . . . as
well as a strengthened commitment to renewable resources and low-income customers.”23
In its decision to approve with stipulations the Utah portion of MidAmerican’s PacifiCorp
acquisition, the Utah Public Service Commission stated that its "task is to consider all
[positive benefits and negative impacts], giving each its proper weight, and determine
whether on balance the merger is beneficial or detrimental to the public." Prior to the
decision, the applicants had argued that Utah law requires a no-harm standard only.24
In the state of Washington, no specific statute exists to require a “net benefits” test, but
the commission has nevertheless used specific guidelines for determining the public
interest. The 1997 merger of Washington Natural Gas and Puget Sound Power & Light
was approved based upon the following four public interest standards design to protect
rates, reliability, competition, and the Commission’s oversight authority25.
The standards state that the transaction: 25
1. “Should not harm customers by causing rates or risks to increase, or by causing
service quality and reliability to decline, compared with what could reasonably be
expected to have occurred in the absence of the transaction.”
Application of MidAmerican Energy Holdings Company for an Order Authorizing MEHC to Exercise Substantial Influence over
the Policies and Actions of PacifiCorp. Public Utility Commission. of Oregon, Docket No. 1209 (Revised 17 Aug 2005)
22 “PacifiCorp Sale Approved by Commission,” Public Utility Commission of Oregon [Press Release]. 24 Feb 2006
<http://www.puc.state.or.us/PUC/news/2006/2006002.shtml>
23 In the Matter of MidAmerican Energy Holding Company Application for Authorization to Acquire Pacific Power & Light, dba
PacifiCorp. Public Utility of Oregon, Docket No. UM 1209 [Order]. (23December 2005)
24 ScottishPower/PacificCorp Merger, Public Service Commission of Utah, Docket No. 98-2035-04 [Report and Order]. 23Nov
1999
25 Fourteenth Supplemental Order Accepting Stipulation; Approving Merger. Washington Utilities and Transportation System ,
Docket Nos. 951270 and 960195 [Report and Order] 5Feb 1997
21
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26
2. “With conditions required for its approval, should strike a balance between the
interests of customers, shareholders, and the broader public that is fair and that
preserves affordable, efficient, reliable and available service.”
3. “With conditions required for approval, should not distort or impair the
development of competitive markets where such markets can effectively deliver
affordable, efficient, reliable, and available service,” and
4. “Jurisdictional effect should be consistent with the Commission’s role and
responsibility to protect the interests of Washington gas and electricity
customers.”
A summary of these and other recent proposed transactions and their reason for success
or failure can be seen on the next page.
Page
27
Recent Proposed Buyouts
Transaction
TPG
acquisition of
Portland
General26
Exelon
proposed
acquisition of
PSE&G
Approved/
Cancelled
March 2005
FAILED
Sept 2006
FAILED
FPL
acquisition of
Constellation
Macquarie-led
Acquisition of
Duquesne
KKR-led
acquisition of
Unisource
MidAmerican
(Berkshire
Hathaway)
acquisition of
PacifiCorp30
2006
FAILED
KKR-Led
Acquisition of
Texas Genco
July 2005
APPROVED
Babcock &
Brown Buyout
Northwestern
Energy
May 2007
FAILED
State
Value
OR
$2.35B
Comments on Decision
High leverage (72% debt) seen as affecting credit ratings
putting customers at risk. Short duration of ownership
expected. Relative stability and autonomy of PGE without
new ownership, “PGE is not a distressed company.”
After 2 years of negotiations and approval by FERC, NJ
Board of Public Utilities conditions forced the parties to
abandon the deal. The BPU, concerned that the merger
would not result in greater competition or lower rates as
planned, demanded heavy divestiture of generation to curb
market power as well as $810 million in rate credits to
customers.27
Killed by Maryland when Constellation announced an
unrelated 72% rate increase and large CEO bonus.
NJ
April 2007
APPROVED
PA
$1.6B
Macquarie Group is already one of world’s largest owners
and managers of infrastructure assets with a reputation for
making long-term investments.
Dec 2004
FAILED
AZ
$3B
Debt levels and inadequate bankruptcy protections cited as
reasons for the failed deal28. Insufficient tangible benefits
also cited.29
March 2006
APPROVED
UT,
WY,
OR,
ID,
CA,
WA
TX
$9.4B
53 commitments made by acquirer and several more specific
to each state. General commitments related to safety,
customer service, system reliability, diversity of resource
mix, use of energy efficiency and conservation, investment
in renewables, “ring fencing” to protect customers from
debts, commitments to building new infrastructure
$3.65B
MT
$2.2B
Consortium including KKR and TPG bought generating
assets with 70% debt financing. The seller, CenterPoint, was
motivated to sell and little opposition was encountered.
Within less than two years from the merger announcement,
owners had retired 3000MW of 14000MW, reducing Texas’
power reserve margins, and sold the company for $8.3B.31
Australian private-equity firm proposed acquisition of
utility recently emerged from bankruptcy. Deal rejected for
putting consumers at risk for higher rates and poor service,
and for concerns over foreign ownership.32 33
“Macquarie-Led Consortium to Buy Duquesne Light in $1.59 B deal.” Power Market Today, 6 Jul 2006
“Unable to reach deal with NJ regulators, PSEG and Exelon call of merger.” Foster Electric Report, 20 Sept 2006
28 “Viability of Debt-Laden Utility Buyouts Scrutinized After Adverse State Hearings.” Power Market Today. 15 Mar 2005
29 Wine, Elizabeth. “The Temperature Rises: Private Equity Investors Still Spending Billions on Energy/Power Deals, But
Trouble is Percolating.” Investment Dealers Digest. 13 2005
30 Stanfield, Jeffrey. “Five Down, OR Expected to OK MidAmerican Purchase of PacifiCorp.” SNL Insurance Daily. 24Feb 2006
31 “Effort to Take TXU Private Leaves Questions Hanging Over Fate of Wholesale Trading.” Power Markets Today. 16Apr 2007
32 “Aussie Bid for NorthWestern Unanimously Rejected by Montana PSC.” Power Market Today. 24May 2007
33 Gouras, Matt. “Consumer Advocate: BBI Expects Large Payouts From NorthWestern.” AP Newswire. 6Feb 2007
26
27
Page
28
Texas M&A Decisions
In Texas, unlike many other states, the PUCT has no explicit legal authority to approve or
reject the buyout of a utility, although it does have the authority to ensure that sales of
generation assets don’t violate market power rules governing ownership of generation
assets and it believes it has an obligation to assure that there is a net benefit to customers.
The Texas Legislature debated giving the Commission this authority but did not do so.
Nevertheless, the PUCT has considerable power to review and impose conditions on
transactions like the TXU buyout. The Public Utility Regulatory Act (2005) also gives the
PUCT the right to review whether a transaction involving a regulated utility is
“consistent with the public interest” and—where the transaction is found not to be in the
public interest—may “disallow the effect of the transaction [in ratemaking proceedings] if
the transaction will unreasonably affect rates or services.”34 In other words, while the
Commission does not have the power to approve or deny mergers, it does have the
authority to regulate transactions that go through and to take punitive actions.
Also,when the Commission has reviewed mergers of regulated entities in the past, a
Commission staffer suggests that the Commission typically applies the net benefits test.
The PUCT will test the TXU transaction against public interest criteria, and while it may
not be able to explicitly reject the transaction, its legislative mandate and oversight
authority does give it the practical ability to demand conditions on the transaction that
ensure the public interest and preserve competition.
Past Texas merger cases offer some indication of the types of commitments that the
Commission can and typically does require. In the 2005 case of PNM Resources and
Texas-New Mexico Power Company and in the 1999 case between American Electric
Power (AEP)-Central & Southwest Corporation (CSW), the Commission found that the
mergers were in the public interest, largely because the entities were able to make the
case that synergies would be created.
The AEP-CSW merger occurred prior to deregulation, when retail, wholesale, and
transmission services were still bundled within one vertically-integrated company. In
November 1999, the Commission approved the proposed merger of Ohio-based
American Electric Power Company (AEP), a holding company of seven domestic utilities,
with Dallas-based Central & South West Corporation (CSW), a holding company of four
domestic utilities operating in Texas, Arkansas, and Louisiana.
Both companies were traded on the New York Stock Exchange and the merger would
result in the conversion of CSW to AEP shares. Hence, no concerns over private
ownership or over-leverage were involved. Because of the lack of overlap in territories,
the only major effect of the merger would be on ownership. Hence, Commission concerns
34
Public Utility Holding Act, TEX. UTIL. CODE ANN. §§14.101 (Sept 2005)(PURA)
Page
29
over risks of the merger were minimal and the Commission focused primarily on whether
the merger would provide benefits to Texas ratepayers.
Ultimately, multiple stakeholders were brought together in a process that produced an
Integrated Stipulation & Agreement ensuring “timely benefits for Texas consumers in the
areas of rate reductions, excess cost amortization, market power mitigation, affiliate
standards, customer service standards, rate moratoriums, jurisdictional issues, customer
education, low-income programs . . . and other . . . provisions.”35 Perhaps of greatest
added benefit to Texas ratepayers were the $84.4 million of merger savings to be shared
with customers, the freeze on rate cases for two years, and the improvement in service
through the adoption of AEP best practices and technology.
In addition to the benefits, several stipulations were put in place to mitigate the risks.
Those stipulations involved allocation of costs across affiliates to avoid crosssubsidization, Commission access to books upon request, agreement to file market power
mitigation plans, continuation of CSW resource planning initiatives, and employee health
and safety commitments.
In a press release announcing the decision, the PUCT, stating the benefits, said “the
agreement, as approved by the PUC, provides for specific rate reductions and service
improvements over a six-year period. Those retail rate reductions include $84.4 million
resulting from merger savings expected in support staffing, corporate programs and
purchasing economies.”36
The February 2000 stock buyout of publicly-traded, vertically-integrated Texas-New
Mexico Power, Inc. (TNMP) by limited partnership ST Acquisitions LP—an investment
firm not involved in the generation, transmission, or sale of electricity—provides an
example of a private take-over of a utility in Texas. The deal essentially amounted to a
“group of institutional investors . . . replacing the institutional investors that currently
own[ed] approximately 65% of the common stock of TNP” with the key benefit being that
“TNP [would] emerge from the Acquisition better able to . . . offer better electric service
as the state of Texas becomes a competitive marketplace for electric energy.”37 Because
the acquisition essentially amounted to no more than a stock transfer, the PUCT
approved it, ruling that “the Order should not be interpreted to mean that the level of
scrutiny afforded these factors must be the same as that [in cases involving mergers of
two utilities] and, other, more traditional sale, transfer, and merger proceedings.” Even
so, TNMP, not the acquirers, was asked to commit to continued quality of service and
customer service guarantees, employee safety guarantees, maintaining employment
Application of Central and South West Corporation and American Electric Power Company Regarding Proposed Business
Combination. Public Utility Commission of Texas.Docket No. 19265 [Order] (Nov 1999)
36 “Electric Merger Gets PUC Approval Result to Lower Costs, Improve Service,” Public Utility Commission of Texas [Press
Release] 5Nov 1999 < https://www.puc.state.tx.us/nrelease/1999/110599.cfm>
37 In the Matter of the Application Regarding TNMP Enterprises, Inc. and the Merger of ST Acquisitions Corp Public Utility
Commission of Texas, Docket No. 21112 [Application] (Feb 2000)
35
Page
30
levels within state, financial integrity and maintenance of bond ratings, and maintenance
of capital expenditures.38
Finally, in the Commission’s April 2005 decision to approve the acquisition by PNM
Resources of Texas-New Mexico Power Company, the risks were relatively small and the
benefits promised to Texas rate payers material enough to warrant approval.
PNM Resources, an Albuquerque-based energy holding company, sought to acquire
TNMP, a Forth Worth-based transmission and distribution utility with principal
operations in Texas. The major concerns of the Commission involved service and
reliability. The applicants readily addressed these concerns through five specific
commitments.
The minimal financial risk involved in the transaction was reflected in un-changed credit
ratings by S&P and Moody’s and in the increase in stock prices and outlook.
Nevertheless, stipulations were attached to the deal regarding accounting for transaction
costs, capital structure, and credit ratings.
To guarantee net benefits as opposed to merely “no harm,” the applicants agreed to a
9.3% annual rate reduction for Texas customers applied equally across customer type and
a freeze on base rate for two years.
The private equity consortium proposing to acquire TXU--by virtue of being financial
companies rather than utilities—would be hard-pressed to prove the synergies that AEPCSW or PNM-TNP were able to prove. But like Macquarie in Pennsylvania, the
consortium has made a number of commitments related to rates, Oncor capital structure,
and infrastructure investment to support the case that the acquisition would result in net
benefits.
TXU Buyout Settlement Issues
Texas regulations and Texas Energy Future Holding’s commitments have begun to
ensure some of the control necessary not only to prevent harm, but to promote benefits to
Texans. Texas Energy Future Holdings has committed to establishing separate boards,
management, and headquarters for Oncor (transmission), Luminant (generation and
wholesale) and TXU Energy (retail).
In a press release coinciding with their advanced filing of commitments to the PUCT
related to Oncor, the buyers also stated that “The PUC has and will continue to have
complete authority over utility rates ("wires rates"). There is no basis for wires rates at
Oncor to increase as a result of the transaction.”
38
In the Matter of the Application Regarding TNMP Enterprises, Inc. and the Merger of ST Acquisitions Corp Public Utility
Commission of Texas, Docket No. 21112 [Order] (Feb 2000)
Page
31
To address issues of cross-subsidization and financial abuse, Texas Energy Future
Holdings has committed “that Oncor will not incur, guaranty or pledge assets in respect
of any new debt incurred to finance the merger transaction at closing or thereafter. Texas
Energy Future Holdings is also committing to . . . make substantial investments in new
energy efficiency programs.”39
Another major concern is the lack of financial oversight that regulators have over
privately-held companies, which are not subject to the accounting and corporate
governance standards as outlined in the Sarbanes-Oxley Act of 2002 and are not required
to file quarterly and annual reports with the Securities and Exchange Commission (SEC).
Per a leading utility trade group, the American Public Power Association, “private equity
firms are not required to file such forms, however. Indeed, the lack of public disclosure of
their financial condition is one of their principal distinctions from public companies . . .
and the [Federal Energy Regulatory] Commission has pointed to no other substitute
source of information on which it, state commissions, customers, trade associations, and
the public may rely in monitoring the financial condition of private-equity holding
companies that acquire jurisdictional public utilities.”40 To address issues over financial
transparency and accountability, Texas Energy Future Holdings has committed TXU to
filing quarterly reports with the SEC, much like public companies do.
While Texas Energy Future Holdings has made a number of commitments to help
address regulators’ concerns, more may still be required to ensure that, at a minimum, the
deal does no harm to the public interest. Examples of commitments that have addressed
Pennsylvania concerns (Macquarie-Duquesne) and Oregon concerns (MidAmericanPacifiCorp) are outlined below.
“Texas Energy Future Holdings and Oncor Electric Delivery File Voluntarily Expedited §14.101 Report with Public Utility
Commission of Texas.” Texas Energy Future Holdings [Press Release] 25 April 2007
40 Kelly, Susan N., Richard Meyer and Randolph Lee Elliot. “Post-Technical Conference Statement of American Public
Power Association and National Rural Electric Cooperative Association.” Technical Conference on Public Utility
Holding Company Act of 2005 and Federal Power Act Section 203 Issues.” 4 Apr 2007
39
Page
32
Benchmarking against Stipulations Made in Oregon’s MidAmerican-PacifiCorp
Case and Pennsylvania’s Macquarie-Duquesne Case41,42
Commitments Required by Oregon/Pennsylvania
Texas Regulation or Texas Energy Future
Holdings Commitment
Accounting & Transparency

All books and records to be held in Oregon

Record retention for three years (OR)

Requirement that Berkshire Hathaway also
comply with the MEHC commitment related to
accessibility (OR)
Holding company and utility books to be kept
separate (OR)



Annual report to Commission as to all
commitments made in transaction Settlement
(PA)
Annual reports filed to the SEC (PA)

Books and records can be kept outside of
Texas, but must be produced upon
request—per precedent in AEP-CSW case
(TX)
 Records to be held for three years (TX)
 No known commitments pertaining to
KKR, TPG, Goldman Sachs



Ring-fenced (Oncor, Oncor Electric
Delivery Holdings) and competitive books
to be kept separate (TEF)
Unknown
TXU Corp. and Oncor to file quarterly and
annual reports with SEC (TEF)
Other Texas Regulations:
 Annual Gross Receipts Assessment and
Service Quality reports (TX)
 Wholesale reports filed to include all
information on pricing, date, type and
parties involved (TX)
 Identical annual report to be filed to that
required by FERC (TX)
 Records to be maintained per utility System
of Accounts (TX)
 Retail Electric Provider quarterly and
annual reports filed pertaining to
competitive market indicators and
technical market mechanics (TX)
41
42
Application of Transfer of Control of Duquesne Light Holdings, Inc. (“DLH”) to the Macquarie Consortium. Pennsylvania
Public Utility Commission, Dockets A-110150F0035 and A-311233F0002 [Final Decision] (20 Mar 2007)
In the Matter of MidAmerican Energy Holding Company Application for Authorization to Acquire Pacific Power & Light, dba
PacifiCorp. Public Utility of Oregon, UM 1209 [Stipulation] (23 Dec 2005)
Page
33
Commission Audits




Availability of employees, officers and directors
to testify upon request (OR)
Audit of holding company accounting records
relating to PacifiCorp to determine
reasonableness of allocation factors used to
assign costs (OR)
Reasonable access to books and records,
officials and staff, upon request (PA)
Access to all information provided to stock,
bond, or ratings analysts (PA)
 Unknown
 Commission review of transactions
between regulated and competitive
affiliates (TX)

Records to produced upon request by the
Commission (TX)
 Nothing stipulated
Cross-Subsidization

Commission access to all PacifiCorp, MEHC,
and Berkshire Hathaway books of account,
documents, data, and records pertaining to
affiliate transactions (OR)
 Annual Report of Affiliate Activities (TX)
 Filing of all affiliate contracts and
agreements (TX)

Annual filing to include organization chart,
narrative description of each affiliate, revenue
for and transactions with each affiliate (OR)
 Records of all affiliate transactions to be
held (TX)

No cross-subsidization between non-regulated
and regulated businesses OR between regulated
businesses (OR)
PacifiCorp and subsidiaries not to make loans,
transfer funds, or serve as guarantor for MEHC
or Berkshire Hathaway (OR)
 Arms-length transactions (TEF)







PacifiCorp not to use assets to back securities
issued by MEHC or Berkshire Hathaway (OR)
No issuance of dividends to PPW or MEHC if
unsecured debt rating falls below BBB- or lower
by S&P or Fitch. Issuance of Duquesne
dividends to be approved by Pennsylvania PUC
(PA)
Ring-fencing provisions for PPW holdings (OR)
MEHC to obtain non-consolidation opinion to
demonstrate strength of ring-fencing such that
PacifiCorp and PPW could not be pulled into
MEHC bankruptcy. No non-utility or foreign
utilities to be held by PacifiCorp or subsidiaries
(OR)
Notification of Commission 30 days before PPW
issuance of debt (OR)
Commission approval over all amended
Page
34
 Restriction on sharing of credit or
financing arrangements unless proven to
not negatively impact the public interest
(TX)
 No use of regulated rate base to securitize
loans for non-regulated businesses (TX)
 No known provisions regarding payment
of equity holders that is contingent upon
capital structure
 Oncor to be ring-fenced with Oncor Electric
Delivery Holdings (TEF)
 Unknown
 Unknown
 Unknown
agreements with affiliates (PA)


Separate debt from affiliates (PA)
Commission approval to provide service to
Duquesne as provided by other utilities in
which Macquarie has interest, most likely
limited to sharing of best practices (PA)
 No transaction-related debt in Oncor (TEF)
 Unknown
Other Texas Regulations
 The same products, services and benefits
offered to affiliates are also to be offered to
similarly-situated competitors (TX)
 Tying arrangements prohibited (i.e.
transactions dependent on action of
affiliate) (TX)
 Competitive affiliates not to have
preferential access to Transmission &
Delivery information (TX)
 Compliance audits to be performed on a 3year bases to ensure compliance with crosssubsidization rules (TX)
 No sharing of directors, property,
equipment, computer systems, office
systems, or corporate support systems
without approved Chinese walls (TX)
 No transfer of employees for less than one
year between regulated and non-regulated
businesses who hold proprietary
knowledge of business (TX)
 Physically separate offices (TX)
Page
35
Cost Allocation



Filing of an Inter-Company Service Agreement
(IASA) that includes corporate and affiliate cost
allocation methodologies, with Oregon PUC
approval (OR)
Submittal of corporate cost allocation
methodology used for rate setting (OR)

Cost allocation for investments, expenses and
overheads to comply with the following (OR):
o Costs allocated to PacifiCorp by MEHC must
be proven to be necessary to regulated
operations and not duplicative
o Cost allocation based upon Generally
Accepted Accounting Principles (GAAP),
with allocation of indirect costs across
affiliates based upon cost-driving factors and
allocation of direct costs directly
Allocation of holding company costs to utility to
the extent appropriate (PA)
Time reporting systems for executives (OR)

Audit trail for costs subject to allocation (OR)

Exclusion of all merger transaction costs from
accounts and provision for accounting of these
costs (OR)
Unrestricted Commission access to all written
information provided by and to credit rating
agencies (OR)


 Unknown
 Unknown
 Advertising and branding costs/programs
are not to be shared, with the exception of
access to bill inserts that similarly-situated
entities also have (TX)
 For shared services, recording of all
affiliate costs as direct or indirect according
to GAAP (TX)
 Unknown
 Unknown
 Unknown
 Unknown
Other Texas Regulations
 Any transfer of assets between businesses
to be at market value (TX)
 Transactions at $75K per unit or $1 million
are to go through competitive bidding
process (TX)
Changes of Control (including M&A)


Notification upon board approval of any
acquisition representing 5% plus capitalization
of MEHC or change in control of any material
part of MEHC (OR)
Oregon PUC approval of any mergers outside of
Oregon (OR)
 Generation facilities required to obtain
Commission approval before change of
control and to file at least 120 days before
the proposed closing date (TX)
 No comparable law or stipulation
 For regulated utility, report of transfer of
assets required within 30 days of closing
(TX)
Page
36
Capital Structure & Risk











No payment to PPW of dividends if doing so
results in common equity as a percentage of
total capital falling below 48.25% (OR)
Consolidated capital structure of PPW Holdings
not to fall below 48.25% either for three years
and slightly lower levels thereafter. Common
equity capital not to fall below 35% of total
adjusted capital (OR)
No payment to PPW or MEHC that will reduce
PacifiCorp common equity capital below 35%
total adjusted capital, without commission
approval (OR)
MEHC and PacifiCorp to maintain separate
debt and preferred stock (OR)
MEHC and PacifiCorp to maintain separate
credit ratings (OR)
MEHC to establish a captive insurance
company to replace Scottish Power’s in order to
ensure that PacifiCorp operations and costs not
be born by regulated accounts (OR)
 Oncor debt-to-equity ratio to remain at or
below 60:40 (TEF)
Punishment for ratings downgrades resulting
from the merger by reducing the assumed yield
on incremental debt by 5-10 basis points (OR)
No claim for increase in cost of capital for 5
years if due to a downgrade resulting from the
transaction (PA)
Berkshire Hathaway and MEHC may not
advocate for higher cost of capital for
PacifiCorp than what it would have been absent
MEHC ownership (OR)
Duquesne long-term debt to total capitalization
ratio not to exceed 60% (PA)
 Nothing comparable stipulated or required
by law
Duquesne not to request capital structure in
regulated rates beyond a “reasonable range of
that used by other companies” (PA)
Page
37
 Unknown regarding Oncor Electric
Delivery Holdings
 Unknown regarding Oncor Electric
Delivery Holdings
 Unknown regarding debt
 Nothing comparable required by law or
stipulated
 Not directly applicable
 Oncor not to support cost of debt higher
than that requested by TXU ED prior to
announcement of merger (TEF)
 No transaction-related debt at Oncor (TEF)
 Oncor not to exceed level designated by
PUCT (currently 60%) (TEF)
 No known commitments regarding TXU
Corp as a whole
 Nothing directly comparable, but PUCT
has the same authority to determine what is
reasonable via rate hearing (TX)
Operational

MEHC to honor existing PacifiCorp labor
contracts (OR)

Commitment to Quality of Service Plan with
specific metrics for customer service and
reliability (OR)

Continuation of customer service quality
performance standards and penalties,
amounting to payment of customer guarantees
as decided by the Commission (OR)
Commitment to meet PacifiCorp’s portion of the
NWPPC energy efficiency targets of OR, WA,
ID
MEHC to sponsor third-party market potential
study of additional demand system
management (DSM) and energy efficiency
opportunities (OR)
No changes to PacifiCorp employee benefit plan
for two years that would result in a decrease in
benefits (OR)
Commitment to current pension funding policy
for two years (OR)
Duquesne headquarters to remain in Pittsburgh
(PA)





Page
38
 Inclusion of negotiated commitments
regarding reliability, customer service, and
employee safety (TEF)
 Jobs to stay in Texas as operations not to be
materially impacted (TEF)
 Customer service reports filed include all
tariff (i.e. # customers under specific service
plan) and non-tariff related activities, but
penalties unknown (TX)
 PUCT authority to remain the same
regarding determination of penalties on
Oncor side (TX)
 Continuation of commitment to reach
Commission-mandated efficiency and
demand system management goals (TEF)
 Filing with Commission of annual energy
savings goals to reduced projected growth
in demand by a certain rate (TX)
 Not outlined
 Not outlined
 Oncor, TXU Energy, and Luminant
headquarters to remain in Texas (TEF)
 TXU Corp unknown.
 TEF pledges that Oncor will exceed goals
via doubling of Energy Efficiency/demandside management (DSM) investments
(TEF)
 Capital expenditure commitment at Oncor
(TEF)

Reliability & Resource Adequacy
Continuation of PacifiCorp Integrated Resource
 No known stipulations or legal
Plan filing according to existing schedule and
requirements
commission mandates, using locations and
technologies that encourage broad participation
of multiple stakeholders (OR)

Annual report on state of IRP commitments (OR)

Specific commitments to transmission
investment (OR)
Specific system reliability investments (OR)
Development of transmission projects upon
which PacifiCorp states will agree (OR)
Source future generation resources according to
existing regulations within each state (OR)



 No known stipulations or legal
requirements
 $3 billion over five years capital
expenditure commitment at Oncor (TEF)

No known stipulations or legal
requirements
 No known stipulations or legal
requirements

Maintenance of staffing levels within each state
to ensure safe and reliable service (OR)

IGCC working group to explore and file findings
related to costs and timing, siting, engineering
studies for meeting resource needs by 2014, per
2005 IRP (OR)
Commitment to current planned funding levels
outlined in 2006 and 2007 plans (PA)


RFP issued for IGCC exploration (TEF)
$1 million committed to Texas FutureGen
(TEF)

No known stipulations or legal
requirements
No specific ownership commitment, but track
record suggests nothing but long holding
periods for utilities (PA)

No comparable track record for KKR or
TPG



No known stipulations or legal
requirements

Unknown

Unknown
Other Texas Energy Future Holdings
Commitments
 Majority ownership for at least five years
(TEF)
 Increased commitment to IGCC (TEF)

Unknown
 Doubling purchase of wind (TEF)
Other Texas Regulations

Unknown

Unknown

Unknown

Unknown
 Detailed annual Generation Capacity
Reports to be filed with Commission (TX)
 Quarterly Wholesale Electricity
Transaction Reports including information
on all contracts and transactions (TX)
 Annual projected assessment of system
adequacy (TX)
 Monthly report of transmission and
Page
39
generation resource adequacy (TX)

 Provision for publication of all information
related to load and resource output (TX)
Unknown
Rates

$142 million rate credit to Oregon customers
(OR)

MEHC not to recover acquisition premium
through rates (OR)
Merger costs to be excluded from future
transmission and distribution rates (PA)
$10 million in low-income bill payment
assistance not to expire (OR)
Continued Customer Assistance Program
Funding consistent with its needs analysis (PA)






Coordination with community-based
organizations to administer low-income
assistance programs (PA)
Commitment to match customer contributions
to the Dollar Energy Fund (PA)
 15% rate reductions for retail customers
through December 2008 (TEF)
 $100 customer appreciation bonus to
eligible customers (TEF)
 Acquisition costs not to be recovered in
Oncor rate base (TEF)
 $150 million to low-income customers over
five years through TXU Energy Access
Program, including (TEF):
o Energy efficiency programs for
low-income customers
o Bill pay assistance
o Lower prices
 Continued work with 400 social service
agencies to distribute $5 million annually in
aid to “in need” customers (TEF)
 Waiver of deposit requirements for lowincome customers at least 62 years of age
Study to implement project to manage overdue
payments by low income customers (PA)
Task force to explore and commitment to
expanding Low Income Usage Reduction
program (PA)
Commitment not to file increase in distribution
rates prior to January 2010 (PA)
 Nothing comparable explicitly outlined

Duquesne not to claim increased cost of capital
as direct result of transaction for 5 years (PA)
 Nothing explicitly outlined

Unknown

Unknown

Unknown
 Waiver of deposit requirements for all
electricity customers with no more than one
late payment in the last 12 months
 No penalties for cancellation of month-tomonth service
 Summer moratorium on disconnects for
critical care, low-income and elderly
customers


Page
40
 Implied in TEF commitment to introduce
energy efficiency programs for “in need”
customers
 Oncor not to increase debt in rate hearings
through 2007-2008 (TEF)
Environment











Investment in community renewable projects
through the Public Utility Regulatory Policy Act
(OR)
Maintenance of Blue Sky tariff to support green
power development (OR)
Solicitation of outside environmental counsel
(OR)
Establish within six months of a global warming
working group—consisting of regulatory,
environmental, consumer and educational
stakeholders—to identify cost-effective
measures for reducing greenhouse gas
emissions and to file a strategy with the
Commission (OR)
Self-certification to ISO14001 standards at
thermal power units (OR)
Commitment to acquire 1400 MW of new costeffective renewable generation within 10 years
(OR)
Affirmation of prior PacifiCorp commitment to
consider advance coal-fuel technology (OR)
Unknown
Participate in EPA sulfur hexafluoride Emission
Reduction Partnership (OR)
Unknown
 Retail electric providers to meet Renewable
Energy Credit requirements as allocated by
the Commission (TX)
 Unknown
 Establishment of a Sustainable Energy
Advisory Board (TEF)
 Unknown
 Unknown
 Doubling of wind purchase from wind
generators to 1500 MW (TEF)
 $2 billion commitment to cleaner energy
technology (TEF)
 Investment in FutureGen (TEF)
 Commitment to join US Climate Action
Program (TEF)
 Support for a mandatory cap-and-trade
system (TEF)
 Installation of emissions controls on 3 coal
plants (TEF)
 Not applicable

Install $812 million in emissions-reduction
technology on PacifiCorp’s coal fleet (OR)
Enable PacifiCorp to acquire ownership in
geothermal plant from MEHC and to commit to
increasing capacity therein (OR)
Unknown

Unknown

Unknown
 Double investment in demand-side
management (DSM) to $400 million (TEF)

Unknown
 Incremental $200 million to be kept out of
rate base (TEF)

Page
41
 Increase generation facility efficiency by 2%
(TEF)
 Executive compensation and performance
goals tied to climate change goals (TEF)
Social & Economic Development






Consultation with regional advisory boards to
ensure local perspectives on community issues
(OR)
HQ to remain in Oregon with a balance of
employees between Oregon and Utah (OR)
Continuation of existing economic development
initiatives, utilizing MEHC’s expertise in
maximizing effectiveness of such efforts (OR)
 Directors to include a number of Texans,
per TEF pledge and announcements thus
far (TEF)
 All three operating businesses to remain in
Texas (TEF)
 None explicitly outlined
Establish Economic Development Program to
attract industrial employers (PA)
Comparable levels of community support
contributions as in previous years ($2.9 million
in 2006) (PA)
PacifiCorp will sustain at least the same level of
community-related contributions
 Unknown, but potentially not applicable to
growing Texas economy
 Outside of low-income customer assistance,
no other community development
programs outlined
Support of Competitive Markets

Unknown

Unknown

Unknown

Unknown

Pledge to “support competitive markets”
including corporate cost allocation provisions,
independent assessment of non-regulated
affiliate costs and economic development
program (PA)
 Market power mitigation plans to be filed
with Commission outlining plans to reduce
ownership or control of generation assets
with greater than 20% share of any ERCOT
zone,but with clauses grandfathering prederegulation incumbents such as TXU
(TX)43
 Independent System Operator certified by
the Commission to monitor wholesale
market within each zone (TX)
 Independent Market Monitor to monitor
and prevent market manipulation and to
recommend measures to enhance efficiency
of the market (TX)
 Penalties for market power abuse if
wholesale unit prices rise substantially
above marginal price (TX)
 No directly comparable pledge
(OR) = Stipulations required by Oregon PUC in MidAmerican-PacifiCorp merger
(PA) = Stipulations required by PA in Macquarie-Duquesne merger
(TEF) = Commitments made by Texas Energy Future Holdings
(TX) = Required by Texas law
43
Public Utility Holding Act, TEX. UTIL. CODE ANN. §§39.154 to 39.156 (Sept 2005)(PURA)
Page
42
With a legislature that seems to have stalled in creating the laws that would have tunedup 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.
As summarized in a Dallas Morning News editorial, “TXU emerged as one of the Texas
[legislative] session's biggest winners after beating back bills that would have forced the
company to break apart, sell power generating facilities and reconsider its plans to build
three pollution-intensive lignite plants. Lawmakers lacked the political will to take on
TXU and its cadre of lobbyists.”44
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.
In particular, the ring-fencing provisions in place to prevent cross-subsidization between
the regulated and competitive businesses also appear to be as strong as those made in
Oregon. These provisions—such as financial and legal separation--are designed to
insulate the regulated utilities from risks taken by unregulated affiliates. But the
Commission should consider shoring up on its ability to monitor cross-subsidization, in
other words, the use of the regulated business with its stable profits and captive
customers to support the activities of competitive businesses. For example, it could
establish yearly audits (instead of every three years) and it could request access to all
records related to affiliate transactions. Furthermore, tied to the compliance audit, it
could more thoroughly monitor cost allocation.
Also, while Texas Energy Future Holdings as made commitments to maintain the capital
structure at Oncor, more could also be done to ensure that the capital structure at Oncor
Electric Deliver Holdings be kept in check and that penalties are enforced for
deteriorating in credit ratings.
Finally, few commitments are made and few regulations in place to protect a still-fragile
competitive market in Texas. While the PUCT has some authority by way of the required
market power mitigation plans, many generation facilities affiliated with TXU and other
utilities that were incumbent before deregulation are grandfathered under Texas law such
that they are not required to file market power mitigation plans if they own or control
more than 20% of capacity in a power region.45 Therefore, it is ultimately up to the
legislature to ensure that the proper controls are in place to prevent market power and
market abuses.
44
45
Balance of Power: TXU, this legislative session was all about you.” Dallas Morning News: Editorial, 31 May 2007
Public Utility Holding Act, TEX. UTIL. CODE ANN. §§ 39.154 (Sept 2005)(PURA)
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43
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.
Pre-Buyout TXU
TXU Operational Performance
Although financially a healthy company today, TXU has shown some operational
weaknesses that create a third factor on top of deregulation and PUHCA repeal that has
attracted the buyers.
In March, the PUCT launched an investigation into TXU Wholesale due to wholesale
transaction prices that appeared to be 4% higher than they should have been,
subsequently recommending that TXU Wholesale be required to pay $210 million. TXU’s
reaction was to deny any wrongdoing and threaten to shut down power plants, which
would jeopardize supply.46 A final decision regarding the allegations and subsequent
penalty has not been reached.
The most high-profile complaint against TXU was its proposal to build eleven new
pulverized coal power plants fast-tracked by Governor Perry. In late 2006 and late 2007,
TXU and the Texas legislature were confronted by the public and environmental
advocacy groups over the impact the plants would have on climate change and air
quality. An inevitable blow to TXU’s strategy of providing low-cost generation that could
be built with efficiency and scale, 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.
Finally, although not a factor in KKR, TPG and partners’ bid for TXU, the proposed $279
million payout that CEO John Wilder reportedly stands to gain upon closing of the deal
(more as the premium for TXU paid by the buyers increases) has raised some eyebrows.
Retail
It is amidst such accusations and backlash, coupled with high prices in comparison to
some new entrants, that TXU retail sales volumes have decreased 11%, 17%, and 12% in
2006, 2005, and 2004 respectively. Given the increase in retail prices and demand, these
declines can be attributed to customer attrition.
46
Carr, Housley. “Texas PUC Orders TXU’s Rates to be Investigated; Staff Urges Market Penalty.” Electric Utility Week. 2
Apr 2007
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44
TXU Energy is now focusing on several initiatives in an effort to retain existing customers
and acquire new customers both inside and outside of ERCOT. On the customer service
side, TXU is focusing on improving the online customer experience and tools, reduce call
center wait times, and improve effectiveness of the call center reps. A company that had
become complacent in such matters due to a lack of competition, TXU has made major
investments in technology and training programs aimed at improving such customercentric capabilities. TXU claims to have reduced complaints to the PCU by 50% in 2006
despite higher prices.47
In addition to improving customer service, TXU has focused on tailoring products to
meet individual customer needs. In 2006, through its “Pick Your Plan” initiative, TXU
offered 13 different residential products, nearly triple the number offered by its nearest
incumbent competitor Reliant. Plan options include month-to-month plans, three-year
contracts, various mixes of renewable generation, and plans that track fuel prices. The
plans are meant to address customers’ diverse needs, values, and tolerance for risk. In
2007, TXU is shifting focus to demand-side products that will help customers to save via
lower consumption or consumption by time of day.
Recent loyalty plays include customer appreciation bonuses and rebates as well as a
loyalty program whereby customers receive points each month that their account remains
in good standing.
The success of these marketing initiatives—coupled with an increase in outdoor, TV,
radio, and direct mail advertising coinciding with expiration of price-to-beat -- remains to
be seen.
While a number of competitive and market factors could affect TXU’s strategy, its goal is
to increase its ERCOT residential load 10% by 2010 in part by increasing out-of-territory
customers from 13% to one-third. While TXU has seen modest growth in its ex-territory
small business and residential segments, these gains have far from made up for
commercial and in-territory losses so far.
47
TXU Annual Report 2006 (27 Feb 2007)
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45
Retail Sales Volume (GWh)
Commercial & Other
25,466
Ex-Territory Small
Business
15,843
363
3,089
10,476
30,897
674
3,416
14,031
9,004
671
3,663
7,753
29,239
25,932
Ex-Territory Residential
In-Territory Small
Business
In-Territory Residential
2004
2005
2006
TXU Annual Report, 2006
Market share has decreased among all retail customer segments. Nevertheless, TXU’s
objective of achieving 40% residential market share in ERCOT from 37% in 200648 would
be attainable with or without new owners.
Wholesale
According to TXU’s annual report, it currently maintains 18% of ERCOT peak capacity,
under the 20% of ERCOT allowed by law. Capacity varies by zone such that, in 2005, TXU
maintained 54% capacity in its home Northeast Texas zone and 44% in the North zone.
TXU’s primarily baseload capacity consists of 5,837 megawatt (MW) of lignite and 2300
MW of nuclear, which has high fixed costs, but low variable costs. In contrast, 50% of
total ERCOT baseload (71% total capacity) is low fixed, high variable cost natural gas.49
Because prices in the market are based upon natural gas prices, TXU’s mix of capacity
allows it to maintain a low-cost advantage and better margins. “Tight supply in this
market creates a structural advantage for TXU.”50 In part due to the natural gas prices
that have elevated market prices, TXU Energy (wholesale and retail) gross margins have
risen from 32% in 2005 to 49% in 2006.51
Finally, TXU has also learned to take advantage of tight supply by “stringently
manag[ing] risk.” Per CEO John Wilder, “One of our most significant accomplishments
during the turnaround is our commodity-risk hedging program . . . [which] reduces
exposure to changes in future electricity prices due to changes in the price of natural gas.
It substantially reduces commodity exposure inside TXU and enables us to increase the
certainty of our cash flows.”52 Moving forward, TXU will continue to capitalize on its fuel
hedging capabilities to mitigate risks associated with volatile fuel prices.
Wilder, John C, “TXU.” EEI Conference. 7 Nov 2006
Shields & Company, April 4, 2007
50 TXU Annual Report 2006 (27 Feb 2007)
51 TXU Annual Report 2006 (27 Feb 2007)
52 TXU Annual Report 2006 (27 Feb 2007)
48
49
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46
Transmission and Distribution
TXU Electric Delivery, which legally changed its name to Oncor after the buyout
announcement, is still a regulated business.
TXU Electric Delivery undertook two major initiatives. First, it put itself up for sale but
withdrew the effort after receiving negative reaction to the plan. Second, it then
established a joint venture with InfrastruX group to provide construction, power
restoration, and maintenance of the grid, a deal to be terminated upon close of the
buyout.
TXU also finalized an agreement with Current Communications Group, LLC to utilize
TXU’s distribution network as a broadband-enabled smart grid that can more effectively
detect, prevent, and restore outages, and more efficiently distribute advanced meter
monitoring and products such as time-of-use plans. Already in 2006, Current installed
fiber optic cables across much of TXU’s ERCOT distribution network. And TXU ED,
which has already installed 285,000 advanced meters, plans to install 500,000 more in 2007
and 3 million by 2012. Texas legislation will allow Oncor to pass these costs on to
consumers through the rate base.
The buyers have pledged to hold on to a majority stake for five years; to establish a
separate company with a separate board and separate headquarters from the rest of TXU;
to maintain a 60:40 debt-to-equity leverage ratio; to remain true to TXU Electric &
Delivery plans by committing $3 billion in capital expenditure over the next five years;
and to double investments in demand-side management programs without seeking to
cover in rates the additional $200 million in expenditures.
ERCOT President & CEO Sam Jones stated in a letter responding to US Representative Joe
Barton’s concerns that the deal might impact on reliability, that “ERCOT has determined
that the proposed buyout [of Texas Utilities Corporation (TXU) by Kohlberg Kravis
Roberts & Co.] does not represent a threat to the reliability of the ERCOT grid. The
electric transmission and distribution function will remain regulated under the
jurisdiction of the PUCT.”53
TXU Financial Performance since Deregulation
Despite the accusations by regulators and the public that TXU pricing and market
manipulation have hurt Texas ratepayers, and despite related bad press, TXU has
managed to focus on one group of stakeholders: Wall Street. It has promoted its successes
in reorienting TXU to a competitive market, completing a $1.2 billion restructuring in
2004 and, more importantly, outlined its plans for growth. TXU is widely viewed as one
53
Letter for Electric Reliability Council of Texas in Response to U.S. Rep. Joe Barton, 29 Mar 2007
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47
of the electric power industries success stories, the stock price having outperformed the
Dow Jones Utility Index since late 2004.
TXU Stock Price Performance vs. Dow Jones Utility Index and S&P
(2000-Present)
TXU
Price Change
Dow Jones
Utility Index
S&P
Year
Most of the other recent buyouts that have either moved or crashed involve a clear
problem case. PGE was owned by Enron and needed a new parent or permission to
rebuild as a standalone company. PacifiCorp was in trouble with regulators in Oregon,
Washington and Utah. Its owner Scottish Power, overwhelmed by the complex multistate regulatory morass that limited its return, wanted out. Duquesne’s merger with
Allegheny failed and, as a small player, its board and CEO tried many times to sell.
TXU is different. It is arguably a healthy company that successfully recovered from some
serious foreign investment debacles and has had outstanding stock performance. Is there
any reason that stand-alone TXU could not provide the same benefits promised to
customers in terms of rates, the same commitment to environmental stewardship, the
same investment in conservation, and the same plans to build cleaner generation
capacity? Finally, would any benefits provided by the new owners benefits that would
not be possible or likely under existing ownership—be enough to outweigh the risks
posed by the transaction?
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48
Potential Benefits and Risks to the Buyers
In recent years, private equity funds have dramatically increased the number and scale of
their transactions, especially in the past year.
On the demand side, forecasts for electricity consumption are positive and, given little
demand elasticity for electricity, will continue to accelerate unless significant gains in
efficiency and conservation can be achieved (also a potentially lucrative area for the
buyers). Rising prices driven by supply and demand for fuel and capacity shortages are
also a draw.54
TXU in particular has healthy cash flows that are stable on the transmission and
wholesale side and, therefore, attractive to private equity buyers. Industry-leading
margins also give TXU room to compete by lowering prices. TXU’s reliance on nuclear
and coal generation give it a competitive advantage in that most competitors in the state
buy generation based upon higher-priced natural gas. Hence, reducing prices by 15%
makes TXU even more competitive while not resulting in razor-thin margins.
The buyers may also see opportunities as follows:
 By selling off minority interests in each of the three businesses—retail, wholesale
and transmission—they may be able to improve TXU’s credit facility while also
producing returns for investors. For example, the sale of a minority 49.9% stake in
delivery could result in $3B55 and selling a minority stake across all three
businesses could pocket the owner billions more—perhaps enough to satisfy
debtors and credit agencies, cash in on some returns for investors, and invest in
remaining assets.
 A 15% retail rate cut looks good in the eyes of the public, but with 23.5% gross
margins in competitive businesses in 2006, TXU appears to have room to reduce
rates while still achieving healthy margins. And it looks unlikely that other
providers will be required to follow suit.
 While nobody will balk at rate reductions, TXU nevertheless retains the ability to
increase rates after December 2008, giving it enough time to stabilize its customer
base at lower rates.
 The ability to turn new demand-side offerings into profitable retail products—for
example, technology that will allow end users to control electricity use on their
premises, control bills real-time, or control electricity use wirelessly or remotely.
 With the help of their partner Goldman Sachs, often believed to be the masters of
hedging, continue to realize gains on fuel price hedging.56 A precedent for this
has been set by the Texas Genco buyout, in which Goldman Sachs was granted an
“Private Equity Firms Discover Electricity – And Lead the Charge for Energy Investment,” Wharton Private Equity Review.
Knowledge@Wharton,26 Apr26, 2007 <http://knowledge.wharton.upenn.edu>
55 Moore, Raymond E., CFA. “Au Revoir TXU.” Shields & Company [Analyst Report]. 4Apr 2007
54
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
off-take agreement that allowed Goldman’s commodity trading house, J. Aron, to
manage 25% of Texas Genco’s 5,200 MW baseload generating capacity.57
The bet that investor-owned utility stock prices will continue in a positive
direction such that TXU assets will sell at a premium in five years, producing the
desired returns.
Deal Financing and Resulting Capital Structure58
The new TXU that would emerge under the banner of Texas Energy Future Holdings may
be one with more freedom from the strain of public and shareholder scrutiny. And it
would be much more highly-levered, raising fears that long-term investments in supply
and reliability would be more costly for the customer and less desirable for the owners.
The structure of deal includes a $33 billion buyout of TXU equity and assumption of $12
billion in existing debt.59 To finance the deal, the buyers will contribute $8.5 billion in
equity, including a $1 billion equity bridge, a financial instrument in the form of the
banks’ own cash. The equity bridge is an arrangement that “allows leveraged buyout
firms to buy companies with even less cash upfront. The idea is that the LBO firms will
find other investors who will ante up cash after the deal is announced . . . these bridges
can lead to trouble, however, if the private equity firms cannot find investors.”60
In addition, the buyers will take on an additional $24.5 billion in debt to finance the deal.
Counting the equity bridge as equity, this would bring leverage for the deal above 80%.
While not atypical for a leveraged buyout, it is hard to imagine where the buyers will
place all of this debt in a corporation that, with an 85% total debt to total capital ratio as of
the end of 200661, is already leveraged beyond the 50-60% of typical utilities.
The major credit rating agencies acted quickly in expressing concern over the leverage.
Standard & Poor’s recently downgraded TXU debt to below investment grade and put it
on Credit Watch with negative implications. Primary reasons cited included immediate
price reductions to customers to support the approval, which would “reduce cash flows
somewhat through 2008,” exposure to large fees associated with the cancellation of eight
coal-fired plants, and the continuing decline in retail customers.62
Moody’s shares the opinion that the buyout would be bad for bondholders in the longterm, saying that, despite the owners pledge to hold on to TXU assets for five years,
“Effort to Take TXU Private Leaves Questions Hanging Over Fate of Wholesale Trading Arm.” Power Markets Week, 16
Apr 2007
58 “TXU to Set New Direction as a Private Company,” TXU [News Release]. 26 Feb 2007.
<http://www.txucorp.com/media/newsrel/detail.aspx?prid=1020>
59 Klaus, Faith. “Electric and IPP Update.” Bank of America. [Analyst Report]. 26 Feb 2007
60 Sorkin, Andrew Ross. “Private Equity Buyout of TXU is Enormous in Size and Complexity.” The Wall Street Journal, 27
Feb 2007
61 Bloomberg Financial Analysis. 14 May 2007
62 “Ratings Agencies React Swiftly Over Debt Concerns.” Electric Power Daily. 27Feb 2007
57
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“Moody’s views the motives of private equity buyers with skepticism.”63 In
downgrading TXU debt to Ratings Watch Negative, Fitch argued that “the acquisition of
TXU would be funded through a highly leveraged entity, or result in the incurrence of
substantial indebtedness at the TXU holding company or subsidiary levels,” adding that
there is “uncertainty concerning the strategic direction of the company as well as likely
changes to the financial practices and corporate structure of TXU and subsidiaries.”64
Combined with various factors that could negatively impact earnings, all three of the
major corporate credit rating agencies feel that TXU’s credit facility could come under
strain.
The ratings agencies have based their opinions on total corporate debt. To protect against
risk introduced at the parent and subsidiary levels, the buyers have committed to keeping
the debt off of Oncor’s balance sheet so that debt related to the transaction cannot be
passed through to customers via the rate base. In addition, the Oncor debt-to-equity ratio
will remain at around 60% as prescribed by ERCOT.
So that leaves the deregulated side. By some estimates, $12-$14 billion of the new debt
could realistically be securitized by the generation arm Luminant, where most of the
generating assets lie. The remainder of the debt would most likely come in the form of
more expensive second lien and unsecured notes.65 Due to existing TXU debt covenants,
none of the new debt would supersede the old debt.
As argued by Boston University School of Management energy expert Mark Williams,
“Overall a leveraged buyout isn’t a bad strategy. But when it comes to the utility sector,
when you’re increasing debt, then what you’re doing is to pay that debt off.” And in a
business with a predictable revenue stream that is unlikely to increase dramatically,
regulators are concerned that “you’re going to meet [debt obligations] by decreasing
costs, which also affects the three measurements: that’s the safety, dependability of
delivery, and ultimately then the costs.”66
Finally, ownership of regulated and unregulated businesses by a holding company raises
questions over cross-subsidization—essentially the ability to use a regulated business’s
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 addressed concerns over cross-subsidization quickly and rather
unambiguously by announcing that the company would be broken into three distinct
businesses with separate boards, management teams and headquarters. Oncor
“Moody’s Says TXU Buyout Bad for Bondholders.” Power Market Today. 28Mar 2007
“Ratings Agencies React Swiftly Over Debt Concerns.” Electric Power Daily. 27Feb 2007
65 Klaus, Faith. “Electric and IPP Update.” Bank of America. [Analyst Report]. 26 Feb 2007
66 “Visibility of Debt-Laden Utility Buyouts Scrutinized After Adverse State Rulings.” Power Markets Today, 15 Mar 2005
63
64
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(transmission & delivery) is to be headquartered in the Dallas suburb of Irving while
Luminant (generation & wholesale) is to be headquartered in Dallas. TXU Energy (retail)
would also remain in Dallas. Further, a separate holding company would be placed
between the parent, Texas Energy Future Holdings, and regulated Oncor.
Potential Benefits and Risks to Ratepayers
At first blush, the buyout by KKR, TPG and Goldman Sachs is a win for all sides.
Shareholders will receive a 10% premium if they vote for the deal. Customers will receive
a 15% rate reduction. And Texas Energy Future Holdings is credited with making
addition efficiency investments and, most of all, with putting the nail in the coffin of eight
coal-fired plants.
It is not out of the question that, if the deal goes through, the buyers could de-lever by
selling minority stakes in the business or pieces, such as generation assets that are above
the share of capacity in its home markets at which concerns over market power abuse are
raised. They could also reduce the exposure of the new TXU and its subsidiaries by
seeking co-investors and reducing costs. It is, thus, not inconceivable that they could
achieve a reasonable amount of leverage within a relatively short period of time. Add to
that cost-cutting and a well-executed strategy, and they may even be able to innovate on
the supply side, the demand side, or both.
In theory, their freedom from the short-term demands of Wall Street gives them the
flexibility to innovate. But history does not clarify whether the private equity buyers will
really focus on performance of an asset they intend to hold or whether the claim is
rhetorical. Their reputation is that they will buy it, strip it, and then flip it. So it would be
reasonable for ratepayers and regulators to be nervous despite the buyers’ stated
“commitment to new generation, alternative generation, conservation, and efficiency.”
Cost Reduction & Synergies
In other states, commissions have also looked for benefits resulting from synergies
created by the combination of two utilities, which could result in cost savings through the
reduction of duplicative and, therefore, redundant operations or overhead. Similarly,
Commissions can also look for a sharing of best practices across the merged entities
through cross-pollination of resources and expertise. Financial buyers are unable to
provide such benefits by nature of their businesses. While not necessarily precluding
investor buyouts, such lack of potential synergies makes demonstrating cost savings or
other operational benefits all the more critical for these buyers.
Rates
TXU Energy rates will be held steady in the near term, but there is no guarantee that they
will not increase after December 2008, in part due to the upward direction of electricity
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52
prices across the nation. With the elimination of price-to-beat, TXU has the opportunity in
the near term to price low enough to win new customers or, at a minimum, stanch the
bleeding of existing customers. Then, in December 2008, when TXU is no longer
committed to keeping rates low, they can raise prices again. Depending on the state of
competition in Texas and consolidation of players at that time, TXU competitors could
follow in pursuit of profitability . . . and may have to if the price of natural gas upon
which they depend continues to rise..
Balance Between System Investment and Rates
In reviewing merger proposals, there is an inherent struggle to determine the appropriate
balance between system investments and rates. Oregon is a prime example: On the one
hand, the Commission raised concerns about the low level of investment that TPG
proposed in its acquisition of Portland General. On the other, MidAmerican’s emphasis
on system investment also raised concerns because system investment would ultimately
result in higher rates to customers.
As it stood, PacifiCorp under Scottish Power had already published plans for a 4% annual
rate increase due to investments. Hence, while the lack of investment in PGE was
worrisome, the commitment to investment by MidAmerican was perceived to tip the
balance too much in the other direction. Per the Citizens’ Utility Board of Oregon, “as rate
base rises, with little apparent concern for the effect that it has on rates, customers will
begin to realize that MidAmerican’s benefits for customers somehow feel more like
benefits for shareholders.”67 The TXU buyout is more likely to raise concerns about lack
of investment.
Fair Competition and Market Power
Long term investments and rates are the most obvious concerns that regulators and
ratepayers might have about the transaction. The National Regulatory Research Institute,
a policy research agency within the National Association of Regulatory Utility
Commissioners (NARUC), has also identified several structural, though less obvious risks
inherent in utility mergers and acquisitions, risks that were addressed by PUHCA 1935
but are no longer covered under PUHCA 2005 or existing state and federal statutes. These
include transfer pricing between affiliates, cost allocation and cross-subsidization, and
financial abuse.
Transfer pricing occurs in one of two ways: When a utility subsidiary or affiliate charges
above-market costs for goods and services believing that the utility in a non-competitive
or near-monopoly market can pass those costs through to customers. Per NRRC, “passing
through of the cost might adversely affect customers, particularly captive customers who
as a practical matter do not have a choice. Hence, there is the moral hazard created by the
67
MidAmerican Energy Holdings Company & Pacificorp, Application for Authorization to Acquire Pacific Power & Light: Comments
of the Citizens’ Utility Board of Oregon. Public Utility Commission of Oregon, Docket UM 1209 [Public Comments], 14 Oct
2005
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53
holding company structure.”68 An example of this in TXU’s case might include the selling
of wholesale power to retail that, until recently, had a strong enough foot hold in certain
ERCOT zones as to be a virtual monopoly.
TXU’s loss of market share in North Texas makes it less and less like a monopoly, so
transfer pricing between retail and wholesale may not be an issue. In addition, while
transfer pricing between the unregulated businesses and Oncor could be a concern, the
buyers have made commitments that set the stage for preventing this and maintenance of
separate Oncor books should allow for the monitoring of such activities.
Cross-subsidization tends to occur when a utility and its affiliate share operating, capital
or administrative accounts. Sharing costs makes efficiency sense by creating synergies,
but also creates problems: Because regulated company costs can be passed through to
customers, there is a natural temptation to shift as many costs as possible to that unit. For
example, TXU Energy (retail) could fund demand-response product development, which
could eventually be commercialized, through investments in Oncor’s smart grid. The
commitments made by Texas Energy Future Holdings to separate Oncor and to put ringfencing around it with a separate holding company between Texas Energy Future
Holdings and Oncor would essentially prevent this. However, that’s not to say that TXU
Energy could not benefit from secure loans from or with assets secured by Luminant
(generation and wholesale), which maintains a near monopoly in the Northeast ERCOT
zone.
Repeal of PUHCA 1935 also opened the door to other forms of financial abuse where state
laws did not cover the gaps left by PUHCA repeal, including the use of utility assets to
collateralize affiliate loans. For example, Luminant could conceivably secure
infrastructure-development loans at a lower rate using Oncor’s assets. Holding
companies could also potentially treat the regulated unit as a cash cow to provide
working capital to affiliates, thereby jeopardizing the reserves required by the utility to
maintain reliability. On a related note, “the holding company structure can lead to utility
expenditures that support technological innovation of unregulated subsidiaries or
affiliates within holding companies.” While such innovations can be useful, they may
also detract from needed innovation in less profitable, regulated affiliates.
Per the National Regulatory Research Institute, “Although commission authority
concerning cost allocation, cross-subsidization, and transfer pricing is common, most
state commissions have not been concerned as to whether they have authority to protect
against corporate abuses [such as those described above.’”69
Burns, Roberts Esq. and Michael Murphy Esg.“Repeal of the Public Utility Holding Company Act of 1935,” National
Regulatory Research Institute. [Briefing Paper]. August 2006
69 Ibid.
68
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Local Ownership
Beyond concerns over market power manipulation through market share are concerns
over the political leverage that might result in longer-term consolidation of industry
players, particularly on a national basis. As in any difficult decision, there are always
trade-offs. Some industry followers would argue that consolidation is needed—that the
industry is too fragmented and balkanized and that consolidation would lead to
economies of scale that would benefit the industry and ultimately ratepayers. Others
might suggest that the efficiencies gained in scale would not be enough to outweigh the
risks of loss of local ownership and oversight.
In Oregon, opponents of the PacifiCorp-MidAmerican deal stated that “troubling is the
loss of local concern by a detached and disinterested corporate behemoth. PacifiCorp may
well become one utility in a national stable . . . one need only look at the
telecommunication industry to find an example of an industry tired of local affairs, local
concerns, and individual state regulation, so much that it convinced Congress and federal
regulators to ignore local concerns and set uniform national policy in order to preempt
state regulation . . . establishing conditions to ensure that local concerns are not a thing of
the past will be difficult.”70
Transparency and Reporting
Ownership of utilities by holding company or by private entities raises concerns over
transparency. Concerns over holding company ownership derive mostly from the
multiple layers of ownership that must be monitored in order to prevent crosssubsidization, inappropriate cost allocation, and other corporate abuses. While most
utilities are required by state law to file reports detailing operations and some level of
finance, the existence of multiple layers of regulated, unregulated, and holding
companies—especially those straddling multiple states — makes this more difficult. One
concern about the MidAmerican-PacifiCorp deal in Oregon was that, “this transaction
creates enormous uncertainty not only about decision-making, but also the history to
trace decisions . . . such decisions must be well-recorded, transparent, and accessible to all
parties.”71
In Texas, a number of audit and reporting measures and processes have been put in place
relating to transmission, wholesale, and transactions across affiliates that must be
followed regardless of ownership. It is perhaps for this reason that the current
Commission is not likely to be any more concerned about monitoring, if not controlling,
the new TXU than it was the old TXU.
70
71
MidAmerican Energy Holdings Company & Pacificorp, Application for Authorization to Acquire Pacific Power & Light: Comments
of the Citizens’ Utility Board of Oregon. Public Utility Commission of Oregon, Docket UM 1209 [Public Comments], 14 Oct
2005
Ibid.
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55
As in private equity buyouts in any industry, opponents can argue that lack of strict
financial reporting requirement to the SEC makes it more difficult for federal and state
bodies to prevent abuse. They can also argue that privately-owned companies are not
beholden to the same reporting and corporate governance standards as are publiclyowned companies post Sarbanes-Oxley. To address this criticism, the buyers have
committed to filing quarterly financial reports to the SEC—although it is not clear
whether these reports will be by operating company or at the holding company level.
Regardless, when it comes to reporting to the SEC, PUCT staff claims that the extra level
of financial reporting is nice to have but not critical to the Commission’s mission.
Because the industry is critical to the public interest and historically heavily regulated, it
may be that reporting requirements are already stricter than they are in other,
unregulated industries.
Long-Term Ownership
Private equity’s reputation for strip and flip strategies has led to concerns by regulators in
the TPG-PGE, Babcock & Brown-Northwestern Energy, and KKR-Unisource deals that
the buyers would acquire the companies only to strip them for their assets and turn a
profit as quickly as possible, jeopardizing future resource adequacy, rates, and reliability
due to a disregard for the long-term planning typically required for utilities to adequately
serve the public.
Long-Term Investment
As mentioned earlier, it is hard to fathom how the buyers will see such returns, let alone
returns in the low to mid teens that they typically require. Upon closing of the deal,
interest coverage will be very low—one projection has cash flow equal to interest
coverage until year four—and that’s assuming that TXU is able to maintain 2006 cash
flow levels.72 Per Institutional Investor, “even the savviest of LBO practitioners are
beginning to wonder how long these flush times can last. Many deals are being financed
with as much as 70% to 80% borrowed money. That is fine when rates are low and credit
is strong. But when interest rates rise, it’s a recipe for trouble, especially when private
equity firms are issuing new debt from their portfolio companies.”73
Given the new TXU’s credit facility, it is difficult to guess from where they’ll find the
funds to make investments in new generation or end-user technologies without selling
assets. Although they have publicized plans to build new, clean nuclear and IGCC
capacity, the time horizons related to siting, permitting, planning, and building these
types of capacity are longer than the five years that the buyers have committed to holding
a majority stake in the enterprise. This compares to a typical 5-year time horizon for
building a coal plant or, in TXU’s best case scenario, 3.5 years.
72
73
Moore, Raymond E., CFA. “Au Revoir TXU.” Shields & Company [Analyst Report]. 4 Apr 2007
Paulden, Pierre. “Leveraged Burnout?” Institutional Investor, 11 May 2006
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KKR and TPG Hold and Sell Track Record
Concerns over the buyers’ intentions to invest, or not, in strengthening the company are
valid. The 2004 buyout of Texas Genco by a consortium including KKR and TPG is
perhaps the best case in point. Within months of closing the deal for the power generation
company, the investors had spun off major assets and, within 13 months, had sold the
rest of the company for double the price they bought it at. At the same time, TPG has a
reputation for buying distressed assets, turning them around, and making tidy returns.
Though it has completed dozens of deals, KKR is perhaps best known for its leveraged
buyout of RJR Nabisco in 1989 made famous in the book Barbarians at the Gate. Since then,
the “leveraged buyout” firms have come to be known as “private equity” firms and, in
many cases, sealed their reputations for buying companies, stripping their assets, or
flipping them for a profit. Both KKR and TPG have been involved in deals that have been
criticized for quickly turning a profit for the owners while producing little added value,
at the same time, both have also made smart investments that have made them lots of
money while also benefiting the target companies.
On the former side are both firms’ acquisition of Texas Genco where, within 13 months of
closing the deal, the buyers sold off some generation assets and then doubled their
investment by selling the bulk of the company to NRG.74 Another example is TPG’s
acquisition of UK retailer Debenham’s, in which it turned a £600 ($1.2B)75 investment into
a £1.8 ($3.6B) billion gain, but after 2 ½ years, left the company saddled with debt and
unable to produce the capital expenditures needed to update its shabby stores.76
To their credit, KKR and TPG aren’t always guilty of stripping and flipping so much as
making savvy investments. In 1997, KKR bought KinderCare and held onto it until 2004,
when it sold the company for 2.7 times its investment.77 In fact, one KKR executive
indicated that KKR’s average holding time is seven and one-half years.78
Perhaps most notably is TPG’s 1997 acquisition of a 60% stake in then-private J.Crew,
which was a has-been retail chain. TPG held onto the company for nine years before
taking it public. In the interim, TPG brought in retail visionary Michael Drexler, who had
once been at the helm of the GAP, and gave him an ownership stake. Drexler changed the
culture and turned the company around. Under TPG ownership, the chain also cut back
on the number of stores. The 2006 IPO of J.Crew was one of the hottest in the sector. TPG
turned a tidy profit, but also left the company in much better shape.79
“Effort to Take TXU Private Leaves Questions Hanging Over Fate of Wholesale Trading Arm,” Power Markets Week,
Apr 16, 2007
75 At May 14, 2007 exchange rate <http://www.oanda.com>
76 Cranage, John. “Debenham’s Broken Dreams Show the Danger of Private Equity. ” Birmingham Post. 23 April 2007
77 Carey, David. “KKR Gets $1B for KinderCare.” TheDeal.com. 9Nov 2004
78 Washington, Stuart and Lisa Murray. “KKR a Kiss and Run Merchant.” The Sydney Morning Herald, 27 Nov 2006
79 Rosenbush, Steve. “How Texas Pacific Cleaned Up at J.Crew.” BusinessWeek Online. 6Feb 2007
74
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Select KKR/TPG Deals
Firm
Target
Timeline
Returns
KKR
(club
deal)
Sealy
•Bought ’04
•IPO in ’06
$809M on $327M investment, but left mattress firm
holding lots of debt, which handicapped firm in
using cash flow to pay off debt and dividends
KKR
(club
deal)
Yellow Pages
Group
•Bought in ’02
•Sold major stake in
’04
$343M investment to $1.2B
KKR
ITC Holdings
(transmission)
•Bought in ‘03
•IPO in ’05
$610M equity stake. Sold stake for $250m. Still holds
~$1B in publicly-traded shares
KKR
(club
deal)
Evenflo
•Bought as part of
Spaulding in ’98.
•Sold in ‘04
Bought for $89.1M in equity. Sold privately to
Harvest Partners for $120-$200M
KKR
KinderCare
•Bought in ’97.
•Sold in ’05
Made 2.7 times original stake by selling privately for
$1.04B eight years later
TPG
J.Crew
•Bought in ‘97.
•IPO in ‘06
Paid $560M for 60% stake, including $125m equity.
Credited with turnaround. Has made 600% gain
TPG
(club
deal)
Burger King
•Bought in Dec ’02
•IPO in ’06
Have made 4.5 times original investment of $620M
in equity
TPG
Continental
Airlines
•Bought in ‘92
Made $700M on $66M investment after turning
bankrupt airline around
TPG
MEMC (semiconductor)
•Bought in ’01
•Sold in ‘04
Bought troubled chipmaker for $6 (yes, $6) and
$910M in debt. Sold half of stake for $1b and still
owns $750M in shares
Given their histories, it is hard to imagine that the private equity buyers are interested in
TXU for the long haul. Furthermore, TXU can hardly be considered a distressed
company. And given that turnarounds tend to be the exception rather than the rule in
private equity, who wouldn’t question whether the buyers intend to flip whatever assets
allowable in the near-term in order to turn a profit?
However, their histories also suggest that a five year ownership horizon is not out of the
question and that value can be added in that timeframe.
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Potential Environmental Benefits and Risks
Pre-Buyout TXU
When it comes to environmental stewardship, TXU has not set the bar terribly high for
any potential suitor—other than perhaps one looking for the subject of a dramatic
makeover.
To its credit, per a PUCT representative, TXU has been meeting its state-mandated
requirements for efficiency and demand-side management investments, in part through a
venture that has enabled it to facilitate, through the installation of advanced meters, the
creation of new retail products centered on time-of-use and other demand-management
options. Under the new initiative, TXU expects to replace the meters of all 3 million
customers by 2012. Overall, it had committed $200 million to such demand side
management (DSM) programs and energy efficiency. In a recent report sponsored by the
National Resources Defense Council, every $1 in demand-side management could create
a $4.50 energy savings.80
While renewable energy represents only a fraction of the power that TXU Energy uses, it
was nevertheless the top purchaser of wind power in the state—at about 750 megawatts.
But on the generation side, the company’s pulverized coals strategy more than offset any
environmental benefits created by such actions on the retail and electric delivery sides.
TXU’s plans to build 11 of the dirtiest pulverized coal plants destroyed any social capital
it might have built via those initiatives. On the contrary, it drew negative attention to
TXU and to Texas on a national level. In fact, the 11 plants would have added more coalfired electricity capacity than has been added in the entire U.S. in the last ten years.81
TXU Corp.’s environmental performance and strategy also earned it the dubious
distinction of a top-ten spot on the Climate Watch List. The list was created by socially
responsible investors under the leadership of Ceres--a leading coalition of investors and
environmental groups--to identify companies lagging behind their industry peers in their
response to climate change and subsequently file shareholder resolutions with those
companies. According to Ceres president Mindy Lubber, “many U.S. companies are
confronting the risks and opportunities from climate change, but others are not
responding adequately – and they may be compromising their long-term competitiveness
and shareholder value as a result.”82
Optimal Energy, The Natural Resources Defense Council and Ceres. “The Power to Save: An Alternative Path to Meet
Electric Needs in Texas,” Ceres, Jan 2007 <http://www.ceres.org/pub/docs/Ceres_texas_power.pdf>
81 Thomson, Vivian E., David Gardiner and David Grossman. “TXU’s Expansion Proposal: A Risk for Investors,” Ceres, 25
Feb 2007. Ceres. < http://www.ceres.org/pub/publication.php?pid=236>
82 “TXU, Exxon Mobil Among 10 'Climate Watch' Companies Targeted by Investors.” Ceres [Press Release]. 13 Feb 2007
80
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And while it would seem that TXU’s coal strategy was mainly an environmental and
health risk, there were also economic risks inherent in the strategy—though perhaps not
great enough to offset the potential profits from cheap coal. Assuming that the coal
plants, though carbon capture-ready, did not have the technology in place to reduce
carbon emissions; assuming climate change legislation passes between now and when the
plants would come online; and assuming the plants would not be grandfathered to make
them exempt from the legislation, TXU might have had to pay between $917-$2.3 billion
annually due to emissions and purchasing carbon credits. Furthermore, it would have
been the third largest emitter of CO2 of all 3000 U.S. electric utilities.83
So far, Wall Street seems to have endorsed Wilder’s strategy via healthy market returns.
Likewise, Institutional Investor had named Wilder the top CEO in the power industry for
2004 and 2005.
But if the electricity industry pulse is any indication, the strategy would produce only a
short-term competitive advantage. Per a new GF Energy survey of 97 North American
electric utility executives, 96% expect global change to have a significant impact on their
technology choices in the next three years and 89% believe that new environmental
standards and/or uncertainties will make it more difficult to build fossil plants in the next
three years. 84 There seems to be consensus that climate change is and will continue to be
a major industry issue and that climate change legislation is inevitable. And a majority of
utilities are making this a key part of their strategic planning process.
TXU would undoubtedly continue to lead the charge in lobbying against climate change
legislation.85 But in such an environment fraught with regulatory risk, it is hard to
believe that TXU’s coal strategy would continue to be rewarding.
Post-Buyout TXU
It would appear that the success of the TXU buyout hinges on the environmental strategy
of KKR and TPG, especially given the support they garnered from key environmentalists
and their position on global warming that is diametrically opposed to that of the old TXU.
On this point, they appear to have learned a lesson or two from past utility buyout
attempts. Prior to finalization of the commitments made by MidAmerican in the
PacifiCorp buyout, one of the arguments against the transaction was that,
“MidAmerican’s effective silence on the connection between global warming and
PacifiCorp’s future is disturbing. It is decidedly not a benefit to have an owner of a coalheavy utility that does not have a position on how global warming affects operations and
future investment. As the would-be owner of two utilities, each of whose portfolio makeThomson, Vivian E., David Gardiner and David Grossman. “TXU’s Expansion Proposal: A Risk for Investors,” Ceres, 25
Feb 2007. Ceres. < http://www.ceres.org/pub/publication.php?pid=236>
84 “GF Energy 2007 Electricity Outlook”, GF Energy. pending public release 18 June 2007 <www.gfenergy.com>
85 “TXU Pursuing IGCC in TX for PRB, Coal, Lignite,” Power Market Today. 12 Mar 2007
83
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up is mostly coal, MidAmerican may well have an incentive to fiddle as the world
burns.”86
KKR and TPG did more than just pre-empt such opposition, but went further by making
environmental stewardship a key benefit—if not the key benefit—of the transaction rather
than a potential harm.
Representing a commitment to work proactively with multiple stakeholders on the issue
of climate change, the buyers committed to:





Join the US Climate Action Partnership, which is developing a climate-change
program
Support a mandatory cap-and-trade system for carbon emissions
Establish a Sustainable Energy Advisory Board, consisting of a diverse set of
stakeholders
Include on the TEF Board William K. Reilly, who is both chairman emeritus of
World Wildlife Fund and a former EPA administrator (but who is also already on
the TPG payroll as an executive)
Tie executive compensation and performance goals to climate protection goals
Some of these commitments may seem merely symbolic, but one could argue that they
provide intangible benefits by setting a new standard in utility leadership and
encouraging a more innovative stance towards solving environmental problems.
Per Peter Altman, coal campaign director of National Environmental Trust, a nonpartisan group established to inform citizens about environmental problems and how
they affect health and quality of life., “the TXU deal shatters the aura of invincibility
many coal plant developers have assumed, by showing that the growing extent and
diversity of opposition can stop plants that will make global warming worse.”87
It also boosts environmental interests in Washington. One former House Republican aide
says, “it sidelines a major opponent to most of the bills that are out there. They’ll now be
advocating for legislation, for cap and trade.”88
On the demand side, the buyers committed to doubling Oncor’s investments in energy
efficiency and DSM technologies to $400 million. While such an amount might seem like
MidAmerican Energy Holdings Company & Pacificorp, Application for Authorization to Acquire Pacific Power & Light: Comment
of the Citizens’ Utility Board of Oregon. Public Utility Commission of Oregon, Docket UM 1209 [Public Comments], 14 Oct
2005
87 “National Environmental Trust, Innovest: TXU Deal to Send Shockwave Through Other Wall Street Firms Financing
Over
100 Large Coal-Fired Plants Outside Texas.” [Press Release]. 26 Feb 2007.
<http://www.net.org/proactive/newsroom/release.vtml?id=29186>
88 Samuelsohn, Daniel. “TXU Buyout Spurs Talk of Advancing Warming Legislation.” Environment & Energy Daily. 28Feb
2007
86
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a drop in the bucket, it is a step in the right direction given that, according to many
industry leaders, reducing demand may be the smartest way to begin addressing
concerns about energy security and supply.
Per one report, “by investing $11 billion in proven programs and policies focused on
more efficient appliances, office equipment, and building codes, as well as utility
incentives, the Texas economy would achieve $49 billion of economic benefits, a net
economic benefit of $38 billion and eliminating 80% of the forecasted growth in electricity
demand” over the next 15 years, equating to 4000 MW by 2011 and 18,500 by 2021. 89 This
is the equivalent to output of 20 large power plants.
There are those that might even argue that a $400 million investment on the demand side
isn’t nearly enough compared to what utilities are willing to spend on supply.
Environmental Defense spokesman Colin Rowan notes, “We’ve been saying all along that
we don’t need new coal plants in Texas...the state should focus exclusively on optimizing
energy efficiency before building any new power plants.”90
A substantial commitment to reducing demand might seem counterintuitive for a utility,
but the $400 million is not merely a charitable gesture on the part of the buyers. Not only
will they be able to pass at least half of the costs through to Oncor customers, but the
investment may also produce tax benefits and, per the annual report, a platform for
developing retail products.
Finally, and probably most notable from a public relations standpoint, are the generation
commitments made by TXU under leadership of the buyers. First and foremost is the
cancellation upon closing of the deal of the controversial coal build-out, removing from
the equation about 56 million tons of carbon dioxide emission and leaving about 18
million tons.91 The new TXU owners have also committed to installing emissions
controls on the new plants that will reduce sulfur dioxide, nitrogen dioxide, and mercury
by 20% from 2005 levels.92 Still, the three planned coal-fired plants won’t solve the
problem of carbon dioxide emissions.
In a gesture to signal that they’re serious about moving away from coal and perhaps as an
addition means of establishing trust—the buyers have taken several positive steps
towards a cleaner energy future. In the 2006 annual report, published after the deal
announcement and taking into account the probable new owners, TXU stated that it
would invest “$2 billion over next five to seven years for the development and
commercialization of cleaner generation plant technologies, including IGCC, the next
Optimal Energy, The Natural Resources Defense Council and Ceres. “The Power to Save: An Alternative Path to Meet
Electric Needs in Texas,” Ceres, Jan 2007 <http://www.ceres.org/pub/docs/Ceres_texas_power.pdf>
90 “Environmental Group Will Target Other Texas Coal Plants.” Electric Power Daily, 2 Apr 2007
91 Gunther, Marc. “Coal Plants Get Burned.” Fortune, 2 Mar 2007
92 TXU Annual Report 2006 (27 Feb 2007)
89
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generation of more efficient ultra super-critical coal and pulverized coal emissions
technology to reduce CO2 emissions.”93
Already, they have signed contracts to double TXU’s wind purchases to 1500 MW.
In March the company began the planning process for two IGCC commercial
demonstration generating plants in Texas. Requests for proposal were issued asking the
bidders to focus on research and development aimed at improving the efficiency, cost
profile, and environmental performance of gasification technologies.94 TEF also
committed $1 million to support Texas’ bid for FutureGen, a U.S. Department of Energy
project to develop a prototype for a near zero-emissions coal plant.
TEF also took a seemingly positive step by announcing the selection of 1,700 MW
Mitsubishi-designed nuclear reactors on the site of Comanche Peak. 95 We say
“seemingly” because the permitting, siting, planning and building time horizon for
nuclear stretches at least ten years beyond the time when TEF is allowed to exit the TXU
investment. In addition, the buyers have added at least two years on to the process by
selecting the Mitsubishi design, which in contrast to designs by Westinghouse and GE,
has not yet been approved in the U.S.
Given the recent furor surrounding TXU, TEF’s generation commitments would seem to
be the linchpin in their strategy for TXU—yet the timeframes required for getting clean
capacity online and the investors’ typical timeframe for holding a company do not
coincide. One could argue that, even if the clean energy process takes years, Texans will
ultimately accrue these benefits in the long term as the result of TEF laying the
groundwork—regardless of whether they hold onto the company or not. On the other
hand, one could also argue that development of clean technologies is critical and that
future legislation may make it incumbent upon all utilities to make such investments. To
that end, it’s unclear whether the new TXU will continue to fight environmental
legislation as has the old TXU. So far in 2007, it has been successful in its continued
lobbying efforts to curb clean air legislation and prevent a moratorium on coal. It’s
unclear what part the new owners played in influencing the 2007 regulatory standstill.
If the environment were the sole determinant of whether the post buyout TXU is better
for Texas than the TXU Corp. under current ownership, Texans would almost certainly
benefit from the deal. But the regulators who are influencing the stipulations placed
upon the deal should consider the likelihood that legislation would have forced TXU to
change course regardless of ownership. More importantly, the environmental benefits
need to be weighed alongside the other risks as outlined in this report.
TXU Annual Report 2006 (27 Feb 2007)
“TXU Pursuing IGCC in TX for PRB, Coal, Lignite.” Power Market Today, 12 Mar 2007
95 Smith, Rebecca. “TXU Sheds Coal Plan, Charts Nuclear Path.” Wall Street Journal, 10 Apr 2007
93
94
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Conclusion and Recommendations
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.
If this transaction goes forward, Texas regulators have an obligation to impose conditions
on the acquisition that assure customer benefits. The public interest test applicable to this
transaction based on Texas precedent is that the there needs to be net benefit to the
customer. In short, if the buyers are winners, customers need to be winners, too. The goal
is a win-win.
Customers also need to be assured that their longer-term interests will be protected
through financial independence and transparency requirements, financial and
operational performance guarantees, and through commitments to good social and
environmental policy. Environmental commitments are especially important in this case
since they have been so heavily marketed by the buyers and since the TXU eleven-coal
plant strategy engendered such a negative reaction.
The beginning of this report raised a number of critical questions that we said determined
whether this deal should be considered positively by consumers. Having now analyzed
the transaction, reached a number of conclusions about it and considered
recommendations, we are able to provide our answers to these questions. In the end, of
course, it doesn’t matter what GF concludes—customers need to provide their own
answers to these questions.
1.
Is this transaction is in the long-term interest of consumers?
Consolidation of the industry into larger companies with sufficient scale to lower costs
is probably in the long-term interest of consumers especially in the utility sector,
which is still highly-fragmented and inefficient. The agreements that we think the
PUCT and stakeholders can impose on the buyers create the preconditions for the
transaction to be in the long-term interest of consumers, particularly if accompanied
by sufficient financial transparency and tough performance guarantees.
However, it is our view that it is more—rather than less—likely that the owners will
transform the assets using them as a platform for future growth, recapitalizing them
through Initial Public Offerings (IPOs), etc., and, perhaps, selling them. If so, this is
not by definition a long-term transaction and, therefore, the long-term interest of
consumers is not a matter that the commission can rule upon or commit the buyers to.
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2. Does it mean lower electricity rates in the longer-term?
Not necessarily. GF Energy believes that the price of electricity in Texas, and all over
the U.S., is likely to rise as fuel prices go up, as large capital investments are required
and as renewables, demand-response and other global climate-induced investments
are made. The issue is whether the new owners will keep prices as low as possible
and, most important, not be inclined to push price increases beyond what other
publicly-traded utilities will do. We do not believe there can be air-tight guarantees
that the buyers will not be inclined to squeeze the customer.
3. Will it improve or at least sustain current levels of reliability?
That depends on what the Commission requires and on how vigorously it enforces its
own rules. Reliability improvements will require a large increase in capital spending
and improved operating performance. GF Energy believes the PUCT has the authority
to require the new owners to meet performance goals. TXU, like many other U.S.
utilities, will need to increase reliability to meet customer needs in the internet era.
4. Will it encourage innovation in an otherwise conservative industry?
The buyers are definitely innovative when it comes to financial tools, but we see
nothing in the transaction, little in the buyers’ histories, nor any incentives that lead
us to believe it will result in TXU being any more innovative than other utilities—
unless the PUCT develops an innovation requirement. The costs of innovative
investment would undoubtedly be borne by customers.
5. What will it mean for the customer’s right to influence strategic decisions on price,
environment, etc.?
Customers will probably have less direct power over the new TXU companies going
forward as a result of this transaction. Customer power will have to be exerted
through the PUCT so a question remains: To what extent will the Commission ride
the new TXU companies to manage prices and keep environmental commitments?
An effective stakeholder settlement can provide adequate customer protection if
rigorously enforced.
6. Will the customer be better off buying electricity, having it delivered and having it
generated by private-equity owners than by a more traditional publicly-traded
utility?
GF Energy has no hesitation in saying that today’s traditional publicly-traded utilities
are not generally high-performance players. The current business model encourages
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low-risk, low-innovation and moderate performance outcomes. Private-equity owners
are not inherently better unless motivated financially by the Commission to perform.
The buyers implicitly accept the requirement that the public be better off in their
public statements and their state and federal filings. The job of the Texas Public Utility
Commission is to impose a package of commitments on the buyers using existing
authorities, since the legislature has not expanded the PUCT’s existing powers over
mergers and acquisitions. Some of these commitments have already been offered up
by the buyers, others need to be identified, studied and imposed on the buyers.
Because of the magnitude of this transaction—the largest private equity buyout in
history, GF Energy concludes that the PUCT should invite the active participation of a
broad range of stakeholders who will need to sign off on the agreements reached between
the Commission and the buyers. Texas has experience with such collaborative processes
including a “stipulation” that included stakeholder buy-in in the acquisition by American
Electric Power of Central and Southwest. And there are good models in other states
where the sale of PacifiCorp to a Warren Buffet- controlled utility company operating in
Oregon, Utah, Washington, and California, was approved through a “stipulation” agreed
to by more than 20 parties.
The buyers believe they will win much more than customers; otherwise the deal makes
no sense. They launched the acquisition with a pro-environment, pro-consumer, probusiness friendly blast. To close the deal, they need to make good on their initial
commitments and as in any successful negotiation, commit to more than they did going
in. The Texas Legislature’s decision not to act does not excuse the PUCT from doing its
job of protecting customers and assuring a transparent financial reporting arrangement.
Many of the safeguards involving transparency, cross-subsidies, and financial stability
are already being applied to TXU and need to be realigned to deal with the new
organizational structure already being implemented by TXU.
The commission already has at least three major TXU reviews underway. It is responding
to the buyers’ acquisition filing, it has opened a rate case for Oncor, and it is reviewing
the alleged wholesale market manipulation by TXU. Based on what has happened in
other states when a commission opposes a merger, even without explicit merger approvereject 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.
GF Energy does not believe it needs to recommend that the PUCT do its job; there is no
doubt that it will. What we do recommend is that the Commission review the PacifiCorp
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“stipulation” and other recent mergers and acquisitions to assure itself that Texans win as
much or more than customers in other states.
And, we recommend that the PUCT launch a collaborative settlement involving a broad
range of public interest organizations representing low-income customers, retirees, labor,
public power and cooperative customers as well as environmental stewards. It is in the
PUCT’s interest that its final decision on the buyout is credible and legitimized by key
stakeholders.
Finally, we recommend that the PUCT provide assurances that it has sufficient authority
to maintain adequate state-level oversight over the TXU companies. We live in an era in
which there is steady consolidation of assets into very large global entities—the WalMartization of the world. The PUCT is not going to turn that around even if it wanted to.
And Texas, with its reputation for being business-friendly, is home to many of the largest
global oil and energy companies, as well as more than its fair share of Fortune 500
companies.
The utility industry remains highly fragmented in the U.S. and its job of generating,
transmitting and selling electricity is crucial to economic growth. Countries without
reliable electricity also have low economic growth rates. We believe the commission has a
public service obligation to assure that Oncor and the other TXU off-shoots provide
reliable and safe service as part of their review of the transaction.
The specific issues about which the commission needs to be concerned are complex, but
the underlying principle is straightforward: If this transaction is a win for the buyers, it
also needs to be a win for the customer. There is a long regulatory history supporting this
net benefit position.
We now turn to the specifics that we recommend the Commission consider in its
determination on the buyout of TXU.
1. Financial Transparency
Because the new TXU will ultimately by controlled by companies based outside of
Texas, that have fewer public disclosure requirements than publicly-traded
companies, that is likely to frequently shuffle equity and debt, and which is driven by
short-term gain, it is critical that the Commission require adequate financial
transparency.
This is also critical because of the new organizational structure of the post-buyout in
which separate companies doing business with each other will all be owned by the
same parent, Texas Energy Future Holdings, creating the potential for cross-subsidies,
over-charging, administrative conflicts of interest, etc.
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Therefore, GF Energy recommends the Commission provide the consumer with
strong assurances that there will be very transparent financial analysis based on
separate financial accounting, affiliate interest reports, frequent audits and an outright
ban on any cross-subsidies. In addition, we support the tentative agreement on ringfencing with tough PUCT enforcement powers.
Finally, it is vital that the Commission impose tough change of control provisions that
give it adequate information in a timely way regarding changes in ownership and
control.
The Commission also needs to demand that there is no change in the cost of capital
because of the transaction—that customers will not have to pay more because the cost
of capital goes up. There needs to be clarity too about debt, preferred stock and other
quasi-debt increasing mechanisms that the new owners could use to leverage debt
beyond what appears on the surface.
The bottom line is that private equity relies much more heavily on debt than healthy
utilities. It is often argued that debt is less expensive than equity, especially at this
point in history, but the Commission needs to be sure that debt does not cost the
customer more than the current TXU debt-equity ratio does. A separate bond rating
for each of the new operating companies is one way for the customer to have an
independent assessment made by Standard & Poor’s, Moody’s and Fitch to assure the
financial integrity of the new assets.
2. Operational and Customer Performance
The best practical way to assure that the customer’s direct interests are protected is
through operational and performance guarantees that allow the PUCT to fine the
companies if their performance falls below prescribed or pledged levels. This includes
commitments to capital investments that need to be made in specific timeframes.
Some of these performance metrics are already in place, but the Commission might
consider conditioning its review of the buyout on tougher approvals and larger fines.
While the commitments made at Oncor are adequate, Luminant needs to commit to a
specific generation capital investment budget. Both companies as well as TXU Energy
need specific performance criteria related to outages, recovery times after outages,
quality of service, etc.
In addition, all three of the new operating companies need to continue existing labor
contracts and commitments to community-related support.
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4. Environmental Commitments
The buyer commitment to terminate eight of the 11 planned TXU coal-fired plants was
the public relations angle used to launch the buyout. Natural Resources Defense
Council, Environmental Defense and other environmental stakeholders need also to
buy-in to the final settlement to assure consumers that Texas Energy Future Holdings
is committed not just to reducing the number of coal-fired plants built, but to serving
as a model player, recognizing of course that a federal global climate law will almost
certainly be passed in the next few years and that there will be a heightened
commitment to renewables. Demand-response will also be much more important.
GF Energy believes the Commission should require Luminant to commit to a specific
investment budget for renewables—wind, solar, etc.—as well as to advanced coal
including integrated gasification combined cycle (IGCC). The verbal commitments
made to date are not sufficiently binding. In addition, the TXU nuclear decision for a
new reactor design that has not been licensed in the U.S. is not credible and the PUCT
needs to require a more specific commitment from the buyers that includes a realistic
timeframe.
The Commission also needs to require an effective demand-response program and
determine which operating organizations are responsible for its implementation—
Oncor, TXU Energy, or both. Demand-response is emerging at the US electricity
industry’s leading mechanism for meeting global climate goals.
Finally, GF Energy believes the Commission should require that Texas Energy Future
Holdings establish a global climate working group with a six-month to one-year
charter to develop specific policies and programs for Texas Energy Future Holdings
and its holding companies to implement.
5. Social Commitments
The buyers have already made a commitment to low-income customers; GF Energy
also recommends that the buyers commit to aggressive economic development
programs, to keeping employment in the Dallas area at agreed levels for at least five
years, and to maintaining a Corporate Social Responsibility office at the holding
company level that is responsible for CSR reporting according to Global Reporting
Initiative standards.
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Appendix A: Lessons from Other Deregulated Industries
For all of the analysis done on the winners and losers in deregulated industries,
surprisingly little has been devoted to the impact on consumers.
In several industries, including airlines and electric utilities, it was the companies
themselves seeking deregulation to fight declining profitability brought about by
overcapacity and the inability, due to regulation, to compete on price. It was not a
consumer revolution. The deregulation campaigns were promoted to the public as a way
of increasing options and innovations, and lowering prices, while maintaining supply
and service quality.
While options increased and prices decreased initially in several deregulated markets—
including airlines, telecommunications, and trucking—these benefits came with strings.
For example, in the airline industry, lower prices came with a hub-and-spoke system that
increased travel times, more crowded planes, and fewer amenities. Airlines were most
adept at implementing price discrimination, with the advent of restricted fares and
Saturday-night stays to serve the lower end of the market, as well as frequent flyer
programs to identify and reward lucrative business flyers.
If the goal of deregulation is to increase competition, consumers should theoretically be
the beneficiaries through increased innovation and service offerings, as well as lower
prices. However, it does separate winners and losers both at the industry level (through
bankruptcies and mergers and acquisitions) and the employee level (through wage levels
and employment conditions). When you count employee welfare as part of the equation
to determine whether deregulation has helped or harmed the public, the benefit of
(sometimes) lower prices appears less rosy.
Regulation was often put in place to prevent monopolistic pricing, which harms
consumers. But deregulation does little to prevent oligopolistic pricing, which can equally
disadvantage customers, so these matters—such as the class action suit against the
airlines for price fixing—are often taken up in the court system. According to Alfred E.
Kahn, an architect and major proponent of deregulation, “Deregulation shifts the major
burden of consumer protection to the competitive market, and therefore, in important
measure, to the enforcement of the antitrust laws.” He goes on to say, “But the
experiences with essentially unmanaged deregulation in airlines and pervasively
managed deregulation in telecommunications also demonstrate that the focus of policy
should be, first and foremost, on liberating competition from direct governmental
restraint—not on dictating market structures or outcomes.”96
96
Kahn, Alfred, “Lessons from Deregulation: Telecommunications and Airlines after the Crunch.” Washington, D.C.: AEIBrookings Joint Center for Regulatory Studies, 47.
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Did consumers win? It’s difficult to say—or even to define—particularly if you include
how employees, who are also consumers in deregulated industries have fared. In both the
airline and trucking industry, real wages have decreased, and most new jobs added in the
industry have been low-wage positions with few benefits and less desirable working
conditions. Employees in these industries are now working more hours at lower pay.
While it is still too early to conclude how consumers will be affected by deregulation in
the electric utility market, there are some parallels to other deregulated industries. In
many instances, prices have fallen initially . . . and risen later. Cambridge Energy
Research Association estimated that “US residential electric consumers paid about $34
billion less for the electricity they consumed over the past seven years than they would
have paid if traditional regulation had continued.”97 However, most of the savings was
due to mandated residential rate reductions of up to 15%, which will soon expire, and do
not account for the $25-$40 billion losses in California.98 Another study comparing
industrial electricity price data between restructured and non restructured states shows
that there is no evidence of substantial reduction in price, or even in the rate of price
change, in restructure states.99
97
98
99
Blumsack, Seth, Apt, Jay, and Lave, Lester, Lessons from the Failure of U.S. Electricity Restructuring, quoting Cambridge
Energy Research Associates 2005 study, Beyond the Crossroads: The Future Direction of Power Industry Restructuring, p 93.
Blumsack, Seth, Apt, Jay, and Lave, Lester, Lessons from the Failure of U.S. Electricity Restructuring
Blumsack, Seth, Apt, Jay, and Lave, Lester, Lessons from the Failure of U.S. Electricity Restructuring, quoting Jay Apt,
“Competition Has Not Lowered US Industrial Electricity Prices”, The Electricity Journal, Vol. 18, No. 2 (2005) at 52-61.
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The Impact of Deregulation in Various Industries
Airlines
Telecommunications
Trucking
Impact On:
Pricing
• Prices initially decreased, then stabilized /
increased, particularly on concentrated routes
• Estimated $20B yearly savings (Brookings
Institute)
• Price discrimination (e.g., restrictions, yield
management, frequent flyer programs)
• Firms can tacitly collude on pricing
• Long-distance rates declined sharply
• Wireless rates decreased
• Price discrimination: dumping lowpaying customers and “win back”
campaigns for high-profit customers
• Decreased significantly
• Initially decreased, then increased
• Degradation of working conditions (e.g.,
longer hours)
• Unions weakened
• Labor shortage (but wages
have not increased)
• Less experienced/skilled
employees post-deregulation
• Decreased
• Deteriorated work conditions
• Decreased significantly
• Truckers working longer hours
to make up for lower pay
• Deteriorated work conditions
• Decreased significantly – e.g., food, legroom,
crowded planes
• More routes/options due to alliance programs
• Many unprofitable routes abandoned / underserved
• Increased number of options
Service
Innovation /
Market Entry
• Significant short-term innovation – e.g.,
reservation systems, frequent flyer
• Initially many market entrants – very few
remain (bought or bankrupted)
Externalities
• Questions about maintenance, however
safety record high
Concentration
• Post-deregulation industry concentration
matches pre-deregulation concentration
• Airport concentration higher postderegulation
Employment
Wages
Firm Profitability
• Initially stable/increased, then decreased; competition,
economy, war and fuel costs all a factor
• Decreased revenue/passenger-mile
• Hub/spoke system, ground operations costly to maintain
• Stocks faring poorly
• Very high innovation – fiber-optics, wireless
• Initially many new entrants, then
consolidation
• Internet encroaching on long-distance
• More innovative and
sophisticated post-deregulation
• Safety concerns as truckers
working longer hours; more
highway accidents
• Decreased; boom/bust cycles
• Volatile stock prices
• Decreased
• Many bankruptcies
Sources: Kahn, Alfred, “Lessons from Deregulation” (AEI-Brookings Joint Center for Regulatory Studies; Belzer, Michael, “Sweatshops on Wheels:Winners and Losers in Trucking
Deregulation” ((Oxford University Press); Adama, Walter and Brock, James, “The Structure of American Industry (Prentice Hall); Emmons, Willis, “The Evolving Bargain: Strategic Implications
of Deregulation and Privatization” (Harvard Business School Press); Blumsack, Seth, Apt, Jay, and Lave, Lester, “Lessons from the Failure of U.S. Electricity Restructuring”
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