Karl Miller energy expert on Power Generation Market Structure

1. M
MC Energy LLC (MMC) is a private
investment management company that
specializes in the energy sector. MMC acquires,
restructures, manages and controls power and mid-
stream gas and related assets. MMC targets acquisitions
up to US$2bn in enterprise value in North America and
the United Kingdom including electricity generation
plants and portfolios, integrated electricity utilities with
substantial unregulated generation assets and negligible
retail customers, natural gas pipelines and gas storage
assets, and operating assets and late stage construction.
Key to MMC’s strategy is its operating and
risk mitigation capabilities. MMC has an alliance
with Wood Group Power, regarding the operation
and maintenance of power generation assets. MMC
and Wood Group are in the process of establishing
an independent asset management and operations
Company (OpCo). OpCo will be a services
only energy company that will manage and
rationalize power assets for third party creditors
and stakeholders, as well as assets that MMC
acquires and controls.
UK power Features
48 Issue 276 Project Finance International October 29 2003
The UK power generating sector has been hit by declining prices.
The banks which hold 16GW of power generating assets totaling
£6bn in debt have been forced to make provisions against their
loans, sell the assets below par or take over the power stations,
hoping for an upturn. A number of solutions have been put
forward to solve the bankers’ problems. In this article,
Karl Miller, senior partner of MMCEnergy LLC, sets out
his solution.
Restructuring
UK power -
The ARV way
MMC business model
MMC Investment
Management
Capital access
x LBO
x private equity
x limited partners
Transaction origination
x power
x gas
x other
US CCGT
UK coal
plant
Mid-stream
gas assets
Arms length contracts
OpCo
x MMC/Wood Group plc
x Third part asset management
x Proprietary service producers
Acquisitions1
Contract
portfolio
1 Illustrative examples

2. OpCo will have sophisticated asset and energy
management capabilities.These capabilities will allow
MMC to capture the value of a generation assets and
manage partially contracted or merchant facilities on
behalf of the various creditors/stakeholders. Unlike
many financial investors, MMC will not outsource core
operations.
MMC is also a joint venture with Trans-Elect Inc to
acquire selected assets from electricity and gas utilities
in North America.Trans-Elect Inc is currently involved
in assets totaling over US$1bn and representing 14,500
miles of transmission line.
Ķ STATE OF THE UK GENERATION SECTOR
The global utility market environment has been very
badly affected by the Enron fallout, which has caused a
deterioration of market confidence in a number of
players, causing ratings downgrades and urgent short-
term cash collateral requirements.These will be met
mainly by asset disposals. Over the last five years, there
has been a steady decline in UK wholesale power
prices and, some commentators would argue that the
introduction of the New Electricity Trading
Arrangements (NETA) has accelerated this decline.The
‘true’ forward curve also reflects a weak price outlook
over the next 5 years.
This has caused a serious deterioration for merchant
generators, and in many instances created financial
distress, breach of debt covenants and default on debt
repayments.The large players are balanced and largely
immune to the fallout. Official generation capacity
margins are forecast to remain high in the short to
medium term, and unlikely to trigger a recovery in
wholesale power prices. Unattractive economics have
therefore halted new plant investment.
Until there is a significant recovery in ‘true
wholesale’ electricity prices, stakeholders are
exposed to the considerable short-term liquidity
crisis leading to breach of debt covenants and default
on debt repayments. Stakeholders will need to have
a well thought through plan to mitigate their
exposure.The UK power sector is ready for
significant restructuring.
Ķ IMPACT ON MAJOR LENDERS
Power price deterioration and associated revenue
declines have given rise to numerous covenant
breaches and in some cases default on senior or
subordinated debt terms.These have caused lenders
to review the asset restructuring alternatives
available to them. In some cases, banks have
taken ownership.
Where asset sales for cash are being contemplated,
proceeds are well short of current debt levels. Only for
the best (and least geared) assets are senior lenders
likely to avoid any conversion. In some cases more
creative solutions may lead to better value preservation
(tolling, contingent equity, O&M agreements).
MMC analysis of value recovery for lenders on typical
project financed assets indicates 60-70% for senior
lenders and virtually no recovery for subordinated
lenders. Single asset restructurings do not solve the
problem, as lower capital costs allow generators to
accept lower prices. Clearly a more comprehensive
approach is required.
Ķ INTRODUCTION TO THE MMC UK ARV
MMC is targeting an 8-12GW portfolio of non-nuclear
generation, representing a 12-18% market share. MMC
has already bid for control of Drax and will offer Drax
senior creditors participation in the ARV post
restructuring. MMC sees multiple risks with the current
Drax restructuring. MMC is in parallel discussions with
various constituencies, including owners of other
generators to contribute plants into the ARV,
commodity service providers, to act as a preferred
commodity and credit clearinghouse, fuel suppliers and
off-takers under MMC supervision and control, and
Wood Group regarding O&M and term maintenance
provisions, to enhance asset utilization and reduce cost.
A portfolio management approach will allow MMC to
optimize the overall output to the benefit of the ARV
cash flows and net revenues. Operating cost savings
across the portfolio will be substantial. Enhanced cash
flows from the ARV will be utilized to pay down
restructured project debt.
Ķ ARV ROLE IN THE UK POWER MARKET
There is overcapacity in England and Wales and the
generation market is competitive with no player having
more than 20% market share. One third of the
generating capacity is owned by small IPPs competing
for market share.There is a price war caused by
excess capacity and fragmented ownership.There is
currently no economic mechanism to guarantee a
recovery of the fixed costs of every plant (O&M
costs, rates, debt and interest, etc) and this has led to
plant falling into distress.This has resulted in lower
electricity prices from when NETA went live. Prices
have been consistently below £20/MWh on a
weighted average basis.
The ARV with 8-12GW and a ~12-18% market share
will trade the output of all of its plant as one portfolio.
The ARV will rationalize the portfolio in years of
Features UK power
October 29 2003 http://deals.thomsonib.com Issue 276 49

3. excess capacity and its remaining assets will enjoy the
benefit of more sustainable prices.The magnitude of
the value created by the ARV depends on the volume
of generation (MW) it holds, the price change
compared with the status quo and the number of years
of price improvement compared with the status quo.
Ķ ROLE FOR CAPITAL PARTNERS IN THE ARV
The ARV Portfolio will require capital to centralize
liquidity,trading and working capital lines.The ARV
working capital may be funded by combination of
secured debt facilities and private debt placement.
Alternative exits for capital providers including re-levering
the ARV balance sheet through asset securitization.
There is also a rationale for sponsors to transfer non-
distressed assets into the ARV.The value of individual
assets can be enhanced in a portfolio environment. In
order to fully profit from current opportunities,
sponsors need to act swiftly.The ARV facilitates exit
without fear of exiting ‘at the bottom’.
Ķ ARV STRUCTURE
Equity owners will exchange their equity stake in the
power plants for an equity stake/economic interest in
the ARV.This facilitates the operational/legal
combination of the assets without disturbing the
individual debt liabilities of the projects.
ARV equity is allocated to the contributors in
proportion to the individual equity value of the plants
(or cash where MMC brings fresh equity) they
contribute. Both ‘distressed and non-distressed’ power
plants can be combined into one structure that can be
managed and operated for the benefit of the ARV
equity owners.All participants’ interests are aligned to
benefit from any increase of free cash flow.
UK power Features
50 Issue 276 Project Finance International October 29 2003
MMC operational structure
Spares
Structure to allow for inclusion of plants and/or existing project companies.
Energy trading expertise will be provided by MMC – critical to create portfolio benefits.
Arm’s length arrangements for O&M and other arrangements. Potential to consolidate O&M services.
Use of commodity service provider as trading company should maximise netting against the market exposure with minimal costs.
Banks
MMC/capital
providers
O&M support
services co.
Trading company MarketARV
Electricity/fuelElectricity/fuel
Payments/receipts Payments/receipts
Services
Asset providers
Newco 1 Newco 2 Newco 3 Newco 4
IPP co 1 IPP co 4IPP co 3IPP co 2
Asset/share transfers

4. Each of the distressed and non-distressed plants is
valued on the basis of the present value (PV) of future
cash flows (FCF). Owners will transfer the equity
interest in each of the Projects to the ARV and receive
in exchange an equity (economic) interest in the ARV
equal to the PV of FCF.The ARV will be the holding
company for all the specific projects. Liabilities will
remain at the SPV project level and will be satisfied by
distributions from the ARV.The ARV structure ignores
terms and conditions and the level of debt / leverage
on each individual asset.The write off decision is left
entirely with the creditors/stakeholders (within certain
parameters).
Ķ CAPTURING THE UPSIDE
Preserving value for stakeholders is cumbersome and
challenging on an asset by asset basis. Stakeholders
should consider the case for key assets to be aggregated
into an ARV as NETA’s emphasis on predictability and
the wide bid/offer spreads in the balancing mechanism
has constrained single assets but favours portfolio
players. Economies of scale in plant operation, trading
output and management of NETA imbalance risks.
ARV creates a balanced fuel mix and provides multiple
arbitrage opportunities. Efficiency spread in portfolio
enables coverage of merit order.ARV enables
economic decisions to be made about
uneconomic plant within the portfolio and creates
lower Opex due to transfer of best practices and
synergies.ARV substantially eliminates the need
for further debt provision particularly if new equity
is injected.
Ķ POTENTIAL PORTFOLIO UPSIDE
MMC believes that the difference in price between a
price war and a capacity shortage is £46/kW per
year.The ARV pools generation and operates total
capacity as single unit with great flexibility and
optionality.The portfolio approach creates
operational and trading economies of scale.The
creation of the ARV should shorten the price war by
a number of years and create a price benefit of some
proportion of the figure above.These revenue
benefits will to some extent be offset by the cost of
acquiring plant that is subsequently mothballed due to
inefficiency.
Ķ ARV OPERATIONS, TRADING AND RISK
MMC’s core capabilities are in the field of commodity
risk management and operations. MMC will develop
the appropriate risk management philosophy and
execution strategy. Key internal considerations include
cash flow/credit conditions, debt coverage needs, and
value optimization. Key external considerations are
market liquidity, duration of forward market pricing
and credit/collateral needs.
Examples of risk management activities include
creating a portfolio of fuel purchases and power sales of
different durations (near term is highly hedged, forward
years less so). Hedge with options, which provide
downside protection with possible upside benefits.
Bilateral off-take agreements that secure longer term
cash flows by selling the flexibility of the plant at a
premium. Maximize spark spread (fuel conversion)
value optimizing both the power being sold with the
fuel being purchased.
The ARV will extract O&M savings between
the coal stations and between the gas stations
that are contributed. Considering the coal and
the gas stations together, there will be further
cost savings from rationalizing finance, risk
management and measurement, environmental,
health and safety policy, etc. During the transition
period MMC senior management will perform
take responsibility for commodity risk management
O&M using the existing station staff and MMC
will put in place commercial agreements in the
following areas: O&M, trading services and a
trading guarantee facility.
Features UK power
October 29 2003 http://deals.thomsonib.com Issue 276 51
ARV legal structure
In terms of cash distributions, all FCF (after payment
of O&M, etc) is channeled through the equity
participants in the ARV Topco. The entity/economic
interest positions held in the ARV Topco are derived
from the same PV of FCF calculation described in
the general concepts paragraph below.
ARV Topco
Individual
legal entities
ARV equity held by distressed lenders as well as equity
and debt holders of non-distressed assets. Free cash flow
distributed according to equity proportions.
100%
100%
100% equity stake in individual legal entities

5. UK power Features
52 Issue 276 Project Finance International October 29 2003
Pro-rata valuation approach
Independent third party will value assets to
minimise valuation disagreements. The FCF will be
calculated using a combination of common inputs
and plant-specific valuation parameters. We envisage
using common inputs and a number of plant-specific
parameters.
Common Inputs
Forward power price/fuel price curves, cost of debt,
capex, tax rate, certain working capital items, inflation
and environmental issues.
Plant Specific Inputs
Plant capacity, total load factor, generator efficiency, fuel type, plant life, maintenance capex, decommissioning costs and
off-take/tolling/fuel contracts.
Whenever projects are contributed into the ARV, the allocation of the pro rata equity stakes has to be recalculated for all the assets
in the portfolio. Since not all assets will be contributed at the same time it could be that the opinion regarding certain common
valuation assumptions has changed (ie price curves). One approach to deal with this issue is to revalue all the assets based on
the revised common input(s).
Stage 1 - Independent evaluation
Project A Project DProject CProject B
50% 10%15%25%
Evaluation of each asset based on PV of free cash avaliable for debt service
How does the ARV create upside?
There is overcapacity in England and wales and the generation market is competitive with no player having more then 20%
market share. One third of generating capacity is owned by small IPPs competing for market share. Overcapacity creates market
overhang – drag on earnings and cash.
Fixed cost recovery not achievable.
Natural gas cost problematic.
There is a price war caused by excess capacity and fragmented ownership. There are currently no economic mechanisms to
guarantee a recovery of the fixed costs of every plant (O&M costs, rates, debt and interest, etc.) and this had led to plant falling into
distress. This has resulted in lower electricity prices when NETA went into effect. Prices have been consistently below £20.MWh.
The ARV will rationalise the 8-12 GW portfolio in years of excess capacity and its remaining assets will enjoy the benefit of more
sustainable prices, to the benefit of shareholders.
Assuming ARV of
10,000 MW
Generator Market share pre-ARV (%)
IPP 33.3
BNFL/BE 17.9
Innogy 12.3
Power Gen 12.0
EDF 10.3
Cebtrica 6.1
Scots 5.0
Pumped 3.1
Total 100.0
Source: MMC analysis of NGC Severn Year Statement
Generator Market share post-ARV (%)
IPP 18.3
BNFL/BE 17.9
ARV 15.0
Innogy 12.3
Power Gen 12.0
EDF 10.3
Cebtrica 6.1
Scots 5.0
Pumped 3.1
Total 100.0
Source: MMC analysis of NGC Severn Year Statement

6. MMC believes that it can offer significant cost savings
and revenue enhancement to the ARV by actively
managing the volatility of fuel and power prices
through a JointVenture with an investment grade
Commodity Services Provider (CSP) that will offer
pricing and execution of many alternatives,
confirmation of all trades, 24-hour operation contract
and risk management/risk mitigation services,
accounting, settlements and invoicing services.
Ķ SUMMARY
The UK wholesale power prices have declined on
average by 40% since NETA went live, resulting in a
serious deterioration in the financial health of
generators. MMC believes prices have not bottomed.
The structural overcapacity in the industry will persist,
constraining any longer term recovery in prices.
Substantial price recovery will require a new approach.
Lenders and stakeholders of power generators are
consequently exposed to increasing burdens of
ownership that include: earnings dilution and volatility,
sub-par investment returns, short term liquidity
constraints leading to breach of debt covenants,
financial default and foreclosure, and increased political
and market risk.Therefore the sector is ready for
significant restructuring.
A comprehensive and radical industry solution
is called for through the creation of an Asset
RecoveryVehicle (ARV), which will become a
top ranking UK generation company. MMC
believes the concept has broad support from key
market participants.This includes creditor and
corporate owned generators, investors, industry
suppliers and off-takers and the regulators.An
independent non-conflicted party such as MMC
and its capital partners best accomplishes the
pooling of generators into an ARV.
Features UK power
October 29 2003 http://deals.thomsonib.com Issue 276 53
“ ”
A comprehensive and radical industry solution is called for through the
creation of an Asset Recovery Vehicle (ARV), which will become a top
ranking UK generation company. MMC believes the concept has board
support from key market participants.
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