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S&P: Small Retail Providers to be "Squashed" in ERCOT

October  7, 2011
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Stop us if you've heard this before: "A seemingly inevitable shake-out in ERCOT's retail power market is slowly but surely underway as smaller players begin showing signs that operations are untenable."

So says a new report from Standard & Poor's ("Texas's Long, Hot Summer Makes Power Retailers Sweat," Oct. 6) but the quote may as well have been written in the fall of 2005, spring of 2008, or this past February -- all times which have seen churn among retail providers in the ERCOT market, but no fundamental shift in the number or types of REPs competing.

The crux of the S&P report, which is a good read, is that due to looming federal environmental regulations and what was an already tight supply-demand balance in ERCOT, "any major weather event would likely create significant spikes in power prices."

Retailers without generation would be challenged to survive any prolonged and sustained wholesale volatility, S&P says, concluding that only retailers with generation are viable.

That's a reasonable and defensible view of the market climate, but what isn't supported are statements from S&P that suggest this market shift and a "shakeout" in retail providers is already here, including S&P's statement that smaller players have begun, "showing signs that operations are untenable."

S&P correctly notes that August was essentially an ugly month for retail providers, and that its effects may linger with increased bad debt from higher customer usage, and higher forward curves for wholesale prices.

However, S&P's 10-page report does not elaborate on what "signs" it sees (other than a February default noted below) that smaller players' business model is untenable. Matters reached out to S&P for additional details, but the authors of the report were at a remote site and could not be reached for an at-length discussion prior to press time.

"In fact, some power retailers in the region are already exiting the business," an S&P news release says. The actual report, however, only cites three specific exits (two of which are consolidations): Abacus Resources Energy's default, StarTex's acquisition by Constellation, and First Choice Power's acquisition by Direct Energy.

Now, as readers of Matters are aware, there have been a handful of other exits (through sales) since February, but no more than expected at the margins in a competitive market, and not enough to indicate that the business model of small, non-asset-owning REPs is untenable.

Matters would note that all three transactions cited by S&P were initiated prior to the August weather event. It may also interest readers to know that StarTex, which had 170,000 customers at the time of its acquisition, was described as "a small power retailer" by S&P.

"We see these moves as risk-reducing rather than full-valuation exits," S&P says.

"[G]iven the increasing incidence of extreme weather events in ERCOT, we're convinced that generation-light retailers are picking nickels in front of steamrollers -- they may have a long run of small gains, but in the end they will get squashed. The shake-out underway in the retail electric sector appears to be an inevitable development in ERCOT," S&P added.

However, Justin Courtney, Senior Vice President of Stephens Inc., which advises REPs on a variety of strategic endeavors, does not believe owning generation will be a requirement for REPs to remain viable.

Similarly, Young Kim, Associate Director of KEMA's Retail Energy Practice, told Matters that, "I don't see that S&P's claim is grounded in reality."

Courtney and Kim both cited the highly liquid nature of the ERCOT wholesale market as not requiring a REP to own generation. Courtney noted that the wholesale supplier market has become so efficient that REPs of a certain scale can buy power for less using wholesale suppliers rather than owning assets.

The idea that generation will be required for viable retail suppliers in ERCOT seems "far-fetched," Kim added. Kim further said that the S&P report appears to be an "over-reaction" to recent comments from NRG Energy CEO David Crane on the subject of REP defaults.

Indeed, Matters would note that the sale of First Choice Power represented the sale of a retail provider with affiliated assets, and that the buyer declined to acquire these affiliated assets (despite the assets and retail book being offered as a package at one point) -- the kind of sale not contemplated by S&P's forecast.

Granted, the Optim Energy assets had never been integrated into managing the First Choice Power book, were a relatively small portfolio, and may not have been ideal to maximize balancing value for retail hedging (due to location, asset type, etc.), but if S&P is correct that owning assets will be essential (and not just a beneficial competitive advantage) in retailing power in ERCOT, one would have expected the assets to be sold with the retail book, or to another retail provider in a separate transaction, neither of which occurred.

Thus, it's important to remember that all generation is not created equal, and while even higher cost units can offer balancing benefits to retail suppliers in extreme weather, this may not justify their fixed costs for all other times of the year, especially if insurance type-products for retail suppliers to hedge super-peaks are more affordable. Indeed, although NRG Energy did not discuss granular details of its recently announced new asset strategy in response to the August heat, Matters understood from the NRG analyst call that this strategy will rely more on insurance products, and less on assets, to hedge retail obligations at the super-peaks (although the assets will not be hedged and will be available for NRG to lean on for retail obligations)

Notably, NRG indicated that it would pass on the cost of its super-peak insurance to retail customers (though later walked back this comment). Obviously, if NRG raises retail pricing, it indicates there may still be an opportunity for competitors to match or beat these prices, even if competitors rely on wholesale and financial products for hedging, rather than assets.

Matters finds the actions of retail suppliers most informative in this regard. Direct has made no secret about desiring additional generation in all markets, but it passed on purchasing the Optim assets when purchasing First Choice Power. Additionally, Centrica executives have stressed repeatedly that owning generation in the U.S. is not a "must-do at any price" proposition. Centrica told investors, admittedly prior to the August conditions, that under the then-current (July 2011) wholesale energy environment, generation ownership is most beneficial in managing intra-day volatility, but it is not something, "we have to do" (see discussion in 7/28 story).

As another aside, the Abacus default proves that over-reliance on the spot market leads to default -- which had already been established in 2008 and 2005. In other words, Matters sees very little which can be drawn from the default of a REP which was not prudently hedging. The Abacus default doesn't tell us if non-asset owning REPs, which do prudently hedge under their wholesale supplier agreements, can survive volatile wholesale prices and attendant collateral requirements.

Additionally, Courtney noted that while there has been a wave of recent REP consolidation, this has largely been driven by investors in independent REPs seeking to monetize their investment, rather than sales being forced due to the "untenable" business model of independent REPs.

To be clear, Matters has no dispute that retail providers incurred significant losses in August, and, as a result, we may see some, or even a significant number, exit the market (we do dispute that there are "signs" of this occurring to date aside from the 1-2 deals reported in Matters recently). However, even if a dozen retail providers exited the market, that would still leave about 15-20 "small" and "generation-light" providers in the mass market, and Matters does not see these providers being "steamrolled."

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