AGL's opportunistic Loy Yang manoeuvre

AGL's Michael Fraser has won the clearance he needed to pull off an extremely opportunistic transaction that transforms his group's energy portfolio in several dimensions.

The Australian Competition and Consumer Commission's approval of Fraser's planned acquisition of Greater Energy Alliance Corporation, which owns Victoria's Loy Yang A power station, was made possible by the financial stresses being experienced by GEAC, one of its key shareholders and the looming introduction of the carbon tax.

AGL bought into GEAC nearly a decade ago and holds a 32.5 per cent stake. The other major shareholders are Japan's Tokyo Electric Power Company (TEPCO) with a similar stake, Thailand's Ratchaburi Electricity and three super funds. TEPCO, the other big shareholder in GEAC, has some difficult issues of its own after the disaster at its Fukushima nuclear plant in Japan.

GEAC has been in some difficult discussions with its bankers about refinancing its hefty debts, discussions complicated by the imminent imposition of the carbon tax.

That has enabled Fraser to drive a tough deal. AGL will buy out its fellow shareholders at a price that values their equity at $448 million and Loy Yang A's equity at $598 million. It implies an enterprise value for the business of $3.1 billion. Only $200 million of that consideration, however, will be up-front cash, with the rest paid over 15 years.

Moreover, the deal is conditional on GEAC receiving $240 million of cash – ‘'transitional carbon assistance'' from the Gillard Government before 30 June. If the carbon tax isn't repealed by Tony Abbott if the coalition wins the next election Loy Yang A would also receive 40 million free permit – more than $1 billion worth over the next five years – but, as AGL says, the deal would still stack up without the permits (because there would be no tax).

There are a number of reasons why a big lay into brown coal generation makes sense for AGL even though the carbon tax is coming, apart from the fact that it says the deal will be earnings per share accretive and generate a lot of incremental cash flow.

It gets a major position in Victorian power generation, with about 30 per cent of the industry. It increases its own baseload capacity by almost a third. It will own one of the lowest-cost baseload generators in the country, even taking into account the carbon tax. Most importantly, it will have a better balance between the generating capacity it controls and its retail commitments, significantly reducing the risk of a mismatch.

Despite the far higher carbon intensity of brown coal relative to the black coal, which is the major source of baseload power in NSW and Queensland, Loy Yang A is so low on the cost curve that even with the carbon tax it will be among the country's lowest-cost generators.

That's going to become an even more valuable position over the next few years. The soaring demand for thermal coal from Asia, and China in particular, has forced up the price of exportable coal. As contracts with coal producers written in a different era continue to roll off, black coal-fired generators are facing very steep increases in their fuel costs.

Once the Queensland coal seam gas-fed export LNG plants are operating from the middle of this decade something similar will happen to gas prices, which have already been rising. Exporting gas will effectively import international prices – which are substantially higher than existing domestic gas prices – into the domestic energy market.

That's why, despite the fact that it is a very dirty fuel (although Loy Yang A has the lowest carbon intensity of the Victorian generators) the lower-cost brown coal generators will remain relevant and competitive within the energy market whether there's a carbon price or not.

To fund the deal and refinance GEAC, AGL, which had already raised $650 million through a subordinated note issue, has announced a $900 million equity raising. With the federal government contribution more than offsetting the cash outlay to the departing shareholders, the new funds will go to reducing Loy Yang A's debt, which will be a more manageable $1.34 billion post-transaction.