Buying MacGen: smart power play or short circuit?

One of the more unusual bidding contests comes to something of a head this week with the Wednesday deadline on offers for the New South Wales government electricity generator, Macquarie Generation.

There are several layers of novelty and complexity to the auction process, not least that the process pits an $8.5 billion industry heavyweight in AGL up against a $600 million flyweight in ERM Power.

The NSW government started the process hoping to get as much as $2 billion for MacGen, which operates the Bayswater and Liddell coal-fired generators. But as the original queue of interested parties has shrunk, the market’s expectation of the outcome has wound back sharply.

Complicating the outcome is the potential role of the Australian Competition and Consumer Commission. Not surprisingly, given it is a minor player in the energy sector, ERM has been cleared of competition policy concerns by the ACCC. Its preliminary attitude towards AGL, however, won’t be known until Wednesday afternoon after the bids have been submitted.

That’s probably a relief for the NSW government, as it will encourage both bidders to put their best bids on the table. If the ACCC opposed an AGL acquisition of MacGen, ERM might be tempted to put something less than its best bid on the table.

The ACCC’s attitude towards AGL will be interesting. In the past, AGL has been prepared to challenge the commission’s views in court, such as when it bought into the Loy Yang A generation complex in Victoria.

Unlike Origin Energy or Energy Australia, AGL has no generating capacity in NSW or Queensland. There are also constraints on the capacity of the inter-connect between Victoria and NSW that would limit the ability of Loy Yang A to influence the NSW market. Opposition to an AGL acquisition would probably trigger another court challenge.

The Queensland-based ERM is a relative minnow. Today it announced a 48 per cent decline in interim earnings to $14.1 million. It plans to raise several hundred million dollars of equity and about $1 billion of debt if it is the successful bidder for MacGen.

It’s an ambitious strategy that would be transformational if it succeeded. It could make ERM a major player in the national electricity market and give it the platform for a major charge into the NSW retail energy market. However, that would probably necessitate an additional substantial investment in the technology platforms needed to service big retail customer bases.

As the major gas utility in NSW,  AGL is able to leverage its systems by adding electricity customers, while both Origin and Energy Australia have both gas and electricity offers.

MacGen is a big base load generator. Its Bayswater plant produces about 2600 MW and the Liddell plant about 2000 MW, or about a third of NSW’s electricity generation capacity. Liddell, however, is an ageing plant with a relatively short remaining useful life.

Apart from the question mark over Liddell’s future, the value of MacGen is clouded by the fact that its biggest single customer is the Tomago aluminium smelter, which has a contract that expires in 2017. The aluminium industry is experiencing major and painful structural change.

AGL’s interest in NSW generation is obvious. It has a big and growing energy customer base in NSW, where it has been pursuing an aggressive organic retail growth strategy in electricity. As with Origin Energy and Energy Australia’s purchases of coal-fired generation assets in NSW, it would like to acquire MacGen to create a natural hedge against electricity prices for its NSW retail business.

If it were to lose out in the bidding for MacGen, its fallback position would probably be to rely on its Loy Yang A interest, hedging contracts for those periods where the NSW demand fills the inter-connect and NSW prices spike, and the building of a gas peaking plant for which it has permit approval in NSW. The NSW government also has a couple of smaller generating assets to sell.

The industry backdrop of falling demand for electricity (for the first time in local industry history) would make it easier for AGL to cover its exposures in a market with excess generating capacity. It is another factor that will make it more difficult for the NSW government to create real bidding tension for the plants.

Both bidders would know that the condition of Liddell, the structural changes developing in demand and the thin margins in energy retailing in an increasingly competitive environment mean that paying too much for MacGen could have unpleasant longer-term consequences.