RRI Energy (RRI)

TOP CONTRIBUTORS

Michael Buckley

Thomas Shyr

Reliant Energy (NYSE: RRI) is an electric utility in Houston, Texas. Texas' electricity industry was deregulated in 2002; since that time consumers have been able to purchase electricity from multiple providers, rather than single, regulated regional retailers. Reliant Energy is one of these utilities. Additionally, Reliant sells some of the electricity it produces at wholesale rates to other electric utilities.

As an electric provider, Reliant's revenues rise and fall with seasonal fluctuations in electricity use. The company typically has higher revenues in the summer, when air conditioning usage goes up in the hot Texas summers.^[1] Reliant's wholesale electricity business is less dependent on these regional temperatures as the company's wholesale customers are distributed throughout the U.S.

Reliant's electric generating business produced 78% percent of its toal generating capacity of 41 thousand GWh in 2007 using coal.^[2] Rising coal prices and the growing adoption of climate change legislation throughout the U.S. (including a law in Texas requiring 10,000 MW of renewable energy electricity by 2020^[3] threaten the company's margins.

Although Reliant does generate electricity throughout the U.S., it purchases a majority of the electricity that it sells to customers in Houston. Because of this, its net profit margins are smaller than the margins of other utilities that generate their own electricity, in part due to the additional middle-man.

In April of 2010, Reliant announced that it would merge with Mirant to form GenOn Energy^[4]. The newly formed company will have nearly 25,000 megawatts of electric generating capacity, making it one of the largest independent power producers in the United States. GenOn will have operations over most of the United States, with its largest generating capacity in the Mid Atlantic and California regions^[5].

Business Financials

Reliant Energy is comprised of two components: a retail electricity provider and a wholesale electricity provider.

Retail Electric Segment

• In its retail electric segment, the company operates an electric utility that purchases electricity from other utilities, power generators, and wholesale providers, including Reliant's wholesale segment. It then turns around and transmits and resells the electricity to residential and business customers.
• These retail services are primarily in Texas, where over 1.8 million customers are served.
• 65% of its residential Texas customers are located in Houston.^[6]
• Reliant also operates a small retail electricity business in the PJM region (Pennsylvania, Jersey, Maryland), this serves about 93,000 commercial, industrial, and government customers.
• In its main market, Texas, Reliant sells its electricity at competitive prices, since the market for retail electricity is deregulated. In Delaware and Illinois, Reliant is subject to regulation by utility commissions commissions.
• Reliant actually purchases a majority of the electricity used in its retail segment^[7], instead of using electricity from its wholesale electric business. Because of this, Reliant's retail segment has smaller net profit margins than other utilities which generate their own electricity. Specifically, Reliant must purchase electricity, often from generators who have little competition, and then must resell at competitive prices.

Wholesale Electric Business

• Reliant's wholesale electric business sells electricity to utilities and companies that in turn sell the electricity to end users.
• Reliant's wholesale business had a generation capacity of 16,337 MW and operated in five regions of the U.S.^[8]
• These regions are PJM, MISO(Illinois, western Pennsylvania and Ohio), Southeast (Florida, Mississippi and Texas), West (California and Nevada), and ERCOT (Texas).

Key Trends/Forces

Deregulation Means Competition and Pricing Pressure

In Reliant's biggest market, Houston, the company has to compete against almost ten different electric providers. These include Amigo Energy, Commerce Energy, Direct Energy, First Choice Power, Gexa Enery, Green Mountain Energy, and StarTrex Power.^[9]

In 2002, the Texas State Senate passed a bill which deregulated electricity in the state. Prior to the bill, electric providers had a monopoly in their areas and the consumer had no choice regarding their provider. The state regulatory commission regulated electricity prices to ensure fair prices in the monopoly set up. Under deregulation, electric providers no longer have monopolies and instead have to vie for market share against other providers. As new providers entered the state, incumbents like Reliant began to feel the pressure. In fact, in Houston, significant market share has been lost (see below). Moreover, Reliant, like other providers, is forced to lower prices in the face of competition, compressing net profit margins further and further.

Since Reliant does not generate its own electricity, deregulation has placed other pressures on the company. They must purchase electricity from generator's that often have little competition and so little incentive to keep prices low. Reliant must then resell the electricity at competitive prices, competing against utilities that generate their own power. Therefore, net profit margins are being squeezed.

Declining Market Share in Houston

In 2006, Reliant sold 15,447 GWh of electricity to customers in Houston. In 2007, that number fell to 13,516 GWh, a decline of over 12%.^[10] Moreover, Reliant lost over 100 customers in the same time frame, nearly a 10% drop.^[11] Reliant anticipates that this trend will possibly continue.^[12] Since Texas was deregulated in 2002, the competitive market has been continuously attracting new retail electricity suppliers. With more competition, sales volumes and net profit margins have the likelihood of declining, as competitors put pressure on prices and force them to drop. Over 65% of Reliant's residential electric retail customers are in Houston, so further declines there will affect Reliant's net profitability.

Energy Usage Dependent on Weather Patterns

Since a majority of Reliant's operations occur in Texas, the company is susceptible to the prevailing weather in the state. In 2007, Reliant had a net income loss of $283 million in the first quarter^[13], but a net income gain of over $162 million in the third quarter.^[14] The change was due in large part to higher demand for electric and energy services in the summer months of Texas.

Fluctuations in Coal Prices affect earnings

Because Reliant Energy uses coal as a major source of producing power, the price of coal can impact its earnings. In Reliant's wholesale electric business, about 41 thousand GWh were sold and of that about 32 thousand GWh were generated using coal.^[15] With over 75% of Reliant's wholesale electricity generated from coal, the company depends heavily on the fossil fuel. This is particularly true since in some of the energy it sells is regulated, meaning it cannot control the price it sells energy for. As a result, it is unable to pass its costs onto its customers. Therefore, if coal prices rise net profitability will be seriously affected, especially as Reliant has to continually renew coal purchasing contracts. With higher input prices, Reliant will be forced to raise its prices for electricity, which in turn will drive customers to other electric providers that do not depend as much on coal and do not have to raise prices. Therefore, continually rising coal prices will hurt Reliant's revenues and net profit margins.

Renewable Portfolio Standards (RPS) Will Affect Reliant's Coal Driven Portfolios

All across the U.S, states are adopting what are known as renewable portfolio standards- requirements for electric providers to have a certain percentage of renewable energy in their portfolio. Reliant's largest retail market, Texas, has adopted standards that require the state's total renewable energy production capability to reach 2,000 MW by 2009, 5,880 MW by 2015, and 10,000 MW by 2020.^[16] Retail electric providers, like Reliant, are required to contribute their market share percentage of the total renewable energy requirement. For instance, if a company sells 10% of the total amount of retail electricity in the state in 2009, than that company is required to have 200 MW have renewable energy. ^[17] In order to comply with these future requirements, Reliant will have to invest in new infrastructure to generate renewable electricity. Likewise, Reliant will have to purchase electricity from renewable generators, which will be more costly than fossil fuel sources.

Moreover, as renewable portfolio standards become more stringent and more states step in line, Reliant will see less demand for its wholesale electricity, which as of 2007 is generated primarily from coal and natural gas. Changing over to renewable resources to generate electricity will cause Reliant to incur significant infrastructure costs in the future.

Competition

In the deregulated markets that Reliant operates in, competition is fierce. Reliant has to compete against utilities, other retail electric providers, merchant energy companies, and incumbent retail electric providers.

Competition is particularly difficult in Houston, which contains over 65% of Reliant's customer base. New electric providers are entering the market each year, putting pressure on Reliant's margins.

Houston Retail Electric Providers

Amigo Energy - Amigo is a Houston based, privately owned retail electricity provider and a subsidiary of Fulcrum Power Services.^[18] As of July 2008, Coal is the source of about 28% of Amigo's electricity and natural gas is about 60%.^[19]

Commerce Energy (EGR) - Commerce is an electricity provider and a natural gas marketing company. Although based in California, it has a presence in Dallas and Houston.^[20]

Direct Energy - Direct Energy is a wholly owned subsidiary of Centrica, a publicly traded Fortune 500 company. Direct Energy has operations primarily in Canada, Texas, and the northeast U.S.^[21] Direct Energy serves over 5 million customers in North America.

First Choice Power - First Choice is one of the largest retail electricity providers in Texas. It is an indirect subsidiary of PNM Resources, an energy holding company.^[22]

Gexa Energy - Gexa is a Houston based retail electricity provider that served over 172,000 customers in Texas. Gexa offers a 100% wind powered electric service to its customers, called Gexa Green.^[23]

Green Mountain Energy - Green Mountain is an Austin, Texas headquartered electric provider that is devoted to providing clean energy. All of its electricity comes from renewable resources, like wind and solar. Between 1997 and 2007, Green Mountain delivered six billion kilowatt-hours of energy into the U.S.^[24]

StarTrex Power - StarTrex is a Houston based retail electric provider that also operates out of Dallas.^[25]

On a nationwide level, and particularly in its wholesale business, Reliant competes against Dynegy, DTE Energy Company, and the Potomac Electric Power Company.

References

1. ↑ Reliant 10-k (F-60)
2. ↑ Reliant 10-k (pg 4)
3. ↑ State Energy Conservation Office
4. ↑ http://dealbook.blogs.nytimes.com/2010/04/11/mirant-and-rri-agree-to-3-1-billion-merger
5. ↑ http://www.businesswire.com/portal/site/home/permalink/?ndmViewId=news_view&newsId=20100411005036&newsLang=en Mirant and RRI Energy to Merge to Create GenOn Energy - April 2010
6. ↑ Reliant Energy 2008 10-k (Part 1 Item 1)
7. ↑ Reliant 10-k (F 10)
8. ↑ Reliant Energy 2007 10-k (pg 3)
9. ↑ Houston Electricity Choice
10. ↑ Reliant 10-k (pg 2)
11. ↑ Reliant 10-k (pg 2)
12. ↑ Reliant 10-k (pg 14)
13. ↑ Reliant 2007 2nd Quarter 10-Q (pg 1)
14. ↑ Reliant 2007 3d Quarter 10-Q (pg 1)
15. ↑ Reliant 10-k (pg 4)
16. ↑ State Energy Conservation Office
17. ↑ Texas Renewable Portfolio Standard
18. ↑ Amigo Website - About
19. ↑ Amigo Electricity Facts
20. ↑ Commerce Investor Information
21. ↑ Direct Energy website
22. ↑ First Choice Power - About
23. ↑ Gexa About
24. ↑ Green Mountain - About
25. ↑ StarTrex Power - About