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IPP shares fall on concerns EPA haze rule stay could stall ERCOT tightening

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IPP shares fall on concerns EPA haze rule stay could stall ERCOT tightening

Therecent court decision to stay implementation of the U.S. EPA's federal hazerule in Texas could delay the plant retirements many generators in theElectric Reliability Council ofTexas Inc. market have been betting on to increase power prices.

OnJuly 15, the U.S. Court of Appeals for the 5th Circuit of the EPA'sregional haze rule in Texas, criticizing the agency for delay and failing toconsider the rule's impact on grid reliability. Texas Attorney General KenPaxton hailed the decision as a victory.

Additionally,Texas Competitive ElectricHoldings Co. LLC, the unregulated subsidiary of ,suggested in an investor presentation filedJuly 12 as it courtslender support for a new debt refinancing plan, that it wouldseasonally mothball three of its large, older coal-fired plants: the 1,955-MWMonticello; the1,208-MW Big Brown;and the 1,635-MW Martin Lakefacilities.

Independentpower producers with plants in Texas have been expecting that when EFH eventually exits bankruptcy, since the assets require costlyenvironmental upgrades to comply with the federal haze rule. When the TCEHplants, and perhaps some others are retired, the tightened reserve margins inERCOT's energy-only market should improve prices. This has led to a dynamicwhere generators with aging coal assets on the fence of profitability arewaiting for someone else to exit the market, making their own unit economicagain to run.

EvercoreISI analyst Greg Gordon observed in a July 20 note that the EFH mothball planand haze rule court decisions have likely contributed to IPP investor concern.Shares of NRG Energy Inc.,Calpine Corp. andDynegy Inc. alldeclined beginning on July 18, the Monday following release of the courtdecision.

"Theconcern investors have is that this (court) decision, coupled with the recoveryin [Texas] power prices on rising natural gas, will prolong the game of 'chicken'being played amongst operators of struggling coal-fired units in ERCOT — no onewanting to be the entity to bow out and allow others to reap the benefits oftightening reserve margins," Gordon wrote, describing the EFH mothballdecision as, "negative developments for a better supply/demand balance andpower price support."

But while these are not positive developments for IPPs withTexas exposure, he called the share price decline an overreaction on the partof the market. The silver lining among these negative developments, in Evercore'sview, is that coal plant retirements should still ultimately hinge on thecompetitiveness of gas-fired generation, regardless of when that may happen. "At-riskcoal plants are likely to continue to run seasonally until they break and/orrequire capital, so tightening should occur sooner or later, but merchantcompanies will be on the defensive during Q2 earnings calls in terms of [Texas]market fundamentals," Gordon wrote.

Evercore also noted generators in ERCOT still haveopportunities to succeed in a market where the offer cap for scarcity pricingis $9,000/MWh. The addition of more than 6,000 MW of wind capacity installed inTexas since 2011, coupled with forced outages and reserve shortages can introducemarket volatility quickly if the right conditions align. Evercore calculatedthat every hour at the $9,000/MWh offer cap in ERCOT could represent $95million in additional revenue for NRG, $85 million for Calpine, $42 million forDynegy, $32 million for ExelonCorp. and $16 million for TalenEnergy Corp.

"We still think the IPPs are cheap," Gordon wrote."The IPPs exhibit a resilient cash flow profile against both equity andenterprise value under current power market fundamentals, most names seeing animproving [free cash flow] outlook through 2018."