Any publicity may be good publicity in certain quarters, but not where UK power generation is concerned. Recent articles in the UK national press have hinted at the exploitation of ?Chinese walls' as well as price manipulation in relation to newly formed acquisition vehicle, Coal, Gas & Electric Power Limited (CGE). And there are now growing fears that, over the next 18 months, the UK's distressed power plants will fall into the wrong hands.

The negative press has been further exacerbated BBC drama-documentary, aired last month, questioning the country's security of supply. If...the Lights Go Out ? played out in the winter of 2010 ? focused on a blackout caused by a terrorist attack on a section of pipeline in Russia (from where the UK now imports gas). Though the programme failed to convince by giving no clear and logical explanation of the complexities governing the UK's power structure, it managed to hit on number of salient issues regarding security of supply, environmental targets and retail pricing.

With the UK regulator, Ofgem, seeking to regulate ?monopoly businesses intelligently?, whilst guaranteeing security of supply, publicity of this nature is sure to undermine its authority. So whether the regulator takes any investigative action or sits on the fence remains to be seen.

In the meantime, CGE is looking to take control of the distressed power sector, which may have serious implications for the industry. Some industry commentators have even gone so far as to say that CGE may change the face of UK power.

Formed in December of last year, CGE is backed by six banks: Abbey National, HBOS, Lloyds TSB, Royal Bank of Scotland, Bayerische Landesbank and HVB. Over the course of this year, the company intends to acquire an estimated 15% to 20% of the UK's electricity generation market. Some 25 distressed power plants have been targeted, casualties of the wholesale electricity price collapse of the late 1990s which left many plants unable to meet the interest on their loans. The series of acquisitions would provide 10,000 to 12,000MW of generating capacity, half of the UK's £5.5 billion ($10.1 billion) 20,000MW distressed asset base.

CGE goes shopping

In January, CGE made its first move in the UK power sector by emerging as the front-runner in the race to acquire Damhead Creek. The 800MW CCGT power plant, based in Kent, remains one of the UK's foremost distressed assets. Shell Gas Direct has a 15-year gas supply agreement with the plant, rumoured to be as valuable as the plant itself. Other bidders included US utility Calpine and Scottish Power.

Whilst bid details remain sketchy ? it is rumoured that Scottish Power has pulled out ? the deal now seems to have been put on hold. According to one London-based banker, ?These transactions are not straightforward like certain M&A deals. One of the big issues in particular is that no one out there wants to take merchant power risk. What these banks want to do is to par out. In the case of Damhead, it just got too difficult to do.?

The theory behind projects such as Damhead Creek, and the more recent Drax bid, is to collect enough distressed generation assets in order to reach a critical mass, whereby price recovery can be accelerated. Moreover, the less efficient units can be mothballed in order to strike a balance between over capacity and demand.

For some the equation is even simpler: ?What goes off comes back on when the price is right,? says an industry source.

The destiny of the units will in effect be controlled by a number of banks that will have their own interests at heart in relation to certain sell decisions. And ?these banks have diverse interests. What do they really want: a five-year play or a one-month flip? They all have different agendas,? says a London-based corporate financier.

Although most of the criticism levelled at CGE has emerged in the press subsequent to its more recent Drax bid, certain industry players have had reservations from the very the outset. The overriding concern to have emerged from Damhead Creek is the obvious issue of ?Chinese walls'.

Given that the backers of CGE are major creditors to the UK power sector in general, industry players have voiced fears over the strength of the ?Chinese walls' between the investment and project finance divisions of CGE's backers. Some even go so far as to believe that the banks should not have formed the asset recovery vehicle in the first place. ?These banks just don't belong in this sector: neither from a technological nor from a risk capital perspective,? says a project financier.

Unsurprisingly, any allegations of wrongdoing have been strenuously denied. ?There is no way any of CGE's backers would even think of exploiting a ?Chinese wall',? states a source close to CGE.

The fundamental problem does not lie in the relationship between the divisions, rather the reporting structure to the executive committee. Even if the investment and project finance divisions do not communicate to each other, each will be telling the executive committee a similar story. Thus, questions arise as to what kind of corporate exposure or risk the bank (as a whole) may be taking in light of the disclosed information.

As yet, the Financial Services Authority (FSA) has taken no action. However, should CGE succeed in its strategy to acquire a portfolio of assets, the authority would be wise to take a closer look. Since the implementation of its Conduct of Business Rules, the Financial Services Authority (FSA) has sought to crack down on the movement of information within firms that conduct what it calls ?designated investment business?. Under COB 2.4 (Chinese walls) the strict guidelines for those firms qualifying under this category are set out.

Whether a breach is proved or not, there are those who believe that the conflicts of interest will cause no shortage of internal tension between the relevant departments. Though how this will manifest itself is, for the moment, unclear.

Drax back in the frontline

In late February, CGE tabled a bid for the assets of Drax, the UK's largest coal-fired power plant, representing 6% of total capacity. According to a statement put out by the North Yorkshire-based utility, the ?indicative portfolio offer?...suggests that Drax Holdings should exchange all its assets (including the Drax power station) save for the benefits associated with Drax's claims in the TXU administrations, but not its liabilities, for a mix of undefined senior debt and mezzanine debt instruments in CGE Power.?

The offer comes hot on the heels of Drax's protracted £1.3 billion restructuring process, which was finalised in December of last year (for full details on Drax's restructuring see www.projectfinancemagazine.com). The majority of lenders had turned down International Power's increased offer of 95p ? up from 75p in the pound ? on the junior debt tranches. The final restructuring was welcomed by a 99% acceptance level.

A rise in UK wholesale electricity prices, coupled with the plant having pre-sold over 50% of its power for the next six months, contributed to the refusal of International Power's offer. When questioned on its failure to acquire a sizeable portion of debt, International Power refused to comment, except to say: ?Drax has ceased to be an issue.? The global power generation company eventually acquired £1 million (£1.8 million) of the restructured debt.

Fortunately for the banks involved, Drax is finally trading at par. Another AES plant, Fifoots Point in Gwent, South Wales, has only managed to trade at a meagre 10p in the pound.

Since the Drax offer was made, CGE has come under further fire. The asset recovery vehicle has been accused of blocking cash bids for bank-controlled assets, effectively ruling out the cash players. However, whether the plant owners will be swayed by a cash injection of 70p in the pound rather than 100p in JOE (joint-owned entity) debt instruments remains to be seen.

Although the industry is in dire need of capital investment, there are those who remain sceptical. According to an industry analyst, ?Who's going to invest money into this sector? If the major industry players aren't willing to do so, then who is??

Certainly there is market suspicion of CGE's motivation. And it is rumoured, rightly or wrongly, that some of CGE's backers have implemented a separate P&L for their distressed debt trading desks in order to buy paper.

Industry sources have also queried the fact that the asset recovery vehicle has been set up with some £20 million in working capital. ?You could have set the company with £1 million. Why give £20 million to tie up the market?? asks an industry banker.

One theory is that CGE is being used as a vehicle in order to push up bids on a number of the UK's distressed assets. Another is that the regulator may have a vested interest in seeing CGE push the recovery numbers. Though difficult to prove, few industry experts have been able to ascertain what it is that CGE is attempting to achieve by its presence in the market.

The price is right

Whilst the scramble for distressed assets continues, there is a fear, among industry sources, that CGE's backers have sought to buy power assets in order to keep them off-line. The lack of power generation would inevitably mean an increase in price. Furthermore, the environment for other distressed assets would become even more favourable.

According to one project finance lawyer, ?What these banks are effectively trying to do is manipulate prices; they want to take 15,000MW off line in order to achieve optimisation.?

But not everyone agrees. ?Why would this be in the interest of the banks anyhow? These banks will want to maximise revenues as well as attempt to reduce their costs over time,? says a senior analyst at Standard & Poor's.

A source close to CGE remains adamant: ?Even if CGE were to end up owning 15% of the UK market, it doesn't have that kind of power to fix market prices.?

Whether or not CGE has the intention, let alone the capability to fix market prices, remains in contention. Though what is clear is that the banks have a very narrow agenda. ?Their main concern is to get all their money back, which at one point they were in fear of losing. Furthermore, the main driver is to try and drag up the weakest performers; and make the portfolio loss provisions lower than they otherwise might be,? states a London-based project financier.

What CGE amounts to is a self-help routine for the banks involved. Though CGE was unwilling to comment, there is a rumour beginning to circulate that once the consolidation and refinancing process has taken place, then the consortium will contemplate an IPO. ?I'm sure they'll try it, but not at the moment. Give it 18 months to two years, and some investors may take the bait,? muses a London-based banker.

Short supply

Although the government may have shown its commitment to renewables by imposing a 10% target by 2010 and 20% by 2020, the UK remains coal dependent. Some tough decisions will have to be taken later this year in relation to the implementation of the new emissions rules. Therefore, coal-fired power plants may be hit by job losses if government ministers take a hard line on sulphur regulations.

Even so, the government and regulator have not addressed the UK's core energy needs. With uncertainty over nuclear power and North Sea gas running out, the government has failed to give the industry a clear five- to ten-year clear view. The future demand for power may be such that generators, which do not comply with the environmental emissions rules, will be given waivers and switched back on.

Nevertheless, the regulator may, before time, face another crisis in the form of the distressed power market. If CGE is found to have discriminated against certain bid offers in the form of a veto, it will open the floodgates for litigation.

Moreover, if the industry continues to forsake re-capitalisation, there may even be wider repercussions. ?Could we be seeing the vertical re-integration of the industry, back to the days of three household names?? asks an industry source. Whether CGE will play the catalyst in closing up a market that took so long to de-regulate remains to be seen.