Chapter 1

A. Rationale of the Study

The Manila Electric Company (Meralco) operates the electricity distribution franchise in Metro Manila and the entire provinces of Bulacan, Rizal, and Cavite; and portions of Laguna, Quezon, Batangas and Pampanga. With over 4.8 million customers and 30,247 GWh of energy sales in 2010, it is one of Southeast Asias largest distribution utility. The franchise area of Meralco is home to 25.5 million people, roughly a quarter of the entire Philippine population of 94 million, and it is within Meralco's service area where almost half of the country's Gross Domestic Product (GDP) is produced, one-third from Metro Manila alone. Consequently, 54% of the total electricity usage in the Philippines, or almost three-fourths of all electricity used in Luzon, is consumed in the Meralco area. Meralco also has majority ownership on Rockwell Land Corporation, known for its upscale real estate developments in Makati City, Pasig and Ortigas. Other subsidiaries of include Meralco Industrial Engineering Services Corporation, Corporate Information Solutions, Inc., Meralco Energy, Inc., e-Meralco Ventures, Inc., Meralco Financial Services Corporation, and Clark Electric Distribution Corporation, all of which play a supporting role on the distribution business. Brief History The company was organized as the Manila Electric Railroad and Light Company 108 years ago in 1903 to provide electric light and power and an electric street railway system to Manila and its suburbs. The facilities that Meralco built to provide these two services represented for many years the largest single investment of American private capital and know-how in the whole of East Asia. Since the 1960s, the company was dominated by the Lopez Group through its subsidiary First Philippine Holdings Inc. However, a series of internal and external events in the mid-2000s triggered a change in ownership in Meralco. The table below summarizes the current ownership structure of the company.
Shareholder Beacon Electric PLDT Group First Pacific Total San Miguel Group Lopez Group Others Free float (PCD Nominee) Total Percentage of Ownership 34.8 6.1 40.9 34.9 9.5 4.7 10.0 100.0 Remarks Holding company 50% owned by Piltel and MPIC Controlling shareholder with voting agreement with the Lopez Group Owns or controls over 3,000 MW of generation capacity through SMC Global Power Inc. Founding owners of Meralco who have been selling down; controls power companies First Gen and EDC

Source: Meralco SEC Form 17-A 2010

The Rationale of the Study Last January 20, 2011, Meralco Chairman Manuel Pangilinan announced that the company is moving into power generation, with an initial plan to construct a peaking power plant in Calamba, Laguna with a rated capacity of 150MW. The plant is expected to be operational by the first-half of 2012 at an indicative cost range of US$120m to US$150m to run on mixed fuel. Mr. Pangilinan further disclosed that the company intends to put-up a 1,500 MW portfolio of greenfield power plants. This plan of the company should be a long-term positive, not so much in terms of earnings contribution, but more because it should cap total power costs to the customers of Meralco. Consumer groups have erroneously blamed rising power rates solely to Meralco, not realising that much of the recent increases came from the generation rates, not distribution rates that Meralco earns from. However, the plan carries two risk: First, is on what will be the corporate vehicle that should implement the plan given the existing ownership mix of the company (considering EPIRA rules). Second, is on what kind/s of power plant should Meralco build so as to maximise its capital expenditures and minimise opportunity cost. The two risks stated above shall be the focus of this paper. The research and the strategic proposals that are in this paper shall be limited to finding, proving and quantifying solutions and ways to minimise the risks.

The creation of a peaking plant by Meralco should cap generation rates, which surprised on the upside in a big way in 2010 in terms of the spot market. The latter operates in the Luzon grid where Meralco is located.

Recently, Meralco Chairman Manuel Pangilinan in a media disclosure said that the company is moving into power generation. They are planning to undertake a 150MW power plant at an indicative cost range of US$120m to US$150m to run on mixed fuel. The targeted commencement of operation would be 1H12, and the company has identified Calamba, Laguna (south of Metro Manila) as the power plant site. The said power plant is part of Meralco's long-term plan to put up 1,500 MW in terms of greenfield power plants.

They are planning to undertake a 150MW power plant at an indicative cost range of US$120m to US$150m to run on mixed fuel. The targeted commencement of operation would be 1H12, and the company has identified Calamba, Laguna (south of Metro Manila) as the power plant site.

Existing ownership profile make power generation move difficult, in our view Despite the announcement, we believe that the existing ownership structure of Meralco raises questions on whether the plan to move into power generation would materialise according to plan. The reason is the fact that the owners of Meralco include parties which have a large amount of power generation capacity, which could lead to a violation of limits on cross ownership between power generation and distribution companies. This raises the possibility that the ERC may end up raising a legal issue on the power generation move, putting the plan in jeopardy. In our view the best resolution would be for an ownership consolidation to take place at Meralco. We believe this would entail the First Pacific Group eventually buying out both San Miguel Group and Lopez Group (none of the groups have commented on this recently). Currently, First Pacific Group has a right of first refusal agreement with the Lopez Group, should the latter decide to sell off their remaining stake. Less clear would be the San Miguel Group, which had acquired its stake in Meralco a few years back in the hope of gaining management control. There are two existing questions for this paper: What will be the best corporate vehicle to implement the backward integration? Second is what will be the best type of power plants for Meralco in the longer-term? (Given the assumptions on the first question and current Philippine regulation)

++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ MPI to enter Power Generation through Beacon. Not through Meralco. It has a safer balance sheet and as a hedge against the current ownership mix in Meralco SMC and FPH are both power producers. If according to MPI it plans to enter power generation primarily to put a cap on power rates. It must ensure that the IRR is sufficient so that it is not return-destroying, and the NAV is sufficient for Piltel and MPI (not to drag down their values). Having stable power rate, oil and gas sources must never be option since these have prices that are volatile and may require extra costs in hedging and risk management expenses. Nuclear is expensive. Renewable must be proven as a choice. Though capex intensive, sustainable naman ang price and abundant govt incentives for renewables. (ERC: FiT Rules; fixed for atleast 12 years) Political On the Paper: Meralco to get into power generation through Beacon as a hedge to ownership tussle and its strong balance sheet. To choose renewable mimic Ayala. Now:

There are two existing questions: What will be the best corporate vehicle to implement the backward integration? 1. Beacon Electric Asset Holding, Inc. joint venture of Piltel and Metro Pacific to hold 38.8% of Meralco; has a healthy balance sheet with below 20% debt coverage; capacity to raise more funds via IPO and as Meralco shares as collateral on bank loans. logical option given the current ownership profile of Meralco to avoid legal issues with ERC though bad for the long term. 2. Meralco Energy, Inc. dormant subsidiary of Meralco purpose built for power generation but with no experience in building power plants post-Marcos administration; has a clean balance sheet profile; can raise more funds only through IPO; ERC may raise legal issues given the background of the Lopez Group and San Miguel as power producers. difficult to implement and may require first the consolidation of ownership within Meralco. What will be the best type of power plants for Meralco in the longer-term? Given the assumptions on Q1 and Philippine regulation. RE Energy; EPIRA
Beacon Electric Asset Holdings, Inc. was established in March 2010 to hold the investments of PLDT Communications and Energy Ventures (formerly Piltel) and Metro Pacific Investments Corporaton (MPIC) in Manila Electric Company (Meralco). Both MPIC and Piltel own 50% each of the company, which in turns own 38.8% of Meralco.

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Moving into power generation is a logical evolution Recently, Meralco Chairman Manuel Pangilinan in a media disclosure said that the company is moving into power generation. They are planning to undertake a 150MW power plant at an indicative cost range of US$120m to US$150m to run on mixed fuel. The targeted commencement of operation would be 1H12, and the company has identified Calamba, Laguna (south of Metro Manila) as the power plant site. The said power plant is part of Meralco's long-term plan to put up 1,500 MW in terms of greenfield power plants.

A long-term positive as it may cap total power costs to consumer This development should be a long-term positive, not so much in terms of earnings contribution, but more because it should cap total power costs to the customers of Meralco. Consumer groups have erroneously blamed rising power rates solely to Meralco, not realising that much of the recent increases came from the generation rates, not distribution rates that Meralco earns from. The creation of a peaking plant by Meralco should cap generation rates, which surprised on the upside in a big way in 2010 in terms of the spot market. The latter operates in the Luzon grid where Meralco is located. Existing ownership profile make power generation move difficult, in our view Despite the announcement, we believe that the existing ownership structure of Meralco raises questions on whether the plan to move into power generation would materialise according to plan. The reason is the fact that the owners of Meralco include parties which have a large amount of power generation capacity, which could lead to a violation of limits on cross ownership between power generation and distribution companies. This raises the possibility that the ERC may end up raising a legal issue on the power generation move, putting the plan in jeopardy. In our view the best resolution would be for an ownership consolidation to take place at Meralco. We believe this would entail the First Pacific Group eventually buying out both San Miguel Group and Lopez Group (none of the groups have commented on this recently). Currently, First Pacific Group has a right of first refusal agreement with the Lopez Group, should the latter decide to sell off their remaining stake. Less clear would be the San Miguel Group, which had acquired its stake in Meralco a few years back in the hope of gaining management control.