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"Spark spread" sets value, but as prices diverge from system

lambda, merchant plant buyers will be flying blind.

Many power plants will be bought and sold in the next decade. Some utilities will divest power plants as required by regulators; others will sell for strategic reasons. Most of the plants sold likely will become merchant plants, with no guaranteed market for their electric output. Merchant plant activity is already significant and growing. The value of these plants will depend on how well they can perform in an uncertain market.

Plant owners in a competitive market constantly will re-evaluate their portfolios of generating assets. In so doing, their expectations of plant financial performance may differ, based on market prices, risk-return requirements, tax factors, upgrade plans or operational practices. Indeed, alternative valuations will make many plant sales transactions feasible. How will potential buyers and sellers set a value on merchant plants?

Current or prospective owners likely will use several new measures of a merchant plant's value. Of those, the "spark spread" will prove the most critical (em and the most uncertain (em as wholesale power prices evolve from a simple mirror of short-term variable costs (system lambda) to reflect more long-term fixed costs. Moreover, buyers must time their investment to anticipate a positive spark spread for the specific niche in which the plant operates.

Valuation: Price vs. Fuel Cost

The value of a power plant (like any productive asset) equals the discounted net cash flow it is expected to generate for the owner over its expected financial lifetime. Most merchant plants operate simultaneously in two related and volatile markets: power and fuel. %n1%n Within the spread between those two markets, known as the "spark spread," %n2%n they must produce enough revenue through power sales to cover all operation, maintenance and other fixed costs, service all debt, meet other financial charges (such as taxes) and earn a profit for equity investors. Yet, a spark spread sufficiently positive to do all this is not guaranteed. Indeed, the spark spread could be negative (see Figure 1).

Four considerations determine the value of a power plant: 1) the outlook for an adequately positive spark spread; 2) the likely sales volume at the expected electricity prices; 3) plant-specific cost factors (plant type, fuels, age, condition, etc.); and 4) the uncertainty and risk associated with each of the above considerations. Each of these factors is likely to be highly dynamic, even for an individual plant. As a result, the value of a plant to prospective owners will vary over time.

Spark spread marks the most uncertain component of this valuation and the element over which the plant owner exerts the least control. Fuel prices and wholesale electric prices are inherently volatile (see Figure 2). A company can manage spark spread in two ways: strategic investment in plant assets and by coordinating fuel management with power marketing.

Usually, the cost of new capacity will set an upper limit on the value of existing plants (em companies will not pay more for an existing plant than a new, highly efficient one. And