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Did Power Plant Buyers Pay Too Much?

Fortnightly Magazine - November 1 1999

Homer City's all-in cost on a reasonable capacity factor assumption is comparable to that of a new combined cycle.

Power plant valuation requires a detailed look at several potential revenue sources. Our simplified CMP portfolio analysis - examining only potential energy market values - indicates the need for a more sophisticated asset-specific type of approach. In addition to energy market value, a complete valuation would include an estimate of value flowing from the ancillary services market, trading and retail value, and plant site value.

Finally, the transaction may need to be analyzed to see if the deal itself adds value to the asset. For example, frequently there are transition contracts offered by the seller that provide additional value. Tax value issues and IRS rulemaking also may impact asset value, particularly if contract restructuring is involved. Niagara Mohawk's independent power producer restructuring is a case in point.

Book Value Multiples:

How They Foster Confusion

Confusion about the relationship between net book value and power plant market value may result from the tradition of price regulation in the utility business. The net book value is similar to what regulators call the "rate base." Both are measured as original cost minus accumulated depreciation. The reason some people may attach undue importance to net book value as an indicator of power plant value may be that utility revenues are tied systematically to the similar measure, rate base, under cost-of-service regulation.

Regulators determine utility-allowed revenues using the actual expenses that utilities incur, plus a return on rate base, plus an annual depreciation expense. Utility revenues based on expenses simply "pass through" the utility to entities such as fuel suppliers, workers and taxing authorities. On the other hand, the return on rate base and depreciation expense provide utility investors with their return on investment and a return of investment. Hence, plant revenues and rate base are linked strongly under cost-of-service regulation. Net revenues are the basis of plant value under both cost-of-service regulation and competition.

Competitive market revenues are not tied to rate base. Rather, competitive market prices are determined by the relationship between supply and demand, and power sales result from a plant's competitiveness relative to other suppliers. Low-cost power plants will sell more power than will higher-cost rivals, and prices will reflect the supply/demand balance and the value consumers place on reliability.

There is no systematic relationship between net book value and market value because net book value affects neither the market price for power nor the operating costs of a power plant. Consequently, would-be buyers of generating assets should base their bids not on the asset's net book value, but on estimates of market revenues, net of power production costs. An accurate projection of net revenues provides a solid foundation for power plant valuation in the emerging competitive U.S. power market.

Competitive Value:

Tied Closer to Demand, Capacity

The process of determining a power plant's market value requires a team of analysts, each contributing specialized skills across diverse fields such as finance, fuels, engineering and computer science. Steps include:

* Forecasting hourly power demand over