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Did Power Plant Buyers Pay Too Much?

Fortnightly Magazine - November 1 1999

a 20-plus-year period.

* Forecasting changes in the amount and character of generating capacity.

* Forecasting the costs of inputs such as fuels and capital.

* Assessing the likelihood and timing of technological innovation.

* Including these parameters in a simulation of the operations of the market with an overlay of theories on bidding behavior and market equilibrium conditions.

* Analyzing and projecting revenues from ancillary services, plant optionality value and trading value.

* Analyzing the plant's site value, including transmission access, environmental status, expansion potential, etc.

The primary sources of power plant value are illustrated in figure 1. Of course, long-term market price forecasting is more an art than a science, but understanding and quantifying a few fundamentals and their impacts on power prices can facilitate a solid revenue forecast. These fundamentals include:

* Replacement costs and the impact of incremental capacity that places a long-term "cap" on prices in the energy market.

* The inelasticity of power demand, the absence of short-term substitutes, and the attribute of electricity as an essential commodity with high outage costs mean that reliability commands a premium in both the energy and ancillary services markets.

* Price volatility results from power's inelasticity and the absence of large-scale storage technologies, and enhances a power plant's trading value, retail value and "option" or "reserve" value.

Clearly, there are many pieces to the power plant value puzzle. The following describes the key aspects of a projection of energy market revenues (figure 1).

Price Expectations. A competitive power price forecast depends first and foremost on an assessment of the supply/demand balance in a given market. Power prices and power price volatility are influenced more heavily by the supply/demand balance than are the prices of other commodities. What makes electricity unique, of course, is that it cannot be stored, and the price of power will spike when unexpected plant outages and transmission congestion accompany high demand caused by extreme temperatures. Suppliers not only benefit from these short-term price spikes, it is likely that many suppliers will depend on high-price periods to recover fixed costs. However, if an abundance of capacity is available in the market during peak demand periods due to overly exuberant development or lackluster demand, prices will not rise dramatically and many suppliers will have difficulty achieving fixed-cost recovery. Therefore, the price of power and the profitability of power plants both are highly dependent on the supply/demand balance.

An efficient power market will trend toward an equilibrium supply/demand balance, and prices will approach the cost of replacement or incremental capacity. In other words, consumers will be willing to pay just enough for electricity to provide for a reliable power market. The resulting prices will provide incentives for developers to construct only as much capacity as the market needs. If prices are higher than the cost of new capacity, then developers will achieve a return on their investment higher than their cost of capital. They will continue to build until the amount of new capacity is sufficient to drive prices down to equilibrium levels. If prices are lower than