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California's Power Gamble: Long-Term Contracts, Locked-In Risk

High profit potential will attract new power plants, forcing prices down and stranding the state's long-term electricity purchases.
Fortnightly Magazine - May 15 2001

to alleviate problems for this summer, but he hasn't communicated a long-term fix," said Lawrence J. Makovich, senior director of Cambridge Energy Research Associates. Makovich said Davis has to reform the market to encourage power providers to make necessary investments in California. California's greatest impediment to fixing its power problems is tough environmental standards and other regulatory hurdles that make it "very difficult and expensive to build power plants in California," he said. Maybe so, but market prices for the power will reflect these impediments.

Risk and Reward for Power Producers

Many claim that power makers are reaping extra high profits in today's California power market. Is that really true? What is the logical return on equity for a typical power plant investment in California?

Consider Table 1. It shows the average return on equity earned over the last five years by seven major power producers: Dynegy, Williams, CMS Energy Corp., Duke Energy Corp., AES Corp., Calpine Corp., and Reliant Energy.

The five-year average return on equity for these major energy companies ranges from 12.1 to 20.86 percent. It is likely that, given the negative risk factors listed above, projects in California might require returns at the higher end of the range, if not beyond.

Nevertheless, the various mitigating risk factors also discussed here might provide some offset. In fact, an argument could be made that generation investments in California are less risky than the financial markets as a whole. Following this line of reasoning, an investor in the California market should earn no more than the returns posted by various common financial market indices in recent years. These indices are shown in Table 2.

The range of the 10 indices shown in Table 2 is from 15.83 to 21.12 percent over a period of 15 years. High-tech stocks dominate the high end of the range. The Wilshire 5000, representing the total market, is at 16.64 percent. The range of the 10 indices shown in Table 2 is from 15.18 to 34.76 percent over a period of 5 years. Therefore, a generous return to a relatively less risky investment as evidenced by the California power market would result in a rate of return on equity of about 16 to 18 percent.

We could leave the question right here, and let the economists continue to debate with each other. In the alternative, however, we could try to crunch some numbers, and see what they say.

First, let's make some assumptions for typical new investment in generating capacity:

Plant Type - Combined-cycle turbine
Fuel - Natural gas
Avg. capacity cost - $600,000 per MW
Avg. heat rate - 7000 Btu per kWh
Annual capacity factor - 50%
Cost of pollution credits - $8 per MWh
Annual O&M cost - $10.00 per MWh

Table 3 shows the fuel-specific operating cost ($/MWh) for the new plant, depending on the plant heat rate, and based on different wholesale natural gas prices at the California border. (Fuel cost equals gas price times heat rate divided by 1,000.) With the fuel cost in hand, we can then determine return