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Why Aren't Distressed Assets Selling

'First movers' will be positioned to extract the most value from the acquisition of generation infrastructure.
Fortnightly Magazine - May 15 2003

MW translates to a 9 percent increase in total U.S. capacity. With demand growth expectations of roughly 2 percent per year, the United States should absorb this new supply this year. An additional 50,000 to 65,000 MW under development will likely achieve commercial operation in the next couple of years, and this will extend the recovery period between one and three years. However, this assumes no retirements, normal weather, and it ignores the fact that the United States was short of capacity in many regions before the new capacity was built.

The stalled state of restructuring in many parts of the country, most notably the Southeast and Midwest, has created an environment where independent producers may only have access to an incremental market for energy. Integrated utilities with rate-based assets, acting under an obligation to serve, receive compensation for the use of their own assets and assets under contract through cost-of-service prices, set by state public service commissions to provide utility fixed cost recovery.

What is left for the independents in some regions is a very thin energy market with many independent competitors. In such markets, lack of liquidity, reliable access to the grid, and largely term contract structures make for small incremental volumes and limited market influence from independents seeking to bid wholesale prices to levels sufficient to secure fixed cost recovery.

Figure 2 illustrates that, even under conservative conditions, most regional power markets will begin to provide equity cash flows by 2006.

The retirement of older capacity could accelerate higher market prices. Retired capacity would accelerate achievement of a supply-demand balance that would support higher power prices. The conservative estimates shown above do not consider the potential for capacity retirements. Currently, 60,000 MW of coal capacity nationally could retire between 2003 and 2005 due to emissions concerns and poor operational records. These coal-fired power plants have been running at capacity factors of under 50 percent.

With demand growth and the potential for regulatory movement and capacity retirements, now is the time to develop strategies for taking control of distressed assets. There is reason to believe that well organized first movers will be in position to extract tremendous value from the distressed asset pool and have limited competition for the best assets.



During the past 18 months, spot power prices have been low relative to strengthening gas prices, creating financial difficulties for independent power producers. Fixed-cost recovery for power plants is possible only if power prices sufficiently exceed marginal fuel and variable costs of producing power. The difference between power and fuel prices, the "spark spread," typically ranges between $75 and $85/kW-year for new gas-fired power plants, the overwhelmingly predominant independent technology, to cover fixed costs and provide a 12 to 15 percent return on equity.

The regional spark spreads required to provide these returns are shown in Figure 1. No U.S. region provided equilibrium returns for new gas-fired power plants at the end of 2002, and power prices in only a few markets were high enough relative to gas prices to provide debt coverage. The inability to provide debt coverage