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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

the case if these utilities enjoy access to a relatively high concentration of distressed merchant assets in or connected to their load area. At the other extreme, a utility may be limited in its capacity to embed generation in its rate base, or it may find few assets compatible with its load service or financial constraints.

In assessing generation acquisition or contracting opportunities, utilities are evaluating a variety of approaches to financing acquisitions or otherwise stepping into assets that present opportunities to convert from a contract to an ownership position. From a financing perspective, municipal and regulated utilities are less motivated to seek high rates of equity return as investor-owned utilities and other buyers, but they are motivated to acquire supply at relatively low and stable rates, given their regulatory (prudence) review criteria. Some of the more attractive approaches and capital combinations that are emerging in today's market include:

  1. Use of flexible loan structures, with equity return features and conversion rights granted to the lender, and the acquiring utility providing term contract commitments to support the asset's underlying collateral value;
  2. Load-backed acquisition utilizing a project finance structure with accelerated interest and principal payment rights to lenders, potentially serving as a framework for the next round of limited utility-backed generation project financing;
  3. A sale-leaseback structure, whereby the utility may act as lessor or lessee depending on its ability to place the asset in its rate base and its comparative depreciation benefits relative to a financial counter-party;
  4. Convertible term contract commitments (toll or power purchase agreement), whereby a rating downgrade or other material adverse change to the asset owner triggers defined utility contract conversion rights, including a conversion to equity, or liquid security enhancement (including asset pledge); and
  5. Contract buy-down as a restructuring solution, whereby a utility may proactively seek to buy down an existing term contract from a generation asset in exchange for ownership or control rights to the asset.

With average gas-fired combined-cycle market values falling from approximately $600/kW on a constructed cost basis to approximately $200 to $400/kW, depending on market location and asset features, the opportunity to lower embedded capital costs and maintain supply flexibility features to respond to both uncertain market price and load conditions is growing increasingly attractive.

Of the capacity available on the market, the large majority is gas-fired, largely in the combined cycle, peaker, or cogeneration classes. In addition, a significant component of coal-fired capacity is available on the market, with price ranges reflecting competing generation sources and the environmental compliance risk reflected in the asset's emission control technology. Coal assets may present an attractive acquisition if environmental upgrade potential is high and the acquiring utility does not face significant market price exposure. A gas-fired asset will prove more attractive if the utility faces considerable load shaping obligations.

When Markets Will Recover

The current oversupply situation will not persist indefinitely. Power developers have added more than 70,000 MW of new generating capacity over the past few years. With a total U.S. installed capacity base of 786,000 MW in 1999 when the new building began, this 70,000