RATE UNBUNDLING: ARE WE THERE YET?
FEBRUARY 15, 1996
An evolving market demands a greater focus on power prices and required return on equity.
Valuation can be difficult even in stable markets, and executives setting their company's strategic course need to understand how the market for power projects is evolving and what may lie ahead.
Under traditional rate base regulation, significant emphasis was placed on historic or embedded costs for valuation of electric generation property. However, considering the electric industry's restructuring activities and the increase in sales of electric generation property during the past 10 years, there has been a reasonable and logical shift to examining and emphasizing the income approach for valuation. Risks associated with the cash flow expected from electric generation need to be carefully assessed during the valuation process. Further, such risks in many cases have changed rapidly as deregulation and financial pressures from many sources have evolved. Much more change is in store.
Trends in Value
Like volume in the market for power projects, value too has evolved. Figure 1 depicts changes in volume in the market for power projects since the late 1980s, and Figures 2 and 3 show several measures of trends in value. Dollars per kilowatt ($/kW) for fossil-fired projects appears in Figure 2, and the pro forma after-tax return on equity (ROE) expected by buyers appears in Figure 3.
Dollars per kilowatt is an often- calculated measure of price. The necessary data are usually available, and the math is easy. Considering this measure alone, the value of projects sold actually increased during 2002. The price for natural gas- or oil-fired power projects in 2000, 2001, and 2002 averaged $505/kW, $500/kW, and $560/kW, respectively. This increase during 2002 refutes the position that the financial pressures on sellers during 2002, and a dearth of buyers, depressed project values. However, $/kW is a version of the market approach to appraisal and, like dollars per square foot for real estate, comparisons based on $/kW assume comparability when in fact little comparability may exist. From this perspective, it is not surprising that the data in Figure 2 shows large variances and no meaningful trend in value. Dollars per kilowatt is at best a signpost to value. More careful evaluation of a facility's revenues, costs, and risks is necessary.
The income approach to valuation is the gold standard among participants in the market for power projects. While value is thus determined by every line in a detailed forecast of cash flow, two stand out as particularly important; power prices and the required ROE.
The risk associated with power prices is one of the factors that differentiates projects. Some generators sell power under long-term contracts with fixed prices and, as long as these contracts are with creditworthy entities that continue to perform, these projects are exposed to no market risk. If they match the power sales contract with a long-term, fixed-price fuel contract, these projects have a fixed operating margin and their cash flows can involve little risk.
At the other end of the risk spectrum are pure merchant projects. These have no fixed-price power and fuel contracts and they