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Business & Money

An evolving market demands a greater focus on power prices and required return on equity.
Fortnightly Magazine - May 1 2003

sell power into what can be volatile markets. On the strength of forecasts about the course of deregulation, power prices, and fuel prices, merchant projects began to be developed in the mid-1990s.

Of course, not all projects were or are contract-secured or merchant; some are a mix of the two. The contract-secured and merchant segments bound the possibilities. Unrealistic forecasts, errors in judgment, and other factors led to the troubles that now hinder many merchant projects.

Required ROE

As independent generation segmented, investors recognized the differences in risks. Accordingly, this led to segmentation in the second important factor that drives value: required ROE. Merchant risks were higher, and investors in such projects commanded higher returns. Trends in ROE since 1989 appear in Figure 3. The ROE data should be considered with several qualifications in mind. Buyers' return expectations change over time, and not all buyers are the same. In addition, while substantial academic effort is devoted to estimating a correct ROE, practitioners work in an environment that requires the application of some judgment. The data in Figure 3 is based on discussions with various participants in the market since 1990 and on occasional published reports. Vertical lines at the right show the range of actual experience, and the horizontal lines show trends in that range since 1989.

The concept of financial diversification indicates that spreading an investment across several assets will eliminate some of the risk. Unsystematic risk or asset-specific risk is effectively eliminated by meaningful diversification. However, systematic risk or market risk of an asset is not reduced or eliminated by diversification. In evaluating the expected cost of equity capital for generating assets, these risk concepts need to be considered.

Subject to the qualification above, power project values increased as return expectations declined during the early 1990s. The PURPA-based industry matured, it learned to manage risks, and new entrants increased competition. Returns went down, and sales values went up. Many of the new entrants were unregulated utility subsidiaries.

When merchant projects debuted, competition was scarce, return requirements were high, and asset prices were low. Then, like the PURPA-project segment of the market, the merchant segment began to mature. Competition increased, return expectations went down, and the sales value of merchant projects in both development and operation went up.

Beginning in 2000, when competitive markets for power became very volatile and the functioning and regulation of markets for power proved uncertain at best, the future of merchant generation began to look bleak. Return requirements increased, and values declined. Further, the risks associated with merchant operations loomed so large during 2002 that there were few transactions on which to base an estimate of the required return.

The Road Ahead: What Will Drive Volume and Value?

Several related factors will drive volume and value in the market for generating facilities during the next several years.

First, financial pressures on more than a few of the past's most active firms are acute. AES, Calpine, CMS, Dynegy, Duke, El Paso, NEG, NRG, Mirant, Reliant, and others are already selling some of their most valuable assets. More