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Business & Money

The consequences of exuberance are all around us.
Fortnightly Magazine - January 2004

Business & Money

The consequences of exuberance are all around us.

Much of the 160 GW of new generation capacity added to the U.S. inventory since 1998 is now under water, economically speaking. At a per-megawatt cost of $300, this represents $50 billion of investment-much of which is concentrated in Texas (23 GW), Illinois (14 GW), and Georgia (11 GW). The key question for both merchant and other plant owners is how long it will take for plant values to recover.

Although the value of electric generating capacity has probably bottomed out, the pace and extent of any rebound must be assessed on a county-by-county level. Some areas face an immediate need to build; others have enough generation for the foreseeable future. New capacity will have to be pulled in by clear signals from those in charge of the grids, which will be a varied lot thanks to FERC's diverse treatment of regional wholesale markets.

Investors put $50 billion into new generating capacity because they expected that electricity restructuring would lead to the formation of a small number of effective, regional transmission organizations (RTOs), which would make the location of a generating facility less important in the future. Based on that assumption, developers placed many plants close to a source of fuel, not close to market. For many companies, that has turned out to be a fatal mistake.

Developers and the banks that financed them also expected revenues to come from capacity payments-an expectation that now seems to many merchant power plant owners like a distant dream of something that existed once, and might one day return, but is now typically absent and much missed.

Valuation Realities

The consequences of the exuberance in generation development are all around us. Among the most interesting:

  • Generation development is at a standstill. No one will finance a plant without a capacity revenue stream.
  • Only bargain-hunters are active. Fire sales of power plants include the recent acquisition of the Congentrix fleet of plants by Goldman Sachs-a firm that has been pretty good at calling the tops and bottoms of the generation value cycle. We take their acquisition as a good sign that the cycle is at or near the bottom.
  • Lingering uncertainty about transmission and capacity rules. This prevents most buyers from re-entering the market. Regulatory risk is deemed to be very high.
  • Regional differences persist. Some areas, like Entergy, are so well endowed that relief simply is not in sight. But other areas, like New York and Connecticut, need either generation or transmission projects to begin or resume development.
  • The buyer matters. The nascent state of competitive retail markets makes the incumbent utility the only buyer of capacity services. Usually, a monopsonist and buyer's market is a deadly combination for sellers-the inverse of the market power problem FERC usually worries about-and it exists in most of the areas that had a lot of merchant generation development (see Figure 1).

These factors conspire to effectively negate the value of most merchant plants for investors. Demand is there for a qualifying facility (QF) or other plant with