Business & Money

Some independent power producers failed to contain capital and O&M costs, adding to financial pressures.

Merchant generators can substantially increase cash flow by revamping their capital allocation processes. Based on several recent client engagements, a PA Consulting study found that merchant generators often follow a flawed allocation process that misappropriates cash toward wasteful maintenance and capital expenditures, resulting in reduced asset values and erosion of precious cash reserves.

Our study of recently acquired generation assets representing 36 plants and 32,410 MW found a lack of control in the level and growth of non-fuel maintenance expenses and of capital allocated to projects related to operations and maintenance (O&M). Even more troubling is that this lack of investing discipline occurred at a time when merchant producers were under very serious financial pressures.

This situation is the result of a poor capital allocation process that often fails to:

• Tie capital or O&M plans to the company's production strategy;
• Rigorously analyze multiple options and risks for each project;
• Evaluate the impact of single projects on the entire portfolio of investments; or
• Manage the benefits and risks of the projects and portfolio.

O&M Expenditures

Initially, we discovered a disturbing rise in the non-fuel maintenance expenses of divested assets. This is surprising because conventional wisdom suggests that merchant owners of divested plants tend to be very cost-conscious, trying to squeeze as much profit from their recently acquired assets as possible compared with their previous owners-regulated utilities that could pass on operating costs to ratepayers.

In fact, not only were post-divestiture costs higher, but they kept growing. The PA analysis showed that while maintenance costs before divestiture actually shrank slightly on average, post-divestiture maintenance expenses grew at a compound annual average growth rate of 34 percent from 1999 to 2002, defying the conventional wisdom that competition alone would control expenditures. Of course, the traditional argument for post-acquisition maintenance cost increases holds that plants were under-maintained prior to being purchased, but the PA research does not show this to be the case.

Even when maintenance costs are compared with actual net generation, a similar trend is evident. The average maintenance cost ratio did dip in 1999, but this one-time event was driven in large part by a spike in net generation. By 2000 the maintenance ratio returned to within a few pennies of the 1998 level, and by 2001 the ratio was a full 7 percent above the highest level recorded since 1988. What's more, the maintenance ratio continued to rise another 30 percent in 2002 (see Figure 1).

This rise in maintenance expenses is even more surprising because many of these merchants companies were at the same time experiencing dire financial circumstances and were all undergoing significant restructuring. Yet neither their senior nor plant management were able to significantly limit the growth of maintenance expenses.

In fact, we found another surprising trend-an increase in both O&M expenses and O&M capital investments, in spite of these companies' financial problems. Generally, in times of financial distress, companies find slashing capital budgets easier than cutting operating expenses, first eliminating