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long as a strategy. The boom-and-bust cycle is alive and well. Every expansion period-like the merchant boom we have experienced-is followed by a period of contraction, consolidation, and rationalizing. The process of consolidation and rationalization is just beginning, and some players will not survive the experience.
The purchases of MidAmerican Energy by Warren Buffett and of DPL by KKR are only two examples of the potential for new players to enter the market with innovative or disruptive business strategies in an effort to capture advantage.
Investor-owned utilities see significant buying opportunity from among the merchant assets built during the boom. The Federal Energy Regulatory Commission (FERC) considers the utility purchase of a merchant power plant a threat to wholesale competition going forward. State utility commissions perceive such purchases as undermining the arms-length nature of the competitive power markets in ensuring that customers get the least-cost, most reliable energy supply to ensure resource adequacy. For the investor-owned utility this often represents a catch-22. While it makes no sense to build new generation in an overbuilt market, regulators at both FERC and state levels are prepared to restrict or punish the utility for such an initiative. The back-to-basics strategy further exacerbates this problem. Power contracts are not included in the ratebase calculation; thus, the utility is further incented to build new assets in overbuilt markets in an attempt to drive 10 percent growth. For municipal and cooperative utilities, the fear of getting involved with potentially uncreditworthy merchant generators or projects means they, too, are building to meet their resource needs in an era of substantial oversupply.
After the trashing of SMD, will FERC use its regulatory review authority to bring intense pressure on the holdouts? Remember what FERC did to the holdouts on Order No. 636? Some firms that resisted FERC found themselves starving or strangled by regulatory delay or disapproval, and some did not survive the experience.
The Ticking Time Bomb of Merchant Financial Structuring
Excess generating capacity and weak demand is slowing recovery in the merchant energy sector. Energy Velocity data shows there has been a significant decline in the average capacity factor over the past 10 to 15 years. Many merchant projects built since 2000 were expected to run as base-load units, replacing older, less efficient units. The average capacity factor of the 900-plus units built since 2000 is less than 25 percent, and the lion's share of units dispatching as base load came online between 1955 and 1991. The overbuild and low capacity factors mean that mini-perm refinancing just completed by many merchant plant owners may not last long enough to get through the crisis to equilibrium. Purchase power agreements (PPAs) are being imputed as debt on balance sheets, setting up an argument for high returns on equity in rate cases at FERC, but the rating agencies seem to be treating PPAs like debt.
Private equity firms are making investments in merchant generation that are not subject to the Public Utility Holding Company Act. KKR's proposed purchase of UniSource and Texas Pacific Group's proposed purchase of Portland General Electric are