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Business & Money

Merchant Power:
Fortnightly Magazine - January 2005

projects tend to be combustion-turbine peakers with heat rates over 11,000 Btu/kWh in regions such as SERC and the East Central Area Reliability Coordination Agreement, which have ample reserve margins and substantial coal and nuclear generation. The Duke GE 7EAs in Georgia, Kentucky, and Mississippi purchased by KGen are examples. High-value projects tend to be combined-cycle facilities with relatively low heat rates purchased by ratepayer-at-risk entities. The purchases by Avista, GenTex, Puget Sound Energy, and city of Brownsville () are examples.

While $/kW is a popular measure of value, a project-specific forecast of net income is a universally employed and more reliable guide to value. Discounted cash flow (DCF) remains the gold standard of valuation. Due to uncertainty surrounding operations, power values, and fuel costs over time, several scenarios and probabilistic Monte Carlo results also are often considered. While a facility currently might be out of the money due to its heat rate and non-fuel variable operating costs, changes in markets over time, and a focus on high-value time periods may support some capital value. For example, such analysis is the only way to support capital value for the DENA and NE&GT peakers purchased by KGen and American Municipal Power - Ohio.

One of the critical inputs to DCF valuation is the discount rate or rate of return that a buyer requires. As a benchmark, power projects with contract-secured revenues and costs will sell for pre-tax returns of 14 percent to 18 percent. Some high-quality, low-risk projects sell for more aggressive returns, and those with resource risk, technology risk, or that have defects in key supporting agreements demand higher returns.

After tax, the return range for high-quality projects is in the single digits to low teens. For merchants, due to comparatively high risk and complexity, rate-of-return thresholds become less meaningful. For example, buyers might focus on adverse circumstances and bid only what appears to be a break-even price. They may be willing to risk a positive return on uncertain markets. Differences among bids more likely are determined by how they view the risks than the rate of return each requires.

The Implications of Reintegration

Reintegration by regulated utilities through merchant acquisitions is, in many respects, controversial. First, it represents a concentration of ownership and potential loss of the benefits of competitive power markets. Several of the acquisitions by regulated utilities have been controversial for other reasons. Arizona Public Service purchased five projects from its affiliate Pinnacle West, and some allege that the price paid represents a bailout at the expense of ratepayers. Edison's arrangements concerning Mountain View were negotiated and not the results of a broad competitive solicitation for new capacity. A contract with an affiliate also is involved. Interveners in proceedings at the California Public Utilities Commission asserted that the transaction is a bailout, allowed concentration of generation, and reduced the role of independent generators in California.

While the current opportunity to purchase assets for prices below what they cost to construct appears attractive, a focus on discount can miss an important point. Such a focus is backward looking, and value