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Business & Money

Merchant Power:
Fortnightly Magazine - January 2005

ought to consider the future. Coal-fired and other non-gas assets, for example, might be worth more than they cost to construct because of the fuel diversity and other benefits they provide. As market prices for coal have increased along with gas prices, the values of generating facilities fired by fixed-price coal have increased.

Many existing projects with fully contracted revenues and costs also involve an element of merchant risk. What is contracted now will at some time become merchant, and buyers of contracted projects must consider such project's merchant residual value or "tail." Buyers' methods vary. One approach is to take pure merchant prices today, inflate them forward to the residual period, and then discount them back. Another is to estimate operating margin during the tail and then discount that value back at a rate that reflects higher risk. A third is to apply a conservative multiple to a forecast of earnings during the first year of residual period operations. B&Co has seen 5 times earnings before interest, taxes, depreciation, and amortization (EBITDA) applied to relatively near-term forecasts, and 3 to 4 times EBITDA applied to values 20 and more years in the future.

Finally, the merchant business model is evolving. It has not been entirely abandoned for a return to long-term power contracts that are supported by utility balance sheets, regulatory commissions and ratepayers. While many future projects will be supported by such contracts, and those currently being proposed by Pacific Gas & Electric and the New York Power Authority are examples, hybrids are on the horizon. "Hedged generation" in the lexicon of the deal structure involves projects supported by contracts that track what a project can sell and allow owners and lenders to manage operating margins. Long-term fuel contracts with prices that are arithmetically linked to power values are an example. Wind projects in gas-dominated systems that use long-term gas contracts to hedge power value are another.


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