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Power Measurements

Private equity rolls the dice.
Fortnightly Magazine - January 2005

Power Measurement

Private equity rolls the dice.

Overbuild in power generation markets causes a slow revenue recovery not only for combined-cycle, but for all types of plant within any region. Standard project discount rates do not apply to merchant plants and current market conditions find many merchant projects struggling. One way some new players in the power generation market are looking at the valuation is to separate out "extrinsic" value and apply a higher discount rate or "haircut." An alternative approach is to price the "whole curve" on a risk-adjusted basis.

Global Energy Decisions recently updated its , which assesses changing power-generation asset valuation for more than 5,000 power plants in North America, and confirms that the recent spate of private-equity purchases within the merchant generation sector is at dramatically higher discount rates than previously seen within the sector.

This blood-in-the-water signal is attracting private-equity firms looking to extract value from the merchant generation sector in this weak market environment. Why? The deterministic plant value is significantly depressed through the 2005-2010 time frame, with a significant chance of needing cash injection just to remain operational. Many merchant generators will not survive the experience.

Extrinsic value dominates value in the early part of the project life cycle because of uncertainty. The Entergy power market, for example, is one of the most overbuilt markets in the United States. In combination with an uncertain regulatory future, significant transmission constraints, and a market dominated by a handful of power buyers, significant market risk likely will prevail there for a long time.

The study found plant net present value forecast at $97/kW deterministically and $269/kW when accounting for the extrinsic value using a more rigorous stochastic analysis of expected value. Even so, healthy gross-margins are not predicted for a long time.

With such significant uncertainty surrounding asset valuations, recent sales confirm that the private-equity players are winning asset sales despite project discounting at real, pre-tax rates of 20 percent. This compares with utility rates closer to 12 percent. This differential reflects the significant risk the private equity players are taking in buying merchant assets in locations where limited liquidity and transmission means that there may be no natural home for the power in the current market.

These private-equity players are betting that improved market conditions will alleviate the current lack of demand for their product. It's all about timing: If the market recovers as expected, they will see significant returns for their investors. However, a delay in recovery of a couple of years will destroy their returns and result in the same assets being sold again in a few years.

Are market prices for wholesale electricity recovering? Not yet. While coal and nuclear-power generation asset values have increased, gas-fired combined-cycle power plant prices continued to decline between 2003 and 2004, with overall combined-cycle values falling by 11 percent.

As reserve margins in a power market increase, volatility decreases, because any price shock in the market is absorbed fairly quickly with available generation. Look again at the Entergy power market in recent years, where volatility decreased significantly. This