THE POWER PLANTS OF AT LEAST FIVE UTILITIES IN NEW England and California get swapped this year for more than $5.3 billion. And happily, those holding bonds on the plants will be given cash for...
Building the Perfect Generation Portfolio
Finding and applying the efficient frontier.
Electric power industry participants spend a great deal of time deciding how to invest in power generation assets. Typically, though, their process focuses exclusively on the potential financial impacts of acquiring an individual asset—not on the impacts to the generation portfolio as a whole. The result can be an unbalanced, undiversified portfolio of power assets that is inconsistent with the organization's desired risk profile. Worse yet, the organization may not understand the relationship between the expected return of an asset portfolio and the risk it faces. Implementing an efficient frontier approach to portfolio assessment can solve this problem and set the foundation for a successful power generation asset base.
With the evolution of power markets toward deregulated wholesale markets, there has been a fundamental shift in power-plant asset ownership. Accordingly, non-traditional power-plant owners have emerged in the form of investment banks, private equity funds, and energy hedge funds. As a result, power generation assets are more widely distributed among a larger field of owners. Wall Street's entry into the power business has created a flurry of transactional activity.
While in most current U.S. power markets there is a surplus of generating capacity, deals still continue. Despite the dearth of new construction deals so prevalent in the late 1990s and early 2000s, buying and selling of existing assets continues. Much of this activity is driven by the very surplus of capacity mentioned above. Power prices are depressed by the over-supply conditions, creating financial hardships for many of the power plants developed during the aforementioned boom. It is worth noting that power prices are not low, per se , from a historical perspective—but this is due to massive escalation of the key factor of production—fuel. Oil, gas, and coal prices are extremely high, causing a commensurate increase in both revenues and costs. Accordingly, while actual power prices are high, they provide extremely low gross margins and low (or even negative) cash flow to many of today's power plants. The resulting financial burden has spurred transactions in the form of bankruptcies, reversion to creditors, and general asset spin-offs.
Buyers of power-plant assets use a number of tried-and-true approaches to asset valuation, including discounted cash flow and option-pricing models. While the valuation approaches employed generally are sophisticated, they focus almost exclusively on individual assets. Conspicuously missing is consideration of the asset portfolio as a whole. While portfolio valuation and assessment tools do exist, they are frequently viewed as black-box methods that are not completely understood, and are thus overlooked. Webb, Scott & Quinn addresses this issue by using the efficient frontier approach, performed in an analytical framework that includes an innovative application of Decisioneering's Crystal Ball risk analysis platform—already an industry standard (see “ Efficient Frontier: A Brief Overview ”).