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What's That Power Plant Really Worth?

An analysis of current valuation trends explains why some assets command better values than most.

Fortnightly Magazine - January 2007

are now entering, includes significant liquidity flowing into energy infrastructure. Before we jump in with both feet, however, it may be instructive to look back so as not to repeat the mistakes of the past.

One of the key problems of the last boom-and-bust cycle was the way merchant developers and their bankers were incented financially to make the deal, close it, and then get the merchant plant operational on time and within budget. This was true for both greenfield development and acquisitions. Additional pressure was created as both U.S. and international banks competed to finance merchant projects. Neither the developers nor the bankers adequately assessed the bigger, regional perspectives or the overall risk.

As overbuilding became obvious in some regions, many developers did not want to discard their projects. The general feeling was that as competition spread, older, less efficient units would be retired and the newer, more efficient units would take their place.

One of the key differences in today’s market is that many new investors are, or are backed by, sophisticated risk experts from the financial industry. Instead of being incented just to get the deal done, these players must get the deal done and ensure that the deal has real future value. These investors aim to capture good opportunities, rather than build long-term infrastructure portfolios. They want to buy low and sell high and then move on to the next opportunity. These investors always consider risk, resale value, and the likely number of buyers that will bid for their assets in the future.

Another key trend is that more robust hedging mechanisms are being implemented in the acquisition financings. Financial players such as Goldman Sachs, Merrill Lynch, and JP Morgan are setting up complex derivative structures to hedge future cash-flow risk. Hedges reduce the risk involved in these deals and improve the liquidity by attracting more lenders and lowering debt rates.

As the number of buyers in the market is increasing, the race to get the best deals is heating up. Good opportunities are becoming increasingly difficult to find. Neophyte players may be too eager to invest quickly, rather than waiting for their very best option. If underlying risks and cash flow are not properly assessed, these buyers could get stuck with overpriced, non-performing assets.

Why Is Asset Market Activity Increasing?

Lately, we have seen significant market activity, particularly in the Northeast and Midwest regions. While some risk still is present, market conditions in these regions are improving.

In New England, the forward capacity market settlement, which was just approved by FERC, sets the capacity price at $3.05/kW-month to $4.10/kw-month range from years 2007 through 2010 for all of New England. After year 2010 there are floor and cap mechanisms for the first three successful forward capacity auctions to keep the prices in $4.10/kW-mn-$10.50/kW-mn range. Figure 6 illustrates the historical and forecast New England capacity prices. Compared with the past, the new rules give a significant boost to distressed assets by giving cash-flow certainty for several years.

Similarly, PJM is seeking approval for a forward-based locational capacity market