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Post-Meltdown Valuation

Credit-quality concerns join fuel and market factors to affect power-plant valuation

Fortnightly Magazine - January 2008

Figure 2, “Generic Combined-Cycle Plant NPV Analysis”) . Furthermore such markets as Entergy, TVA, MRO, and SPP provide lackluster returns and the initial years’ debt-coverage ratios for these markets are below 1-times earnings. Comparing these returns to a standard 16 percent ROE threshold, very few markets can fully support new combined-cycle entry. This indicates new gas-fired combined-cycle generation projects either must be supported with some long-term capacity payments or a different capital structure to justify the investment.

Generic combined-cycle net-present value (NPV) results don’t necessarily give the whole picture for some regions such as SPP, Entergy and TVA. While a generic combined-cycle plant shows a reasonable NPV for these regions (ranging from about $500/kW intrinsic and extrinsic value), most of the cash flows occur in future years, assuming a healthy recovery in these markets. A generic combined-cycle plant in the Entergy market, for example, likely produces investment-level merchant revenues for at least 10 years (see Figure 3, “Generic Combined-Cycle Annual Projection”) .

In regions with structured capacity markets, generating assets’ values are strongly supported by installed-capacity (ICAP) payments (see Figure 4, “Generic Combined-Cycle Net Present Value”) . Particularly in markets such as New England and East PJM, energy revenues are expected to comprise only half a plant’s total value. Comparing these to the likes of ERCOT, these markets seem to be evolving toward a two-part market with lower energy revenues and strong capacity revenues. On the other hand, a merchant generator in ERCOT can receive compensatory value from the energy market alone.

Finally, the intrinsic value of western markets is extremely low compared to other regions. This indicates that under normal hydro and weather conditions, merchant cash flows in these markets will be quite suppressed due to high reserve margins. However, high volatility driven by hydro conditions, weather patterns and transmission issues create some revenue potential presented as extrinsic value.

Boom-Bust Cycle

The next build cycle is already underway in several markets. However location and timing are critical. Asset investors should pay attention to the fundamentals and focus on location factors that can have major impacts on unit profitability.

The markets clearly anticipate new GHG-emission regulations, but there is major uncertainty about impacts and both significant risk and potential for newer power-generation technologies. Future GHG regulation is a key risk factor for the next decade. Such strategies as hedging positions and diversifying portfolios, both technologically and geographically, are more critical than ever. Building the optimal portfolio in line with corporate risk tolerance is a key challenge.

As clean-coal technologies compete with new nuclear technologies for the base-load future of power generation, higher construction costs and regulatory risks will continue to cause project cancellations. New base-load generation resources are needed to replace aging generation fleets, but there are significant uncertainties for different technologies and generation fuels. Natural gas-fired combined-cycle generation, often underutilized, is waiting to pick up the pieces and could end up being either a spoiler or surprise winner in the race for market share.

Investors shouldn’t forget: The boom-bust cycle is alive and well in the power-generation sector. Signposts will provide