A recent Accenture survey shows utility executives believe smart grid capabilities will transform the industry and bring competitive opportunities.
Volatile markets call for alternative financial models.
How is the financial crisis affecting the power sector? In short, in a big way. The electric power industry is second only to financial services in terms of reliance on credit markets and is second only to railroads in capital intensity. Of course, the huge fixed-cost structure of the power industry stems from the need to invest billions of dollars each year in generation, transmission, and distribution assets.
For the past decade, the power industry enjoyed broad access to plentiful and cheap capital from an assortment of investors, including banks, mutual funds, pension funds, insurance companies, hedge funds, and credit default obligations. But the credit crisis has virtually dried up capital or made it extremely expensive, especially for the merchant-power sector. Even after the current crisis resolves, structural changes on Wall Street that require lower debt levels (de-leveraging) and maintenance of tighter capital costs likely will permanently increase the yield spreads and debt costs for the industry.
Should the power industry adapt its approach to capital markets in this environment? The answer, of course, is yes.
An independent analysis of both the utility sector and the competitive or merchant-generation sector differentiates their financing risks and demonstrates the qualitative differences. The analyses, while providing a novel application of the discounted-cash-flow (DCF) model, concludes that multiple frameworks are necessary to establish a power company’s or project’s current cost of capital, especially under volatile capital market conditions. Finally, the analyses reveals that in today’s capital markets, it is critical to balance or combine the alternative approaches to the cost of capital in order to develop a long-term view.
Before the Crisis
The U.S. utility industry uses corporate financing to fund capital expenditures and other needs in all segments of the power industry. Debt funding is structured with recourse to the corporate issuer, and thus is included in the balance sheet of the company. Utilities generally have enjoyed favorable debt financing terms, because they have relatively stable and predictable cash flows. The credit ratings of utilities have drifted down from A and A- in recent years to BBB and BBB+, but they’re still investment grade. As a result it’s still feasible for utilities to finance capital requirements based on their credit-worthiness, particularly if multiple companies join forces. Also, in recent years there have been relatively few huge capital investments ( e.g., in new coal or nuclear projects) that would require massive spending on individual projects. Even so, utility capital spending has been high and is projected to remain high, as utilities invest in large transmission, smart metering, energy efficiency and environmental upgrades.
By contrast, the U.S. merchant-pow-er sector is focused largely on unregulated wholesale generation plants, although there are a handful of merchant transmission projects and companies in the U.S. market. Examples