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Capacity Value Trap

Are merchant power assets overpriced?

Fortnightly Magazine - December 2011

value on a long term horizon than assets trading above book. Price-to-book value has been a critical tenet of value investing ever since. Economist James Tobin in the 1960s pioneered the idea of examining the ratio between the market value and replacement value of a company’s physical assets. Examining a company’s “Tobin’s q,” or ratio between the market value of a company’s securities in the capital markets and the replacement value of its assets, has become a standard tool in the value investor’s kit. On this theory, a decline in market value substantially below book value should provide some initial, prima facie evidence of undervaluation.

However, comparing trading value with replacement value might be misguided in the case of merchant power assets at the present time. First, it’s not at all clear that replacement value and book value ultimately converge, at least in anywhere near the time-frame relevant to equity investors, in the case of merchant power plants. In the history of merchant power markets in the United States, there’s no clear pattern of asset values paralleling replacement cost. While some large utilities may have longer time horizons, many assets are sold after a holding period of five to 10 years. Given that deregulation occurred in the 1990s and prices still haven’t reached replacement cost, it’s not at all clear that a holding period of five to 10 years is long enough for this convergence to take place.

Second, and perhaps most importantly, comparing the ratio of replacement cost to market value of merchant and regulated assets and concluding that merchant assets appear cheaper misses the point that their risk profiles not only differ greatly, but the difference is widening. The discount rate used in calculating the market value of a merchant asset, the numerator in the Q ratio, will be higher than in the case of regulated assets. This reflects the fact that the variability of cash flows for a merchant asset will be higher than for regulated assets. Merchant assets’ cash flows are affected by changes in natural gas and coal prices, changes in industrial demand, and other relevant factors such as changes in the transmission system. Regulated assets’ cash flows vary much less, as they are guaranteed a stable rate of return by regulatory formula.

There are a number of factors suggesting that the risk profile of merchant assets and the risk premium they should be accorded are rising. Even though prices for merchant assets have declined considerably since 2008, the risks associated with their cash flows have arguably increased considerably since this time. Indeed, during the course of calendar year 2011, the risk that the cash flows of merchant assets will not reach the value necessary to reflect replacement costs has increased considerably in markets in the U.S. Northeast, for three reasons:

1) Signals of a long-term, sustained decline in natural gas prices: Natural gas sets the marginal price of power in most merchant markets in on-peak hours. There’s increasing acknowledgement among industry experts, government, and the investment community that Northeast natural gas prices are in long-term, structural