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Capacity Value Trap

Are merchant power assets overpriced?

Fortnightly Magazine - December 2011

decline due to abundant shale gas resources. A number of natural gas producers have seen their share prices erode considerably amid the reality of sustained sub-$5/MMBtu gas. The likelihood that gas prices will stay low merits further analysis, but the likelihood of sustained low prices for natural gas in North America has increased significantly over the past two to three years. This development heightens the risk that merchant power prices might not return to their pre-recession heights for a long time.

2) Tougher political environment for environmental regulations to get passed: Stricter environmental regulations would be a positive for merchant power valuations. A premium on carbon would drive up the marginal cost of power in merchant markets and increase coal-to-gas switching, as gas plants run more often. Although most of EPA’s new regulations affecting coal plants remain on the horizon, changes in the political and economic environment in 2010 and 2011 have considerably lessened the likelihood of additional changes in environmental regulation that would drive the value of merchant gas assets further upward in the foreseeable future. Most notably, the chances of a carbon cap-and-trade scheme being implemented in the near future have deteriorated considerably since 2008 and 2009, when the House of Representatives passed the Waxman-Markey bill. Although the EPA is expected to release some regulations that might lead to coal retirements, the contents and price impact of such regulations are still unclear. 9

3) Changes in the political environment and interference in merchant markets: Perhaps most importantly, there’s an emerging trend of increasing interference in merchant, competitive markets in the Northeast by state regulators (see “ Trusting Capacity Markets ”). In the first quarter of 2011, New Jersey announced the long-term capacity agreement pilot program (LCAPP) program to subsidize new combined cycle gas turbine (CCGT) generation by effectively guaranteeing certain capacity prices to new plants. In the second quarter of 2011, Maryland also issued a draft RFP for new, subsidized CCGT capacity.

Merchant power generators in many ways stand in the cross-hairs of the rising trend of states to get involved in subsidizing new generation. They stand exposed to lower energy prices resulting from new build of subsidized power plants. More importantly, they also derive a substantial proportion of their earnings stream from capacity market revenues—which will be reduced as new capacity is subsidized by the state programs.

In contrast, regulated utilities are significantly less exposed to political efforts to subsidize prices artificially. Toying with regulated utilities’ returns on equity and ability to recover costs can take many months or years, as states must demonstrate in regulatory proceedings which such changes are necessary. But subsidies that artificially lower capacity market prices can be introduced through an act of the legislature, beyond the scope of justification in the quasi-judicial proceedings of a PUC. Moreover, merchant generators often aren’t as politically connected or well known in their communities as regulated utilities are. While regulated utilities employ thousands of workers and have contractual relationships—and the continual ability to promote their causes—with millions of customers, the names, let alone reputations, of most merchant