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Capacity Value Trap

Are merchant power assets overpriced?

Fortnightly Magazine - December 2011

generators are unknown to the general public. Their political power in the context of pressure to reduce overall consumer bills is therefore greatly reduced.

Bearing out these forces, at the same time that state governments implement programs to subsidize new merchant generation, PUCs so far haven’t shown widespread reluctance to challenge regulated utilities’ ability to recover rising costs—or returns on equity investment. There might be a significant risk of future disallowances and deferrals of cost recovery for major upcoming T&D capital expenditures. But so far these haven’t materialized.

Subsidizing merchant generation probably isn’t the most efficient way to reduce consumers’ overall energy bills, most of which have been rising because of high oil prices. But it represents the politicians’ easiest avenue of attack.

Value Trap or Real Value?

Whether merchant power assets represent a value trap or a real opportunity to generate value through capital appreciation depends on one’s view of the macro-economic demand picture—both in the long-term and, to a degree that’s perhaps surprising, the near-term.

The degree of recovery in merchant asset valuations will depend partly on long-term factors— i.e., utility executives and private equity investors’ views of long-term gas prices, demand growth and future environmental regulation. These long-term estimates will drive estimates of projected future cash flows for a 20- or 30-year asset.

For some merchant assets—particularly non-gas assets—rising gas prices are a key variable. Investors who believe gas prices are likely to rise—because, for example, they believe natural gas demand in power, industry and transportation will increase, or that shale gas will have a smaller effect on prices than currently expected—are likely to favor non-gas merchant assets in markets where natural gas-fired power is the marginal fuel. For merchant gas assets, potential investors are likely to focus on recovery in power demand, which could cause market heat rates to rise; where the margin between market heat rate and plant heat rates increases, spark spreads increase. In certain markets where coal retirements are pronounced, prices could also rise as the impact of coal retirements is felt. 10

But another potential linchpin to merchant power valuations will be whether the near-term macro-economic situation continues to deteriorate in 2012, particularly employment conditions and incomes. Even though power plants are long-life assets, the near-term economic situation in 2012 will help determine whether the political risk of state governments and PUCs’ interfering with wholesale market prices is locked in for the long-term. State governments have related their efforts to subsidize generation to the failure of the capacity markets to spur adequate new capacity. Their true motivations are likely to create jobs through new build generation and to show they are taking immediate actions to reduce consumers’— i.e., voters’—overall energy bills. The proportion of consumer spending going toward energy generally—including oil and gas as well as power—has been surging, and recently crossed 5 to 6 percent, a level that some economists have viewed as important in the level of pain it inflicts—particularly on lower income people. 11 Although the industry clearly differentiates between transportation fuel costs, which have been increasing, and the