By some measures, merchant power assets look like a bargain, selling for well below their replacement cost. But whether low prices signal a buying opportunity or a value trap depends on the...
Capacity Value Trap
Are merchant power assets overpriced?
cost of electricity, the general public frequently doesn’t. This has led to pressure on state governments and regulators to do something to assist ratepayers, and voters, to mitigate the impact of higher costs.
2012 is shaping up to be a critical year: one in which politicians and PUCs will make decisions about whether to lock in contracts to build and subsidize new capacity for 10 or more years. New plant construction that is subsidized now won’t be removed once economic conditions improve. A general improvement in labor markets and the economy would increase people’s incomes and hence reduce the percentage of income being spent on energy. It would help short circuit the need for new jobs from new build generation and the perceived need to intervene in markets in the name of helping voters to lower their energy costs. Conversely, if the near-term employment and income situation continues deteriorating, the pressure on politicians to take action to create jobs and lower energy prices will intensify. If that happens, merchant power plants’ lower valuations might indeed represent a value trap—one that investors should be tired of falling into.
1. Davis, Travis, “Investing in utilities: what to consider during periods of inflation, deflation or stagflation,” Morningstar, June 6, 2011.
2. This is partly because such firms are more costly to arbitrage. Following periods of very low investor sentiment, when lower volatility, higher dividend paying, older firms become relatively over-priced, there is some evidence that younger, non-dividend paying, distressed firms show relatively high returns. See Malcolm Baker and Jeffrey Wurgler, “Investor sentiment in the stock market” Journal of Economic Perspectives, December 2006.
3. PPL Q1 2011 Earnings Call, May 2011.
4. PEPCO Q1 2010 Earnings Call, May 2010.
5. Dominion 2010 Summary Annual Report.
6. Exelon-CEG Public Merger Conference Call, April 28, 2011, filed with SEC (Rule 425).
7. PWC quarterly M&A report Q3 2010.
8. U.S. Energy Information Administration, Assumptions to the Annual Energy Outlook 2011.
9. See Burr, Michael T., “ Battle Lines ,” Public Utilities Fortnightly , November 2011.
10. See MISO Study, “Impact of EPA Regulation on MISO,” October 2011.
11. See the research of James Hamilton at U.C. San Diego.