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Trusting Capacity Markets

Does the lack of long-term pricing undermine the financing of new power plants?

Fortnightly Magazine - December 2011

Risks

There’s a perception that new generation can’t be built without long-term PPAs of close to 10 years or more. As noted, this perception is largely created by current low-priced market fundamentals and the preference among developers to lay off risks onto contract counterparties. Reliance on long-term contracts is also rooted in the regulated past of the industry, including qualifying facilities (QF) under the Public Utility Regulatory Policies Act (PURPA). However, a number of observations about customer preferences and contracting practices in other capital-intensive industries suggest that widespread current perceptions might overstate the need for long-term contracting as the industry evolves.

First, most retail customers are unwilling to commit to long-term contracts. The reluctance isn’t unique to restructured electric power markets. This is also the case for most energy commodities sold in retail markets, including commodities with even higher price uncertainty, such as gasoline. If fixed-price contracts are signed in other retail market segments, they rarely go beyond the next season ( e.g., heating oil), or the next two years (mobile telecom service). In fact, long-term contracts between retail customers and suppliers are uncommon even in the most risky and capital intensive portions of the energy industry—such as oil and natural gas exploration—and remain uncommon despite the high and unpredictable nature of risks, such as oil price movements based on a wide range of geopolitical influences, including cartel behavior.

Second, other capital-intensive industries with significant price risks generally require that investments are backed by companies with sufficient equity. However, such “balance sheet financing” of major investments is less common in the electric power industry. 10 While numerous examples of balance-sheet financing and generation investments without long-term PPAs or other long-term price hedges exist—including merchant wind power development—project financing arrangements supported by long-term PPAs remain the first choice of most power plant developers. 11

The lower reliance on balance sheet financing in the power industry doesn’t mean that project developers in other industries wouldn’t prefer the lower risk and financing costs they would be able to achieve if they had long-term sales agreements. Nor does it mean that power industry developers are unable to develop projects without long-term sales agreements. Rather, the relatively low levels of balance-sheet financing in the power industry appear to be an artifact of industry evolution. Specifically, the merchant generation sector has evolved based on: 1) long-term PPAs with regulated utilities, starting with mandated QF contracts in the late 1980s and early 1990s; 2) project development efforts by small companies without much equity; and 3) a reliance on highly leveraged financing arrangements.

Third, large competitive retail electricity providers and companies in other capital-intensive industries, including in oil and gas, also tend to be partially (but not fully) vertically integrated to manage risks and reduce transactions costs. Many competitive retail providers have bought physical assets or signed a portfolio of contracts to manage overall supply obligations and associated risks. Such a partial vertical re-integration appears to be becoming more prevalent in electricity markets. In the United Kingdom, for example, all major retail suppliers have re-integrated into the generation business.