Sales prices for power generation assets in the United States during the past two years have climbed to unprecedented levels. This trend should continue. More than 20,000 megawatts of generation assets have been sold, with another 20,000 MW announced. During the next five years, it is expected that 70,000 to 140,000 MW will change hands. We have seen only the beginning of a massive redistribution of generation assets - from regulated utilities to unregulated marketers and plant operators.
In fact, the prices we've seen for generation assets may turn out to be bargains. Don't compare the price paid to the booked cost in the hands of the former utility owner. Instead evaluate the price in the context of the strategic objectives of the buying companies.
Of course, there is no single correct asset strategy. Here we take a look at various strategies for asset sale and acquisition, with examples taken from among recent transactions. These strategies may involve a full ownership interest, or perhaps only the management of leased assets or sale of management services. However, while ownership and control differ significantly in terms of capital requirements, risk and other characteristics, the steps in acquiring ownership and control are largely similar. Hence we treat acquisition of ownership and control in a similar manner.
Why They're Selling: Players and Strategies
Power plants involved in sales transactions vary widely in terms of geographic location, transaction price, power plant technologies and other items included in the sale such as power purchase agreements. However, all completed or announced sales are based on either of two reasons:
1. Compliance with state regulatory or legislative guidelines related to restructuring for retail access; or
2. An intent to focus on a core business, deemed to be something other than building, owning or operating power plants.
Regulatory Compliance. Regulatory and/or legislative policies underlie many of the recent transactions - especially in California, where the state forced two major investor-owned electric utilities to divest 50 percent of their fossil generation assets, and the third large IOU decided on its own to sell.
San Diego Gas & Electric was the only one of the three California IOUs that was not required to divest any of its generation assets by the California Public Utility Commission's December 1995 restructuring order. However, after seeing transaction prices obtained by Southern California Edison Co. and Pacific Gas & Electric Co. in their auctions, SDG&E decided to sell all of its generation assets and purchased power contracts in order to exploit the "hot" market conditions for generation assets in California.
Similarly, in other states, restructuring legislation requires, or at least strongly encourages, divestiture of utility generation assets. For example, in Maine, restructuring legislation requires the state's IOUs to divest their generation assets by 2000. In Massachusetts, while divestiture of generation is not mandated, full recovery of stranded costs is more difficult for utilities that do not divest all their non-nuclear generation.
Core Business Focus. GPU Inc. is the most prominent example of a company that had this driver as the principal reason behind generation asset divestiture. In October 1997, GPU announced plans to auction 5,300 MW of non-nuclear generation, stating that it felt that a much greater size would be required in order to compete in the competitive generation market of the future, and that GPU did not have the resources or strategic intent to achieve these economies of scale. Instead, GPU indicated that it intended to focus on what it considered to be its core business: energy distribution.
Recently, AmerGen Energy Inc. acquired 810 MW of GPU's nuclear assets (in Three Mile Island, Pa.). Edison Mission Energy bought another 940 MW of GPU's coal assets (GPU's share of the Homer City, Pa. plant). Sithe Energies has just bought the remaining 4,117 MW of GPU's non-nuclear assets.
Meanwhile, Montana Power Co., with its low-cost generation assets, did not have regulation motivating its announced asset divestiture. Instead, its management made the strategic decision to transform the company into a transmission and distribution-only operation and to focus on its core strength of customer service. Montana Power's generation assets (2,600 MW) are being sold to PP&L Global (parent of Pennsylvania Power & Light Co.).
As another example, Commonwealth Edison recently put up for sale 5,400 MW of its coal-fired assets. The cash generated from the sale will support ComEd's focus on superior operation of its nuclear plants and its regulated energy delivery systems. The sale will also enable Unicom Corp. (the parent company) to invest in new growth markets. ComEd expects to receive exceptionally high prices based on the number of companies that have expressed an interest in acquiring these assets. No buyer has been chosen yet.
Why They're Buying: Players and Strategies
The strategies that lie behind decisions to purchase generating plants vary widely. However, in general, one can pare them down to three approaches:
1. Economies of scale (fuel supply chain);
2. Asset-backed trading (retail and wholesale energy
3. Operational efficiency (management services for other asset owners).
Economies of Scale. The scale-driven strategy involves acquiring ownership of assets on a national basis. The goal is to create economies of scale across fuel management, supply chain/logistics management and operations management functions. Typical assets are base- and intermediate-load units. As such, the transactions will be relatively simple and often will involve selling into the local power pool or spot wholesale market.
Integration between asset management and plant operations is critical to the success of a scale-driven strategy. As the asset management group creates and refines the portfolio of assets, it needs to have input from plant operations to ensure that the asset adjustment is creating value for the company. For example, if the prospective (to be acquired) plant uses or can be converted to use the same fuel as existing resources, the "coal pile" potentially can be optimized across multiple sites, reducing capital invested in inventory. Other examples of value creation include savings through equipment standardization, reduced logistics costs and increased buying power though scale repurchasing.
The importance of plant operations is based on the need to drive the company to operational excellence and attain a low-cost position, while generating at high load factors. By acquiring multiple assets with similar fuel types and technologies, owners can create a low-cost operating model across the entire business. Companies pursuing a strategy to support scale efforts include Williams Energy Services Co. and Duke Power Services.
Both Williams and Duke are leveraging their fuel procurement and power marketing abilities with asset transactions. They view coal and gas plants as fuel converters and try to acquire plants in regions where they can derive profitability by more strategically procuring fuel for the plant. This is evident in Duke's latest acquisition of PG&E gas-fired assets in California.
It appears also in a recent tolling deal between Williams and AES Corp. In that transaction, AES acquired 2,600 MW of Southern California Edison's gas-fired assets. It then arranged to take gas from Williams Energy Services Co., convert it to electricity at a set price and transfer the power back to Williams for marketing. Based on this tolling deal, AES was able to finance 90 percent of this $780 million deal with nonrecourse project financing.
(Note: Enron has not yet entered the asset-buying spree, despite its desire for a national presence. It may be that Enron feels that the prices seen in the market are too high and the assets being sold will be back on the auction block at lower prices.)
Asset-Backed Trading. Some plant buyers may seek to acquire generating assets to fulfill unique market needs. Variations of this strategy can be extremely diverse; they range from ownership of must-run units to supplying on-site emergency backup power to large-volume users with critical applications. Another example, now emerging, uses ownership of generation to provide backing for commodity marketing.
The asset-backed operating strategy may be the toughest to achieve and is dependent on integration of asset management, marketing and sales, and plant operations. Marketing and trading functions work closely with asset management to build a portfolio consistent with the strategy. For example, trading and sales departments can provide insight into the regional transmission grid and assist in developing a plan for asset acquisition. Marketing also must work closely with operations to ensure assets are operating to meet customer needs. The essential point is that marketing and trading functions set the direction of the company under this model, with appropriate checks and balances from asset management.
Naturally, asset ownership will remain an important element of an energy marketer's portfolio as long as market liquidity remains an issue, allowing the marketer to avoid the kind of "squeeze" and subsequent financial exposure seen in the Midwest last summer. In fact, energy commodity marketers, particularly the top 20, are realizing the advantages associated with ownership of assets. In general, owning or controlling generation assets allows a marketer to have customized, higher margin products, offer price insurance in a volatile price environment and prepare more credible responses to bid proposals.
The types of assets owned will vary with the strategy. While backup generation providers will likely build on-site generation for their customers, energy marketers may seek to acquire or control must-run and/or peaking assets in resource-constrained areas to maximize revenue and maintain supply in a region. Companies that appear to be pursuing this strategy include Southern Energy Inc. and Dynegy.
Southern Energy in May agreed to pay $537 million for nine power plants owned by Commonwealth Energy and Eastern Utilities Associates, totaling 1,260 MW of generating capacity. Southern Energy will own and operate the plants, but Southern Company Energy Marketing will sell output to COM/Energy, EUA and the open market. This move will leverage Southern's trading and marketing competencies, while giving it an asset-backed presence in the Northeast.
Dynegy CEO Chuck Watson recently described his goal for his company - to be among the top five asset owners. Dynegy would achieve that goal by acquiring a critical mass of generation assets (2000 to 4000 MW) in each North American Electric Reliability Council, or NERC, region. Dynegy's acquisition of Destec Energy Inc. and the Southern California Edison assets in California marks an element of this national strategy.
Operational Efficiency. Companies that operate generating plants might well seek to provide services to other asset owners (or to themselves, as operators, through a similar type of package). This strategy places a heavy value on operational improvements and less value on trading or marketing. The asset management function must find creative financing solutions to generate a benefit for the client and the services provider. Plant operations, the dominant factor, must bring a high degree of technical skill as well as the ability to integrate the client's former generation employees into its organization.
A tight integration of marketing and trading, asset management and plant operations is critical to maximizing the value of a generation services contract. In fact, all three must be blended to provide an offering that is technically feasible, financially attractive and meets or exceeds the customer's needs.
This strategy may or may not involve ownership of assets. It can vary from a pure outsourcing of operations to a sale-and-leaseback arrangement, by which the services company acquires the asset and charges an all-in management fee (including a capital component). However, companies adopting this strategy must overcome difficulties that could arise due to a lack of standardization. Outsourcing contracts for plant management could encompass a wide variety of generation equipment types.
Nevertheless, the companies that appear to be following this strategy include Sithe Energies and AES. These two companies, long noted in the United States as successful independent power producers, recently purchased assets from Boston Edison and Edison International, respectively.
The authors are executives at CSC Strategic Consulting's Chemical & Energy Group. Dean Maschoff is senior vice president; James Pardikes is vice president; David Thompson is principal; Michael Rutkowski, P.E. is manager; and Nainish Gupta, Ph.D. is a consultant.
How We See It: A Strategy for Asset Acquisition
As evidenced by recent industry transactions, companies are implementing various alliances and other arrangements to fulfill their strategies. A scale-driven player may choose to outsource its marketing function to a large-scale trading organization. A market-driven company may seek alliances with generation service providers to provide technical plant operations expertise. The possibilities for these alliances are endless, but establishing the company's overall strategy is the starting point for any asset acquisition.
Once strategy is determined, there are four key steps to successful asset acquisition:
1. Develop market assumptions;
2. Determine types of assets to acquire;
3. Determine value of target assets; and
4. Determine selling strategy.
Develop Market Assumptions. These assumptions will help in deciding which regions of the country on which to focus. Considerations include regional value drivers, capacity forecasts for the regions, demand and price forecasts and issues related to transmission and independent system operators.
Obviously, all things being equal, an asset owner would like to play in the markets where projected prices are highest, and that depends largely on projected supply and demand. If there are indications that a certain NERC region is going to experience capacity shortfalls, e.g., the Midwest, then asset ownership in that region may be more valuable. But to understand projected capacity fully, the company must look at upgrades, expansions, projected building, deferred retirements, mothballed plants, etc.
Determine Types of Assets to Acquire. Some key factors to consider are whether to build, rent or buy; the location of the asset; industrial customer cogeneration facilities vs. merchant plants; and specific fuel type. The company also must determine the appropriate amount of assets needed given its financial and risk profiles and the anticipated impact on the asset portfolio. These issues will depend on whether the company's strategy is scale-driven, market-driven or involves providing generation services.
Determine Value of Target Assets. Value is in the eye of the beholder. Deals that have appeared on the surface to be overpriced may turn out to be bargains because they fit into the company's asset strategy and core competencies. There are six components related to the value of a generation asset:
Discounted cash flow (present value of projected cash flows from energy, capacity, ancillary services);
Operation and maintenance improvements;
Trading portfolio enhancement;
Site expansion value (ability to expand, repower);
Retail market support; and
Network value (ability to achieve synergies from combining disparate geographic assets).
It is important to evaluate the additional "hidden" value beyond discounted cash flow that the asset is expected to bring. *
Determine Selling Strategy. Selling strategy relies on an understanding of the factors driving sellers. In a deal with multiple parties (e.g., asset control or cogeneration deal), the solution must be customized to fit the needs of all parties. As in any business decision, in order to successfully close a deal, it is crucial to analyze the competition and determine the optimal selling strategy.
* For a more complete exposition on this topic, please see, for example, Donoghue, Dan, Haarmeyer, David and Parker, Seth, "Power Divestiture-The First Wave," Independent Energy, June 1998, pp. 36-40. Please also see Haarmeyer, David, McWhinney, Robert T. Jr. and Moe, Ronald, "The New England Auction: Regional Strategy for Competitive Generation," Public Utilities Fortnightly, Feb. 15, 1998, pp. 34-39.
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