Power Measurement
A look at issues that could keep energy executives up at night.
The most common strategic issue depriving utility executives of sleep is the looming clash of investor expectations for steady growth in earnings compared with what utilities can deliver given slow growth in customers and demand. While many dream of assured regulated rates of return, the reality for most utilities is that the 1.5 percent retail growth experienced between 2002 and 2003 will prove unsatisfactory for earnings. Wall Street expects 10 percent growth. Even with improving gross domestic product, the best organic growth we will see is around 3 percent, leaving a gap of 7 percent.
Bridging the Gap
- Ratebase Additions. On average, ratebase growth was slightly more than 5 percent in 2003. While this makes up a significant portion of the growth gap, it still leaves the industry a few percentage points short of the 10 percent target. Utilities looking to add to the ratebase by buying generation at attractive prices have found it difficult to get their state PUCs to allow them to put it into the ratebase unless they go through a competitive procurement process that demonstrates the prudence of the decision. Additionally, utilities that try to acquire assets through an unregulated affiliate face extensive regulatory attention over the affiliated transaction and whether it is sufficiently arms-length to be prudently recovered in rates.
- Rate-of-Return Hits. Utilities seeking rate increases run significant risk that regulators will respond by cutting allowed rates of return given low interest rates, lower cost of capital, lower perceived risk, and low capital investment.
Working off the excess in new generation supply brought on line in the last few years has resulted in very high reserve margins and commensurate low profitability for natural gas-fired generation across many (but not all) markets. These high reserve margins are a significant turnaround from the situation that existed in the late 1990s. Figure 1 shows cumulative load growth and cumulative generation additions since 1990 in North America. Cumulative generation additions fell behind cumulative load growth during the decade of the 1990s.
Illustrated another way, Figure 2 compares the chronology of new capacity additions by fuel since 1950. The figure is notable for two reasons. First, it compares the staggering level of building during the recent building boom to pervious years and, second, it shows that industry has relied almost exclusively on natural gas capacity to meet incremental load growth for the coming years. With this, the path toward fuel diversity for power generation has swerved. It remains to be seen how this development will play out in the market and whether increasing the reliance on natural gas fuel will have long lasting implications for other sectors of the economy.
Acquisitions
Consolidation in the energy industry is coming. Pressure to grow earnings likely will result in some consolidation in the utility and other sectors of the energy industry as investors seeking higher returns and share prices will be affected by the market perception of the growth potential of the stock.
"Back to basics" is not likely to last long as a strategy. The boom-and-bust cycle is alive and well. Every expansion period-like the merchant boom we have experienced-is followed by a period of contraction, consolidation, and rationalizing. The process of consolidation and rationalization is just beginning, and some players will not survive the experience.
The purchases of MidAmerican Energy by Warren Buffett and of DPL by KKR are only two examples of the potential for new players to enter the market with innovative or disruptive business strategies in an effort to capture advantage.
Investor-owned utilities see significant buying opportunity from among the merchant assets built during the boom. The Federal Energy Regulatory Commission (FERC) considers the utility purchase of a merchant power plant a threat to wholesale competition going forward. State utility commissions perceive such purchases as undermining the arms-length nature of the competitive power markets in ensuring that customers get the least-cost, most reliable energy supply to ensure resource adequacy. For the investor-owned utility this often represents a catch-22. While it makes no sense to build new generation in an overbuilt market, regulators at both FERC and state levels are prepared to restrict or punish the utility for such an initiative. The back-to-basics strategy further exacerbates this problem. Power contracts are not included in the ratebase calculation; thus, the utility is further incented to build new assets in overbuilt markets in an attempt to drive 10 percent growth. For municipal and cooperative utilities, the fear of getting involved with potentially uncreditworthy merchant generators or projects means they, too, are building to meet their resource needs in an era of substantial oversupply.
After the trashing of SMD, will FERC use its regulatory review authority to bring intense pressure on the holdouts? Remember what FERC did to the holdouts on Order No. 636? Some firms that resisted FERC found themselves starving or strangled by regulatory delay or disapproval, and some did not survive the experience.
The Ticking Time Bomb of Merchant Financial Structuring
Excess generating capacity and weak demand is slowing recovery in the merchant energy sector. Energy Velocity data shows there has been a significant decline in the average capacity factor over the past 10 to 15 years. Many merchant projects built since 2000 were expected to run as base-load units, replacing older, less efficient units. The average capacity factor of the 900-plus units built since 2000 is less than 25 percent, and the lion's share of units dispatching as base load came online between 1955 and 1991. The overbuild and low capacity factors mean that mini-perm refinancing just completed by many merchant plant owners may not last long enough to get through the crisis to equilibrium. Purchase power agreements (PPAs) are being imputed as debt on balance sheets, setting up an argument for high returns on equity in rate cases at FERC, but the rating agencies seem to be treating PPAs like debt.
Private equity firms are making investments in merchant generation that are not subject to the Public Utility Holding Company Act. KKR's proposed purchase of UniSource and Texas Pacific Group's proposed purchase of Portland General Electric are two examples. Will these private equity companies accelerate the M&A potential of the industry by using these acquisitions as cash cows for other purchases while using allowed rates of return of regulated utilities to smooth their overall portfolio returns?
Although much progress has been made in cleaning up the liquidity issues facing the merchant generators, those "fixes" may not be sufficient to carry the merchants through the process of working off the excess. The back-to-basics strategy and the resulting earnings gap will push utility executives to look externally for the quick fix-acquisitions. Those who choose the more challenging path will need to convince their PUCs to let them take advantage of distressed assets or allow power contracts into the ratebase if they expect to beat The Street. If low earnings growth, high reserve margins, and commensurate low profitability aren't causing insomnia already, the new back-to-basics strategy just might.
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