LIKE ANY FRONTIER, THERE'S MONEY TO BE MADE (EM WITH THE RIGHT BLEND OF LIQUIDITY, CREDIT QUALITY, AND FORESIGHT.
.PPA FEW COMPANIES AND INNOVATIVE REGULATORS ARE, TODAY, BEGINNING TO EXPLORE POWER GENERATION FOR THE YEARS AHEAD. INHABITING THAT LANDSCAPE WE FIND A CONVERGENT GAS/ ELECTRIC ENERGY SYSTEM, AN EPOCHAL REORGANIZATION OF THE STRUCTURE OF THE U.S. GAS/ELECTRIC INDUSTRIES, AND IMPRESSIVELY CREATIVE AND COMPETITIVE ENERGY SUPPLY AND MERCHANT BUSINESSES (SEE FIGURE ON PAGE 33). THIS INTEGRATED GAS/
ELECTRIC ENERGY SYSTEM WILL FALL INTO FIVE SEGMENTS:
1) A COMPETITIVE POWER SUPPLY WITH A FEW LARGE AND MANY NICHE GENERATING COMPANIES, CLEARLY LINKED TO A COMPETITIVE GAS-SUPPLY INDUSTRY
2) A QUASI-REGULATED (LARGELY FEDERAL OVERSIGHT) REGIONAL AND NATIONAL ENERGY "NETWORK" OF BIG WIRES AND BIG PIPES
3) AN EXTREMELY COMPETITIVE BULK-ENERGY MARKET DOMINATED BY 20 TO 30 LARGE AND 5 TO 10 ENORMOUS WHOLESALERS AND TRADERS OF MOLECULES AND ELECTRONS
4) A REGULATED, LOCAL-ENERGY LOGISTICS INDUSTRY (WITH STATE OVERSIGHT AND MULTISTATE REGULATORY AGENCIES) OF LITTLE WIRES AND LITTLE PIPES (THERE WILL BE NO SIGNIFICANT PURELY PIPE OR PURELY WIRE COMPANIES.)
5) A COMPETITIVE ENERGY RETAIL INDUSTRY OF 10 TO 20 REGIONAL AND NATIONAL, UNREGULATED CYBERSPACE MERCHANTS THAT EACH PROVIDE THOUSANDS OF MASS-CUSTOMIZED ELECTRICITY, GAS, EFFICIENCY, ENERGY INFORMATION, AND ENERGY-RELATED CONSUMER FINANCING SERVICES TO MILLIONS OF CONSUMERS.
GENERATION: RELENTLESS ENTERPRISE
The new power industry will be characterized by relentless improvements in technology, steady increases in the productivity of capital, balance sheet (not project) financing, highly efficient operations, and portfolio marketing. It will metamorphose from a rate-based function into an enterprise.
The decline of rate-based generation will be accompanied by the rise of enterprise and merchant generation. Change will appear gradually, and then take off. Net additions to the rate base in the form of built or contracted (i.e., QF) capacity will cease; net reductions will follow. Initially, the reductions will come from buying out existing QF contracts and depreciating utility plants. The next step will be substantial write-offs and rate-based generation asset spinoffs to shareholders of utilities, or sales to third parties and accelerated amortization of nuclear plants. Eventually "rate-based" generation will consist of "bad" (i.e., highly uncompetitive and unsalable) nuclear and coal units, and whatever captive and highly dispatchable capacity is required to support network integrity (probably less than one gigawatt for even the most massive network companies, which will be far bigger than any single utility transmission system today).
Special-purpose NuCos (nuclear generating companies) will appear, enjoying particular tax and regulatory treatment and supervised by the Nuclear Regulatory Commission (NRC) rather than any state commission. These NuCos will house "good" nuclear assets, owned by a consortium and operated by highly skilled and financially vigorous engineering firms with substantial sinking funds for decommissioning and spent-fuel storage costs. Tax-exempt bonds will form some part of their capital structure to reduce the cost of capital. Special depreciation treatment might also be invoked to shield cash flow while the sinking fund grows.
Within a dozen years, rate-based generation will form a tiny portion of total generation. The rate-based sales function will have practically withered away, and traditional service areas will be blurred. A largely unregulated generating industry will emerge to serve the unregulated energy bulk and retail sales industries. The ratio of dedicated, term sales (to one or two large buyers, such as utilities, municipal distribution companies, and other buying authorities) to total power sales will decline inexorably. Merchant sales and merchant power plants will dominate.
Merchant plants are balance-sheet financed, with 40 to 45 percent equity and senior debt backed by corporate guarantees. The plants manage a portfolio of sales contracts (ranging from one day to perhaps 10 years) as well as a portfolio of fuel- and risk-management contracts, with no assured revenues for the term of the senior debt.
New generating capacity will be dominated by the combined-cycle gas turbine, and an increasing share of this capacity will be merchant. The first grassroots, merchant, gas-turbine units (in the 100- to 300-megawatt range) will be ready to deploy in three to four years. Merchant plant planning will be quite a growth industry in the next 18 months.
The new power industry will exhibit a new structure:
s GemCos. A few enormous gas/electric manufacturing companies with over $20 billion in production assets will emerge.
s Commodity Players. Several commodity generating companies ($5 to $10 billion in assets) will be built around the assets of existing independent power companies (IPPs) and spun-off utility assets (almost all thermal units, most coal-fired).
s Niche Players. Scores, if not hundreds, of niche generating companies will appear (em ranging from just one to dozens of units, and from a few million to over $1 billion in assets.
s Captives. Captive generation will provide system support for regulated energy network companies.
s Nonplayers. Scattered captive generation will reside in the hands of regulated energy logistics companies (for reasons both logical and unfathomable).
s NuCos. The special-purpose nuclear operating company will appear, a transitional corporate form that will prove essentially self-liquidating.
Scores of existing, project-financed generating plants (QFs and IPPs) will likely be economically and technologically obsolete by end of century, with equity and junior debt extinguished and a portion of the senior debt erased. Many others will seek to reposition themselves as merchant units; less than half will have the right combination of location, fuel and transportation portfolio, heat rates, and operation and maintenance costs, since this is not the purpose for which they were originally configured. The remaining project-financed units (em through a happy confluence of depreciated book value, debt paydown, location, technology, and fuel choice (em will do well and create substantial additional value for current owners.
Existing generating plants (em corporate or balance-sheet financed (em (almost always owned by a utility or major oil company) will experience mixed results. A surprisingly large proportion of the thermal units may actually earn windfall gains when marked to market, despite their generally poor heat rates; others (the break-even prospects) will prove to be sound competitors after a modest one-time write-down. The remaining thermal units will either be shut down as uneconomic even at nominal book value, or grudgingly operated after large one-time write-offs.
The economics of the remaining generating plants (geothermal, wind, biomass, solar, QF hydro, rate-based large hydro, and nuclear) will be so influenced by political considerations that speculation over their future is futile. An additional imponderable is whether the operating licenses of several perfectly serviceable nuclear and hydro assets will be renewed or fall victim to environmental special interests. Environmental pressure may shut down older nuclear and hydro units, but market reality might also shut down several hundred megawatts of renewable assets. The issue of who pays what to whom during this transition is unresolved and will finally be decided by the courts. The current inclination to leave everything up to the pocketbooks of consumers seems untenable.
MONEY AND BRAINS
The more interesting questions of risk and reward concern new entrants. One can expect three waves.
The first wave will comprise three sets of entrepreneurs, with varying degrees of capitalization. Undercapitalized entrepreneurs will most likely fail unless they 'flip' their business concepts or development ideas to substantial corporations. Adequately capitalized entrepreneurs will emerge with the professional discipline and financial acumen to sell or refinance their projects or young businesses at the earliest opportune moment (A few of these may indeed make the proverbial
100-to-1 venture capital return on their $1 to $5 million in seed capital). Resourceful energy companies or financial houses with the foresight to lead the industry in capturing value before their peers will either see the opportunities or rouse themselves to act. (These can expect a return on equity of around 2 to 2.5 times the corporate long-bond rate (em i.e., an enterprise capital return.)
In the second wave will come the imitative companies and financial houses that will seek to buy, develop, or otherwise fund assets similar to those owned or controlled by the first wave. Their returns on equity may cluster around 3 to 5 percent above the corporate long-bond rate (em i.e., somewhere between enterprise and utility capital return.
The third wave will find energy companies or active money managers seeking to accumulate established assets with a demonstrated record of performance (without quite realizing that these assets are available only because the sellers, often first-wave entrants, see margin compression coming) in the hope of making a return on equity in the mid-teens. Unfortunately, actual returns may not exceed the corporate long-bond rate, which suggests that the value added from management may be entirely consumed by the costs of management.
Very few companies will earn first-wave returns. The companies (including financial houses and sophisticated hedge funds) or wealthy entrepreneurs most likely to succeed as first-wave investors are already using two business techniques to position themselves: 1) Opportunities and Concepts Contour Mapping, and 2) Strategic Choke Point Analysis.
Different electricity industry functions in different geographic areas and regulatory regimes are subject to differing paces and magnitudes of change. Contour Mapping aids in understanding, at a fine level of disaggregation, how existing asset values and operating margins are squeezed and where new values may be emerging or expanding. Thus, a comprehensive "Value Map" can be projected over a given planning horizon. Choke Point Analysis reveals how existing regulatory, technological, intellectual capital, cost of capital, and consumer access choke points (which trap and shield value against competition) are being weakened or eliminated because of industry evolution and where new choke points (and, hence, deposits of value) may be strengthened or created.
These techniques are helping the most innovative companies and financial houses create a catalog of dozens of opportunities and concepts to be pursued in the next few years, ranging from potential sites for merchant plants to likely expansion projects to interesting co-investment and acquisition targets.
Pioneering firms know they must have a portfolio of at least two dozen investment ideas to ensure market entry at the right point and commercial success. In contrast, the companies most prone to be disappointed over the next five to 10 years in the new power industry are those that bet on only two or three large development efforts or acquisitions.
In summary, the right combination of liquidity, credit quality, and leading-edge foresight will make the most money (or net value added) in the new power industry. Companies with strong balance sheets and trailing-edge foresight (or leading-edge conventional wisdom) will make nice but not special returns. Investors with cash and conventional wisdom will make, at best, commodity returns. This third group will inherit the new power industry in 20 to 25 years when it becomes the old power industry, on the cusp of yet another transformation. t
Vinod Dar is director in charge of the Worldwide Corporate Strategy Services Group of Hagler Bailly Consulting, an international energy consulting firm, resident in the company's headquarters in Arlington, VA. The author's last article, "The Electric and Gas Industries are Converging: What Does it Mean?," appeared in PUBLIC UTILITIES FORTNIGHTLY, April 1, 1995, p. 21.
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