Business & Money

An evolving market demands a greater focus on power prices and required return on equity.
Fortnightly Magazine - May 1 2003

An evolving market demands a greater focus on power prices and required return on equity.

Valuation can be difficult even in stable markets, and executives setting their company's strategic course need to understand how the market for power projects is evolving and what may lie ahead.

Under traditional rate base regulation, significant emphasis was placed on historic or embedded costs for valuation of electric generation property. However, considering the electric industry's restructuring activities and the increase in sales of electric generation property during the past 10 years, there has been a reasonable and logical shift to examining and emphasizing the income approach for valuation. Risks associated with the cash flow expected from electric generation need to be carefully assessed during the valuation process. Further, such risks in many cases have changed rapidly as deregulation and financial pressures from many sources have evolved. Much more change is in store.

Trends in Value

Like volume in the market for power projects, value too has evolved. Figure 1 depicts changes in volume in the market for power projects since the late 1980s, and Figures 2 and 3 show several measures of trends in value. Dollars per kilowatt ($/kW) for fossil-fired projects appears in Figure 2, and the pro forma after-tax return on equity (ROE) expected by buyers appears in Figure 3.

Dollars per kilowatt is an often- calculated measure of price. The necessary data are usually available, and the math is easy. Considering this measure alone, the value of projects sold actually increased during 2002. The price for natural gas- or oil-fired power projects in 2000, 2001, and 2002 averaged $505/kW, $500/kW, and $560/kW, respectively. This increase during 2002 refutes the position that the financial pressures on sellers during 2002, and a dearth of buyers, depressed project values. However, $/kW is a version of the market approach to appraisal and, like dollars per square foot for real estate, comparisons based on $/kW assume comparability when in fact little comparability may exist. From this perspective, it is not surprising that the data in Figure 2 shows large variances and no meaningful trend in value. Dollars per kilowatt is at best a signpost to value. More careful evaluation of a facility's revenues, costs, and risks is necessary.

The income approach to valuation is the gold standard among participants in the market for power projects. While value is thus determined by every line in a detailed forecast of cash flow, two stand out as particularly important; power prices and the required ROE.

The risk associated with power prices is one of the factors that differentiates projects. Some generators sell power under long-term contracts with fixed prices and, as long as these contracts are with creditworthy entities that continue to perform, these projects are exposed to no market risk. If they match the power sales contract with a long-term, fixed-price fuel contract, these projects have a fixed operating margin and their cash flows can involve little risk.

At the other end of the risk spectrum are pure merchant projects. These have no fixed-price power and fuel contracts and they sell power into what can be volatile markets. On the strength of forecasts about the course of deregulation, power prices, and fuel prices, merchant projects began to be developed in the mid-1990s.

Of course, not all projects were or are contract-secured or merchant; some are a mix of the two. The contract-secured and merchant segments bound the possibilities. Unrealistic forecasts, errors in judgment, and other factors led to the troubles that now hinder many merchant projects.

Required ROE

As independent generation segmented, investors recognized the differences in risks. Accordingly, this led to segmentation in the second important factor that drives value: required ROE. Merchant risks were higher, and investors in such projects commanded higher returns. Trends in ROE since 1989 appear in Figure 3. The ROE data should be considered with several qualifications in mind. Buyers' return expectations change over time, and not all buyers are the same. In addition, while substantial academic effort is devoted to estimating a correct ROE, practitioners work in an environment that requires the application of some judgment. The data in Figure 3 is based on discussions with various participants in the market since 1990 and on occasional published reports. Vertical lines at the right show the range of actual experience, and the horizontal lines show trends in that range since 1989.

The concept of financial diversification indicates that spreading an investment across several assets will eliminate some of the risk. Unsystematic risk or asset-specific risk is effectively eliminated by meaningful diversification. However, systematic risk or market risk of an asset is not reduced or eliminated by diversification. In evaluating the expected cost of equity capital for generating assets, these risk concepts need to be considered.

Subject to the qualification above, power project values increased as return expectations declined during the early 1990s. The PURPA-based industry matured, it learned to manage risks, and new entrants increased competition. Returns went down, and sales values went up. Many of the new entrants were unregulated utility subsidiaries.

When merchant projects debuted, competition was scarce, return requirements were high, and asset prices were low. Then, like the PURPA-project segment of the market, the merchant segment began to mature. Competition increased, return expectations went down, and the sales value of merchant projects in both development and operation went up.

Beginning in 2000, when competitive markets for power became very volatile and the functioning and regulation of markets for power proved uncertain at best, the future of merchant generation began to look bleak. Return requirements increased, and values declined. Further, the risks associated with merchant operations loomed so large during 2002 that there were few transactions on which to base an estimate of the required return.

The Road Ahead: What Will Drive Volume and Value?

Several related factors will drive volume and value in the market for generating facilities during the next several years.

First, financial pressures on more than a few of the past's most active firms are acute. AES, Calpine, CMS, Dynegy, Duke, El Paso, NEG, NRG, Mirant, Reliant, and others are already selling some of their most valuable assets. More sales are on the way. Most of these firms are under pressure from lenders to stop construction programs, raise cash, and reduce debt.

These potential sellers must make difficult decisions. In particular, many would like to sell their merchant projects and keep their high-quality, contract-secured projects so that they have stable earnings for the future. However, with merchant projects likely to require book write-downs, selling contract-secured projects may be the only way to raise the necessary cash.

On the buy side, there are a few survivors and many new entrants. FPL Energy is an example of a long-term buyer who remains active. New participants include private equity firms such as Kohlberg, Kravis, Roberts, and Co. now prospecting for facilities at attractive prices. A quandary many of these will face is that, as explained above, the prices for high-quality, contract-secured projects have not declined. Private equity buyers with high return requirements may not be able to purchase such projects, and many of those buyers will be left with no acquisitions or projects that do involve substantial risk.

Another important factor that will shape the future is the development of trading companies. Nearly all of them have failed. BP Shell remains, and several banks are venturing back. These participants in the market for power provide investment-grade power purchase or tolling contracts to power project owners. With such a contract in hand, a power project moves off the merchant line in Figure 3 and down to the contract-secured line. Liquidity and value rise.

Several regulatory forces are also affecting the market. The Federal Energy Regulatory Commission's nascent standard market design initiative will evolve and, to some extent, shape the risks borne by participants in wholesale power markets.

But state-level regulation is also critical. Deregulation and divestiture are proceeding in Texas, are on hold in many other states, and are retreating in still others. Some may encourage utilities to build their own generation again, some may allow utilities to purchase power projects and bring them into rate base, and other regulators may focus on careful oversight of utility contracts and spot power purchases.

Many challenges remain. Values are determined by the market and income approaches; less weight is placed on the cost approach for valuation of electric generation assets. Volume and value in the market for generating assets will be determined by the financial pressures on sellers, the evolution of new entrants, trading companies, and regulation. Project-specific assessments of risk will be of critical importance in the valuation process of electric generation assets.

Business News Bytes

NorthWestern Announces Whopping $900 Million Net Loss

NorthWestern Corp. expects to report a $900 million net loss for 2002, and it will ask the SEC for a 15-day extension to submit its annual report while it continues to evaluate internal accounting and financial controls. The company said it probably would restate results for the first three quarters of 2002. Northwestern also said it is anticipating that approximately $800 million in charges will be taken against its full-year results, up from $700 million in charges the company estimated in February 2003. The company cited rising charges for the write-downs at Expanets, its communication business, and its Blue Dot air-conditioning subsidiary as contributing to the higher estimate.

PPL Files To Deactivate Four of Its Connecticut Power Plant Units

PPL Corp. said subsidiary PPL EnergyPlus told the Federal Energy Regulatory Commission it is preparing to file an application to temporarily deactivate four of the five units at the company's power plant in Wallingford, Conn. In the application, PPL will inform the independent system operator in Connecticut, ISO-New England, that the company would like to place the units in reserve status for two to four years. PPL EnergyPlus President Paul Champagne said, "Current prices in the region do not justify continued operation of these Wallingford units, and our internal projections show that the right economic decision is to deactivate them for at least two years, and perhaps as long as four."

Duke Energy Downgraded By Moody's

Moody's placed Duke Energy Corp.'s, and subsidiary Duke Capital's, long-term and short-term debt ratings on review for potential downgrade. "The review is prompted by concerns over cash flow coverage metrics at Duke Capital and the uncertainties associated with forecasting cash flow contribution from both [subsidiaries] Duke Energy North America and Duke Enegy International," analyst John Diaz said in a release. "In addition, volatility in the trading and marketing operations can have a direct impact on the organization's posted collateral requirements, thereby pressuring working capital and liquidity."

CMS Energy Gets Refinancing, Pays With Asset Sales

CMS Energy Corp. arranged $850 million in refinancing. The financing comprises a 13-month, $441 million revolving credit facility and a $409 million facility with maturity dates ranging from 13 months to 18 months. The latter facility amends the company's existing $300 million and $295.8 million revolving credit facilities, under which $409 million is outstanding. The lead lenders on the financing are Citibank, Merrill Lynch, and Deutsche Bank. The company said that it expects to repay the loans with proceeds from asset sales.

Progress Energy: Relocate Your Business to Beautiful S. Carolina

Progress Energy received approval for a new economic development rider meant to attract interest from companies that are considering locating in South Carolina. Under the program, businesses that move into a vacant property served by Progress Energy can qualify for a 50 percent discount on electricity used during the first year of occupancy.

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