Power Measurement
Merchant-Energy
Bottom Fishers
Private equity rolls the dice.
January 2005
By Gary L. Hunt and Grant Thain
Overbuild in power generation markets causes a slow revenue recovery not only for combined-cycle, but for all types of plant within any region. Standard project discount rates do not apply to merchant plants and current market conditions find many merchant projects struggling. One way some new players in the power generation market are looking at the valuation is to separate out "extrinsic" value and apply a higher discount rate or "haircut." An alternative approach is to price the "whole curve" on a risk-adjusted basis.
Global Energy Decisions recently updated its Power Generation Bluebook, which assesses changing power-generation asset valuation for more than 5,000 power plants in North America, and confirms that the recent spate of private-equity purchases within the merchant generation sector is at dramatically higher discount rates than previously seen within the sector.
This blood-in-the-water signal is attracting private-equity firms looking to extract value from the merchant generation sector in this weak market environment. Why? The deterministic plant value is significantly depressed through the 2005-2010 time frame, with a significant chance of needing cash injection just to remain operational. Many merchant generators will not survive
the experience.
Extrinsic value dominates value in the early part of the project life cycle because of uncertainty. The Entergy power market, for example, is one of the most overbuilt markets in the United States. In combination with
an uncertain regulatory future, significant transmission constraints, and a market dominated by a handful of power buyers, significant market risk likely will prevail there for a long time.
The Power Generation Bluebook study found plant net present value forecast at $97/kW deterministically and $269/kW when accounting for
the extrinsic value using a more rigorous stochastic analysis of expected value. Even so, healthy gross-margins are not predicted for a long time.
With such significant uncertainty surrounding asset valuations, recent sales confirm that the private-equity players are winning asset sales despite project discounting at real, pre-tax rates of 20 percent. This compares with utility rates closer to 12 percent. This
differential reflects the significant risk the private equity players are taking in buying merchant assets in locations where limited liquidity and transmission means that there may be no
natural home for the power in the
current market.
These private-equity players are betting that improved market conditions will alleviate the current lack of demand for their product. It's all about timing: If the market recovers as expected, they will see significant returns for their investors. However, a delay in recovery of a couple of years will destroy their returns and result in the same assets being sold again in a few years.
Are market prices for wholesale
electricity recovering? Not yet. While coal and nuclear-power generation
asset values have increased, gas-fired combined-cycle power plant prices continued to decline between 2003 and 2004, with overall combined-cycle
values falling by 11 percent.
As reserve margins in a power
market increase, volatility decreases, because any price shock in the market
is absorbed fairly quickly with available generation. Look again at the Entergy power market in recent years, where volatility decreased significantly. This reduced the extrinsic value of power plants. We expect the volatility to come back as the reserve margin erodes with retirements and load increases. In the meantime, though, merchant plant owners will have a difficult time
covering their costs, and many
projects will remain troubled.
This is the bottom-fishing environment of the private-equity firm, which searches for attractive assets at low prices that nevertheless make money
by leveraging market uncertainty and extracting the extrinsic value of an asset. With production cost close to market price, an investor can get significant value from this uncertainty. In fact, the value of the asset actually increases with the uncertainty.
In our recent study of changing power generation asset values, we found uncertainty increased extrinsic value (15 percent vs. 25 percent). That is, expected value can be more than 100 percent of the deterministic value of an asset that does not measure this uncertainty. Its effect on cash flow is illustrated in Figure 2.
The process of rationalizing merchant-generation investment and asset portfolios is well under way. The first round of fallout took out the weakest players. Now merchant projects hanging on to hope must critically assess the potential for future cash flow. While that analysis varies significantly from region to region, one thing is constant: Uncertainty both creates heartburn and adds value in an industry struggling
for profitability.
At this stage of the merchant-generation business cycle, private equity firms are searching out bargains from among available assets. While the
haircuts they extract are painful,
this process of rationalization can be expected to speed the recovery of
the sector.
Gary L. Hunt is president, Global Energy Advisors, and Grant Thain is vice president, Global Energy Software-business units
of Global Energy Decisions. Hunt can be contacted at ghunt@globalenergy.com
and Thain at gthain@globalenergy.com.
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