The market for power plants in the United States is both turbulent and evolving. It is also fracturing into new segments. Once-hot business models have become orphans, once-boring models have become the most sought after acquisition targets. All this activity creates both opportunities and risks for buyers and sellers. Understanding the market is the key to success.
Many speeches, articles and books describe the growth of and now tumultuous times for both independent and utility owners of electric generating capacity in the United States. A measure of the change, and one that is an indicator of whether much money is being made and lost, is activity in the market for power project ownership. After beginning in the 1980s with sales of PURPA projects and then rising rapidly as regulated utilities began to divest their assets in the mid-1990s, sales of net operating equity interests peaked at over 55,000 megawatts in 2000.
Then, most visibly beginning in mid-2000, power companies started coming under financial pressure. From the 55,000-megawatt peak in 2000, power plant sales declined during 2001 and fell to a low of approximately 12,000 megawatts during 2002. From over 150 transactions during both 2000 and 2001, the number fell to 62 last year. Buyers that buoyed the numbers during 2001 and prior years were absent or turned into sellers during 2002. AES, Allegheny Energy, Calpine, Mirant, NRG and the PG&E National Energy Group are examples of buyers during 2001 who had turned into sellers by 2002. Stock prices declined and remain low, bankruptcies have been declared or are eminent, many projects that are under construction have been abandoned or mothballed, and lenders are holding substantial amounts of troubled debt.
This distress for some in the industry means opportunity for others. Substantial sales are likely during late 2003 and 2004, but they will be a lagging indicator of the changes in value and strategy that are happening now.
Uncertainty in markets usually sends buyers toward higher-quality assets, and the prices of lower-quality assets decline. This is exactly what happened to power plants during 2002. Although many factors determine the value of a power project, the amount of merchant risk has become one of the most important. Until last year, transactions involving merchant risk were common. By last year, many merchant assets were for sale, but few sold.
Of the 62 already-operating projects that sold during 2002, only two were merchants. The other 60 transactions involved projects whose revenues were secured by long-term contracts that shifted market risks to other parties, usually the ratepayers of a regulated utility.
Another segment of the market showed a similar flight. While power projects under construction did sell last year, most were purchased by reluctant buyers who did so to protect their existing investments in the projects. Several were taken by constructors who were owed substantial sums, and several others were taken by lenders through foreclosure proceedings. At least one solicitation of a partially-constructed merchant plant attracted material interest but no bids. Although the project was 50% constructed and major components were on site, the projected spark spread did not justify the risk of completion. In another solicitation, the bids received were actually negative. Potential buyers were not willing to put up any cash, and they wanted the lenders to reduce the debt the project will have to repay in the future.
An example of why buyers were so reluctant is the plight of several recently-completed merchant projects in the western US. Although the heat rates for these natural gas-fired combined-cycle projects are nearly 7,000 Btu/kWh and they are designed for baseload operations, they have actually been operated only sparingly. Power prices have rarely been high enough to cover the fuel and variable operating costs.
The prices of projects sold also indicate a flight to quality. This is great news for sellers of projects with contract-secured revenues that involve little or no merchant risk. While $/kW is a signpost to value at best, the average price paid for an oil- or natural gas-fired facility actually increased during 2002. The average prices during 2000, 2001 and 2002 were $505/kW, $500/kW and then $561/kW last year. Deal-specific prices have occasionally topped $1,000/kW even during the first third of 2003.
More telling, but more difficult to track, is the after-tax return on equity required by buyers. As risk rises, so too does this return. Deals done during 2002 and early 2003 provide no indication that this return has increased for facilities with contract-secured revenues. Buyers are willing to accept the lowest returns for high-quality projects with well-hedged energy operating margins. Interest in this type of facility is high, and competition among buyers remains intense.
In contrast, the returns required on merchant facilities have increased so much that very few deals are closing. This is a classic flight to quality. The yields on high-quality assets do not change, and the spread between high and lower-quality deals increases. The auctions of merchant power projects noted above show that such projects often have very low value. In the case of a 7,000 Btu/kWh project that cannot cover its variable costs, even though it is already constructed at a cost over $400 million, its capital value is nearly zero. Lenders and owners face what could be a substantial loss.