Is the US Independent Generator Model Dead?
Independent power companies in the United States are having a hard time persuading utilities to enter into long-term contracts to buy their electricity. Independent power companies generate about 42% of electricity in the United States. Regulated and
municipal utilities and electric cooperatives generate the rest. The market share held by independent generators reached a plateau in 2003 two years after Enron went bankrupt. The Public Utility Regulatory Policies Act that required utilities to buy electricity from independent generators was gutted in 2005. Proposals for a “mini-PURPA” in the form of
a national renewable energy standard appear to have stalled in Congress.
What’s the future for the true independent power company? Will the trend lines start to reverse with relatively more new generation being put into rate base?
Four top US power industry veterans debated these subjects at the 22nd annual global energy and finance conference hosted by Chadbourne in Utah in June. The debaters are Michael Schwartz, at the time senior vice president of Duke Energy Ventures and now CEO of New Wave Energy, Larry Kellerman, CEO of Quantum Utility Generation and a former managing director for power and utilities at Goldman Sachs, Robert Hemphill, president of AES Solar, and Jonathan Bram, managing director of Global Infrastructure Partners. The moderator is Ken Hansen from the Chadbourne Washington office.
MR. HANSEN: We have assembled an eminent panel to debate the issue. Speaking first in favor of the resolution that the independent generator model is dead is Michael Schwartz.
Ability to Innovate
MR. SCHWARTZ: My comments break down along two lines.
In the renewable energy sector, demand is driven by state renewable portfolio standards. Candidly, I do not see state RPS targets driving “inexorable” and “sustainable” growth in demand. One need look no farther than what happened in Connecticut last year and what is currently happening in Maine where opponents of RPS targets are attempting to roll them back. The recession and growing concerns about economic development and local job creation are changing the dynamic around state RPSs.
Turning to the rest of the independent power sector, the challenge of procuring power contracts is a manifestation of a much deeper and more fundamental dysfunctionality afflicting competitive power markets that calls into question the decision to deregulate electricity generation. I know this is an incendiary assertion to make before this august group, but, hopefully, you will give me a couple minutes before you start throwing things of increasingly heavy weight at me.
The US electric utility industry is bifurcated into two distinct segments: regulated and unregulated entities. In contrast to five years ago where independent generator NRG Energy was trading at, let’s say, a price-to-earnings multiple of 16, we now see materially higher PEs for regulated utilities than for independent generators. Look at the numbers. Southern and Duke are trading about 17. NRG is at 9. AES is outperforming in the nonutility sector at about 11. This has led to an equity premium for regulated utilities, and recent M&A transactions are evidence of this flight to quality and the premium on the equity side for regulated utilities.
This flight to quality can also be seen in the debt markets with a current spread between regulated utilities and nonutility generators in terms of cost of debt.
Why is this happening?
Independent power companies no longer can provide low cost power to the market and customers.
Outside of the renewable energy sector, who are the innovators? Who is deploying capital across the US energy spectrum in advanced commercialization of new technology? It is not the independent power companies. Duke Energy is building one of the first integrated-gas combined-cycle power plants in the United States of America. We are completing an ultra-super-critical coal facility, moving on nuclear, making commercial-scale investments in the smart grid and deploying capital around electric vehicles and distributed generation. The innovation and the deployment of capital in new technologies are in the regulated utility sector, not the independent power sector. We are operating under long-term integrated resource plans that promote technology development and fuel diversification in support of long-term customer needs and in an effort to drive down customer costs.
Look at the competitive markets. There is significant doubt about the ability of these markets to attract the capital required to build new gas peakers, yet alone intermediate or base-load generation. For the most part, states and competitive markets have abandoned the RFP process. There is no regulatory oversight to promote long-term development of technology and fuel diversification, and there are key questions around the ability of competitive markets to meet the long-term needs of customers.
MR. HANSEN: Speaking in opposition to the resolution is Jonathan Bram.
MR. BRAM: Let me provide some historical context. Why were independent power companies able to build such a high market share by 2003? What changed? What does it mean for the future?
There was a boom in construction of new power plants by independent power companies from the late 1990’s to 2003 when the sector reached a plateau. Two factors contributed to this. One was that after a decade of virtually no new construction, there was a need for significant new generating capacity, and the independent generators built it. That was when there was a four-year backlog for new gas turbines that we thought we would never see again until we saw the four-year backlog for wind turbines. So there was a period of lots of new
It was also a period when utilities were being forced by their regulators to divest massive amounts of generating assets.
These trends did not end with Enron. They ended with the California energy crisis. They created a massive increase in independent ownership of generating assets, which came to a screeching halt around 2001 or 2002 because of the financial crisis, the recession that followed the terrorist attacks on September 11, 2001 and the halt in further deregulation that was in part a reaction to the California energy crisis.
From that point forward, the market penetration by independent power producers remained static, which is logical because the people in this room are highly economic. From around 2001 to today, market prices have not justified new construction. Market prices basically justify discounts to new construction of anywhere from 40% to 50%, which is why you saw secondary sales of relatively new power plants in the period 2003 to 2004 going at 30% to 40% of construction costs and now edging up somewhat to the 40% to 50% range. These projects are not retaining full value because of the big reserve margins and excess capacity in many parts of the country and, if there is one thing about the folks in this room, they do not build things that the world does not need.
This condition will not last forever. Life is long and cyclical and, right now, there is no part of the country where market prices justify new construction. There are episodic places where utilities can build new power plants because they are able to convince their regulators that an additional rate base investment makes sense. A lot of the technological innovations that Michael Schwartz talked about — from IGCC plants to nuclear — do not make sense on paper. Therefore, it should not be surprising that folks who need nonrecourse financing to build, and who actually have to justify something in the four corners of a spreadsheet, are not building today.
That said, there are large parts of the country where people think there is value to switching to renewable energy. When
we get to a position where we need to add new generating capacity, I think you will see much more support for renewable portfolio standards.
As we stand here in the middle of a deep recession, I would say that it will be a few years before supply and demand move back to equilibrium. The skills that the independent developers have are unquestionably valuable to society. Everyone loves the irrational optimism of developers. When it comes time to site and build something on a cost-effective basis, there is no doubt that the entrepreneurship will add value. On the other hand, when it comes to build a nuclear power plant, I don’t think these skills will add enough value, because I don’t think you could ever justify such a power plant without the safety net of the regulated ratepayer who will pay for the mistakes or benefit from the success, whichever happens.
What is most interesting to me is to think about where we are now. As we get to a point where supply and demand move closer to equilibrium, will this partially deregulated system that we find ourselves in provide enough reward to independent generators to build new power plants?
That is a problem. In parts of the country, states are basically saying “No.” That is what Maryland and New Jersey are saying. They are trying, in essence, to exercise monopoly power by signing contracts to add some capacity to keep the market fully supplied, so that the only place you will ever see equilibrium power pricing is in a market study as opposed to the real world. That means it will be very difficult for independent developers to add new capacity.
However, where there is a demand — for example, for renewables in states where utilities are willing to sign power purchase agreements — independent developers have enormous penetration because of their energy, effort, hard work, skill and capability. The good days will return. However, in the meantime, if you are looking to build new generating capacity that is not needed because reserve margins are still in the mid-20% range on a national basis, it does not matter whether you are an independent generator or a regulated utility. New growth will have to wait until we emerge from the recession and there is new demand for electricity.
MR. HANSEN: Now an opening statement in favor of the resolution from Larry Kellerman.
Dependent Power Producers
MR. KELLERMAN: The heyday of the independent power producer has passed. The IPP business model that justified the independent power industry and allowed it to flourish no longer exists. We have moved from a world in which independent power producers existed in a win-lose relationship with utilities. IPPs have been eclipsed and are being replaced, sometimes in the same company, with DPPs.
The power producers of this era and the future are going to have to function in a more positive, constructive and dependent relationship with the utilities of North America than they have had to do in the past.
Let me take you through the three eras of the non-utility generation business to give you a sense for why that is the case.
The first era began in 1978 and lasted through the mid-1990s. It was the PURPA era. It was the era of QFs. The era was characterized by above-market contracts shoved down the utilities’ throats against their will and whose legacy is a series of both strange relationships and stranded costs with which many utilities are still wrestling today. The objective function of the IPP sector during that period was to create the highest spread between the sometimes rightfully constructed, sometimes artificially constructed, characterization of avoided cost under PURPA versus the cost structure that they were able to enjoy. The result over time was a legacy of long-term contracts binding utilities to buy electricity at above-market rates. These were highly lucrative power contracts with highly attractive returns, and they turned a number of early movers in the industry
That was the first era of the IPP industry, the PURPA era, and it formally died in 2005. It really started to die in the mid-1990s when PURPA contracts started to tail off. Taking its place in the mid- to late 1990s and somewhat peaking in the early to middle part of the last decade was the independent merchant energy industry.
The ascendency of the merchants took place in a frothy period of unrealistic market forecasts and unrealistic lending practices of the financial community. Wherever you had a section of 36-inch gas pipeline near a 345-kv line, someone was building a gas-fired power plant and getting it financed. At the same time, there were many auctions in which utilities were forced to divest their older generating assets, and tens of billions of dollars of capital were pumped into the sector. Since then, tens of billions of dollars have been lost through a series of well-known bankruptcies and, today, these merchants are engaged in consolidation and cost reduction rather than robustly looking to grow. That was phase two of the IPP industry.
Now I would like to bring you to phase three, which I believe we have started to enter. It is an environment in which the interests of non-utility generators are going to be much more tightly aligned with the interests of the regulated utilities. Unlike the last two eras, where the objective function was to increase price, the objective function of the new era of DPPs is to reduce your costs enough to be able to compete on price with the regulated utilities. Without legislation forcing utilities to do what they sometimes did not want to do and without the flawed market forecasts and flawed lending practices of the past, the non-utilities of this era can no longer afford to be truly independent.
Therefore, the era of independent power producers is over. The era of competing with utilities is over. The era of viewing utilities as true customers or as true counterparties is upon us. It is an era not of independent power producers but of dependent, co-dependent or inter-dependent power producers.
MR. HANSEN: Our final opening statement will be from Bob Hemphill.
MR. HEMPHILL: The Chadbourne slide that indicates that the market share of independent generators has remained fixed for the last eight years is not surprising. If no one is building anything, why would there be a shift in market shares?
I find it unconvincing evidence that the independent generator model is dead.
The other piece of data that I find interesting is that if you look at what actually has been built in the United States over the last four or five years, it has been at least half renewables and, in the renewables sector, a healthy 90% to 95% of projects have been built by independent generators. Why is that? Is it because utilities are models of innovation? Is it because utilities are nimble and fleet of foot? Is it because utilities are able to leverage their projects at 85% and thus have a lower cost of capital? Those are not the utilities that I know.
If you look around the world, you will see, time and again, instances where the competitive landscape for innovative and new technologies has favored independent generators. For years and years, Eskom in South Africa was probably considered the most difficult utility in the world to deal with, and that was quite an achievement, given utilities in general. Unfortunately, Eskom — nimble, fleet-footed and innovative — was unable to keep the lights on in South Africa, which is kind of what they teach you on day one in utilities school: “Do not let the lights go out.” Consequently, the South African government has now excluded Eskom from participating in the upcoming renewable construction proceedings, and has forced it to serve only as the contracting party.
The Long Island Power Authority recently released a 2,500-megawatt RFP. The company is not crazy. If it thought it was better at generating electricity, then it would be building new power plants. Southern California Edison announced that it would do 500 megawatts of rooftop solar; it stopped after about 130 megawatts with the admission that it was not any good at this. The argument that utilities really know how to do things and will out perform, out think, out play, outwit and out run independent power producers is flawed.
I am willing to cede the territory of nuclear power. When I look at the most recently published Duke numbers, which were flawed in the way they calculate construction interest, I still get something like $7 million a megawatt. David Crane was quoted as saying that, for NRG, the first couple of nuclear units will cost $10 million a megawatt, but once they are built, the company will have learned a lot and, therefore, be able to get the price down.
My company, AES, has come to an agreement to purchase Dayton Power & Light, which may undermine my arguments, but if there is such a high quality premium on utilities, how come we are picking them up at a 13% premium to what their current trading is, and how come that is cash-and-earnings accretive to AES, which is trading at this remarkably low multiple? That does not look to me like a signal that Dayton Power & Light is benefiting from the flight to quality that my colleagues have mentioned.
In conclusion, I guess I would say I really wish that you could still get a standard offer four contract just by showing up at Southern California Edison’s offices. That was great. And I really wish that all those Japanese banks were still around that would give you 100% debt financing. That was fabulous. I agree those days are not likely to come back, but the fact remains that the IPP industry has consistently shown itself more creative, more willing to take risk and to profit from those risks, more innovative in financing structures, and a much more rapid adapter of technologies that make sense; nuclear and integrated-gas combined-cycle project do not. A colleague of mine characterized IGCC as “combined cycle at $5 million a megawatt,” and that price has probably gone up since the start of this panel.
Whether the heyday is over depends on how you define “heyday,” but I see every possibility that independent generators will maintain a dynamic and interesting share of the generation market in the United States.
MR. HANSEN: Does any of you have anything you would like to add to your opening statement?
The Texas Example
MR. KELLERMAN: In support of our contention that the heyday of the IPPs is over, I give you Texas. Five, six, maybe even seven years ago, power in Texas cost retail consumers less than the national average, while gas prices were in the very high single digits to low double digits per mcf. Today, gas is barely $4.50 an mcf; yet Texas retail prices are above the national average.
Why is that?
The available generating capacity is still well above peak loads. There has not been a lot of new construction. There is a competitive power market and there are competitive retail suppliers that are supposed to bring competitive dynamics and drive down prices. That has been an abject failure by every mathematical or objective standard.
What we have created is an environment in which once-strong utilities with good credit ratings, Texas Utilities and Houston Lighting & Power, are now either on the verge of bankruptcy or fundamentally non-existent, replaced by a plethora of very high-cost retail energy distributors and a large number of independent generators who do not offer any cost efficiencies and whose objective is to increase the wholesale price of power. What we have in Texas is something that is diametrically opposed to the promise of the wonderfully-sounding, attractive notion of competition bringing down prices. Instead, we have a flawed market structure in which utilities have taken a back seat to a series of competitors whose interests are not in keeping power prices low or keeping the lights on.
MR. HANSEN: Bob Hemphill, any response?
MR. HEMPHILL: Yes. A comparison of the kind that Larry Kellerman makes, while intriguing, says nothing about what prices would have been had the old triumvirate of Texas Utilities, Houston Lighting & Power and Southwest still been in charge. The fact that prices are above the national average is unconvincing because we do not know what would have happened in the alternative.
MR. HANSEN: Michael Schwartz?
MR. SCHWARTZ: I think we are on two different wave lengths. I am known as an unrecovered developer. I agree that independent generators have been able to deploy projects, new technologies and innovative commercial constructs that would never have been fully deployed by the regulated utilities. My argument is a strategic one. The regulated utility model in the United States provides a vehicle for long-term planning, for goal-setting, and for establishing some kind of construct that balances long-term and near-term objectives. That is absent in the independent power market. What I am arguing is that what replaced the regulated generators is strategically flawed and dangerous. We have to look at the relationship between the IPPs and the regulated utilities in a different way.
MR. HANSON: Jonathan Bram?
MR. BRAM: I have two observations. First as it relates to ERCOT and Texas, there is no evidence of a huge windfall for wholesale generators. To the extent retail rates are high, it is probably because they are under-regulated. The problem is between the bus bar and the customer. Just look at the prices that people are paying for combined-cycle power plants in ERCOT. There is no evidence that in that very liquid market people are getting some huge premium over replacement cost for power plants. The top of the range today is probably low for similar assets in other markets. I agree with Mike Schwartz that in a lot of these markets, there is no means to assure adequacy. ERCOT is probably the place where supply and demand are coming closest to equilibrium; minor issues can cause large upsets, like in February and August when there were outages and brown outs.
Second, it would be very interesting to see what would cause someone to build a new merchant power plant in Texas. The day will come soon when more generating capacity is needed. I am not sure that market provides any incentive for anyone to build. The easy days of signing a standard offer contract with a utility, and then waiting a few years to see whether gas prices go up or down, are over. The days when utilities and public utility commissions would hand out real options to people, who would then wait to see which way they would go to make their $25 million, are behind us. However, there will definitely be a role for independent generators going forward because those are the people who are capable of actually building things at the least cost, which adds efficiency and is really important to our overall economic growth.
MR. HANSEN: Bob Hemphill, do you have a question for Larry Kellerman?
MR. HEMPHILL: I thought we were talking about independent generators. Larry, both you and your colleague have eloquently and persuasively indicted something called the “competitive market system,” which may be flawed, but I don’t think that is the fault of the independent power industry. We are on the wholesale end of the business, and you are talking retail.
MR. KELLERMAN: Good point. Let me refocus from Texas to New Jersey and Maryland, two states that your colleague, Jonathan Bram, said are tilting away from a purely competitive market. The fact is that New Jersey and Maryland have been forced into doing what they are doing because the independent power community was not motivated enough to take actions that would align generation with demand. Is it the fault of the IPPs or of the market structure? The fact is that action was not being taken. The problem with market signals in PJM is that you worry about being kicked in a place you don’t want to be kicked. When you relieve a constraint, the resulting forward market price, after that constraint is relieved, is now dialed back to market equilibrium.
What you have is a market structure that produces the opposite of what society wants. Society wants relief from constraints. If I am a rational independent generator in the PJM market, what do I want? I want the preservation of constraints. That is the only way I am going to get high prices. The market structure makes no sense.
What Maryland and New Jersey are saying is that they have to do something to protect their consumers, and that means they have to dictate where, when, how and who builds new generating capacity. The market forces are not doing it. This is an example of where independent generators are not stepping up to do what the brilliant Harvard-trained economists who came up with the whole notion of capacity markets failed to foresee when thinking through how their models would work in the real world.
MR. HANSEN: Michael Schwartz, your question for Jonathan Bram.
MR. SCHWARTZ: Jon, I truly get your point about the dynamic of the current market. Do you see pressure or an incentive to move ownership of generating assets from publicly-traded companies that are focused on near-term earnings to privately-held enterprises who can manage through volatility, and particularly to infrastructure funds such as yourselves?
MR. BRAM: I think funds like ours have a role to play. An independent generator business is a challenging model to conduct in a public company. Bob Hemphill’s company is one of the few that have survived. There are always about five, but the list turns over from year to year. When this conference first started, it was O’Brien Environmental Power and Catalyst Energy. Think of all these companies that existed for a time, but don’t any longer, because the public market does not appreciate NPV value creation. It is looking for growth in earnings per share. It is looking for pops. The reality is we are in a long-cycle business, so a company like AES could build five projects in two years, and then nothing for 10, because it is being rational; there is no demand for additional generation. It has always been a challenge for the public markets to value these companies fairly.
MR. HANSEN: Jonathan Bram, do you have a question for Mike Schwartz?
MR. BRAM: I think you pointed out that utilities currently enjoy a cost-to-capital advantage. The independent power business was built on having a cost-to-capital advantage that was based largely on more leverage — utilities were at 50-50 debt to equity while independent generators had 80% leverage. When they got to scale they could even have debt at a holdco level on top of debt at the project level. This gave them a lower cost of capital on an all-in basis.
This is no longer true. Lenders are more risk averse. Utility trading values are near an historic peak in terms of price to earnings, which is typical of a period when people are frightened.
If you fast forward to a world where suddenly we need to build, which means the recession is over, demand has caught up with supply, and interest rates are at more normal levels, Treasuries will no longer be at 3%. They will be at 5% to 7%. If the market responds to all the paper the US government has printed to get out of the recession, the rates could be much worse. Do you agree that in such an environment, independent generators are likely to have a cost of capital that is equivalent to that of utilities?
MR. SCHWARTZ: I think there is another factor at work called a “flight to quality.” Certainly I can see a period when there is a need for significant new generation, but the question as coupon rates rise is what will happen with the spreads. The regulated utility construct provides greater certainty for cost recovery, thereby mitigating risk and thereby driving down coupon rates. Given this, I am not sure that independent generators will be on a level playing field with utilities. Going forward, the question will be what part of the spectrum of new opportunities should be funded and owned by regulated utilities, who have a service obligation and are assured recovery of their capital costs, versus independent generators, who have neither.
MR. HANSEN: Larry Kellerman, do you have a question for Bob Hemphill?
Migration to Utilities
MR. KELLERMAN: Bob, your company has been one of the most durable, successful independent generators in the world. AES created a business model several decades ago that has been proven to be not only viable, but also resilient and flexible.
AES started building cogeneration facilities in the early days of the independent power industry that are still generating value for your firm. It migrated into the merchant market, acquired power plants being divested by utilities and was successful in that business model. Isn’t it a statement of both your success and flexibility as a business as well as how the market has dramatically changed from the classic independent generator model that AES has been largely focusing its new investments on acquiring utilities — first, Indianapolis Power & Light and, now, Dayton Power & Light — and building other power plants with long-term output contracts with utilities as opposed to really being in the competitive markets?
MR. HEMPHILL: That’s fair, but honestly, we had a whole hour of discussion about, “Why is it so hard to get power purchase agreements,” which was fine, although somewhat self-reverent. The real question is: how can it be that there are other industries in the world that actually make things and sell them to people and, unbelievably, do not have long-term contracts? That’s probably true of almost every other industry in the world. Many of them have high capital costs. Many of them have variable fuel costs. Many of them have technology challenges and yet, somehow, those companies, with the exception of the automobile industry, seem to survive, and many of them actually thrive and profit.
So I am a little mystified about why we all seem to think that it is impossible for us to do business without the solace and comfort of a long-term power contract.
Now, I would be the first to tell you that if I had the choice, I would absolutely much rather have a long-term offtake agreement with a monopoly provider with high credit. It is a terrific business model. But I do not see what should prevent the business model from moving more toward a merchant-based model. The argument, “Well, that will never support the construction of new capacity,” just can’t be right. It supports new capacity in every other industry in the world except this one.
MR. HANSEN: We have reached the end of our debate. Each of you will have about a minute to make a closing statement, in the same order as the opening statements.
MR. SCHWARTZ: First, let me apologize about the distracting proposition regarding re-regulation, but my reality is that politicians are loathe to address strategic issues that have a time scale well beyond the next election. Second, there is no pressure to change policy or regulatory direction in a falling or stable price market, which means nothing will happen in the near term. Third, unfortunately, political action in this country is derived from crisis, and the question in my mind is whether we are on the edge of an impending crisis.
If we are fortunate to have a sustained economic recovery, and there are 15 to 25 gigawatts of coal retirements in the northeast and mid-Atlantic states, then what happens? Is it another California-like energy crisis if our capacity markets are unable to respond? Could we see a federal clean energy standard that would create demand for clean energy for the foreseeable future? Could we see more states moving in the direction of Maryland and New Jersey, with probable litigation and co