A panel of power industry veterans had a wide-ranging discussion in New Orleans at the Infocast projects & money conference in January about the impact of falling oil prices on the US power sector, whether the basic power industry business model is being turned upside down by cheap natural gas and distributed solar and, if so, what emerges as a new business model, whether distributed solar is a good place to invest capital and other topics.

The panelists are Nazar Massoud, a principal with Energy Capital Partners and a former Goldman Sachs managing director, Todd Carter, senior partner and founding president of Panda Power Funds, Joe Kerecman, director of government and regulatory affairs at Calpine, Scott Taylor, chief financial officer of Moxie Energy and a former managing director in the wind and solar groups at AES Corporation, and Grant Davis, managing director of Tenaska Capital Management. The moderator is Keith Martin with Chadbourne in Washington.

MR. MARTIN: The power industry business model appears to be undergoing as significant a transformation as after the Arab oil embargo in the 1970’s when the independent power industry was born. In 1978, the US Congress ordered utilities to buy electricity from independent generators. This led to deregulation of the generation side of the business in many states. Now it seems like we are reinventing things again and are entering another period of significant change in the basic power industry business model. Nazar Massouh, do you agree?

MR. MASSOUH: I agree that we are going through a big transformation. Some of it is driven by forces within the power industry itself. Some of it is driven by the Environmental Protection Agency. Some of it is driven by forces in the oil and gas industry. I have had the pleasure of working across industries, and I would say that the latter probably has had the biggest impact on the power industry by lowering natural gas prices from where they were in 2008. In preparing for this panel, I looked at where gas prices were in the 1990s and, surprisingly, they were about the same as they are today.

MR. MARTIN: So as transformational a period today as after the Arab oil embargo. Todd Carter, do you agree?

MR. CARTER: I completely disagree. [Laughter.] We are an independent generator building power projects in different parts of the country. We have not seen much change in how we do business. Low gas prices are creating opportunities for us to build more power plants, but the basic business model is the same as in the past.

MR. MARTIN: One yes. One no. Joe Kerecman, major transformation or not?

MR. KERECMAN: My frame of reference is PJM. There were 797,000 gigawatt hours of energy produced in PJM in 2013. Of that, about 1,948 gigawatt hours came from oil, so oil-fired generation is practically non-existent. Solar was only 355 gigawatt hours in 2013. Wind was 15,000 gigawatt hours. The story in PJM today is about how nuclear is suffering, coal is in transition, and gas is picking up market share because of low natural gas prices. There is a lot of opportunity for independent generators not only because of low gas prices, but also because PJM is changing its capacity market design with higher performance expectations on which some of the intermittent resources will not be able to deliver.

MR. MARTIN: Does that mean transformation in the basic business model or is it just more of the same with independent power producers seeing some new opportunity in PJM?

MR. KERECMAN: There is a greater opportunity to develop in PJM.

MR. MARTIN: Scott Taylor, are we in a transformational period as significant as the late 1970s?

MR. TAYLOR: I agree with Todd Carter. I think this is just an extension of the existing business model and not a period of transformational change. It is consistent with what was intended to occur in 1978 with enactment of the Public Utility Regulatory Policies Act and its mandate to utilities to buy from independent generators. Our industry has seen changes in the generating mix over the last 35 years. Think about some of the rice hull projects that we financed in the early years. Geothermal was big. There has been a gradual shift in the generating mix, but even the growth in renewables, some of which, like rooftop solar, involves significantly disruptive technologies, is still playing out against a backdrop of the same basic business model.

MR. MARTIN: Grant Davis, same business model?

MR. DAVIS: I disagree with Todd Carter. We are in a transformational period. I don’t know whether it will take five years or 10 years to play out fully, but the power industry is in the midst of some fundamental changes in how it has operated over the last 20 years.

Major Transformation?

MR. MARTIN: Nazar Massouh, you think we are in a period of transformational change. What emerges at the end of this period?

MR. MASSOUH: The oil and gas industry is having a big impact on our sector, perhaps not for the reasons that are obvious because we no longer use oil to produce electricity, but we do use natural gas. Gas was $13 an mmBtu before prices collapsed. Prices would have come right back up, just like they did for oil, except they never recovered because of unconventional techniques for producing gas. Furthermore, close to half of our natural gas produced unconventionally is actually associated gas. It comes out of oil wells and is associated with oil production. The reduction in oil prices could lead to a reduction not only in oil output, but also output of associated gas. That could put upward pressure on the price of natural gas.

Low gas prices are what has allowed us to do a lot of things in the last five or six years.

I feel sorry for people in the renewable energy space because low gas prices are making life difficult. If gas prices were still $13, we would have a lot more renewables, and we would have coal plants that would be retrofitted instead of being shut down. I don’t know whether the coal generating capacity that will be shut down will reach 100,000 megawatts, but it should be close to that number.

I started with an independent power producer in the mid-1990s, and the first thing I learned was the stack works: you dispatch hydro, nuclear, coal and gas in that order. What is happening is transformational because the traditional stack no longer holds.

MR. MARTIN: What is the current stack?

MR. MASSOUH: Hydro and nuclear are still there, but natural gas is by far the cheapest source of production outside of the renewable energy producers who do not have to buy fuel.

MR. MARTIN: So the transformation is not so much in the business model as a shift in who supplies electricity?

MR. MASSOUH: More in what energy sources are used to generate our electricity rather than who generates it.

MR. MARTIN: Grant Davis, you believe we are in a transformational period. What emerges at the end of it?

MR. DAVIS: That is a good question. If I had the answer, I might have earned enough to retire by now. I think 10 years from now, we will look back and see some fundamental changes. The mix of generating assets or the stack is an obvious one. I think we will see changes in the regulatory environment relative to renewables, relative to demand-side management and the utility model. There is pressure to move away from sole concentration on large generating stations to more of a distributed generation model.

More of the Same?

MR. MARTIN: The rest of our panel believes it will be more of the same. Todd Carter, is it easier or harder today to get a power contract with a utility?

MR. CARTER: The changes that the gentlemen are talking about are not driven by falling oil prices. We are in a transformational period in the power business.

MR. MARTIN: Transformation to what?

MR. CARTER: We are building power projects that use natural gas. Gas has been the biggest game changer of all the trends that are visible today in the market. Low gas prices put pressure on renewables. They put pressure on coal. They will lead to a reduction in carbon emissions as gas replaces coal. The reduction will not be the result of government regulation, but economics.

I agree with Grant Davis about utilities and distributed generation. It is a different business today than it was 35 years ago. Everything is different. You have to stay on top of the changes and be at the forefront of the transformation.

MR. MARTIN: It is a harder business today because you do not have long-term power contracts for your projects. You are building gas-fired power plants that sell on a merchant basis into PJM and ERCOT.

MR. CARTER: No doubt it is a tougher business for independent generators. There are people in our business who are waiting for a 30-year power contract, they are waiting for a 20-year contract, they are waiting for a 15-year contract. Guess what? That model and that business shut down more than 10 years ago. There are still some long-term power contracts to be had, but they are few and far between, so we look to build in markets where the additional electricity is needed. Texas is a fast-growing market. It is a different place than PJM with its older asset base, but we like the transparency of both markets.

MR. MARTIN: Scott Taylor, you think it is more of the same.

MR. TAYLOR: I should clarify that. I agree with the comments just made. I am not suggesting that there are not big changes going on with coal going away and gas replacing it. I was more responding to the suggestion by NRG CEO David Crane that the market will turn upside down: IPPs and utilities will go the way of the dinosaur and consumers will turn to distributed generation. I am not suggesting that distributed generation will not have an impact on our industry, but that impact will be a lot smaller than many predict and, at the end of the day, we will still have a healthy IPP business and a healthy utility business.

Each of us must adapt to the changes, but the basic business model will remain. Utility-scale projects will still be needed to serve demand. I am not saying that renewables and distributed generation will not benefit from some of that growth, but the distributed generators are not going to turn the market upside down in the same way that gas has turned the market upside down by slowing the adoption of renewables and replacing coal. The industry is in a slow evolution of the sort that Congress set in motion in the late 1970’s; nothing more.

Falling Oil Prices

MR. MARTIN: Let’s drill down into several factors that affect the market, starting with oil prices. They have been dropping dramatically. Oil is under $50 a barrel today. Some people think the price will fall as low as $30 a barrel before turning around. What are the effects of the falling oil prices on the independent power market?

MR. DAVIS: I think there is very little impact. We will end up with less associated gas as oil wells are shut down. That could affect whether gas prices keep falling. There are some impacts of falling oil prices in some of the regional markets in terms of a reduction in electricity demand due to a slowdown in drilling, but that is on the margin and not a fundamental impact.

MR. MARTIN: So no real impact. Scott Taylor?

MR. TAYLOR: I agree with Grant Davis. I don’t see any major impacts from falling oil prices. Within our industry overall, oil is not a major player. Some of the LNG export terminals that are planned may suffer, as they may find it harder to find buyers willing to lock in prices under long-term contracts. Demand for electric vehicles may suffer.

MR. MARTIN: What about in New England where fuel oil is used more heavily than in other parts of the country?

MR. TAYLOR: I don’t know the New England market well, but I believe oil is only on the margin in New England in January and February, so consumers will benefit a little bit, but low oil prices should not have a big effect on the shape of the power market in New England.

MR. MARTIN: Joe Kerecman, you are nodding yes. You agree with Scott Taylor.

MR. KERECMAN: PJM and New England are moving to capacity markets that reward performance. There are severe consequences do not perform. What we are doing at Calpine is relying on dual fuels. We have some oil peakers in PJM, but the rest are combined-cycle gas-fired power plants with oil as a backup fuel. Lower oil prices reduce the cost of the backup fuel, but it is not a big effect because we not talking about the cost of our primary fuel. We use oil as a backup to reduce performance risk.

MR. MARTIN: Todd Carter, any effects?

MR. CARTER: I agree with what has already been said. The only other effect I would add is the slowdown in new oil drilling is freeing up workers who can help build our projects.

MR. MARTIN: Nazar Massouh?

MR. MASSOUH: Not surprisingly, I am a bit of an outlier in this group. I believe low oil prices will have an impact. Whether it will be severe, time will tell, as it depends on how long oil prices stay at $46 a barrel.

There are two primary areas where I see an effect.

One is on overall gas supplies. If oil prices remain as low as they are today, I get a little concerned about a possible tightening of gas supplies because of the loss of associated gas.

The second effect is on electricity demand. A lot of the growth in ERCOT, for example, has been driven by the oil and gas industry and new drilling. Fortunately, Texas is a low-cost oil producer, so perhaps we will not see as much of an impact in Texas. In places like Oklahoma, Colorado and North Dakota, we can see a greater effect. We live in a world with less than 1% annual growth in demand for electricity. In such a world, a reduction in demand growth to 0.5% is huge. I can see some impact on power demand, particularly if the slump in oil prices persists for a while. On the other hand, falling oil prices have led to lower gasoline prices at the pump, putting more money in consumers’ pockets and helping the national economy to grow, so declining electricity demand in some areas could be offset by additional demand in others.

MR. MARTIN: Does anybody in the audience see collapsing oil prices having an effect on the independent power market? [Pause.]

Nothing? [Pause.] That’s news in itself.

MR. CARTER: I think that we in our industry tend to focus solely on our industry and not think enough about the external factors. Let’s go back to 2007. What changed our industry is not that we created a new, more efficient turbine or we were able to build a natural gas-fired power plant more cheaply. What changed us is the fad that the oil and gas industry figured out a way to produce natural gas for a lot less.

I look at the renewables industry, and the same is true. What introduced renewables into the world of power generation is the technology improved so significantly that it brought down the cost of utility-scale solar from $230 a megawatt hour to maybe $80 today. That is huge improvement. I would like to challenge all of us to think more outside our industry for trends that affect us. Anyone building a power plant must think at least 10 or 15 years out. We have to because a power plant is a 30-year asset, and some of these changes could have a significant impact on the economics.

MR. MARTIN: Let me ask a quick question as a bridge to something else. Grant Davis, Nazar Massouh, you guys have money; you invest in things. You three guys in the middle are developers focusing on power projects that use natural gas. Are you two guys with the money putting your money into gas-fired generation?

MR. MASSOUH: The answer is absolutely.

MR. DAVIS: Yes and, in fact, Tenaska is on both sides of that equation. We have money, and we are also developers.

Market Shares

MR. MARTIN: Next question. The independent power industry seems to have peaked in terms of market share at about 42% of US generating capacity; it hit that about 2003 and its market share has not moved since then; the utilities are the rest. Many people thought the utilities would start reclaiming market share. Now the distributed generation companies come on the scene and are asking for a share of the market. Who cedes market share to them: the independent generators or the utilities?

MR. CARTER: There are more people on this panel that have capital than what you just mentioned.

MR. MARTIN: Panda Power Funds! [Laughter.]

MR. CARTER: It depends. Somebody had data earlier today showing that there will be a ton of distributed generation. If that were a profitable business, I promise you we would invest in it. I promise you Calpine and everyone else on this panel would invest in it. We always look at new technologies.

MR. MARTIN: Let’s drill down on that. You have companies like SolarCity and Vivint growing at a 100% annual growth rates. Some of the smaller companies are growing at 200% a year. Why isn’t that a good place to invest?

MR. CARTER: Listen, I like solar; we built a very large solar project in New Jersey of all places. Why did we build it? We built it because there are state regulations that give us an incentive to build it. I am glad those companies are growing. We don’t see that as a big investment from our perspective, but we look at things a little differently than they do.

MR. MARTIN: If the rest of you were starting over today or you were just figuring out where to deploy capital, would you put your capital into rooftop solar?

MR. MASSOUH: I am on the board of one of these companies, Sungevity, and we made an investment. The investment was backed by 20-year contracted cash flow from their existing customers. We are not taking the risk that the solar rooftop industry will continue to grow. Most of the rooftop companies remain funded largely by venture capital. None of us is a venture capitalist. None of us is paid by our investors to take venture capital types of risks, so that is why none of us on this panel would invest in these businesses. Will they make an impact? Yes, but Scott Taylor said it well earlier which is that they will make an impact up to a point. They will not replace conventional independent generators. I have a lot of respect for David Crane, but I disagree with his predictions about the long-term direction of the industry.

MR. KERECMAN: There are three critical ingredients for rooftop solar. One is a high retail electricity rate. Another is a sort of regulatory cram down of the net metering rules. The third is sunlight.

You almost have to consider California separately from the rest of the market. California is not representative of the larger US. Is the distributed generation model taking hold outside California? I’m not so sure. Obviously New Jersey has a lot of solar penetration, but solar insolation is not as good in New Jersey as in California. To the extent distributed generation has taken hold in New Jersey, it is really through force feeding of a business model. Returning to PJM data for 2013, solar accounted for just 355 gigawatt hours out of 797,000 gigawatt hours in total.

MR. MARTIN: You are director of government and regulatory affairs and tend to see through that lens. You don’t think that distributed generation works without government support. Todd Carter, you appear to believe the same thing. You built a solar project in New Jersey, but only because of the strong government support. Is there anybody on this panel who thinks that distributed solar is where you would put your money were starting over today. Scott Taylor nods no.

MR. DAVIS: Our affiliate has done utility-scale solar. It is a challenging market for a private equity investor. There is another player at the table.

MR. MARTIN: Who is the other player at the table?

MR. TAYLOR: The tax equity.

MR. MARTIN: So too many moving pieces; government is a big part of it.

MR. TAYLOR: The returns are too low relative to private equity expectations.

MR. MARTIN: Then let’s move in a different direction. Tom Fanning, CEO of Southern Company, sees a silver lining in that demand for electricity will increase as the market moves to electric cars. Will the collapse in oil prices put an end to that dream?

MR. TAYLOR: I do not understand how electric cars were going to be the cure for demand growth, even before oil prices collapsed. Even if electric cars reached 20% of the US auto market, that would lead to only a 5% increase in demand. It is not a substantial enough number.

MR. MARTIN: Isn’t that a substantial number given how little electricity demand is increasing currently: about .9% a year?

MR. TAYLOR: Over time. What is total US generating capacity: about a million megawatts?

MR. MARTIN: A little over.

MR. TAYLOR: So that’s 50,000 megawatts. That is a big number, but it is not a game changer.

Utility Death Spiral?

MR. MARTIN: Next question. EEI, the trade association for the regulated utilities, put out a paper a couple years ago that used the words “death spiral.” The author saw the distributed generators picking off utility customers, not just any customers, but the most creditworthy customers. Then rates have to go up for the remaining customers to support the grid. Higher rates push more people to distributed generation. Do any of you worry about a decline in the creditworthiness of the electric utilities? After all, as independent generators, they are your customers.

MR. KERECMAN: At some point, the cost of reliability has to be assumed by somebody. You cannot put your solar panels on the roof and expect the utility still to be there if something goes wrong. The fundamental system has to come up with an answer.

MR. MARTIN: The regulators will have to step in; solar customers will have to pay more despite not using the grid as much? Nazar Massouh?

MR. MASSOUH: What we do not spend a lot of time talking about is that rooftop solar is a peak shaving tool, and that is pretty valuable to the utilities. Granted, the generation is intermittent and unpredictable, but I think the utilities tend to exaggerate the impact on them. If you look at the history of operation even in California, which probably has the highest penetration, utilities are getting used to distributed generation because rooftop solar is generally there most of the time and probably easier to predict than it is to predict wind generation. Look, utilities are not going away, and they definitely will have to continue to provide generation of last resort directly or by buying from independent generators.

MR. MARTIN: When utilities need more power, they may go to independent generators for power. The distributed generators sit on one side of the utilities picking off utility customers. The independent generators sit on the other side looking to supply those same customers through the utilities. The distributed generators are growing rapidly. Isn’t all the new load growth being filled by the distributed generators? Todd Carter.

MR. CARTER: We do not see that much growth in distributed generation. We pay attention to it of course, but we do not see it. But, listen, we are not in every market either. We like PJM, and we like ERCOT. We do not see as much distributed generation in those markets as what you just described.

MR. MARTIN: You will find additional market share out of the coal retirements or, if not, what else is creating opportunity?

MR. CARTER: I have never seen gas-fired power plants beat coal plants so significantly as I see now. The reality is we are putting some coal plants out of business. I am sorry for the coal guys. I think they have more issues than the bare economics, but that is part of life. You have to get more efficient in how you do things.

MR. MASSOUH: Let me put some numbers around what Todd just said. The reason we do not see the distributed generators is when we got involved with Sungevity several years ago, it was advertising it would double its installations from the year before. It was going to double installations from nine megawatts to 17 or 18 megawatts. To your point, displacing a 1,000- or 2,000-megawatt coal plant makes a difference. The growth rates for distributed generation are very high in percentage terms, but distributed generation is still having a very minor impact on the industry.

Other Oportunities

MR. MARTIN: If you were starting over today, would a good place to invest be conversions of coal-fired power plants to run on gas? The last time I checked, coal accounted for about 38% of US generating capacity. Retirements are expected to accelerate.

MR. KERECMAN: That may make some sense where the coal plants are close to the gas supply. Conversion does not require a huge investment. The coal plants probably also have a high heat rate. Of course, you have to de-rate the plant when you make the conversion, so it is probably more about a capacity play and then, from a capacity standpoint, like I said earlier, the rules are changing, so the converted plant needs to be pretty reliable. These coal plants are 40 to 50 years old. They were installed as base-load resources. They have not been operating as base-load resources, so they have been basically having to cycle. That makes them even more unreliable. It is an interesting question, but, from an efficiency standpoint, I wonder whether it is a great use of gas.

MR. MARTIN: Not much opportunity. Scott Taylor, agree?

MR. TAYLOR: I have a view, but it is probably self-serving, so I think I will pass.

MR. KERECMAN: It probably makes sense for some of the regulated utilities. The investment goes into rate base. It is fairly easy to switch, but the plants are on the margin and these plants are not made to operate as peakers, so the only value they really provide is reliability in a capacity play.

MR. MARTIN: A number of years ago there were several European utilities looking at a play in the US market at coal-fired power plants. Do you see any merit to such a play today?

MR. TAYLOR: No. It is good to swim against the current sometimes and pick the contrarian view, but that is one play that I would never think about tackling.

MR. KERECMAN: Are you asking about developing a coal plant?

MR. MARTIN: Just buying existing coal plants.

MR. KERECMAN: If you buy them very, very cheaply and have a very short horizon in terms of how long you can use them, then maybe.

MR. TAYLOR: I agree with that.

MR. MARTIN: Next question. Many people predicted, after the Public Utility Holding Company Act was repealed in 2005, that we would see a wave of utility consolidations. We have not seen much, but recently Exelon bought Constellation and is planning to buy Pepco. NextEra is buying Hawaiian Electric. Are we about to see more consolidations?

MR. MASSOUH: That is a tough one to predict.

MR. CARTER: Apologies to my utility friends, but I think utilities are a lot alike; they can be herds of sheep. If you start to see a few acquisitions, then a lot more may be on the way.

MR. MARTIN: Larry Eisenstat, this is your area of expertise. Are we about to see a wave of utility consolidations and, if so, why now and not earlier?

MR. EISENSTAT: I do not foresee a wave of utility consolidations. There are significant regulatory hurdles. For one thing, the local public utility commissions will try to extract whatever consideration they can.

MR. KERECMAN: Mergers are hard to do.

MR. MARTIN: Next topic: energy storage. Many people think energy storage will be a game changer, but no one has figured out how to make the economics work, at least as a standalone storage unit or by adding additional capital cost to an existing utility-scale renewable energy project. What do you think is the future for utility-scale storage and, if it is a bright future, what is the path forward?

MR. CARTER: Judging from the fact that a lot of people in the audience just headed for the exit when you mentioned that, it kind of gives you an idea what most people think about storage. [Laughter.] Listen, if it worked, we would love it. We have lots of wind in Texas that does not blow when you need it. It would be great if we could store the electricity. The technology is not yet competitive.

MR. MARTIN: Does anyone see a path forward for storage? Nazar Massouh?

MR. MASSOUH: Batteries and energy storage are probably where distributed generation was about 10 years ago, so maybe at some point, but not in our investment horizons.

Trends

MR. MARTIN: What are the most significant current trends in today’s market? Let’s start with Grant Davis and then move across the panel.

MR. DAVIS: The merchant generation model will probably dominate things for the next two to three years.

MR. MARTIN: Many of us are old enough to remember the last rush to do merchant power projects that ended badly around 2000 or 2001. Many of the bankers who financed the last wave of merchant plants are no longer working in the industry. Why is this a different merchant phase than we experienced before?

MR. CARTER: Today is completely different than the last round. For one thing, capital is not easy to come by. We have done $5 billion worth of projects, but not many banks were involved.

MR. MARTIN: Why is it a different marketplace?

MR. CARTER: We are in the midst of a transition in terms of market exit. The number of coal and nuclear power plant retirements is creating an opportunity to build highly-efficient new power plants that burn cheap natural gas.

MR. MARTIN: Grant Davis, why do you think the current rush to finance merchant power plants will end differently this time than it did before?

MR. DAVIS: I am not convinced that it does end differently, quite honestly.

Our industry has a tendency to overshoot, and we cannot necessarily rely on the capital markets to be our discipline. Just because someone will make money available to us does not necessarily mean we should build. I worry about repeating the same mistakes as in the past.

MR. CARTER: Grant, I am sorry, but I disagree with you. The only projects we are financing are ones where it is clear the debt can be repaid. We have sold power forward and expect capacity payments over time that make us feel pretty good about being able pay debt service. That is different than what happened the last time. Not many quasi-merchant plants are being built this time around.

MR. MASSOUH: I tend to agree. I think three things are very different than they were back in the late 1990s. First, there are a lot fewer developers and fewer capital providers. The independent power producers who drove the growth and the overbuild in the late 1990s are hardly building. What remains are private equity-backed developers who tend to be a lot more disciplined. Second, all these projects have a lot more equity in them. Third, hedging is being used to reduce risk. All of these projects are structured so that if you get the merchant-for-gas wrong, you are not immediately in default and turning the keys over.

MR. TAYLOR: The market is a lot more disciplined than before. I was around then, but I was not involved in any merchant projects, so I cannot do an actual comparison, but I do know have to satisfy three parties today — equity, debt and hedge providers — before a project can be financed. All three are sophisticated, well aware of what happened the last time and determined not to see the experience repeated. A lot of due diligence is done. A large cushion is built into the economics.

MR. MARTIN: Bob Simmons of Panda, do you want to add anything? You are on the front line raising money for some of these projects.

MR. SIMMONS: The industry had a “Field of Dreams” model before