Reading the current market
A panel of company CEOs and investors talked at the annual Infocast “projects & money” conference in New Orleans in January about where the opportunities and pitfalls are in the current market and what to expect in the year ahead. The panelists are Paul Segal, CEO of LS Power, Paul Gaynor, CEO of Longroad Energy, Himanshu Saxena, CEO of Starwood Energy Group, Herb Magid, head of Ares EIF, and Grant Davis, managing partner of Infra-Energy Capital Advisors. The moderator is Keith Martin with Norton Rose Fulbright in Washington.
MR. MARTIN: Herb Magid, and then each of you in turn, how would you characterize the current market?
MR. MAGID: It is almost as if someone took all of the pieces of the industry that we knew and threw them against the wall. They are falling together in different patterns. It makes for a very interesting time, but also I think a very nervous time for anyone involved in the business.
MR. DAVIS: It is a seller’s market, probably with the exception of greenfield merchant plants in PJM. The wall of capital that continues to chase operating projects is leading to distorted returns.
MR. MARTIN: It is distorting returns downward?
MR. DAVIS: Yes.
MR. GAYNOR: There is a lot of anxiety in the renewables business. The last 90 to 100 days have been spent watching tax reform and the base erosion and anti-abuse tax, or BEAT, and trying to figure out what they will do to the tax equity market. Now we are waiting for the solar tariff shoe to drop. So it has been a period of anxiety for developers, but there is a fair amount of permanent capital and debt capital seeking to invest at the same time in the sector.
MR. SEGAL: In the context of new projects, it is an incredibly difficult time. This has a lot to do with the oversupply of capital. People are so eager to find projects to finance or in which to invest that the returns are extraordinarily low, and financiers are going beyond discounting the known cash flows in their eagerness to find projects. The assumptions bidders are using are incredibly aggressive, and that makes it objectively a very difficult time. The low returns leave people like us frankly with very little to do in terms of new development activity.
MR. SAXENA: The deals we are seeing are moving up the curve in terms of risk. People are having to take more risk to make minimal returns. People who never used to be willing to take development risk are taking development risk today in order to find projects. People who never used to do merchant deals are doing merchant deals. People who said that they would never go into Mexico are now in Mexico. People who have never been to Chile are now in Chile. The oversupply of capital is leading to more risk taking in the market.
MR. MARTIN: Does anybody think that any type of capital is in scarce supply?
MR. GAYNOR: Early-stage development capital is not nearly as easy to find as later-stage equity or debt.
MR. MARTIN: Development capital has always been hard to find. Is it any harder to find today than in the past?
MR. GAYNOR: No. It is easier to find today, but remains relatively scarce given the larger wall of capital chasing deals. There is no wall of early-stage development capital. We just raised a bunch of development capital. We have a good track record of delivering on projects. It was bloody hard.
MR. MARTIN: Himanshu Saxena, how do you square what Paul Gaynor just said with your comment that financiers are having to take greater risk to deploy capital?
MR. SAXENA: It depends on the asset class. Finding development capital for a transmission project is nearly impossible. Any project that will take five to 10 years to build is very hard to fund in the development stage. There is more early-stage capital for solar projects that take six to 12 months to develop.
MR. MARTIN: Herb Magid, are you more willing today than you were in the past to fund development efforts?
MR. MAGID: We have always funded development, but I agree with Himanshu that it is difficult to put a lot of money out the door in development-stage projects, so of necessity, most of the capital gets invested at a later stage.
MR. MARTIN: Why are projects in such scarce supply?
MR. SAXENA: One reason is the difficulty finding long-term buyers for electricity. It still used to be possible five years ago to enter into long-term power purchase agreements from gas plants. We don’t see any buyers today for electricity from new gas-fired power plants. Consequently, there has been no recent new construction of gas projects other than in PJM with heat-rate call options. Even that activity has dwindled in the last 12 to 18 months.
Corporate buyers have taken up part of the slack, but the number of corporate PPAs is not huge. Most markets are oversupplied. New power plants are not needed in most parts of the United States. Some projects that are being built are built unnaturally in the sense that these markets do not need the additional electricity. Developers rely on retirement forecasts to create opportunity. That’s why projects are scarce. I suspect things may remain slow in 2018 for new-build gas activity.
MR. MARTIN: Where are there opportunities, if any, starting with Paul Segal?
MR. SEGAL: Adding first to what Himanshu said, the utilities invested a lot over the last 10 to 15 years in transmission and distribution, but very little in new generation. Now some of them think they are missing an opportunity. An increasing share of renewables projects are ending up in utility rate bases either because the utilities are building them or asking for build-own-transfer bids in place of signing more traditional power contracts. That is taking the opportunities away from the community in this room.
In terms of where we see opportunity, I think the opportunity this year is to spend a good amount of time on the beach for anyone thinking about new power plant development. We are spending our time in the secondary market, essentially buying projects or portfolios of projects that are 15 to 20 years old, often from private equity funds.
MR. MARTIN: What type of assets?
MR. SEGAL: Mostly gas fired.
MR. MARTIN: What discount rate must one use to win such bids?
MR. SEGAL: This becomes much more a question of assumptions than discount rates. We seek very high returns for those investments, but the assumptions we make in terms of what we will be able to do with the assets and what will happen in the market will drive the ultimate internal rate of return. It is less a matter of cost of capital and more what we can do with the individual assets over a short period of time.
We are also spending a lot of time on transmission development opportunities. This has proven to be a very difficult, but very rewarding game. Very few projects are being awarded in the competitive transmission sphere. We are hoping that the regulators see the benefits of competition and open up more opportunities to competitive bids. There is a genuine consumer benefit when projects are put out to bid for interesting new ideas and risk transfer.
MR. GAYNOR: We are spending most of our time on utility-scale wind and solar projects, especially solar in places like Texas, Colorado and southern PJM.
MR. MARTIN: You told me in an airport last fall that the competition for power contracts is “brutal.” Are these merchant projects?
MR. GAYNOR: The beauty of solar compared to wind is you do not have to put as many dollars out the door ahead of getting a PPA. That allows you to place a lot of different bets at the same time. Once we secure a PPA, then we can move into spending more significant development capital.
The other place we are spending time is on fixer uppers. They are either good assets that are in the wrong hands or assets that need to be restructured because, for example, the tax equity is under water. We have a pretty healthy effort underway on the repowering front. We take a wind project that has reached the end of the tax credit period, put on repower kits and capitalize the project.
MR. MARTIN: Grant Davis, name one opportunity that you would be pursuing if you were still at Tenaska.
MR. DAVIS: A key area of focus for the institutional investors I work with is selected M&A around gas-fired power plants and, outside of power, midstream storage.
MR. MARTIN: Herb Magid, one opportunity.
MR. MAGID: The window for development and construction of new gas plants is pretty well closed at the moment, but there are opportunities in the secondary market where we have been both a buyer and a seller. It is a very, very weak market for buying assets. The winner is the guy who can see an asset and not beat up on it much during diligence.
MR. MARTIN: Not see the risks that others might see.
MR. MAGID: The way to win is to take a view on a particular market or particular asset and go proactively to the owner and say, “We see some value here,” or participate in a way where you are taking some extra risk, but it is a risk you understand. It is a much more difficult market, but three are still plenty of opportunities if you are careful about assumptions.
MR. MARTIN: Himanshu Saxena, one opportunity.
MR. SAXENA: We build a lot of renewables. We buy gas. We build transmission. We expect in 2018 to do more renewable energy projects with corporate PPAs. We just signed a long-term PPA with General Motors for a wind farm we are building in Ohio. We get calls from corporations that are interested in buying renewable energy. Everything else seems fairly saturated.
Potential inflection points
MR. MARTIN: Let me throw out a series of questions without directing them to any one person. Where do you see potential inflection points in the next few years?
MR. GAYNOR: We have heard numbers as high as 50,000 megawatts of wind farms can be built between now and the end of 2020 and qualify for tax credits at the full rate using equipment stockpiled in 2016. One potential inflection point is what happens after 2020 and who is left holding the bag with all of this equipment to the extent it does not get fully deployed.
If production tax credits disappear for wind, what will power buyers do? Will they be willing after 2020 to start paying more for power? Will true equity and tax equity investors be willing to earn less to make the deals work? Will turbine vendors cut their prices enough to make the deals work? All of that will be pretty interesting.
MR. MARTIN: Does anyone see other potential inflection points?
MR. MAGID: I expect a pretty dramatic pullback in five years from investing in renewables. People who want renewables will have them in their portfolios by then. Others will have bid too much for them in the current market and realize that they made lousy investments. The same thing will happen that we are seeing today in PJM capacity. The pack will move to another flavor of the month. I do not see renewables remaining a frothy market in the long term. The sovereign wealth funds and pension funds will have something for their annual reports and then move to the next big thing.
MR. MARTIN: Paul Gaynor, that’s your livelihood.
MR. GAYNOR: He may be right. People said that about the wind industry in 2003. There are always winners and losers in each of these markets. When do you get in? When do you get out? What is your investment horizon? These are never easy questions to answer. To me, that sounds like a great opportunity for someone like us.
MR. SAXENA: The renewables market has been one where you can build an asset with a contract and sell it to a six-percent buyer. You can play that game all day long.
To my mind, the inflection point is a future shift in the debt market. There are a lot of large asset portfolios trading. We did a term loan B financing in early December that was 3.5 times overbid. There is so much liquidity in the debt markets. When it stops, the asset values will start to drop, and I think that is a serious risk.
MR. MARTIN: Congress enacted a $1.5 trillion tax cut at the end of the year. What effect do you expect this to have on your businesses?
MR. SAXENA: Not much for us because I think tax equity remains plentiful and tax equity yields continue to fall. We are seeing deals this year with better pricing than in December. As long as tax equity is alive and kicking, renewables will live. We are not seeing any effect in other parts of our business.
MR. DAVIS: The biggest hope for an impact would be an acceleration in economic growth. One of the big weaknesses in the power sector is lagging demand for electricity. It would help if the economy would grow faster.
MR. MARTIN: This is a market with a lot of strong cross currents. Many people believe storage is certain to replace gas peakers because it can perform the same task more cheaply. Do you share that view?
MR. GAYNOR: It depends on the part of the country. We built two large utility-scale batteries to support our wind farms in Hawaii. The batteries were very expensive, but they made sense in Hawaii. They make sense in California. They probably do not make sense in places like ERCOT.
MR. MARTIN: Why?
MR. GAYNOR: Because there is enough resiliency and the grid will not pay for the quick response. You do not need it unless you are way out at the end of a line or something like that. We are working on one deal where the utility is telling us it will do solar, but the solar has to come with storage. To Herb’s point, the utility’s position may be more philosophically-driven than technically driven.
MR. DAVIS: Storage is a little bit like bitcoin. You can’t go to a cocktail party without people asking what you think about bitcoin. You can’t go to a power conference without people asking what you think about storage. Everybody would like to be ahead of the curve as storage matures, but from an investment perspective, we are probably 10 years away from it becoming broadly economic and there will probably be a technology switch in the middle of that period.
MR. MARTIN: Gabriel Alonso, who was CEO of EDP Renewables North America, said that when PPAs are being signed to supply electricity at 1.6¢ to 1.8¢ a kilowatt hour, the ability to earn another penny a kilowatt hour by providing ancillary services from a storage facility starts to look attractive.
Where do you see current opportunities, if any, to add storage aside from Hawaii and California?
MR. MAGID: The industry is transforming so fast that it would not surprise me to see storage take hold more quickly than anyone expects today.
Society wants it. You go to battery storage conferences and see there are a lot of companies working on better batteries. It is just a matter of time before we start to see major breakthroughs. I think we will see it take hold first with distributed generation as a way of offering more reliable service.
MR. MARTIN: Does anyone see current opportunities for storage besides Hawaii and California?
MR. SAXENA: We made an investment in a battery storage developer in California who is installing batteries in places like Home Depot retail warehouses. This goes to Herb’s point that there is still a lot of opportunity in places like California to install batteries behind the meter.
MR. MARTIN: Paul Gaynor, when you reinvented yourself as Longroad Energy Partners, you shifted from all wind to about 30% wind and 70% solar. Why keep a foot in both camps? Why not go all solar?
MR. GAYNOR: I think you have to offer both technologies to succeed in the current market, depending on the part of the country. In PJM, there is demand from the corporate sector, mostly data centers, for 10-year PPAs. If you think about developing solar versus developing wind in PJM, wind is multiples harder on a degree of difficulty, so you have to have the ability to do solar in that case. In MISO and in parts of Texas, wind will be more competitive. It is just a matter of having a full toolbox.
MR. MARTIN: Paul Segal, LS Power has put substantial resources into transmission. How long does it take to finish such a project, and why move into a regulated business?
MR. SEGAL: Getting one of these projects awarded is difficult. The awards process can take a year to three years. What we like about the business is there is a high barrier to entry. The ISOs and utilities want to see a high level of competence and experience. Transmission is much harder than developing most forms of generation opportunities. When we get awarded a long duration rate-regulated rate of return, that is obviously a highly financeable, very durable stream of cash flow.
MR. MARTIN: Herb Magid, you put a lot of effort into transmission over many years. What lessons did you take away from the experience?
MR. MAGID: They are great assets once you get them. The issues are how long they take to develop and how much money you want to put into them. They are riskier than power plants. You are developing something that runs hundreds of miles and will face unrelenting environmental opposition.
MR. MARTIN: So the lesson is you have to be patient, it is better to put your money elsewhere or what?
MR. MAGID: The lesson is that you really have to go in with someone who has done it before. It is easy to underestimate how hard it is.
MR. MARTIN: Himanshu Saxena, Starwood appears to have focused in the last two years on wind and gas-fired generation. Will that remain your focus in 2018?
MR. SAXENA: Wind, gas and transmission will remain our three areas of focus in 2018. We made our first coal investment recently, so we are starting to look as well at assets that are currently out of fashion.
MR. MARTIN: The US added 25,000 megawatts of new generating capacity last year. It is hard, as Paul Gaynor said, to find utilities willing to sign long-term PPAs. Corporate PPAs are substituting for them, but only around 2,850 megawatts of corporate PPAs were signed last year. Paul Segal, how does the independent power business thrive in such a market?
MR. SEGAL: Our market has evolved as capital has become more freely available. I imagine the vast majority of new capacity additions were gas-fired generation that is being built on short-duration price signals. Short-duration capacity clears and has probably inflated energy margins in places on the grid where gas is constrained. Investors are making assumptions that these conditions will persist at the same time that significant investment is being made to relieve gas constraints.
I think a more realistic point of view will emerge as to the likely profitability of new investment in truly merchant power projects. We all need to adjust to the idea that there is less to do in an environment where demand growth, except for perhaps around the Gulf Coast, is muted or even non-existent.
MR. MARTIN: How hard is it to arrange a hedge today in places like ERCOT, PJM or ISO-New England?
MR SAXENA: It is very easy, but you may not like the price.
MR. GAYNOR: It is easy on one level, but it is expensive from a developer’s point of view. It takes a lot of time to get there, and usually you have to commit big dollars before what a developer would consider a comfortable commitment point. Most hedge providers have limited bandwidth. They often staple the hedge to a tax equity investment.
MR. MARTIN: They will not provide the hedge without also acting as the tax equity.
MR. GAYNOR: There are many of those institutions that will not do one without the other. It is hard to run a true competition in such a market. That is where Himanshu is right. You might not like the price ultimately on offer. It is a white-knuckle ride where you are praying that gas prices stay at a certain level the day that you are ready to close.
MR. MARTIN: Do you expect to see a hedge this year on a utility-scale solar project, and why have we not seen one so far?
MR. GAYNOR: Yes, you will see one.
MR. MARTIN: Why have we not seen one so far?
MR. GAYNOR: I don’t know. My sense is that most people are waiting for the Suniva tariff decision.
MR. MARTIN: What hard-won lessons have any of you learned from your exposure to quasi-merchant or hedged projects?
MR. SAXENA: Location really matters. In certain parts of the Texas panhandle, for example, you are seeing basis risk of $10, $12 or $14 a megawatt hour, and those projects are getting destroyed.
MR. MARTIN: The basis risk of $12 to $14 a megawatt hour is the exposure to the generator?
MR. SAXENA: Correct. The spread is very wide, and it is killing the projects. If you are making $20 on the hedge and you have a $14 negative basis, your take-home money is $6, and that is not enough to cover your costs in most cases.
MR. MARTIN: John Eber from J.P.Morgan argued on a cost-of-capital call last week that the market is underestimating the basis risk in projects with hedges or virtual power contracts. Basis risk is the difference in pricing between the hub and the bus bar for the project to which the generator is exposed under most contracts. How big a risk is this in your minds, and how are people covering it?
MR. GAYNOR: It is among the top three risk items that we look at before we pursue or spend any significant development dollars. It is at the top of the list.
MR. MARTIN: What are your other two?
MR. GAYNOR: The quality of the solar or wind resource and land. How hard will it be to get land control? For example, does someone else own subsurface mineral rights?
MR. MARTIN: I have two more questions before turning it over to the audience. Paul Segal said the competition for assets does not turn on who has the cheapest cost of capital, but rather on who is willing to make the most aggressive assumptions. Do the rest of you agree?
MR. SAXENA: Yes. If you are bidding on a gas-fired power plant in PJM and you have a consultant curve that shows $350 a megawatt day in 15 years and you believe that curve, your cost of capital can be 30% and you will still win the auction. On the other hand, you could say the market flattens out at $100 and your cost of capital could be 8% and you will not win. The cost of capital alone is a meaningless number.
MR. MAGID: It is also the quality of the bidder. There are lots of people that throw in bids from one auction to the next to have an oar in the water, but without being serious bidders. The auction process is breaking down. There are more opportunities today for a buyer and seller to get together directly.
MR. MARTIN: Who has the cheapest cost of capital in the current market?
MR. DAVIS: Asian investors and some of the infrastructure funds.
MR. MARTIN: Let’s leave room for a few audience questions. Buz Barclay from Rimon.
MR. BARCLAY: It is a tough market. Are you seeing equipment vendors stepping up to help with pricing?
MR. SAXENA: We are seeing a lot of constructive financing from large OEMs. One of them is putting its profit from the turbine sale back into the project as preferred equity. This particular vendor has done this consistently in the last 10 deals it has done. The turbine suppliers are eager to find creative ways to make your projects work. They cannot sell their turbines fast enough.
MR. EISENSTAT: Larry Eisenstat from Crowell & Moring. This is a question for Paul Segal. Do you see storage as a means to defer or possibly avoid having to build transmission?
MR. SEGAL: Every situation obviously is specific, but we are seeing a number of situations across the country where storage is being considered as an alternative to transmission investment that may have been triggered by other asset retirements and reliability concerns. I think it will be a tool in the tool kit for transmission owners and potentially independent developers playing on the transmission side.
The key to maintaining functional markets is to ensure the asset is used in a way that does not interfere materially with truly competitive markets to the extent the asset sits within competitive markets. We are going to see utilities, as they have with wind and solar, look at storage as an opportunity to deploy capital.
MS. BARROW: Deanne Barrow with Norton Rose Fulbright. Paul Segal, you said that when buying assets, it is not about discount rates, it is about assumptions. So my question is, for utility-scale solar, to what extent are valuations being driven by extending the life of the asset, and what are you seeing as typical assumed lives?
MR. SEGAL: We developed several solar projects in the late 2000s and financed them early in this decade. Those were projects that had significant profitability, and there was really no discussion about value beyond the PPA life. That is where we started.
Several years later, there was still an opportunity to get a low- to mid-single digit return during the PPA life relying on actual expected operations versus what might be on a piece of paper.
Lately, we have seen very little opportunity to do more than recover our investment during the life of the PPA, and all of our return on investment, return on equity, would need to come from assumptions that we would make, or that an investor would need to make, for the period after the PPA.
That has not been a very attractive opportunity from our perspective. Nevertheless, we are seeing an enormous number of projects, maybe fewer than have been happening over the last few years, continue to get financed.
MR. MARTIN: Two final questions. The Financial Times reported in December about two companies that added blockchain to their names. One was a Long Island Iced Tea, a soft drink maker, that added blockchain to its name and saw its share price shoot up 500% in one day. Rich Cigars saw a 2,000% increase in one day after refocusing its business model on blockchain.
There have been some multimillion dollar initial coin offerings where virtual platforms for electricity sell tokens that are a cost of entry, like a subway token to come onto the platform, to buy electricity. Does this suggest that there might be another possible outlet in the not-too-distant future for some of the power from your projects?
MR. SAXENA: I have seen reports that cryptocurrency mining would take more energy than electric vehicles in the future.
MR. MARTIN: Not just that, but GTM reported that China, which does most of the bitcoin mining, will use as much electricity by 2020 as the entire globe does currently.
MR. SAXENA: A hedge fund that is the largest shareholder in Atlantic Power is urging the company to use its surplus electricity for bitcoin mining. The response by the company is the same response that I would have given, which is this is very, very new. You do not know what the credit would be on the other side. If bitcoin mining turns out to be a viable buyer base, then by all means. It is the same thing as selling electricity to data centers. The market is evolving. Will independent generators be selling electricity directly to cryptocurrency miners in the next five years? I just don’t know.
MR. GAYNOR: Cryptocurrency mining is still a little too opaque to generators like me. It still sounds like a really long putt to be able to persuade lenders and tax equity investors of the stability of the potential revenue stream. I am not sure why a generator would spend a lot of time on it until some of these fundamental issues are sorted out.
MR. SEGAL: Usually when something does not make a lot of sense, it does not work, and I would throw this one into that category. I wish them luck. When you look at the economic cost of providing all of this energy to this outlet, is there an offsetting or commensurate economic gain? I don’t see it.
MR. MARTIN: Last question. Does any of you see any other potentially disruptive business models or technologies currently in the market or on the horizon?
MR. SEGAL: We are surrounded by them: batteries, distributed generation, micro-grids, LEDs, community solar, energy efficiency. This is part of why we are here talking about an unclear path forward for our industry. We are surrounded by disruptive technology and disruptive events. That is the challenge and potentially also the opportunity. ¥