Reading the market
Many market participants gather at the Infocast Projects & Money conference in New Orleans each January to get a read on what to expect in the year ahead. A group of investors and the CEO of one of the most successful independent power companies had a wide-ranging discussion about the state of the market and where they see opportunities. The panelists are Paul Segal, CEO of LS Power, Himanshu Saxena, CEO of the Starwood Energy Group, Bruce MacLennan, a partner in Global Infrastructure Partners, and Steve Petricone, a managing director at Fortress Investment Group. The moderator is Keith Martin with Norton Rose Fulbright in Washington.
MARTIN: Herb Magid from Ares said two years ago on this panel that the market feels like someone has taken what we knew and thrown it against a wall. That makes it both a challenging time and also a nervous time for investors. Paul Segal, two years on, has the picture become clearer?
SEGAL: I don’t think so. The industry is still in a state of rapid change. We continue to see outside ERCOT flat-to-falling demand for electricity. We have incredibly cheap gas. There is a real dedication toward renewables and moving to a cleaner power grid in the future, driven in many cases by state action. We can continue to expect basically zero-cost energy to flood the grid.
MARTIN: Zero cost, not so much nuclear at this point, which was supposed to be too cheap to meter. In this case what is cheap is solar and wind.
SEGAL: Solar and wind, and that forces firms like us to re-evaluate continuously where to go, not remain stagnant, not stick with one particular strategy.
MARTIN: So maybe the picture is a little clearer. Everything is moving toward renewables.
SEGAL: Broadly speaking that’s right.
MARTIN: Himanshu Saxena, clearer picture today or is it still as if what we knew has been thrown against a wall and bounced off in pieces?
SAXENA: I think that in the last five years, we had expected certain markets to break. California was one of those markets that we knew was going to break; we just didn’t know when that would happen. This year, you start to see capacity pricing in California at six times what it was last year. You could buy a CCGT in California for $70 a kilowatt two years ago and now it is worth multiples of that. The same thing is happening in Texas. For years, there was no price signal in Texas to build new capacity. Last year, summer pricing in Texas was $150 to $170 a megawatt hour.
So we see these markets are starting to break. California and Texas are examples. We see similar things in New York. There is a point in time where renewables become too large a share of the market, and failure to do a proper redesign of the market leads inevitably to markets breaking. So we think MISO will follow the same trajectory.
MARTIN: What does it mean for a market to break? What market design is needed?
SAXENA: Markets have to compensate dispatchable resources properly for the reliability and capacity value they provide. These resources cannot just be free insurance for the markets. If the markets do not pay for this insurance, these dispatchable assets will shut down, thereby hurting the reliability of supply.
MARTIN: What do you foresee for MISO?
SAXENA: Coal retirements will create reliability issues in MISO. There will be pockets of opportunity for new development. Renewables are the future, but that future is not in the next five years. That future may be in the next 15 years.
What happens between now and 2035 when renewables become the predominant mode of electricity generation in this country? I think there will be a lot of distress that will circle through the markets and will hit a lot of existing assets along the way. It will create reliability issues.
MARTIN: Why reliability if renewables, possibly with storage, are filling the gap?
SAXENA: California is a prime example. There are days when solar and wind are producing out of synch with peak demand, and storage is not quite there yet to solve the mismatch. Gas has been the fuel of transition. The shift to renewables is not going to happen overnight. It will happen over the next 10, 15 or 20 years. I think gas plants will remain valuable probably for another two to three decades.
MARTIN: Bruce MacLennan, you heard Robert Simmons from Marathon Capital say, on the panel immediately before ours, that the market is still awash in liquidity. Do you agree and, if so, what is the evidence?
MACLENNAN: I agree. You could pick almost any piece of the capital structure.
We own a large renewables development business called Clearway. The pricing we get on construction debt for both wind and solar projects is cheaper than ever for contracted projects that are not as straightforward as they used to be, so that is an example from the bank market.
More broadly, I think we are off to the fastest start in terms of new issue volume in the US high-yield market in history. In the first seven trading days, roughly $17 billion was priced. Maybe even more of a headline was the $12 billion done last week, of which $6 billion, or half the market, was E&P and oil services companies that had largely been out of the high-yield market for the last six months.
SAXENA: I think it depends on what kind of capital is being invested. There is a lot of debt, there is a lot of capital for green investments and there is just a lot of money flowing into solar and wind. But there is not much money flowing into thermal energy projects. Gas and coal are really largely out of favor. Renewables are deeply in favor.
You can also break down the market by revenue structure. If you have anything that looks contracted or has pretend contracts, there is too much money for those deals, but anything that looks merchant has a harder time raising money. Activity in merchant deals was very muted in 2019.
MARTIN: Paul Segal, you said two years ago that it was a good year to sit on the beach. The wall of capital had driven down returns to a level that it didn’t make sense for developers to develop new projects. In addition to spending time at the beach, you were going to buy 15- and 20-year old gas-fired power projects and spend time on regulated transmission lines. Has anything changed?
SEGAL: Can I back up for a second? I am going to disagree with Himanshu a little. I don’t think that things are breaking. I think that they are appropriate price responses to current market conditions. Markets are generally showing that they can work. The fact that we have a material move in a capacity market when capacity is in short supply is exactly what we would want and how a market should function.
I also think there may be an emerging liquidity issue with hedge-counterparties for combined-cycle power plants in PJM.
MARTIN: Not enough of them?
SEGAL: Correct. The interest in building new combined-cycle gas plants in PJM has been puzzling for several years. It was a good area in which to invest 10 years ago. It was probably still an okay idea five years ago. But developing new combined-cycle gas plants in PJM today — and frankly in most of the country — seems like a pretty bad idea and will likely cause destruction of equity capital. I think we are seeing it today. There was an announcement yesterday that some power plants that were just built in this last cycle were turned over to the mezzanine lenders or preferred equity.
I am perplexed about that. I was optimistic two years ago that there would be more deal flow in this space. But the last two years in the gas-fired world has felt a little like 2003 to 2005 when there was a gap between what folks like those of us sitting here would be interested in paying for one of those projects, and what sellers are willing to take.
MARTIN: The bid-ask spread is too wide today.
SEGAL: It has been too wide for the last couple years.
MARTIN: What do others see as opportunities this year? Steve Petricone?
PETRICONE: I agree with Himanshu that there is not a lot of available capital in certain sub-segments within the larger power sector. At Fortress, I sit on the credit side, which represents about 75% of our over $40 billion in assets under management.
But credit is a bit of a misnomer because we have the ability to invest across the capital structure and across sectors within the supply chain and energy.
Probably about half of our investments are in upstream oil and gas. We are also heavily invested in power. We are opportunistic investors. We look for places where there is a lack of capital. Current examples are merchant gas-fired generation and gathering and processing midstream or other sponsor-backed midstream.
We look at these as opportunities because of the disruption being caused by this secular trend from thermal to renewables. Some of that disruption is caused by fundamentals, but some of the disruption in capital supply is caused by an exodus by investors, disproportionate to the risk. We think the actual risk for some investment opportunities may be lower than the perceived risk during this transition. We think that is a really interesting spot.
MARTIN: This reminds me of a book by P.J. O’Rourke called Holidays In Hell. He went into Lebanon on vacation shortly after the outbreak of the Lebanese civil war. He was the only passenger in a boat going in while all the other boats were heading out to sea. You are going into sectors that you say people are fleeing, and that is why there is a shortage of capital. You are looking for a higher yield.
Bruce MacLennan, where do you see the greatest opportunity this year?
Opportunities in 2020
MACLENNAN: There has been a lot of discussion already on this panel about the opportunity or lack of opportunity in thermal power. We were more balanced between thermal and renewables in the past than we are today. In recent years, our focus in the power sector has been almost entirely on renewables.
We will continue to look for platform opportunities in the renewables space. I imagine we will pay more attention to storage. Storage is not yet ripe for a fund of our size, since we have to deploy capital on a large scale, but are paying more attention to the work that others are doing to start up development pipelines and to advance storage assets.
Our goal is to put capital to work, ideally in a platform that has a combination of existing operating assets that provide a foundation and a development pipeline that is meaningful in relation to that base. That type of opportunity offers the best balance of risk profile and return opportunity for us.
MARTIN: Grant Davis said a couple years ago on this panel that storage is like Bitcoin: you can’t go to a cocktail party without somebody asking about Bitcoin. You can’t go to a power industry conference without somebody asking about storage.
Let’s drill down into storage. The panelists on the panel immediately before ours suggested that storage is still a long way off. Bruce MacLennan, why is storage a good investment today? You can lose a lot of money being prescient.
MACLENNAN: I think it is a good area to investigate and then the investigation will reveal how good an investment it is at this point. My sense is that we are reaching a point with so much investment in renewables that the transmission system either needs major upgrades or other fixes like storage to handle congestion.
It is obvious in our renewables development business that interconnection is getting harder. At some point soon, a large portion of the solution to integrating renewables and intermittency is not going to be more high-voltage transmission lines and upgrades and substations, but putting much more meaningful quantities of storage on the system. So it seems time to investigate.
MARTIN: Himanshu Saxena, what are the opportunities this year?
SAXENA: We have been doing this for 14 years, and most of the work in the first 12 was on power. We did a lot of renewables and transmission during that period. We also bought four coal plants, so we have been looking at everything power-related. We saw 2019 as a year where there were not a lot of interesting things for us to do in the power sector. We looked at other opportunities. We did our first midstream deal at the end of last year and then, on December 30, we announced our first chemicals deal. We invested in a $1-billion plant in Texas to convert natural gas into ammonia.
It is a new year. We are stepping back looking at the broader picture. There is too much natural gas. The price of natural gas will remain low for the foreseeable future. Converting it into electrons when there are excess electrons in most markets is not so interesting at the moment. It feels very artificial to build new combined-cycle gas turbines in PJM. Nobody needs them.
So is there stuff we can do with the natural gas? Maybe it is converting gas into LNG or chemicals that can be put on a ship and transported globally. Some of those deals are far more interesting from risk-return standpoint than investing in another solar project with a 5% return or a storage project where you don’t know where your revenues are going to come from for the next 15 years because the markets are not ready for it yet. We are having to be far more creative than we were in the last 15 years.
MARTIN: Does anyone expect a recession this year or, if not this year, then next year?
SAXENA: I think it depends on the elections.
MARTIN: So if Bernie Sanders wins?
SAXENA: Gas prices would go up to $10. Fracking would be dead.
PETRICONE: At least fracking on some public lands. It could have an impact on crude, too.
SAXENA: Seventy percent of fracking today is on public land. We have seen studies that say $2 gas would go to $14 if you ban fracking on federal lands.
MARTIN: What happens then if your strategy is to take advantage of cheap gas, and you have this looming election? Why is it sensible to put all your chips on products that can be made from gas?
SAXENA: We don’t make macro bets that the gas prices are going up. We lock in our returns under contracts, so the residual value of the assets is exposed to a structural change, but as long the contracts are alive and you are appropriately structured with pass-through of costs, you are okay. These are 15-year contracts. In 15 years, we may have seen three new administrations.
MARTIN: What changes in your general approach if we get into a downturn in the business cycle?
SEGAL: Not much changes for us. I think we anticipate that there will be a down cycle at some point. A down cycle is frankly historically overdue. Liquidity at some point will flow out, and capital will become less available.
You have to be prepared for that. And you have to be prepared for and thinking about eventualities like what happens if we have an extreme-left Democratic president. We are in a world of political volatility at the federal level and at the state level in many states. You have to plan around what might happen in terms of resource extraction, permitting, new projects and things like carbon pricing.
MARTIN: Is it an opportunity to shift to renewables and out of fossil fuels?
SEGAL: We all have that opportunity now. It is just a question of how you decide to spend your time and capital. My sense is that we will eventually have some version of a carbon tax. More renewables will come into the market over time. Battery storage is not economic in most places today, but it is becoming economic in California, if it isn’t already, and much of the rest of the United States is moving slowly from a policy perspective to where California is.
SAXENA: There is an old adage among traders: “Don’t let the fundamentals get in the way of technicals.” We are looking at both today. Somebody offered us a coal plant in Texas for a dollar, so we are making decisions, not whether coal is going to be around for the next 30 years, but whether we can make a decent risk-adjusted return on such an investment in the next five years.
We are at a point today where making a decent risk-adjusted return on renewables is very hard. There is immense downward pressure on prices. There is too much capital. PPA prices are not strong enough. The numbers don’t pan out.
But you can make a decent return from thermal investments — both gas and coal — if you pick the right spots in the market. So we are not making macro bets on where the power industry is going in the next 30 years. We are looking at what happens in the next five years and how to extract value from that.
MARTIN: Probably the most interesting story from the previous panel and this one so far is how many of you are looking to invest in fossil fuels. At the same time, you fear it will be a bad bet if the Democrats, particularly Bernie Sanders, win the election. How do you square that?
SEGAL: My perspective is the following. We will need gas in some form to firm the grid for a long time. I think the question is, for how long and how much energy do we need gas- and coal-fired power plants to produce. We need much less energy from coal-fired power plants today than we did 10 years ago because we have more gas-fired power plants, and we have much lower gas prices.
Ten years from now, we will have a lot more renewables, and we will not need as much electricity from combined-cycle gas-fired power plants. What you might think about is how long we will need a combined-cycle power plant to act like a combined-cycle power plant instead of acting like a peaking power plant that will run 2% of the time and provide critical services that the grid will still need.
As we underwrite projects, we think about how quickly we can get our investment down to what we believe can be justified from a cash-flow perspective by operating as a fast-start peaker as compared to a combined-cycle power plant.
MARTIN: Two years ago Himanshu Saxena, you predicted that by 2023, prices would start to fall for renewables assets because people would already have enough of them in their portfolios and they would be moving on to the next shiny thing. Do you still feel that way?
SAXENA: Solar still has a long runway to benefit from investment tax credits. There is also a lot of offshore wind activity now that did not exist two years ago. If we look out five years, purely from an activity standpoint and ignoring returns, I think renewables will remain one of the busiest sectors, whether or not you make money on it.
The question for us is where to pick our spots, whether it is offshore wind, solar, solar + storage or you name it.
MARTIN: We talked a little about the elections. In which direction do you see the cost of capital moving this year?
MACLENNAN: It seems like the cost of capital has been moving down for the last several years. You wonder how much lower can it possibly go.
Take the spread on a construction loan for a renewable energy project, for example. After quite a long period of stickiness, there was a fairly decent move for projects with a better risk profile. For contracted projects, there has also been a pretty decent move down in tax equity flip yields.
My bet is the cost of capital remains flat to down slightly. Balance that against the potential impact of the election and a dramatic change in economic and energy policy that could push the cost of capital a lot higher 11 months from today. It is hard to handicap the risk.
PETRICONE: I agree. The secondary trading markets in some of the institutional loans have been pretty volatile in the last 18 months.
You had spike up in yields and a meltdown in value at the end of 2018. That was startling. That was followed by a kind of flat-line slow recovery. Then suddenly in November and December last year, increased pricing and lower yields in the secondary market, sustained across the project finance spectrum. It suggests a certain amount of volatility that you tend not to see in the primary deals.
MARTIN: It is uncertainty driven by how exposed this sector is to changes in public policy.
Mr. PETRICONE: To changes in commodity prices certainly. Unlike what we have been describing for renewables, a crisis of capital still exists in the upstream space. You have broken capital structures in upstream and that is having a bleed-through effect at least in the commodity-impacted power space.
SEGAL: I think a lot of this comes down to technicals. There is a view among institutional investors that many of them cannot or will not own fossil fuel assets. My sense is that, for the time being, upstream is definitely a fossil fuel asset and midstream may or may not be. Power generation that is not coal is still not a fossil fuel asset. And renewables obviously are not fossil fuel assets.
I think we will continue to have capital migrate toward and push down discount rates and drive investors to make aggressive assumptions around residual value and what will happen in the future. We may see capital costs increase for fossil fuel assets because they have a sort of ESG-taint to them.
MARTIN: Buz Barclay from Rimôn, question?
BARCLAY: Three of the four panelists are private equity investors rather than the institutional investors about which Paul Segal just spoke. You are still looking for yield in investment-grade assets. If you are stepping out of the renewables market as it sounds like you are, do you see other investors moving into it and can you identify who they are?
SAXENA: A: We are not stepping out of the market. B: We are not yield players. C: We are not looking at investment-grade style returns.
The way we look at the business is this. We are in the business of investing patient capital that sometimes takes years to invest. We are developing a transmission line right now in California, something we competed with Paul Segal on five years ago. That is triple-digit development capital, hundreds of millions of dollars to spend, that takes five years to develop. It is not for the faint of heart. It involves a lot of risk and a lot of work. That is the kind of capital that we are putting to work.
After that asset is built, it will become a prime asset for investors that are looking for a low-risk, stable, cash-yielding investment to buy. We are creating assets that we can sell to the wall of capital that we have been talking about.
Those are the kind of deals that we do. Finding those deals was never easy, and it is only getting harder because everybody is looking for similar kinds of deals. Everybody is moving up the risk chain. Folks that never did development are now doing development. Folks that never took commodity risks are now taking commodity risks. Even people who just did contracted deals are now still doing contracted deals, but they are paying enough that they are taking risk by relying largely on the residual value to get to the expected returns.
MARTIN: Is this any different than any other year? People chase the highest returns on a risk-adjusted basis.
SAXENA: It just feels like there is more competition now than I can remember in the last 12 years. Maybe I am just getting old.
MARTIN: We have another question. Name and affiliation?
MCCAIN. Shelley McCain from Shell. Buz Barclay asked this morning how many of us will make a living doing projects that are less than $50 million in capital cost. I counted two raised hands. Yet we are seeing double-digit growth in the distributed energy sector. What will it take to see a shift in investment strategy from utility-scale to distributed energy?
SEGAL: I think it depends to a large degree on policies at the state level. In places like New Jersey, virtually all of the solar investment to date is distributed. There have been virtually no utility-scale solar or wind projects.
Mr. PETRICONE: I think one change that would catalyze distributed generation investment is standardization of financing structures. We have invested in distributed solar in the past, but there is a lot of friction to it. These tend to be small projects. They are idiosyncratic. It takes a lot of time to make an investment.
MARTIN: You are talking about C&I solar, not residential rooftop, correct?
MARTIN: Paul Segal, you are invested in distributed energy. You bought EVgo, a company with electric vehicle charging stations that is essentially a retail supplier of electricity. Why did that make sense to move into that sector?
SEGAL: EVgo has its particular set of economics, but I think broadly speaking, when we look at the trends and objectives of many state governments, to make any real progress on de-carbonization, you have to look beyond the power sector. We have made incredible progress within the power sector. The transportation sector has not made much progress. Many regulators and policymakers recognize that and want to take steps to accelerate electric vehicle penetration. One of those steps is having places to charge. EVgo is a critical component of that infrastructure.
MARTIN: The rate of electrification in the US transportation sector is not terribly encouraging. There are only one million electric vehicles on the road in the United States. Half of them are in California. That is out of a national fleet of 200 million vehicles. Does anyone else see an opportunity to move into electric vehicles for his company? Steve Petricone, Bruce MacLennan, Himanshu Saxena, all three of you are investors.
MACLENNAN: We don’t yet, although I agree with everything that Paul said in terms of the direction of travel and the opportunity. It is more a matter at this point of scale where, again, we manage a very large fund. I sit here feeling some envy at the flexibility that Paul has to make more of a niche investment like EVgo. That is not something that would fit well within our portfolio in terms of the scale.
For us to get involved, there would have to be a larger scale and more definition of the business model. What does a revenue stream look like? Who ends up owning it? If the utilities end up owning most of the infrastructure, it will be much less interesting.
MARTIN: You sound like one of the investors on Shark Tank. “So I’m out.” Steve Petricone?
PETRICONE: We have not seen opportunities in EV infrastructure yet that are a good fit for us. Part of the problem is the returns are not high enough yet and the business models are not yet well enough defined.
MARTIN: But you seem to like things that are complicated. You did C&I solar. Here you can get in during the early days and help shape the business model.
PETRICONE: Our typical strategy is to take one of two potential routes into a market. One is to be a direct lender to someone like EVgo. Another is to look at the disruption that companies like EVgo are causing up the supply chain and to find another spot in that chain to invest. For example, focus on the disruption caused to internal combustion engine suppliers, bet on their rates of deterioration and potentially be a capital provider to healthier credits among them, as other investors flee.
SAXENA: We used to own a C&I solar company that we have now sold, and we have looked at an electric vehicle company, so we have a basis for comparison. There is a big difference. When you do a C&I solar deal, you know who your customer is. You can have a 15-year contract with the customer. You may not like their credit, but you know where the revenue will come from for the next 15 years.
The EV-charging industry is still figuring out how it will make money going forward. That is very different. There is not as much visibility into how this market will look in the next five to 10 years.
MARTIN: Two more questions. Congress, on December 20, reversed course and increased the tax credit for wind projects that start construction in 2020 compared to 2019. There was the huge slamming of the brakes, with wind developers trying to rescind or cancel arrangements they put in place in 2019 to start construction so that they can qualify for higher tax credits. What effect do you see the one-year extension for wind having on the market?
SEGAL: Incrementally more projects will be built. We are working on a large-scale project out west on which the contracted revenue is lower than we would like. A larger tax credit means the project is more likely to get done.
MARTIN: It helps offshore wind. Those projects got a later start than the rest of the industry and need more time to start construction. Does it drive more business to Texas where it is easier to build projects quickly?
MACLENNAN: I agree with Paul Segal that the effect is incremental. A lot depends on the facts and circumstances. LS Power has a project where the incremental economics will be helpful. Repowerings that are on the margin economically might also be helped where you have not quite gotten to the terms you needed in a restructured offtake contract. An extra 20% in tax credit value might be enough to tip the scale. However, overall, this is a relatively modest and short-dated extension of economics.
MARTIN: Last question. Steve Petricone, starting with you and then going across the panel, what lessons have you learned in a long career as an investor?
PETRICONE: The markets are usually pretty efficient, and if you are going to take a contrarian view, you had better have done a lot of work to justify it.
MACLENNAN: If we had something generic that we could have done better across the 14-year history of our firm, it would have been imagining broader ranges of outcomes. That is not only in a negative way. We have had investments where the outcome was far beyond the upper end of any sensitivity analyzed when we made the investment, and we have had a couple that have gone in the other direction. So try to imagine the unimaginable, but more realistically, broaden the range of things that you at least consider when making the investment decision.
MARTIN: Thomas Jefferson said the older he got, the more he realized he didn’t know. Himanshu Saxena?
SAXENA: What I have learned over the last 14 years is that there is a component of luck in our business. There are certain things that go right and there are certain things that go wrong, and despite all the due diligence up front, all the analysis and just thinking through every single piece of the risk, there are things that happen over which you have no control. There is inherent risk in our business and a lot of this risk cannot be controlled. Luck favors the prepared, but you still need luck.
MARTIN: Paul Segal, what have you learned as a developer?
SEGAL: I have learned that we live in a cyclical business, especially if you are willing to take the commodity risk component of what we do as electricity generators. It is a business that can stay irrational in both directions for longer than you might expect, both to the upside and the down.
The other thing I have learned is in the context of running a business. We are as good as the management and intellectual resources that are sitting around our table, and one of the things that we very actively seek to do is to disengage from things that can be management intensive with low potential upside.