Power squeeze: the bubble bursts

The current economic crisis has forced power companies to rethink their investment plans for the near-term. Chris Webb looks at the implications for security and diversity of electricity supply, their effects on the carbon reduction agenda and the ability of companies to raise finance.

Chris Webb

Last December came the news some energy commentators had been expecting for a while: Eskom, the South African state-owned power utility was to scrap plans for the country’s second nuclear plant on cost grounds. The R100 billion ($10.5 billion) project would have been the largest single investment in the parastatal’s history.

The project, known as Nuclear-1, was a high-profile casualty of the global economic meltdown that has forced industry bosses to revisit their investment plans. Crucially, the crisis comes at a time when governments across the world have set the scene for a new generation of nuclear plants along with exacting targets for carbon reductions and greater use of renewables.

Figure 1: Newly installed power capacity in Europe 2000à‚—2007. Source: Frost & Sullivan
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Now developers fear those ambitions could be stalled, not through any ordinary demand-supply market conditions, but as a result of a stifling shortage of credit. Eskom is a case in point; downgrading of the company’s credit rating had increased the cost of borrowing, making it difficult for the utility to afford an investment of such magnitude.

Portia Molefe, director general at the South African Department of Public Enterprises, tried to put on a brave face, saying the company remained committed to a nuclear power programme in its bid to ease chronic power shortages and diversify the country’s energy sources. “We have to deal with our carbon footprint and we have to diversify our energy mix.” Eskom currently depends on coal for more than 80 per cent of its power generation capacity.

Yet the bad news for South Africa must be put in its true depressing context, coming as it does at the start of a $34 billion five-year investment plan, and it casts a long shadow over future plans. It is also indicative of a problem that is spreading across the globe as financial markets rein in lending and more exotic instruments are dumped.

Jonathan Robinson is a consultant at Frost & Sullivan’s energy and environment practice. He is concerned about slowing investment in Europe. “The expectation is that orders will fall this year and will be very weak in 2010,” he said.

“The effects of the economic crisis will vary from country to country, but we’re seeing even well-capitalized utilities looking to make savings. There isn’t the urgency in the industry that there was, say, a year ago. Electricity prices have dropped [as has] domestic requirement.” The credit crunch is particularly affecting IPPs [independent power producers] and smaller utilities, he says. “Lenders are a lot more risk averse; there is concern about high fuel costs, which in turn is affecting equipment costs. It’s a bit like buying a house at the top of the market.”


But that does not mean to say that new power plants will not be built, says Robinson. “When I talk to utilities they’re conscious of the need to replace ageing plants; and while there is a financial crisis, many schemes were already bogged down by planning difficulties anyway. There are good and bad patches if you look around Europe.

“Germany is looking to replace its nuclear plants and its elections later in the year could spur development. Elsewhere, Eastern European newcomers to the European Union (EU) will benefit from not having to bid for their full allocation of carbon permits; they’ll get 80 per cent of them free from 2013à‚—2020.”

The Large Combustion Plant Directive had already brought pressure to bear on power companies to plan ahead as old and polluting plants are forced to close. So it is just as well for some of the more fortunate à‚— or forward-looking à‚— utilities, that they have secured finance for most of their plans through the traditional route of bond issues. “Vattenfall’s recent bond issue was oversubscribed,” says Robinson, “while E.ON, GDF-Suez and EDF all look stable in that respect.”


But the sense of nervousness in the industry is palpable and a far cry from just a short time ago. After years of low investment, principally because of negotiations within the EU over emissions limits and plant closure dates, a broad consensus had been reached on Europe’s urgent need for new power plants; governments were keen to see them constructed and utilities were prepared to get on and start building them. The rot set in with a surge in raw material costs, fuel price volatility and the slow pace of power plant approvals followed à‚— only to be superseded again by a financial system under siege slowing the market to a crawl.


“The drop in electricity demand and prices, which has been caused by the slowdown, is hurting sentiment in the market, but the longer-term impact is far less severe. Investment to replace ageing plants is simply unavoidable and lower demand for equipment in the short-term will simply result in another boom cycle in a few years time,” says Robinson.

And there are indications that, although bowed, the mergers and acquisitions (M&A) market is far from broken. One European example is that of Welsh Power, which has disposed of its Severn Power gas fired power station development asset and its Carron Engineering & Construction (CEC) engineering business, in a transaction concluded last month with Danish energy company, DONG Energy.

The climate of financial gloom, however, seems to have done little to dampen M&A activity thus far, however. According to PricewaterhouseCoopers (PwC), despite the credit crunch, the number of electricity and gas deals soared to a record 954 in 2008, up 24 per cent from 768 in 2007, itself a record. While the number of deals soared, the value of deals plummeted as companies faced the new reality of the financial crisis and, in key markets, adopted a ‘wait and see’ approach to big acquisitions.

Manfred Wiegand, global utilities leader, commented: “The billion dollar question on the outlook for deal-making is, of course, how long we will have to wait for liquidity to return to the debt markets. Also of importance will be the speed at which climate change policy is clarified in the first year of the Obama presidency, and in the run-up to the December 2009 UN Climate Summit in Copenhagen.”

Mark Hughes, PwC’s utilities market and value advisory consultant, says the coming year will be one of obstacles and opportunities. “The constrained availability of finance will inhibit deal activity and, until that situation is eased, there is unlikely to be a revival in deal values. But with some businesses running short of cash for needed expansion or facing refinancing challenges, businesses and assets may become available for corporates with strong balance sheets and cash flows.”


Another Frost & Sullivan energy industry manager, Cornelis van der Waal, says the severity of the current financial crisis has caught investors, governments and key industry players off-guard. And, he notes, according to some of the world’s leading economists, stability will most likely only return to the global economy within 24 to 36 months. The intervening period spells many difficulties for the energy industry.

Van der Waal said: “The power sector has typically been an industry where long term projects are the order of the day. The construction of a power plant can take up to ten years and the life expectancy of such a power plant can be anything from 20 to 50 years.

Figure 2: All electricity and gas deals by value 2000à‚—2008. Source: PricewaterhouseCoopers
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“The same holds true for the renewable energy industry, where equipment is designed to last for many years, and hence project income is also designed to cover project expenses over a long period. The impact of the financial crisis will therefore probably not have a massive influence on projects already in operation, but will have an influence on new projects.”

Evidence of this is already starting to be felt by equipment suppliers. Recent analysis by Frost & Sullivan shows that wind turbine equipment producers in Europe are predicting a slowdown in the double-digit growth experienced in the industry since the turn of the century. But in his report, van der Waal says although the impact will be negative for equipment suppliers, there may yet be some positives for end-users.


The renewable energy equipment market is changing from a suppliers’ market to buyers’ market. This means that end-users will have more choice when deciding on their suppliers, as competition will increase as less equipment is sold. This in turn will force equipment suppliers to decrease their prices in order to become more competitive, while increasing their after-sales service and support to improve their brand names. These strategies will be essential to maintain their market share in difficult conditions.

However, it is not only turbine suppliers that will see a decrease in demand. Other renewable energy equipment will also be affected as projects are delayed due to difficulties in raising finance. Some projects will even be cancelled altogether.

Frost & Sullivan cites one example of a significant project that has already been put on hold; it is the 750 MW Kufue Gorge Lower hydropower station in Zambia that was set to begin construction in 2009. It is expected that some of the 15 firms interested in investing in this project will pull out amid the financial crisis. The aim of the project was to supply energy to the copper mining industry in Zambia, which is currently experiencing reduced production capacity due to the rationing of power by the state power utility Zesco. It is not clear if and when this project will continue.

In the US, the renewable energy industry has developed around large companies that benefit from tax advantages purchased upfront, as well as accelerated depreciation allowances. However, the current recession reduces most companies’ ability to purchase these certificates. It is anticipated that, with many investors now absent or unable to provide funding, there will be an acute slowdown in renewable energy projects.

Financial giants such as Bear Stearns, Lehman Brothers and Citigroup were once major renewable energy investors. With those players either extinct or dealing with massive losses, it is unlikely that they will be able to invest significantly in new projects. In addition, says Frost & Sullivan, the core group of about ten to 15 players in the tax-equity finance world has been cut in half due to the financial crisis, and the few remaining players are looking for increasingly higher rates of return. What was once an average 6 per cent return on investment, has now risen as high as 10à‚—13 per cent. This raises the costs to developers looking for a financial partner.

In regions such as Africa, where rural electrification projects have shown particular potential for renewables à‚— especially solar power à‚— investment is expected to see a significant downturn. These projects are typically financed through development aid, but it is expected that this form of finance will also decrease, as philanthropic organizations face serious financial restraints as a result of hardship in their local economies.


Back in Europe, where traditionally many of those ‘philanthropic’ organizations are based, home-grown utilities are coming to terms with the scale of the economic downturn. “It’s interesting to see how utilities are reacting to the crisis, and it would appear to depend on how much debt they’re sitting on and how integrated they are,” explains Andy Cox, an energy partner at KPMG.

“There will be tens of billions of pounds [Sterling] of debt refinancing in the current year across Europe. European companies have also got tens of billions of pounds worth of Capex commitments.” Consequently, says Cox, many companies are looking for disposal opportunities to raise cash. “Asset disposal programmes are cutting back their Capex spend as companies are looking at what returns they can get on their portfolio.”

“There’s been a lot of M&A activity in recent years funded by debt and this is having a bearing on companies’ credit ratings. A company with previously an ‘AAA’ rating may now find itself ‘AA’ or lower, depending on how much debt they’re sitting on,” explains Cox. “The maturity profile of this debt will determine who will invest, or not. But the appetite for clever or exotic financial instruments isn’t there anymore, for obvious reasons arising from recent events. Conversely, there’s a lot of activity in equity markets as companies go back to their shareholders for more investment.”

Last year, the rating agency Fitch said a combination of reasonable levels of balance sheet leverage and perceived defensive sector qualities, relative to other sectors, should ensure better access to public bond markets in the first half of 2009 for the utilities sector, and mitigate any build-up of refinancing risk.


A report published as the full blast of the recession in Europe took hold, said the capital-intensive utilities sector, already heavily dependent on bond markets to meet its funding needs, faced a similar reliance on bonds in 2009/2010, with an estimated €51 billion ($66 billion) due for refinancing in the period for the major European incumbent operators. Not all 2008 maturities were refinanced on the bond markets, and therefore revolving credit facilities (RCF) and back-up bank facilities were utilized. Consequently, there remained an additional potential refinancing hangover from 2008.

Despite the ongoing impact of the global financial crisis, Fitch says the European utilities sector remain attractive for investors looking to return to highly-rated corporate bond yields. It said underlying sector dynamics supported this view, with a combination of strong cash flow generation, relatively low average leverage and some defensive recession proof qualities such as less exposure to cyclical revenues. Incumbent energy and utility entities were typically rated from the ‘A+/AA’- range to the mid-‘BBB’ rating category, it said.

Murray Hartley of Arthur D. Little fears the downturn will be prolonged and will affect many future projects. “The general feeling is that there will be a slow down over the next few years before it picks back up in 2012 or so. This is reflecting the fact that there is a certain minimum level of investment required in the sector as we’re at a stage where a lot of ageing or environmentally outdated equipment will need to be replaced anyway à‚— so plant is needed to replace closed capacity.

“The major players are still spending to keep the status quo, but aren’t planning any more projects to meet underlying demand growth. In addition, players will also be seeing some effect from a fall in steel prices, turbine prices, etc., as demand has contracted for these, meaning the already planned projects remain viable.”

“The message from gas turbine manufacturers is that they are not currently getting any more new orders, but nor are they getting any cancellations so far, but as they had such a backlog they are still looking very healthy for the next few years anyway. The people who are getting hit are some of the renewable developers. With the tightening of money, some of the more marginal projects are the ones that are being hit à‚— and these tend to be from the independent developers.”


The message is clear: the pain associated with investing in new generation capacity is less evident for some forms of generation than for others. A look at the main drivers for the gas turbine industry reveals that most of these are not significantly affected by the slowdown. Indeed, industry observers believe that combined-cycle gas turbine (CCGT) plants will remain the technology of choice for new power stations à‚— as they are more efficient and cleaner than alternative modes of generation such as coal fired power stations. They are also much quicker to build than other options such as coal and nuclear.

In the current market environment, high upfront investment costs are deterring investors and this will affect investments in large coal fired power stations much more than gas based generating options. This is because coal fired power plants, in particular those operating on supercritical or ultra-supercritical technology à‚— now the vast majority of all new coal fired plants in development à‚— require significantly greater capital costs per MW than those for CCGT power plants.

In addition, coal fired plants tend to be much larger than CCGT plants, with a typical new coal based power station being in the range of 1000à‚—1600 MW, hence requiring very large amounts of finance at the outset, something that has obviously become more difficult to obtain for certain developers and also has become significantly more expensive. Gas turbines, with their lower upfront costs, are expected to benefit from this.

The experience of Siemens would appear to back up this trend. Siemens’ Alfons Benzinger says the first quarter of 2009 remained strong. “Compared to the prior-year figure for the same period we posted a 24 per cent increase in revenue to €6.2 billion. We have a significant order backlog, which is sufficient for approximately two years. In Q1 2009, too, new orders exceeded revenue, i.e. our order backlog increased.”

Overall the industry’s formerly ambitious plans for expansion look shaky. In its 2007 World Energy Outlook, the International Energy Agency (IEA) forecast a 26 per cent growth in world energy usage from 2005 to 2015; that was reduced in its 2008 review to an annual growth rate of 1.6 per cent due to the impact of the economic slowdown, which is bound to decrease power demand. Yet, despite a short-term slip in demand, in the medium- and long-term the world energy demand is forecast to grow by 45 per cent by 2030. Although 10 per cent lower than the 2007 estimate, this still represents a tremendous growth opportunity, says the IEA.

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