Not very long ago, a new “hot” energy investment market magically appeared virtually every other month offering global companies the promise of incredible returns and almost unlimited opportunity.
Jonathan W. Gottlieb explains.
You will not find the United States on a list of developing countries, and until recently, it was not even on most companies’ list of global investment opportunities. All that has now changed. Utility investors and power developers all over the world are recognizing that the USA may in fact be the biggest and best power market opportunity in the world for new investment.
In recent years, demand for new generating capacity in the USA was slow, regulators controlled companies’ investment choices, and the perceived potential for the highest returns was in the developing world. But with regulatory restructuring and market uncertainty combining with a merging pool of existing players and new market entrants, the US power generation market is up for grabs.
Foreign entrants such as PowerGen, Tractebel, Marubeni, Scottish Power, National Grid, British Energy and Tokyo Electric are stepping in in an effort to seize market share.
The US market is huge, by some measures the largest in the world. Total consolidated assets of all investor-owned electric systems are approximately $572 billion. Invest-
or-owned gas and electric systems combined have assets of more than $710 billion. Investor-owned electric systems operating revenue totals more than $170 billion, while combined revenues top $235 billion. For the last several quarters, however, the increase in investor owned utility (IOU) revenues has been mainly due to the accretive nature of recent foreign investment.
A recent study by Bechtel shows North America as the second largest market in the world for new generating capacity, with 200 GW required between 1998-2007. According to the Department of Energy’s Energy Information Administration, the USA will require 302 GW of additional electric generating capability, or roughly 40 per cent of current utility nameplate capacity by 2015. An additional 35 per cent of current capacity will require repowering or rehabilitation.
Many of the country’s nuclear plants, which currently supply 20 per cent of electricity in the USA, will be close to the end of their useful lives by 2015 or prematurely shut down. Some say this process has already begun with Connecticut Yankee, Millstone and Zion.
These facts are not new, nor are they hidden. Can it be that those companies who are not able to properly interpret these facts so as to see the tremendous opportunity in the US market, are trapped by the fear and uncertainty created by a rapidly changing business environment? Or are they trapped by views of industry naysayers who are unwilling or unable to recognize the true strength and future potential of the market?
Deregulation is redefining and redeploying the US generation market. Announced utility divestitures exceeds 80 000 MW, with 60 000 MW already sold, including 2000-4000 MW of nuclear capacity. Some 28 000 MW was sold in 1998 alone. Almost ten per cent of generating capacity has been offered for sale, and over six per cent has been sold. These asset sales present a unique opportunity for utility investors, but are just the beginning.
It has been estimated that utilities in the US will sell-off 70 000 – 140 000 MW of existing generation over the next ten years. These assets will not necessarily stop running, but their ownership will change, along with their role in the market.
How big an opportunity?
But how big is this opportunity? To answer this question, one needs to look at the existing generation market segmentation. While Southern Company is the largest generating utility in the USA, it controls only four per cent of the national market share for generation. This figure clearly demonstrates that the market is hugely fragmented.
Such a marketplace offers a great opportunity for companies to consolidate market share. On Wall Street this is known as a ‘roll-up’. Roll-ups have occurred in other heavily segmented industries in the USA such as office products, automobile dealerships, pharmacies, and waste disposal companies. It is very possible that the generating market will undergo a similar roll-up consolidation as companies seek to control greater market share.
‘Roll-up’ in the US generation industry is likely to take two forms. The first is the on-going consolidation of the IPP industry. While there are about 230 IPPs in the USA, that number has been declining, and about 30 IPP companies exited the business in 1996. This consolidation is largely being driven by the disappearance of the long term power purchase agreement and its use as a tool to obtain leveraged project financing.
Companies will no longer be able to rely on the credit worthiness of their purchaser to obtain financing. Instead, lenders will look to the credit worthiness of the borrower and the competitive position of individual generating plants when making the decision to lend money. Borrowers will be asked to provide more equity and corporate guarantees before securing financing. The companies that will survive and prosper in the future competitive market, are those that are able to access large pools of low cost capital, i.e, utilities and their subsidiaries.
The second roll-up opportunity is well under way: the restructuring of existing utilities, both public and private, and the disaggregation of existing assets. With such a hugely fragmented business, aggressive companies are looking at forcing consolidation through mergers and acquisitions as well as the direct purchase of assets.
Other players, including some who have successfully deployed a roll-up strategy in non-utility industries, are talking of assembling investment funds to acquire US utilities and break them up, thereby capturing higher value from selling the parts, rather than retaining the whole business. Large horizontally integrated companies will be formed focusing on generation, distribution or transmission. Only the generation business will retain elements of vertical integration with a focus on fuels, marketing, and related services.
The notion that there may be only 10-20 large generating companies is a very real one and supports the roll-up concept. Proof of this trend can be found in the Electric Light & Power annual survey of investor-owned utilities where 1999 marked the first year that there were fewer than 100 investor-owned utilities in the USA.
Market competition has also created limitations in the opportunity for intra-service territory utility growth. The movement toward retail competition means that companies which once owned all the customers in their service territory, must now fight to keep those customers from being tempted away by new market entrants such as power marketers, other utilities or self-generators.
The constraint on traditional electric utility growth rates is a result of regulatory and industry structural changes that have occurred over the past 20 years promoting growth in opportunities outside the franchised service area of the utility. While these changes have traditionally been viewed as a disadvantage to electric utilities resulting in an erosion of customer base, new risk profiles, and an excess of power supply; they also offer an opportunity for future growth if the utility is willing to be aggressive in the new competitive market.
A variety of factors like increased competition, technological advances, and consumer demand for more choice are allowing for the development of new generation based products and services. These are new opportunities for a foresighted
Many utilities have already staked their claim in their future destiny. More than 60 per cent of all new generating capacity in this country over the past ten years has been developed, constructed, and owned by independent power producers. It has been estimated that almost 50 per cent of all new capacity added between now and 2005 – between 32 000 MW and 44 000 MW – will be built by IPPs.
A recent market study conducted by the international consulting group Hagler-Bailly Consulting Inc., showed that 63 per cent of all independent power companies in the US owning or operating 100 MW or more, are utility subsidiaries, fuel suppliers, equipment vendors or financial companies providing services to the utility industry.
As the growth in new market share held by electric utility affiliates demonstrates, the electric generation business in the new competitive market is well-aligned with the traditional core business of electric utilities. Competitive utilities who want to capture and control generation market share will seek to expand beyond existing service territories and pursue new competitive opportunities.
This will require a renewed commitment to project development and acquisitions, and increased vertical integration into financing, fuels management and other support services. And while not every company seeks to be a player in the competitive market, failure to develop the new skills necessary to succeed could mean waking up and finding the generation market in the hands of their competitors.
As the US moves towards a pool-based commodity market, the function of existing utility assets may change, but their importance will not. Utilities need to view their generating assets differently if they want to maximize their value. No longer will a plant be viewed merely as a source of kilowatts for sale to captive customers. In the future, generating assets will be run to maximize their now hidden, yet intrinsic value.
The higher priced services sold from existing generating plants in the future will include spinning reserve, reliable power, voltage support, transmission and loop flow enhancement and similar “ancillary” services. To maximize the value of these services, plant siting will become critical. The location of a plant may determine what ancillary services it is capable of producing and selling to the market.
In a competitive market, the placement of the services currently provided by an integrated utility system becomes a valuable commodity in its own right. Many companies have already recognized that one of the most profitable ends of the generation business will be the provision of ancillary services. These companies are looking for ways to separate those high-end, high-priced services for sale separately or in conjunction with a broader service package.
In 1996, there were 3.5 GW of merchant plant proposals in the USA. Today that figure stands at 100 GW. Some 56 GW (114 plants) of merchant plant was proposed in only 16 months. It has been estimated that 82-85 per cent of all new capacity built will be merchant, with over 85 per cent of those being fueled by natural gas. Already, over 30 per cent of unregulated capacity is merchant.
But there is no reason why merchant plants should all be developed on a greenfield basis. The largest pool of generating assets and sites in this country belong to investor-owned utilities. How competitive will those existing assets be in a commodity market? To put it another way, how efficient a converter of primary input (fuel) are those existing assets?
While utilities in the past have run their plants as integrated parts of a larger system, in the future every plant will have to function and succeed as individual profit centres. Many plants in the future will earn higher margins on the sale of ancillary products and services than they will from the sale of pure electricity.
Furthermore, while demand growth in the USA is only 1.2-1.45 per cent a year, it is competition which is driving the market for new development. The new focus is on efficiency driven by low margins, better heat rates, increased reliability, cycling capability and lower cost. With the typical existing utility plant heat rate of 11 000 Btu (3224 MWh), and new combustion turbine technology of 6600 Btu (1934.3 MWh), it is clear that the existing infrastructure is inadequate to meet the current or future demand profile, leading to a boom in new additions.
To ensure that companies are able to capture the full value of existing generating assets, the new buzzwords must be the four Rs: re-mission – changing the role of the plant from supporting a system to producing high value commodity products and services; repower – integrating modern, high efficiency equipment into an existing asset; redeploy – selling the assets or changing its ownership within a corporate family to capture a greater share of the plant’s benefits for shareholders; and redevelop – developing new generating facilities on an existing site.
Perhaps the most necessary change for companies who want to play a role in the development of new generation services, is a change in corporate culture. Utility executives need to avoid being trapped by their past experiences and their past market analysis. Traders, marketers and financiers run power plants differently to engineers, and these differences will become even more apparent as the role of generating assets change and the value of the products and services takes precedent. No longer can generation planning decisions be viewed solely as technical and engineering issues. Financial and corporate asset management decision will come first and engineering issues second.
Companies will have to become more market and customer focused, and less focused on merely selling kilowatt hours. In the past too many utility executives followed the old adage of Henry Ford: “The customer can have any colour car he wants, so long as its black”.
Strategic pricing, rate design, new service contracts and marketing will be used to capture attractive loads, discourage less desirable customers, and improve the load factor for the remaining system. Successful companies in emerging competitive markets must be able to respond flexibly to opportunities wherever they occur, while maintaining a lean organizational structure to avoid burdensome interdepartmental bureaucratic impediments seizing and exploiting development opportunities.
Competitive generating companies will incentivize employees on a plant by plant basis and provide a clear sense of managerial direction from the most senior level managers to the lowest level employees to prompt timely decision-making. Nothing less than a company-wide sense of mission should be promoted to ensure that all employees are vested with the necessity to become industry leaders. Fostering the ability of employees to develop competitive and entrepreneurial capabilities will result in new opportunities.
The combination of market forces, new demand, accelerating growth and culture change are creating a one-time opportunity for competitive companies to capture a pre-eminent position in the US market. The generation options of the future may not be controlled by existing US utilities, but instead by new market entrants such as foreign companies, oil majors and new domestic utilities formed from the ongoing consolidation of the industry.