Revisiting Your Generation Investment Strategy in a Recession

by Tanya Bodell, CRA International Inc.

The world for electricity-market participants has changed. Last year’s high economic-growth projections have been replaced by recession expectations. Recovery predictions vary from a short-term turnaround in a year to a long-term readjustment of economic fundamentals. What could a long recession mean for the industry? How should your generation investment strategy adapt?

Nearly every assumption an investor in physical generation assets should consider has changed significantly during the past six months:

 

  • Economic Growth. Projections have declined.
  • Electricity Demand. Projections have fallen.
  • Fuel Prices. They and their forward projections have slumped.
  • Construction Costs. They’ve dropped from record-high levels, primarily driven by reductions in cement and metal prices.
  • Cost of Capital. It has risen because of the credit crisis, increasing the cost of money by a reported 200 to 400 basis points.
  • Environmental Policy. It’s uncertain. The new administration continues to support a carbon policy, but it’s less clear how this support will be prioritized in a low-growth world.

 

Some of these factors may have offsetting effects for electricity generators. For example, reduced fuel prices create lower marginal costs to produce electricity, which, if translated into lower electricity prices, may offset the downward shift in demand due to an economic recession. Lower input costs to construction may be offset by higher costs of capital. Understanding the net effect on electric generation performance requires an integrated view that incorporates macroeconomic impacts, microeconomic decisions and policy (see sidebar).

“For instance, in a world of low economic growth, low commodity prices, and high cost of capital, one might see the following:”

 

  • New capacity builds slow down. Reduced demand decreases the need for new generation capacity. Projects are delayed or cancelled.
  • Renewables look less rosy. When projected fuel prices fall, the expected cost of producing electricity falls. When load decreases, demand for the megawatt-hours of renewable resource generation required to meet a renewable portfolio standard percentage decreases. The green spread (the price of electricity plus a renewable energy credit) narrows, and renewable resources require government subsidies. In combination with the withdrawal of tax equity financing, renewable projects are delayed or cancelled.
  • Coal continues to retrench. As commodity prices fall, the economics of coal-fired power plants, which have higher up-front capital costs, fall behind natural gas combined cycles whose all-in levelized cost of electricity is primarily fuel costs. Regions more conducive to coal-fired generation could be disproportionately impacted by an economic slowdown, further reducing new builds of coal plants. In a low-growth world, coal could see continued retrenchment as the dark spread continues to fall, even in the absence of carbon limits.
  • Natural gas may energize. As economic activity falls, emissions decline because of lower demand for electricity and other energy services. With carbon limits, electricity production shifts from higher carbon-emitting, coal-fired generation to gas-fired generation. Gas-fired power plants could have higher capacity factors in a low-growth world, increasing profitability.
  • New nuclear and integrated gasification combined-cycle plants might delay. The higher cost of capital in combination with the lower demand for electricity and emission abatement makes nuclear and clean coal less attractive. This could shift investment in high-capital cost, low-emitting solutions out by 10 years unless otherwise bolstered by government regulations.

 

What does this all mean for investors in electricity generation? Fundamental changes in electricity markets demand that generation owners re-evaluate the positioning of their portfolios in the market and their long-term investment strategies. What seemed to be a profitable strategy six months ago may no longer be optimal. Investment returns on high up-front capital generation such as nuclear and clean coal could be delayed beyond a desired investment horizon. Gas-fired baseload generation might become more profitable. The world has changed; so should your investment strategy.


The Importance of an Integrated Model and Expert Team

CRA has an integrated suite of models that incorporates macroeconomic, microeconomic and policy factors in projecting future states of the electricity industry. The insights described in this column are a national summary of more detailed analyses that examine the impact of an alternative world view by region and on selected generation portfolios, which can differ from the overall national outcome.

These insights and analyses were developed by a team of energy and environmental experts at CRA International that includes Paul Bernstein, Scott Bloomberg, Robert Lee, James McMahon, Scott Niemann, Chris Russo and Bruce Tsuchida.

Author

Tanya Bodell is vice president of CRA International Inc. E-mail her at  Tanya.bodell@fticonsulting.com

“The difficulty lies, not in the new ideas, but in escaping from the old ones.”
John Maynard Keynes (1935)

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