Cheryl Muench, Black & Veatch
The course and the nature of the unregulated generation industry over the past half-decade will be providing raw material for business journals, academic research, internal white papers, and conference submittals for years to come. Because of the velocity of its development and the number of project transactions completed, the involvement of the public markets in financing expansion, the meteoric rise and subsequent collapse of the stock prices of some energy concerns, the boom mentality affecting markets in general, the effects of the California energy crisis, the swift expansion of the industry into new arenas such as energy trading, the taint of scandal that spread from the Enron collapse, and the swift decline in investor favor regarding energy, there is ample raw material for consideration.
The following is a brief and certainly not exhaustive overview of that industry during that time, and some potential implications for the future. This overview is in part based on conclusions made during the course of strategic planning for a large energy engineering, procurement, and construction (EPC) firm. Its theme is that the power industry, like many others, moves through distinct periods, or eras, and is impacted by external and internal forces. The external forces include key events, the regulatory environment, and patterns of demand. Internal forces include the supply response, enabling technologies, and the basis of competition.
The ubiquity of electrical demand and use, the broad swath of client types, the impact on human health and safety, and the very large number of industry participants who are arranged in many tiers, made significant regulatory involvement complex both in its particulars and its implications.
The federal Department of Energy was established in 1977 in response to the failure of supply during the oil embargoes that shocked oil-dependent America during that decade. Created at the same time was the independent Federal Energy Regulatory Commission (FERC) to regulate interstate electric and gas issues. The Public Utility Regulatory Policies Act of 1978 (PURPA) was created soon after. Among other requirements, PURPA required utilities to purchase power from PURPA qualifying facilities and pay the utilities’ avoided cost to the qualifying facility.
PURPA was the first step in encouraging the formation of an independent power industry and a large step towards deregulation. The hoped-for benefits and outcomes over time were modernization of the power generation fleet, higher efficiencies, smaller units closer to customers and potential customers, and lower costs to consumers. The nature of the entrants required more robust participation from the financial community. In addition, generating units were now valued differently. Under the traditional regulatory environment, utilities were allowed to earn a return based on the original cost of their investment. With the enactment of PURPA, the value of a facility came to be much more closely associated with income generated by the facility.
The natural result of these and subsequent regulatory changes was a disaggregation of utility asset ownership. Unregulated power generators were typically either associated with utilities or, beginning from the early days of deregulation, with IPPs or power marketers. Unregulated power generators, who came to control nearly 25 percent of all power plants in the U.S. by 2002, up from less than 5 percent a decade before, found their plans, strategies, and actions replicated throughout the market. Unlike regulated utilities, which were guaranteed a regulated rate of return on their investments (which arguably led to over-engineered plants, maximization of billings, and cost overruns in general), unregulated power generators had a laser-like focus on cost control. Unregulated power generators demanded fixed price contracts, usually provided in an EPC format. These contracts placed significant new demands on suppliers, who were asked to adjust to new levels of risk. In turn, this affected procurement and subcontractor practices.
The unregulated power generation industry, along a number of parameters, became an example of market capitalism stripped almost to its essence. The power, the promise, the results, and the exacting price associated with market forces were on full display as the industry moved further into the era of the 1990s.
The energy cycle roars in”
The energy industry has long been notable for its cyclical nature. The flow of capital, talent, assets and other resources during the design, construction and operation of power generation and power transmission projects has typically had the nature of a headlong boom and then bust cycle.
Several factors contribute to an energy industry “boom and bust,” including the economic cycle, the regulatory structure, the long lead time for design and construction, the high capital costs involved, environmental concerns and delays, interest rates and the willingness of lenders to lend capital into the markets, and particularly the buildup and then draw-down of reserve margins over multi-year periods in the power generation industry.
As deregulation momentum and deregulation uncertainty advanced in the late 1980s and early 1990s, regulated utilities put the brakes on building new plants. Therefore, throughout the 1990s, the United States was in large part working off and living off of reserve margin. Finally, as reserve margins decreased to less than 10 percent, volatility in pricing encouraged numerous participants to propose, design, and build new plants to take advantage of the higher, more volatile prices. Betting on sustained price levels into 2000 and beyond, investors, bankers, and industry participants took part in a project development process that was both accelerated and enlarged. A perceived-and real-shortage of generating capacity, the free flow of capital in search of robust returns to the energy markets, the emergence of a growing energy trading market, the surging stock market, and the intangible but real effects of a “boom” environment, conspired to characterize this period as one of accelerated new build-out of generating capacity.
The high point was mid-year, 2001. There was an extremely robust rush towards development of power generating plants. Energy companies were positioning themselves to gain market power by attaining market share growth. Turbines and other major pieces of power plant equipment were voraciously purchased. Engineering, construction, and EPC firms found it difficult to maintain enough skilled personnel to perform all the work available. Headhunting among firms was prevalent. In the year 2000, around 27 gigawatts (GW) of new capacity came online; in 2001, nearly 40 GW. Forecasts for this year approached 64 GW, with another 50 to 55 coming online in 2003. Original equipment manufacturers followed the same curve. General Electric gas turbines sold at a level of 65 in 1998, reached a peak of 284 in 2001, and are expected to recede to about 50 in 2004.”and roars out
Since that high point, several events have led to a marked slowdown in such development.
The surge of development did in fact put into place a significant amount of additional generating capacity, effectively meeting generating needs in many regions of the country.
The fundamental overbuild led to decreasing pricing volatility and lower overall electricity prices into the future.
The lower prices led to project cancellations, as pro-formas no longer projected the necessary profit for the companies. Between January and April of 2002, 30 GW of capacity had been cancelled, with another 50 GW delayed or otherwise placed on hold.
The stocks themselves subsequently declined in price, leaving many energy-related firms with unattractive debt-to-equity ratios. The major rating agencies therefore reduced their ratings on the debt of many major energy companies. This inevitably inhibited lending and has had the effect of reducing capital spending by the entities as companies focused on shoring up balance sheets.
The Enron scandal has led both individual and institutional investors to view energy stock with disfavor (though this factor can be overstated).
The current economic slowdown, particularly among industrial consumers, and among “dot-com” enterprises which were thought to be high consumers of electricity into the future, has resulted in a near-term fall in electricity demand.
Once the initiating events occurred, subsequent events fell into place with the inevitability of dominoes toppling. The string of causes and effects currently has a dismal familiarity within the industry and is the constant backdrop to many industry discussions.
In the framework of era analysis, then, we make the following observations in summary:
- Key events: natural gas price decline
- Regulatory environment: Energy Policy Act of 1992, Clean Air Act Amendments, deregulation and restructuring, narrowed PUCHA restrictions
- Patterns of demand: retail wheeling begins; wholesale power trading increases demand for low-cost generation; divestiture of generating assets
- Supply response: mergers and acquisitions; power trading
- Enabling technologies: generating equipment becomes more efficient; bundling of services
- Basis of competition: unregulated generation reaches record levels; independent power producers provide cheaper power
The final outcome of these inputs, as we have seen, was the extremely vigorous build-out of generating capacity. The accompanying figure, derived from the Black & Veatch database of projects (MarkeTrak), shows the spike in capacity addition in the most recent time frame (including additions in the regulated generators) taking its place historically among other such spikes in the history of power generation. The previous spike period from approximately 1950 to 1970 was coal-based. The spike immediately succeeding the coal-based spike was driven by nuclear power plant additions. These historical periods were of course themselves participating in an era, each with its own internal and external forces.
The question now before the unregulated power generation industry and its vendors is, “what now?” While overall electrical demand is undoubtedly growing (and would not grow only in the complete absence of economic growth in the United States), current electric demand is roughly being met and new capacity will not need to be installed for several years, until demand again catches up with supply. This assessment of the situation must be balanced with the fact that there are still pockets of demand left unmet, often because of transmission constraints, which have the effect of turning regions into ‘islands’ of power self-reliance. It is a fair assessment to say that for the time being, it will be relatively harder to get an unregulated power generation plant financed. If developers do not have a power purchase agreement in place, or some other binding arrangement for the purchase of the electricity produced, they may find lenders less inclined to rely on pro formas or other projections.
The regulatory structure of the industry remains a patchwork of schemes among the states, is viewed with some suspicion after the California crisis, and many believe requires a continued policy evolution. This too will have an impact on the unregulated power generation industry. In an environment where government regulation is looked upon with more favor, the industry may find the road toward deregulation to be static for the time being, or constrained.
Some unregulated power producers have quite publicly reduced their expectations for growth and reduced their anticipated capital expenditure plans, canceling or delaying projects. This in turn has impacted original equipment manufacturers, other vendors, and engineering design and construction firms.
Unregulated power generators are for the current period concentrating on repairing their balance sheets. By the sale or optimization of assets, cost-cutting measures, and the reduction of capital expenditures, firms will eventually get their houses in order and will again be able to attract capital. This rationalization of assets, accomplished sometimes by sale or acquisition of assets, sometimes by merger and acquisition (M&A) activity, is taking place across several industries currently. M&A activity, reasonably pursued, results in reduced overhead and optimization of service staff, as well as-sometimes-increased power in negotiation with vendors. A hampering factor that may slow this activity is the reduced value of energy stocks nearly across the board, devaluing the typical currency of M&A activity.
Some unregulated power generators with strong balance sheets are in a favored position and are able to continue with their plans for adding new generator capacity or, in an over-capacity scenario, replacing the “build” decision with a “buy” decision. Under these circumstances, they may be able to gain increased market share, and thus a competitive advantage.
Public utilities that before may have spun off their generating facilities, may find a renewed interest in bringing those assets back into the parent firm, or in declining to spin off assets in the first place. The impulse to control one’s own destiny-in this case the ownership of generation, transmission, and distribution facilities-may become a feature of the landscape.
Some elements of the future
Fuel Choice. As the single largest cost of a merchant power plant, every component of the fuel of choice was of great importance. The ability to control or manage the cost of the fuel and the reliability of the fuel supply were key elements of power plant development. Due to several factors, including availability, price, deliverability, and reliability, natural gas became the prevailing fuel for merchant power plants. Over 90 percent of new plants were fueled by natural gas. It is a well-known irony that success can sometimes breed its own problems. Natural gas, selected for its low price volatility and ready supply, now so dominates as a fuel choice, that both supply and low price volatility may be vulnerable going forward. Sharp price fluctuations in gas prices will be amplified as they make their way through a merchant plant’s pro forma, affecting plant dispatch, market prices, and profit margins.
If that is the case, a turn toward coal or nuclear would greatly affect the unregulated power generation business. These much larger projects, with much different finance, vendor, equipment, and schedule arrangements would present a formidable opponent to small gas-fired plants. Base load plants at a low marginal cost of production would affect the volume and nature of supply.
Equipment and professional services vendors will themselves be deriving strategic responses that allow for participation in whatever fuel choices become the new industry standard. Contracts. If base load plants (and their regulated owners) come under renewed favor, it wouldn’t be unusual for their contracts to take a different shape. Unregulated power generation contracts were developed to meet the needs and the velocity of that market. The larger coal-fired and nuclear plants, more complex in design and construction, and of a much longer duration, will require different relationships between the parties-relationships that mutually nourish the project, the process, and the participants.
Industry Participants/Vendors. The unregulated power generation industry drew many participants at each tier of activity. With relative ease of entry, many were entering at the top of the market. More than a few were climbing a learning curve as they took on projects, anticipating that they would be able to apply lessons learned on pricing, project management, design considerations, procurement practices and supply chain management on the next project or the one after that. With the slowdown of the market, several of these firms found the learning curve crumbling under them. Ease of entry doesn’t guarantee ease of exit, and it would not be surprising to see a significant reduction in the number of players over this interim period.
This boom and bust mentality within the energy industry has been damped somewhat in recent years, but seems destined to always be a part of the business. Much has to do with the physics and essential non-storability of electricity itself. Add to that the capital-intensive nature of the investments, the drawn-out payout times, the relative ease of entry into the industry by developers, the abrupt and painful exits of some industry players at all levels in the industry chain, and the long lead time for greenfield development, and you have the ingredients for demand that will never be met with the smooth and direct provision of supply. Rather, it is the nature of the energy industry that demand is met by alternating development activity that is either too slow or too fast, fits and starts of activity, boom and bust investment, and long periods of drought alternating with relatively brief periods of torrential activity. There is no smoothing mechanism that can be applied to the cycle.
This point of view must be balanced by looking at underlying and relentless trends in demand. Private and public forecasts differ on the beginning date of the next wave of development, with some private forecasts predicting new needs by as early as 2005. “Ordinary” growth in demand is consistent with 20 to 25 GW of addition annually.
It is in monitoring such potent and sometimes contradictory trends, and deriving the appropriate range of strategic responses, that successful firms in every tier of the industry will best meet the future. At our firm, a large corporation which performs many contracts under an EPC format, we track every announced power project in the world and follow each one forward from its announce date to its date of commercial operation. We align proposed generation additions with country and NERC regions, and current power demand and supply. We assign growth rates based on regional economies, our best estimates of which plants will be retired or mothballed, current fuel mix, current holders of permits, etc. This level and quality of information informs our relationships and strategies with our clients.
Unregulated power generation firms found themselves for a time to be the consensus choice for supplying power to the country. The nature of the demand, the plants, the markets, the financing, and other elements conspired to reinforce this business model. Notably, that market narrative supports a very robust level of development.
In a like manner, larger market forces, distress in other areas of the energy business, an overabundant build-out, extreme caution exercised by lenders, and stringency among credit rating agencies has had a negative impact on the industry.
The energy market is currently experiencing an interim period, from which a new energy market narrative will emerge. The timing, force, and breadth of this new narrative will be driven by anticipation, greed, caution, tradition, and by innovation. In the process, companies will reinvent themselves, will exit the business or go under, or will re-form into more capable models. Abiding industry participants will be prepared, as always, to make their contribution to the energy market, serving the industry, the economy, and finally, the citizen.
It is our estimation that supply and demand will not rationalize for a few more years, and it is likely, for some of the reasons stated above, that at that time demand will again significantly overshoot supply. We surmise that there will again be shortages, increased price (and fuel price) volatility, and a marked need for new power generation.
We note that this length of time-between now and our perception of when the need will again become evident-corresponds roughly to the design and construction stages of nuclear and large coal fired plants. Those plants, once in place and with their lower generation costs, will be very well placed to participate profitably in the energy markets. This we feel is the opportunity before the industry today: to damp the boom and bust cycle with considered and careful strategic planning, as it moves into yet another era.
Era analysis provides insight and historical focus. It teaches us again the lesson of cyclicality. It allows us to note the external and internal forces that shape an era and its markets. It reminds us that the interplay of key events, the regulatory environment, patterns of demand, the supply response, enabling technologies, and the basis of competition present market opportunities and a choice of strategic paths for market participants.
Muench, vice president, strategic marketing and analysis, Black & Veatch, may be contacted at 913-458-2813.