by Tanya Bodell, FTI Consulting
So ends another year for the U.S. electricity industry with an enduring compression of energy margins, continued uncertainty regarding environmental regulations, and a disturbing number of bankruptcies announced across the electricity value chain.
Peer into the crystal ball for 2012 and the future looks cloudy; a storm of epic proportions might be brewing. Five looming factors that have been dogging the industry could come together in 2012, reaching a coincident peak. The result would be a financial tempest that further erodes value while laying the foundation for increased growth opportunities.
Debt Coming Due
During the easy credit days preceding the global recession, investors in the electricity industry took advantage of low-interest rate loans, with many locking in for a five-year term. The loans that have not been refinanced are now coming due in 2012. Timing could not be worse.
Lower Asset Values
The combination of excess supply, tepid demand, low gas prices and higher coal costs has compressed spark spreads and dark spreads to unsustainable levels. In many markets, the most efficient natural gas plants are operating at less than 60 percent capacity factors. Coal plants are losing money during off-peak hours to stay on to try to recoup costs during on-peak price periods. Energy margins, even if positive, barely are contributing to fixed costs. Traditionally inframarginal units are now at the money with valuations fluctuating wildly with slight changes in market fundamentals. Uncertainty surrounding timing and stringency of Utility Maximum Achievable Control Technology (MACT) standards, cross-state air pollution rules, once-through cooling requirements and hazardous waste status of coal ash challenge post-2015 valuations. Asset values are significantly lower than they were prior to the credit crisis.
Loans made during the height of the market before the recession over-levered power sector assets. Loan-to- (now lower) value ratios in 2012 will attempt to undo that leverage, demanding additional equity investment for refinancing to proceed. Refinancing could be challenged by a continued eurozone debt crisis that has forced major European banks to withdraw from U.S. project finance markets. Even if a credit crisis does not ensue, expect capital to be more costly. Some equity owners will balk, walking away from project loans or declaring bankruptcy to buy time to restructure, turning existing lenders into equity holders.
PPA Expiration Dates
Independent power producers that have been able to weather the storm because of locked-in power purchase agreement prices are about to lose their safe harbor. Twenty-five-year contracts from the late 1980s will be coming due soon. Twenty-year contracts entered during the early 1990s are about to expire. Ten-year deals following the market meltdown in California are about to end. From the perspective of off-takers, these resources already can be replaced with excessive capacity in competitive wholesale markets and renewable power commitments, alleviating any incentive to renew a long-term agreement. The infusion of new merchant power plants will reconfigure the shape of the supply curve and expose those power producers to the rough seas of market prices.
Stubborn Bid-ask Spreads
Asset owners have been trying to wait out the recession; even if asset values are at bargain basement levels, such losses are not realized if they do not sell. At the same time, buyers will not overpay for assets in this environment. The financial strain of trying to hold onto assets in an unsustainable market is beginning to show. The rust belt is sprinkled with more than 7,000 MW of announced coal plant retirements. Distressed debt traders have entered into the electricity industry in force, tracking assets in New England, New York, PJM, Electric Reliability Council of Texas and the Western Electricity Coordinating Council. Bankruptcy filings of Solyndra, Beacon Power, Southern Montana Electric and others are sounding the bell that a much bigger storm might be approaching.
What to Do
Review your portfolio of assets. Understand the potential distribution of outcomes under multiple scenarios. If your assets are out-of-the-money, start developing a restructuring strategy now. If you are long cash, position yourself to take advantage of the coming deluge of acquisition opportunities. Actual events in 2012 might not turn out to be so dire. As with the weather, market conditions are subject to change at any moment. Regardless of the outcome, it pays to take the proper precautions.
Tanya Bodell is a managing director at FTI Consulting and co-founder of the Electricity Consulting Group. Reach her at firstname.lastname@example.org.
“You could be a meteorologist all your life and never see something like this. It would be a disaster of epic proportions. It would be ” the perfect storm.” – “The Perfect Storm” (2000)