by Christopher Dann and Jim Hendrickson, Booz & Co. Inc.
To manage risk and create value for next-generation power, decision-makers should consider four facts during the down cycle: the prevailing wisdom, cycle trap, decision-making under uncertainty and strategic implications.
1. Prevailing Wisdom: Markets Long, Prices Low for Foreseeable Future
Recent mergers and acquisitions (M&A) activity, e.g., Exelon-Constellation, is aimed at long-term generation and supply-side positioning. Beyond these major deals, the prevailing investment wisdom appears more conservative—largely comply, wait and see. While prudent, this approach might misallocate capital and miss opportunities to create significant value at moderate risk. There might be counterintuitive opportunities to create value in existing assets—and greater risk than we believe is being recognized in the focus on renewable development and gas backstops. This is particularly true for unregulated investments, but in the regulated environment these circumstances also could open the door to later prudency discussions.
The recession has left most markets oversupplied. Public policy incentives continue to push more renewables, energy efficiency and demand response into these already long markets while low gas prices, driven by increasing unconventional gas production, further depress marginal market prices and volatility. The long market has put downward pressure on earnings but also has created disparities between valuations and new build costs.
The conventional comply, wait and see wisdom relies on regulation to force out excess capacity—primarily coal—while providing a guarantee to renewable development through tough-to-dislodge subsidies. With coal politically unpopular and renewables popular, this might seem safe. This prevailing wisdom might be correct, and it is reflected in the types of plants under construction. The future likely will be more uncertain than we expect. Political winds reasonably could shift the net economic potential of specific generation assets. Accurately interpreting these uncertainties matter in a market with such attractive acquisition prices versus new build costs and so many critical variables plausibly on the margin.
2. The Cycle Trap: Why the Power Industry Consistently Has Destroyed Value
One of the main reasons companies in capital-intensive, highly cyclical industries tend to destroy value—meaning their return on invested capital is historically lower than their cost of capital—is that companies misjudge the cycle. When prices are high, they often are forecast to remain high forever; companies invest with gusto. When prices are low, they usually are forecast to remain low for the foreseeable future; companies delay investments, missing undervalue asset acquisition opportunities. This pattern has played repeatedly (see Figure 3).
Few stories illustrate the impact of the cycle on power generation investment outcomes better than the differences between two private equity transactions in Texas: the acquisition of Texas Genco in 2004 and TXU in 2007 by a consortium of private equity investors that included two of the same investors (TPG and KKR). Texas Genco was purchased at the bottom of the cycle for about $1.9 billion using $900 million in cash. The assets were sold less than 18 months later as the market was recovering for about $5.9 billion to NRG Energy. TXU was purchased by private equity investors at the height of the cycle in a massive, highly leveraged bet on gas prices. The company is currently worth significantly less than the $45 billion acquisition price. The company, now Energy Future Holdings, recently has been successful in renegotiating its debt burden to try to buy time for a market recovery, but its experience has provided a lesson in market cyclicality. Given that these transactions included some of the same investors, it is safe to assume neither the outsized returns in the first nor the unhappy outcome of the second transaction were anticipated.
Companies that win in this environment have one consistent characteristic: strategic coherence reflected in active, balanced asset portfolio management. A Booz & Co. analysis of industry performance shows that leaders have balanced portfolios, hedge well and tend to invest at the right points in the cycle.
3. Decision—making Under Uncertainty
Companies that beat the average employ more disciplined decision-making and incorporate uncertainty into their evaluations. Strategic decision-making in the power generation market is sensitive to small shifts in critical assumptions. These assumptions often are treated as point estimates, e.g., “We use an $X/mmBtu gas price forecast for our investment decision-making,” or defined within overly narrow ranges. Analysis is not in short supply, but anticipative and dynamic decision-making is. Decision analysis must break down traditional static planning biases and examine plausible scenarios and options against a broader range of uncertainty than the usually inaccurate conservative, yet reasonable risk parameters. This point was more than driven home during the most recent market cycle.
Companies face four portfolio decisions: build, buy, sell or retire. Figure 4 illustrates the probability distributions of rates of return for potential baseload generation investment options. This analysis suggests coal acquisitions could prove attractive—that older, less efficient coal units may retain more value in earnings and optionality than commonly believed. The acquisition price is driven by an uncertainty discount, not fully on fundamentals, which might be more backward than forward-looking. A targeted coal play, combined with superior operating capabilities and well-timed harvest and retirement tactics, might be a superior transitional strategy. Complicating this hypothesis is the high potential downside exposure under reasonable uncertainties for every other asset investment outside of hydro, making regulatory treatment and locational-specific targeting particularly important.
In the coal acquisition case, the widespread expectation is that imminent Environmental Protection Agency (EPA) mandates targeting sulfur dioxide, nitrogen oxides, mercury, fly ash and potentially carbon dioxide will doom a significant amount of U.S. coal-fired capacity. It’s estimated that 40 to 50 percent of coal assets reasonably can be expected to be taken out of service by 2020 because of age and costs associated with Phase II of the Clean Air Act.
EPA rulemakings could become tied up in litigation and court challenges for most of the decade. Federal and state budget crises and the return to an economic fundamentals mind-set might change political priorities. Many of these assets have another 10-20 years of remaining life, and the force out could be as low as 10 percent. Coal offers a regulatory and future gas price arbitrage and will be competitive if regulatory costs are relatively low and gas prices, demand or both increase more than conventionally assumed.
Regulated companies might be more willing to invest in prospective EPA compliance assuming rate base recovery; unregulated companies are more likely to bet on gridlock and acquire noncompliant units that regulated entities might retire otherwise. For the right companies, betting on older or marginal coal units in selective markets could pay off in five to 10 years. For existing owners, judiciously managing the life cycle of older, lower-efficiency coal assets could be a critical value-enhancement strategy. Even beyond acquisitions, the default to natural gas for new growth will be an increasingly marginal decision within the reasonable range of uncertain key variables. Figure 5 illustrates the sensitivity of the preference of building new natural gas combined-cycle (NGCC) capacity over building new coal-fired generation. The exhibit shows the incremental rate of return of gas over coal and the seven most impactful assumptions in the analysis. (Because the coal plant in question is assumed to be new with full environmental controls, the emissions costs of other pollutants are not material to the decision.) Four assumptions—most important, gas prices—will switch the preference from building NGCC to building coal. The tipping point is a gas price of $6.40/mmBtu, which is within the range of recent forecasts. This analysis shows the impact of each sensitivity on its own. When variables move simultaneously, the range of outcomes is more volatile. This vulnerability of investment decisions to critical assumptions is a critical driver of the cyclicality of the business.
Are these variables really uncertain? The rapid expansion of unconventional gas production in North America has driven gas prices down into a range of $4 to $4.50/mcf. Current leasehold terms on many of the unconventional fields (and the need for capital recovery) incent below marginal cost production. Further, there is swing capacity from imported liquefied natural gas. This would seem to cap natural gas prices, reflected in many industry forecasts. Many factors can change this forecast materially: expiring leaseholds, higher than expected depletion rates, environmental constraints on shale gas extraction, higher than expected demand growth from extreme weather, gas for electric substitution and chemical production. Based on experience, there is a great deal more volatility in these variables than often is assumed.
In addition, significant capacity factor risk for NGCC and coal can tip the balance toward either of the baseload alternatives. Capacity factors, particularly of swing and peaking assets, are an overarching variable in investment decision-making. Capacity factors are highly dependent on overall economic and demand growth. The future could be different from current expectations. The unanticipated strength of the demand rebound is a common feature of the cycle. Historically, demand has bounced back strongly after every recession within the past century, usually more strongly than anticipated. There is much trepidation that this will not happen this time because of what some believe is permanent or at least long-term demand destruction from de-industrialization and energy efficiency mandates. While energy efficiency has made inroads and overall energy intensity in the economy has declined, we expect the historical demand trend largely to repeat itself. Continued growth in new electric applications, for example, significant data center expansion and electric vehicles, should drive demand growth. Further, the link between energy efficiency measures and reductions in aggregate energy consumption is highly uncertain; some studies have shown increases in energy consumption with increased energy efficiency. Demand will return and, if history is any guide, more strongly than most anticipate.
4. Strategic Implications
Disciplined decision-making requires a rigorous decision framework that explicitly incorporates and correctly assesses uncertainty. It requires an understanding of the sensitivity of a decision evaluation to assumptions. It requires a broad view of the market and a process for evaluating alternatives and allocating capital to its highest and best use. Disciplined decision-making and capital allocation will allow companies to capture opportunities that are overlooked by others and, by explicitly treating uncertainties, allow companies to mitigate risk and create option value through building downstream flexibility.
Companies, however, must avoid the temptation to make small-scale acquisitions without a clear value-add or capability proposition. A clear added-value proposition—for example, differentiated portfolio, project management or operational capabilities—must be explicitly valued in assessing any acquisition. Inexperienced buyers, in particular, looking for alternative investments should be cautious in this environment.
When uncertainty is overlooked or insufficiently assessed in decision-making, often the first casualty is the appreciation for the value of portfolio diversity. At an industry level, the value of portfolio diversity often has been underappreciated, such as with the gas build of the late 1990s. At a company level, the landscape is littered with the ruins of companies that were built as one-way bets on a particular scenario or set of scenarios playing out. Portfolio coherence—balance and diversity—enables companies to create value over the long term through targeted, forward-looking investments while mitigating the risk from significant shifts in the political and market environment. As the segment performance analysis implies, the coherence of your portfolio will be a key determinate market leadership.
Figure 6 illustrates one case example from our analysis. While largely operating in similar footprints, PPL consistently has outperformed Allegheny (recently acquired by First Energy). Three underlying capabilities tend to be predictive of sustained success: strategic (or portfolio coherence), financial capacity to act and differentiated capabilities. While still a maturing model, PPL’s generation and retail positions were more anticipative and balanced than those of Allegheny. And most important, the PPL’s competitive portfolio management capabilities were producing consistently higher margins at a higher return in invested capital.
The future is more uncertain and volatile than we tend to think. The prevailing, conventional wisdom tends to be wrong. Power generation investment decisions are made under great uncertainty, and the outcomes play out over decades. Such decision-making requires a disciplined approach that incorporates the uncertainty in the underlying assumptions. Decision-making also must consider portfolio effects and the value of a diversified portfolio of assets. If understood and assessed correctly, uncertainty and volatility create significant opportunities for value creation.
Jim Hendrickson, a partner with Booz & Co., has more than 25 years of addressing unregulated and regulated issues at strategic and operating levels for electric, gas and energy companies. He leads the firm’s commodites and markets practice. Reach him at firstname.lastname@example.org.
Christopher Dann, a partner with Booz & Co., has worked more than 16 years with U.S. power and gas executives in addressing their most critical strategic decisions and challenges. Reach him at email@example.com.