By Jeff Bodington, Bodington & Co.
Since divestiture of utility-owned generation began in the mid-90s nearly 400 generating facilities have been sold in more than 75 transactions. While many sales involve individual power projects, most involve portfolios of projects.
Controversy surrounds several aspects of the portfolio sales. Is a portfolio worth more than the sum of its stand-alone project values? If so, why and how much? Is a portfolio a device for creating and exercising market power?
Of 396 projects sold through year-end 2000, 365 were sold as part of a transaction involving at least one other project. During 2001 there were only a few divestitures and the patterns are similar. While these data show that portfolio transactions are common, they may also paint a misleading picture of value.
The 31 single-project sales include some large and high-value facilities such as Homer City. More important, many of the portfolios sold actually have little synergy and thus they yield little extra value to a new owner. Sellers, buyers, regulators, and tax and judicial parties need to recognize this fact. A detailed evaluation of the sales shows why.
First, the number of projects sold in several portfolio sizes through year-end 2000 appears in the figure above. For example, there were 31 stand-alone sales, 14 sales involving a two-project portfolio, and 21 sales involving a portfolio containing five or more projects. While most sales have involved fossil-fired and hydroelectric assets, the figure also shows sales of nuclear units alone. Nuclear sales are usually single-project or nuclear-only portfolio sales that also involve partial interests.
Three sources of value
When a portfolio does have extra value, it comes from three sources: economies of scale, diversification, and market power.
Economies of scale are often substantial. Many aspects of power generation involve fixed and other costs that are not always proportional to the number of projects and their installed capacities and annual energy output. Even many variable costs are low-scaling costs-doubling the number of projects may cause such costs to rise only 50 percent. Transaction costs, maintenance facilities, and many other costs are examples.
Volume discounts can apply to costs such as fuel and vendor parts and maintenance. Revenue and power marketing also involve economies of scale. The incremental administrative cost of marketing more power is often low and near zero.
For these reasons, a portfolio of projects can allow an owner to enjoy both revenue- and cost-related economies of scale. Fixed and low-scaling variable costs can be spread over more projects, capacity and energy sales. In an auction, these higher revenues and lower costs can be considered by a bidder and turned into a higher price than would be justified for the same power projects on a stand-alone basis.
Diversification is another source of potential portfolio value. Fuel, equity, and debt generally cost less when the risks to the providers of these inputs are lower. Combining several projects under one fuel supply contract and one financing can lower fuel and capital costs. Fuel suppliers have more assurance of minimum sales and financing sources have several sources of repayment. Revenue may also be higher. Power marketing entities sometimes pay a higher price for power whose actual supply is lower risk because it comes from several separate projects.
Finally, market power can be created with a portfolio and exercise of this power can be a source of value. In theory, the owner of a portfolio of projects selling into an imperfect market could turn down a price-setting unit thus increasing market prices and thus profits on its other units. This potential is one of the most important reasons for over 100 years of cost-of-service regulation. It has been, and remains, a consideration in designing divestiture auctions. It is also a consideration in contracts negotiated for reliability must-run units.
Federal and state authorities are working to limit the market power that owners of divested projects may exercise. While some exercise of market power has been alleged, particularly in California, nothing has been proved. Economies of scale and diversification are clear and common reasons that portfolios of projects are worth more than stand-alone projects. Both the actual exercise of, and proving the exercise of, market power requires disentangling many factors in a complex, rapidly changing business.
When do portfolios actually yield the benefits of economies of scale and diversifi-cation? In fact, the answer appears to be for only approximately half of the sales to date. Portfolio sales fall into two broad categories, those offered as single projects but sold in sets and those offered only in portfolios. The accompanying table presents a summary of these two characterizations, several subdivisions, and whether or not each actually is worth more because it is a portfolio.
Among those offered on a stand-alone basis, some are sold in what appear to be portfolios because a potential buyer bids on several projects and then wins more than one. In others, a seller after the first round of bidding in an auction may find that one project did not receive any bids. That seller, or its financial advisor, may then call one of the bidders on another project and suggest that their position would improve if they also bid on a second project during the final round of the auction. A bidder is thus cajoled into buying a portfolio so that the seller is not left with a lone and perhaps unattractive and unsold project. Because of the circumstances surrounding this type of transaction, examples are confidential.
In both of those cases there may be some economies of scale and benefit to diversification. However, none of that potential value was paid to the seller. Obtaining the benefits of a portfolio in those two cases is luck, and including an orphan could actually be a net cost. Only in a third case, when a buyer combines projects offered on a stand-alone basis into an all-or-none package for the final round of an auction, does a buyer arguably calculate and pay more for a portfolio. Thermo Ecoteck’s purchases from Southern California Edison are an example. This third type of purchase accounts for approximately 10 percent of all portfolio sales.
In contrast to projects initially auctioned on a stand-alone basis, many are offered only in portfolios. Again, not all such portfolios actually create extra value. First, some projects are functionally dependent, hence the notion of extra value due to a portfolio loses meaning. Geothermal projects purchased by Calpine from PG&E, and hydroelectric power projects that are operated as units, are examples. Next is the portfolio created specifically to dispose of what could be an orphan.
Low-value projects are sometimes tied to high-value projects in the first round of an auction, rather than the second as above, because the seller does not want to have to cajole a bidder into taking a low-value project in the auction’s second round. Many of the large portfolios contain assets of this type and Duke’s purchase of three projects from PG&E involved two large and very valuable baseload plants packaged with a small and little-used combustion turbine. Third are portfolios that have little synergy because the projects are dispersed and/or different technologies. Finally, many projects have been offered only in portfolios that do yield extra value. Numerous examples include Montana Power’s sale to PP&L Global and GPU’s sale to Sithe. These types of sales account for approximately 40 percent to 50 percent of all portfolio sales.
In sum, while portfolio sales are common, only approximately 50 percent to 60 percent yield clear and material extra value. Seller, buyer, tax, and judicial parties need to recognize why and when that extra value is possible.
Bodington, an EL&P Contributing Editor, is president of Bodington & Co., an NASD broker/dealer who advises buyers and sellers of power projects.