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A View on U.S. Power Generation Prospects

12/13/2011 

 

The utilities sector is typically viewed as a low beta investment vehicle with high yield characteristics. Such defensive characteristics can be found across the utilities value chain. This is particularly true for regulated utilities which simply earn a formulaic return on equity (i.e. an allowed ROE set every 2-3 years) and whereby the key driver for earnings growth is to increase the company’s regulated rate base i.e. by growing the company’s assets.

 

 

 

More elastic aspects of the utilities sector are found in unregulated wholesale power markets whereby merchant or Independent Power Producers (IPPs) are more sensitive to swings in power prices and energy margins. The latter depends on what is the power plant’s degree of operating leverage to the marginal fuel that sets the power price in the specific wholesale market. For example, a nuclear plant with a largely fixed cost base and very low variable costs has operating leverage in a region (e.g. PJM or ERCOT) where natural gas plants and their respective cost of fuel sets power prices on the margin. Therefore, an investor should first establish if the specific power producer is regulated, unregulated or a mix of both i.e. an integrated player. The below map shows which U.S. regions have unregulated power markets and whereby natural gas is largely the power setting fuel on the margin i.e. the last unit on the supply curve to meet demand for energy.

 

 

U.S. power generation can also be seen in terms of established capacity and actual energy generated by the available power plants. The below charts show clearly that coal fired generation dominates and that natural gas fired generation has had a boom-bust cycle in the early 2000s which has resulted in a relatively young and efficient fleet across the industry. In addition, nuclear and hydro plants are great sources of CO2 free, base load power (running 24/7) with minimal variable costs. Lastly, renewable energy (4.9% - mainly wind) is a relatively small and yet fast growing energy resource.

 

    

 

 

Capital costs and environmental regulations have been critical factors in choosing power plant technology. This applies especially for building plants in wholesale power markets which experience high power price volatility and only near-term earnings visibility e.g. by hedging power prices via the more liquid market of natural gas futures. Thus, building new nuclear plants for instance is considered a rather risky proposition due to the uncertain capital outlay, as the industry has not been building new nuclear plants since the 3 Mile Island nuclear accident in 1979.

 

 

Coal fired generation in particular is facing strong headwinds from pending environmental regulations which aim to reduce greenhouse gas emissions. Thus, coal plants need to be retrofitted with environmental equipment e.g. ‘scrubbers’ in order to reduce sulfur dioxide and catalytic converters to reduce nitrogen oxides. In the future, carbon capture and sequestration is most likely to become mandatory in order to approve the building of new plants using ‘clean coal’. In light of these high capital costs, the outlook for the industry is for the retirement of a significant number of coal plants, particularly smaller and older plants that lack the necessary scale that would justify a large capital outlay for environmental control equipment.

 

  
 

 

On the other hand, the outlook for natural gas plants seems rather rosy as highly efficient natural gas plants can produce up to 70% lower greenhouse gas emissions than an existing coal fired plant. With the cost of fuel coming down, utilities are increasingly switching to natural gas fired plants as they reduce coal fired output or retire inefficient old coal plants in order to comply with new environmental regulations. Thus, although the U.S. has vast coal reserves, incremental power capacity additions are likely to come largely from natural gas fired plants.

 

As a result of significant projected coal fired plant retirements, certain wholesale markets such as in the PJM (Pennsylvania-New Jersey-Maryland) and New England areas have established capacity markets. These auctions are attempting to incentivize utilities with sufficient premiums (i.e. capacity payments) in order to cover the Net Cost of New Entry (i.e. a new gas combustion turbine) and thus reward utilities for pledging future capacity in order to maintain adequate reserve margins and thus ensure system reliability. These capacity payments constitute a significant source of profitability for utilities in areas of tightening supply/demand. Therefore, operating leverage to natural gas/power prices is not the only factor to consider when investing in players with merchant power exposure. We have to note though that every region is different e.g. Texas (ERCOT) does not have capacity auctions and as such merchant power players in Texas such as NRG Energy are more sensitive to movements in the price of natural gas.

With regards to renewable energy, additional capacity contributions to the U.S. power industry are likely to come from wind and biomass. These increases are supported by State-level renewable electricity standards and Federal tax credits. Apart for credit extension risk, the biggest constraint to higher renewable penetration is transmission. Building transmission lines faces long lead times (due to the long distance from the areas of energy consumption) and potentially lengthy regulatory procedures across different states. In addition, due to the high capital intensiveness of renewable energy, access to capital and project selection is critical.

 

 

Conclusion:

In the short-term our preference is towards steady dividend paying regulated utilities, as the near-term outlook for wholesale power generators is rather challenging due to depressed natural gas prices, compressed margins and a tepid economic outlook that will likely weigh on energy demand. However, wholesale supply/demand dynamics are likely to improve in the long-term driven by coal plant shutdowns and increased demand for natural gas which will enable power price and margin recovery. The main medium-term risk that would dilute this thesis is political intervention by the Republican Party which would influence the implementation and timing of EPA rules.  Therefore, exposure to wholesale power generation needs to meet first our risk-reward criteria.

 

 

 

 

Christos Charalambous CFA  

Senior Strategist

christos.charalambous@edgewealth.com

 

 

 

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