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Deregulation of the US electric power industry and the opportunities it creates for private equity

Fundamental upheaval in the electric power industry is creating unprecedented private equity investment opportunities. One major contributing factor is the deregulation of the United States power markets. Since the advent of deregulation, the private equity industry has assumed a lead role in taking advantage of these opportunities, bringing benefit to its investors, the power industry, and the energy-using population, according to John Buehler of the Energy Investors Funds (EIF).

The Energy Information Association (EIA), part of the Department of Energy, has described the electric power industry as one of the largest and most creditworthy industries in the US, with an estimated end-user market of nearly $250bn of electricity sales in 2002. The delivery of electricity to these retail, commercial and industrial consumers was historically handled by large integrated utilities, which provided generation, transmission and distribution services in monopoly franchise areas.

Over the last 20 years the industry has slowly but deliberately become more deregulated, and the services have become unbundled to various degrees. The generation segment was the first service to become deregulated. A new group of companies called independent power producers (“IPPs”) has developed and flourished within the industry. IPPs may own one plant or many, and collectively they now own a significant portion of over 7,000 power plants in the US. The transmission segment is now undergoing a similar unbundling process and is transforming to a less regulated regime. The distribution segment is changing more slowly and less dramatically.

The Cambridge Energy Research Associates (CERA) schematic below depicts these segments of the current electric industry value chain. This value chain involves assets with over $500 billion in book value, making the electricity sector one of the most capital-intensive U.S. industries.

The Fall of Regulatory Barriers Creates Attractive Market Opportunity

The fall of regulatory barriers has resulted in a number of profound changes in the utility and power generation industries, producing an opportunity for investors to earn superior, risk-adjusted returns. Six major factors make the power industry attractive for private equity investors from a macro-perspective:

1. Size and Stability: The power business is one of the largest industry sectors in the US, accounting for approximately four per cent of the gross domestic product. In terms of revenue, the power business surpasses the telecommunications, airline, and gas industry (Edison Electric Institute). There are over 7,000 utility and non-utility power plants in the US and over 16,000 power generating units (EIA:DOE), including “inside the fence” power generating plants. Most of these power generation facilities have multiple owners, creating a significant number of attractive investment opportunities. Profits and cash flow for operating non-utility power plants do not vary dramatically from year to year due to the basic agreements and economics contained in the underlying power purchase agreements, and inelastic demand growth in capacity.

2. Deregulation: Gradually, politicians and consumer interest groups are realising that deregulation can and has produced lower prices and more choice for consumers. The pace of deregulation has been slow and steady over the last 20 years, with policy makers moving cautiously in the face of utility industry lobbying for long transition periods and other offsets to protect shareholders. The transition period is expiring and deregulation is now accelerating, bringing dramatic changes to the industry landscape. The integrated utility company is being unbundled by deregulation. Generation, wherever possible, has been separated out into utility subsidiaries or sold to independent power producers. Most new generation is being developed and built by IPPs. Private investment in transmission has increased with the support of the Federal Energy Regulatory Commission (FERC). The net results of deregulation and these changes are increased investment opportunities.

3. Regional and Fragmented: According to the EIA there are over 3,000 power companies in the US, operating in over 100 sub-regional markets and ten major reliability zones. Companies are operated on a vertically integrated, cost-plus business model. Service areas have been defined in the 50 states and confined by 51 regulatory authorities. According to CERA, the top ten power companies account for less than 30 per cent of industry revenues (CERA Executive Roundtable, April 22, 2003 - US Power Regional Generation Market Share). Fragmentation has resulted in considerable inefficiency in the operation and management of companies in this sector as many power assets have multiple owners operating in non-core strategic areas. As power companies retrench to a “back to basics” business model (CERA: Picking Up the Pieces, Winter 2004), these “odds and ends” of non strategic power plants provide attractive investment opportunities for the experienced private equity investor.

4. Under-investment: The industry has not invested sufficiently in physical plants to meet growing demand for more reliable power and higher quality transmission systems. The August 14, 2003 blackout in the northeastern US highlights the need to invest in and upgrade the nation’s aging transmission system. California offers another example of this lack of investment in power infrastructure. Demand in California grew 30 per cent in the 1990s, yet utility management added only 500MW of new capacity during this time period. The result was a system that could not handle the state’s increased power demands and typical weather fluctuations. While the combination of several challenges created the problems in California that led to the 2001 energy crisis and rolling brownouts, under-investment certainly played a significant role. Transmission constraints made movement of excess capacity to areas of undersupply impossible. The California Independent System Operator recently warned that California again might have trouble meeting electricity demand in Summer 2004 if weather is hotter than normal or if several power generators trip offline at once. The western corridor system risk is greater as hydro reserves in the Northwest are 75 per cent below normal due to a dry spring and hot weather. California Governor Schwarzenegger estimates the current reserve margin is around seven per cent instead of the 15 per cent margin normally deemed prudent to handle peak demand.

5. Restructuring: An industry-wide decrease in the credit ratings of North American generation companies has resulted in their divesting assets in order to improve their balance sheets. In some cases, the effects of the sector’s financial downturn have been so severe that they have resulted in bankruptcy or creditors taking control of generation assets. It appears that merger and acquisition activity in the sector over the next several years will continue to cause the restructuring of generation portfolios and divestitures of contracted generating facilities.

6. Supply/demand imbalances: Demand is also growing on a regional basis due to the digitalisation of the economy, shifting demographics, and consumption patterns that are unlikely to change over time. The EIA forecasts that US GDP will grow at an average annual rate of three per cent through to 2025. Electricity demand growth is expected to follow the overall growth in the economy at an annual average rate of 1.8 per cent per year from in that period. This will require continuous investment in new plants to satisfy not only this increasing demand, but also the lost capacity represented by retirement of aging and inefficient facilities. Load-serving utilities (utilities that supply power to the end user i.e.,residential, commercial and industrial customers) are entering into long term power contracts with IPPs to avoid the volatility of the merchant or spot market pricing and to ensure that their customers have an adequate, reliable source of power.

Unique Investment Opportunities

The changes in this large, dynamic and capital-intensive electricity market have produced superior investment opportunities, witnessed by a rise in high quality asset sales and a decline in asset sale prices over the past five years. Along with underinvestment in certain power market segments, this new dynamism has resulted in an expanding asset-acquisition opportunity characterised by long-term off take contracts that yield predictable cash flows and equity returns, as described below:

Electric Generation – Divestiture Transactions: These transactions are a critical part of the industry’s restructuring efforts to improve industry players’ financial stability, ease liquidity pressure, and redirect falling credit ratings. According to Public Utilities Fortnightly (March 2004), 16,643 net MW of power generating facilities, valued at $7.3bn, were sold in 2003, contrasted with 11,718MW valued at $4.7bn sold in 2002. Estimates suggest that there is about 60,000 megawatts of capacity currently for sale in the US (Wall Street Journal: Electrical-Plant Watchdogs Open Door to Private-Equity Players, February 9th, 2004). In addition, industry power participants have over $90bn of debt due in the next five years (CERA: Picking up the Pieces, Winter 2004) with limited access to credit, scarce cash reserves, weak balance sheets, downgraded credit ratings, and little or no access to equity capital markets as $200bn of market capitalisation has been eroded (S&P Industry Report Card, US Power Sector, April 2004). As a result, many of these industry participants are motivated to sell their non strategic core assets. The absence of industry buyers in the market provides significant opportunity for private equity investors to acquire power assets at attractive valuations.

Electric Generation – New Construction: From 2002 to 2025, forecasts suggest that 356 gigawatts of new generating capacity is needed. The EIA:DOE projects that between 2002 and 2010, 88 gigawatts of new capacity will be needed, while from 2011 and 2025,268 gigawatts of new capacity will be required—an average addition of 19 gigawatts annually. In addition to meeting the growing demand for electricity, new plants will be built to replace older plants that are expected to be retired. From 2002 to 2025, a total of 62 gigawatts of capacity is expected to be retired, virtually all fossil-fuel fired. The largest component of retirements is expected to be older oil- and natural-gas-fired steam plants, as well as smaller num per cent less efficient than newer natural gas combustion turbine or combined-cycle plants. For oil- and natural-gas-fired steam plants, 35 out of 134 gigawatts of existing capacity is expected to be retired.

Renewable technologies account for just over five per cent of expected capacity expansion by 2025—primarily wind and biomass units. Distributed generation, mostly gas-fired microturbines, is expected to add approximately 12 gigawatts.

Restructured Transmission and Distribution Businesses without Return Caps: The construction of new generating capacity will result in incentive ratemaking and value extraction from assets and companies deployed within these power sector business lines. For example, the Trans-Elect Path 15 Upgrade (the “Project”) is currently under construction and will alleviate the chronic electric transmission bottleneck that exists between surplus demand in Northern California and surplus generation in Southern California. The Project is fundamental to the enhancement of electric transmission system reliability in California. The Path 15 transmission corridor has been designated one of the most notorious congestion points in the US transmission system and is directly credited for at least one of California’s blackouts in 2001. The Project has received support from President Bush, Energy Secretary Spencer Abraham, and FERC Chairman Pat Wood. The regulated transmission system rights provide exclusive entitlements for the use of the new transmission line under a 40 year contract. This contract provides the Project with high intrinsic and franchise value, as well as attractive cash on cash returns.

The Northeast Blackout on August 14, 2003 provided clear evidence that the aging condition of the transmission infrastructure in the US poses significant risk to reliability of our power supply, forcing the nation to reevaluate the current condition of the transmission grid. The antiquated high voltage transmission system requires significant capital investment to meet the increasing demand for electricity. Although from 1955 to 1985 investment in the transmission grid closely tracked or exceeded growth in electricity sales, from 1985 to 2000 investment increased at only one-third to one-half the growth rate of electricity sales (Power Finance & Risk, May 29, 2000). Severe strains on transmission have begun to emerge and linkages between regions are inadequate. Not only is the existing infrastructure antiquated, but there is also a need for additional transmission capabilities. To effectively compete for capital, transmission companies and regional transmission organizations may need to offer greater returns to investors through cost cutting, investment in new technologies, increased electricity throughput and optimizing rights-of-way. Various reports estimate the cost of the 2003 Blackout at from $6bn to $10bn. The Electric Power Research Institute estimates that as much as $100bn may be required to optimize transmission of power from regions of oversupply to regions of undersupply and to ensure that more blackouts do not happen.

During 2002, the first sale of a transmission line occurred. By year-end an additional sale occurred to the private equity firm Kohlberg, Kravis, Roberts. These two transactions represented a total of 6,693 miles of transmission lines. For comparative purposes, in 2001 the US had an estimated 607,861 miles of overhead transmission lines (EEI Statistical Yearbook of Electric Utility Industry 2003). Regulatory policies are promoting independent ownership, operations, and restructuring of these vast transmission systems and creating incentives for private capital resources to seek investments in this vital sector.

The future for private equity in the US electric power industry

Experienced private equity managers will increasingly aggregate investor capital to invest in these US power industry opportunities. As independent, disciplined, focused investors, private equity power funds are uniquely positioned to produce high risk-adjusted returns within existing regulated and deregulated structures and to work with regulators to further refine and improve the regulatory framework for this immense and indispensable marketplace.

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