A few weeks ago, AEP Ohio announced the sale of four of its premier power plants to two private equity firms. The sale included three natural gas-fired plants totaling 2,533 MWs and a monster coal-fired plant totaling 2,665 MWs. This transaction is the second of its kind in Ohio as Duke Energy sold all of its Ohio power plants to independent power producer, Dynegy in 2014. This trend is not only happening in Ohio but in other deregulated states such as New York, Illinois, Massachusetts, Maryland and the list goes on.
I had to ask the question: What is going on in the energy market that is driving the utilities out of the power making business?
Energy efficiency is flattening demand
The U.S. Energy Information Administration (EIA) reports that demand growth for electricity has slowed every decade since 1950. The rate of growth went from 9.8% per year from 1949-1959 to a whopping 0.5% per year from 2000-2015. Increases in demand due to population growth and economic activity are countered by lower energy intensity per capita due to energy efficiency in buildings and end use equipment. In addition to overall stunted growth, the projected sales of electricity are down due to self-generation by large industrials. Overall, the demand picture is fairly stagnant at only a 1% per year increase projected from 2015 – 2040.
Energy prices are below the cost to make power for many
It is no secret that coal-fired power plants are having a hard time competing with natural gas fired power plants. This is due to not only the cost of fuel but also the efficiency of each technology. The average coal plant needs around 11 MMBTUs to make 1 MW of power while a natural gas plant needs only around 7. Since natural gas is now as cheap as coal, this efficiency difference creates a pretty big gap in cost to generate. At $3.00/MMBTU for both coal and natural gas the simple variable cost to produce 1 MW of power is $33.00/MW from coal and $21.00/MW from natural gas. That is a 35% difference in costs!
These marginal costs to produce power are the backbone of the wholesale energy forward markets. Marginal costs set hourly prices which in turn influences traders’ views on the longer term forward markets. As more and more efficient gas fired plants come on line the forward markets move toward the lower marginal costs. In just five years we have seen the forward markets go from an average of $48/MWh to now $30/MWh. Without the assistance from other revenue sources such as the capacity market, coal plants can’t make any money and in fact many are losing money in this price environment.
Utility investors seek strong consistent dividend growth
Typical investors of utility stocks seek the predictability of earnings gained in the regulated market. The utility invests money into infrastructure, asks for a rate of return (many around 10%) on that money from the regulators and rate payers pay for it. This is a simple low risk model for the investor producing a consistent dividend.
In a deregulated model, utilities now have to manage profitability based on their ability to make money selling power from their plants. In this low priced environment, company earnings are under pressure making senior management and Wall Street uneasy. This market risk does not typically fit the profile of the utility investor nor are utilities the best in adapting quickly to market changes. For those who can’t stand this heat they will sell the stock.
The Clean Power Plan
The Clean Power Plan (CPP) is a federal requirement for states to develop plans to reduce CO2 emissions. Although this requirement is being challenged in the court system, the threat still remains. This mandate will accelerate the shift toward less carbon-producing generation such as natural gas and renewables. If the CPP requirement holds, projections by the EIA have natural gas and renewable energy surpassing coal-fired generation in 2024 and 2028, respectively. This would be achieved through a combination of coal retirements and development of renewable and natural gas generation. This shift is likely to occur even without the added pressure of the CPP based on pure economics but this added requirement will hammer the nail into the coffin a whole lot sooner.
Get out while you can
There are only so many buyers for legacy power plants and when the music stops the seller better have a chair. Private equity firms are buying these plants not because they are cash cows but rather are placing their bets that prices are going to increase. In financial terms, they bought the option at a strike price which they will try to reduce through process improvements. In the latest AEP Ohio transaction the value of this option was $417/kW. By comparison a new natural gas power plant can cost up to $800/kW to build. The appetite to purchase these plants is not insatiable and at some point the buyers will be full.