JUICE: Risk and Return

As power producers owned by publicly traded companies find less economic sustenance in California, privately financed and less risk-averse players are entering the state's market. The private companies aim to capture lucrative opportunities created by rising demand, distressed assets, the need for additional generation, and the unsettled regulatory environment. As the Chinese say: "Chaos creates opportunity." For the market, it translates loosely into "More risk means more return." Consider Duke Energy and LS Power. LS Power is a little-known company that is part equity firm and part power buyer. It bought up 4,400 MW worth of Duke's California power plants earlier this year. This week, a company executive announced at a Power Association of Northern California luncheon that the firm planned to "actively pursue gas-fired development projects in California." It was music to the ears of nearly all of the more than 70 industry stakeholders at the June 13 confab. John King, LS Power's Western region vice-president, said the five former Duke generating stations create "a great platform" for the company. It bought the four Moss Landing units totaling 2,530 MW, the 1,002 MW Morro Bay plant, the 700 MW South Bay facility in San Diego County, and the 195 MW Oakland peaker. The old plants, which Duke bought at top dollar at the onset of deregulation, weren't profitable because long-term deals remained elusive, as did financing for plant upgrades. Unlike the case with Duke and other independent generators struggling to secure financing by solidifying their long-term prospects with contracts for power, multiyear deals are apparently not the be-all and end-all for LS Power at this point. King, who worked previously for Calpine, did say that most of the output of most of the units was under contract - none of it long-term. That includes a reliability-must-run contract for the South Bay plant. He told me he wasn't concerned by the reliability-must-run deal's 12-month life, noting that the output was much needed in San Diego. So why does LS Power expect to reap sizable profits from California? It is largely because it represents a different set of players and stakes. The private equity investors - including universities - are more risk-tolerant and "have a long-term framework," King explained. LS's private equity arm has $1.2 billion invested in the power sector under management. "In this business, if you want to raise money, it is through private equity," King said. The investment environment is perceived by the stock market and Wall Street as "unclear and fraught with regulatory risk," California Public Utilities Commission member John Bohn told me. In a report to his fellow commissioners June 15 after meeting with 20-30 financial analysts, Bohn said that "there are some concerns that long-term contracting is dead or dying." In contrast, the debt market - specifically private equity investors - expects higher returns but is also risk-tolerant, he said. "They have more risk capital and are able to hedge as well." LS Power is one firm that owns its power plants, so it can determine its level of risk. Another heading that way is Kinder Morgan, which announced at the end of May that it plans to spend $13.5 billion taking its pipeline company private. The buyback affects gas pipelines east of California. Other private equity firms have invested and continue to invest in parts of publicly traded power plant companies. Those include Goldman Sachs, Morgan Stanley, and hedge funds. They are a growing presence because they see rich opportunity in the short term. They buy interests in assets at low prices and plan to sell high. In addition, peak demand soaring above expectations and growing need for new generation are nothing but good news to them (Circuit, June 9, 2006). At the same time, more players in the market is good news for competition. "There is an awful lot of money running around out there," said Denise Furey, Fitch's senior director. These private investors are used to trading commodities and managing risk and generally look out about five years, she added. The private equity firm that snapped up Texas Genco for $900 million and then turned around and sold it a year later to NRG for nearly $6 billion is not considered the norm. These private equity firms also have an advantage because they have stronger balance sheets and at the same time more distance than utilities and generators from the very conservative credit-rating agencies. They also are not constrained by the challenges of raising public capital. Hedge funds are also big players, but at the same time a real concern for some because of their lack of transparency. The Oregon Public Utilities Commission is trying to put the brakes on Harbinger Capital Partners Master Fund's purchase of Portland General Electric stock because of concerns that it could influence utility operations, according to the Oregonian newspaper. The commission noted that state law requires the out-of-town hedge fund, which holds a 7.4 percent stake in Portland General, to spell out by late July its intentions and the potential impacts on ratepayers. Another downside to private equity stakes in the energy business is their exemption from state energy regulation. "The players provide an important bridge function, but they tend not to exist for very long," Bohn noted. In addition, they would not be affected "by the evolution of policy." Large sums of money move quickly in and out of markets while policy development moves at a glacial pace. When regulators finally agree on the rules for the hybrid market that's arisen from the ashes of deregulation, it may be about the time the big private equity players cash out. What that will mean for the state, ratepayers' pocketbooks, and the environment remains an open question.

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JUICE: Risk and Return

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