September 2012

CRA Vice President Loretta Cross moderates webinar on today’s power sector

On July 19, 2012, the Turnaround Management Association (TMA), a nonprofit association dedicated to corporate renewal and turnaround management, hosted a webinar focusing on the current power sector. Charles River Associates Vice President Loretta Cross of the Energy & Environment Practice moderated the webinar entitled “The Spread and Butter of the Power Sector in 2012.” Ms. Cross was joined by three experts in the energy sector: George Mack, Restructuring & Finance Managing Director, Barclays Capital; Art Stappenbeck, Power Generation Industry Consultant; and Adam Strochak, Business Finance & Restructuring Partner, Weil, Gotshal & Manges LLP. The power market is undergoing fundamental change driven by declining market conditions and increasing regulatory restrictions. In this timely webinar, panelists discussed new developments in the power sector as a result of these fundamental changes, including issues related to restructuring, refinancing, and recapitalizing power facilities.

Key power sector concepts Opening the webinar, George Mack, who works in the restructuring and finance group at Barclays, said that his group spends most of its time—and he spends all of his time—in the power and energy space as a result of the fall of natural gas prices and its impact on certain parts of the industry. “To sum up the situation the [generation] industry faces,” he said, “the cost of generating from natural gas has fallen for the first time to a level where it is competitive with the cost of generating power using coal. That fact is the key disruptor, from my perspective, to the industry. Despite the political noise one hears in the world and even the regulatory issues…at a fundamental level, it is the fall in natural gas prices that has disrupted this industry.” Next, Mr. Mack reviewed the supply curve for the industry, or “the price at which certain volumes of energy is supplied into the market,” he said. The generation assets that supply the US market are:

• Base-load generators. They tend to be nuclear, hydro, and, formerly, coal. They provide the base supply to the country, run day and night, are not designed to be turned on and off, and are the foundation of the generation infrastructure. They are efficient plants that run during all hours, have very little fuel costs and hence low variable cost, and have high-capacity factors of generally more than 70%.

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• Intermediate/combined cycle. After base-load is used up by the market, these assets are turned on to supply the next layer of demand. Many of them are gas-fired, run during the day and shut off at night, and are designed to turn on and off.

• Peaker/combustion turbines. Plants that run only during peak hours when there is very high demand in the market, they are generally less efficient and have a very high variable cost. They are not good suppliers of everyday power, but they are designed to click on and off quickly.

The owners of these plants are either regulated utilities, which typically operate transmission and distribution networks, and, in many cases, generation assets and earn a regulated return on capital (such as Entergy), or independent power producers (IPPs), non-utility owners of power generation assets, such as Edison Mission Energy. Mr. Mack also reviewed how these three components come together to form the typical power supply curve of the US market. First on the curve are hydro and nuclear, because they are the cheapest to dispatch, run all the time, and no other power is needed at this level of demand. As supply increases in response to demand, the natural gas assets kick on when market conditions warrant. “The natural gas portion of this power curve has flattened out in response to the low price of natural gas in the market,” he said, “so that now the incremental unit that is coming on may be a coal plant or it may be a natural gas plant that can compete with a coal plant. The implication for this discussion…is that coal plants used to have no competition, they did not cycle on and off, and now natural gas is competing with coal plants. And so if the coal plant is in the market and does not have a contract to sell its power at a fixed price to a utility, for example, then it may not need to turn on because there is a natural gas unit somewhere nearby that can actually produce power cheaper. The system operator is always going to call on the cheapest unit to provide the next incremental unit of power. The implication of that is the distress we’re seeing on the merchant coal portion of the market,” he said, “or those coal plants that do not have contracts for all or the majority of their capacity for an extended period of time.” Mr. Mack cited one of his current projects, the power company AES Eastern Energy in New York state, as one example. As a result of low natural gas prices, the company’s coal-fired plants were not dispatching like they used to and the company had to file for bankruptcy. Mr. Mack also reviewed some key industry terms such as units of measurement, dispatch, and heat rate. “Heat rate is very important,” he stated. “If a plant converts energy efficiently into power, it will have a low heat rate. Competitive heat rates and fluctuating prices often push coal to the margin.” He also reviewed the terms availability and capacity. “Another term you’ll often hear in the market,” Mr. Mack said, “is ‘dark spread.’ You’ll hear this vocabulary in the market—that ‘dark spreads have compressed and that’s what’s killing the coal sector.’ The dark spread is simply the spread between power prices and the cost of coal, or the cost of generating using coal. And the reason that dark spreads have compressed is that gas prices have fallen and the result is the revenue line for coal-fired generators has fallen while the cost of coal has not fallen….Basically, the margins in coal generation have not come back yet.”

Restructuring in the power sector Lastly, Mr. Mack discussed restructuring in the power sector, particularly the drivers. “Given the current power market dynamics,” he asserted, “un-hedged merchant/IPP generators, particularly those utilizing coal-fired assets, are potential restructuring candidates.” One of the drivers of restructuring is power prices. He said that coal prices haven’t dropped, and because the plants are built on debt and that “starting up a plant is costly…and confidence in starting up is lowered.” Also, due to the nature of coal plants, the “base-load can’t turn on and off based on price,” as

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discussed earlier. The international demand for coal has supported prices to the detriment of dark spreads, but coal prices have started to decline in response to lower US demand and a strengthening US dollar. He also said that the economic downturn has played a factor in the power sector, citing slow growth and the recession. Mr. Mack also mentioned recent EPA regulation that will likely have a significant impact on expectations for future power market conditions. He said that regulation does play some role in the restructuring in the power market primarily because capex requirements to keep coal-fired plants in compliance are very high. He predicts that some of the new regulations, like the Cross State Air Pollution Rule (CSAPR), “will result in high capex at, or shut down of, many coal-fired power plants.” He said that regulation is a source of “additional, but not the majority of, distress in the coal market.”

Market update Mr. Art Stappenbeck, a power generation industry consultant, spoke next on the current market. With the supply of natural gas and capacity greater than 30%–40% in the last few years, he said, the cost is “very competitive with coal prices and a challenge to the coal industry.” He showed a chart demonstrating the capacity factor forecast by fuel type in which nuclear stayed flat, there was some drop-off in coal, and an increase in gas, indicating that the coal plants will be distressed. He pointed out that gas prices peaked in 2008 and the subsequent substantial drop in price was because “every place someone puts a stick in the ground, they discover shale gas,” he said. Looking ahead 30 years, he predicted that natural gas would increase in quantity and coal would remain flat. “Coal assets that want to run full-time will be hard-pressed to do that,” he said. Mr. Stappenbeck summarized his commodity market overview saying:

• Despite new demand sources, gas prices will remain a function of supply;

• As low gas prices persist, more generators will switch from coal to gas; and

• Natural gas will play an increasing role in setting the marginal price of power.

Mr. Stappenbeck also discussed the benefits and challenges associated with renewable energy sources such as wind and solar farms. Some of the benefits include:

• Renewables have long-term viability due to future carbon regulations, load growth, tax credits, and future demand for natural gas;

• Wind power projects produce a small amount of EBITDA (earnings before interest, taxes, depreciation, and amortization) and a stream of tax benefits; and

• Overestimating energy production and underestimating operations and maintenance further reduces EBITDA.

Lastly, he stated some of the challenges of renewable energy sources:

• The price of natural gas will continue to remain low due to shale gas finds;

• You cannot forecast the weather—renewable energy is viable approximately 30% of the time; and

• The average start-up time is one and a half hours.

Regulatory evaluation The last panelist was Adam Strochak, Business Finance & Restructuring Partner at Weil, Gotshal & Manges LLP, who gave a regulatory evaluation of the power sector.

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“Regulation is a critical issue for plants not only from the perspective of capital costs and capex expenditures,” Mr. Strochak said, “but also just in operating costs. Many of the regulatory programs impose significant, ongoing operating costs, particularly [these] emissions allowance programs. What’s happening is that many changes enacted by Congress in 1990 with the amendments of the Clean Air Act have taken 20 years or so to percolate through the regulatory system,” he said, “and we’re now getting application of rules that were originally thought about in 1990 when Congress amended the statute and a lot of these rules are coming home to roost in the industry.” They include:

CAIR/CSAPR • EPA rules designed to reduce emissions of SO2 and NOx

• In 2005, the EPA issued its final Clean Air Interstate Rule (CAIR), designed to reduce emissions through a cap-and-trade system

• In 2008, the US District Court of Appeals overturned CAIR, ruling that the cap-and-trade program was not authorized under the Clean Air Act, but allowed CAIR to remain in place until the EPA could promulgate a replacement rule

• In 2011, EPA issued the Cross-State Air Pollution Rule (CSAPR), which would directly limit SO2 and NOx from power plants; however, CSAPR itself was challenged in court, and so CAIR remains in place

RGGI • Regional Greenhouse Gas Initiative (RGGI) cap-and-trade program requires power generation

facilities in RGGI member states to buy credits equal to the number of tons of carbon dioxide emitted from the facilities

• RGGI has been plagued by over-supply of allowances

Mercury Rule • MATS, a US EPA rule issued in December 2011, finalized technology-based emissions limitation

standards for mercury and other toxic air pollutants from coal- and oil-fired power plants

• These rules are applicable to all coal- and oil-fired electric generating units with a capacity of 25 megawatts or greater and will require the installation of technology to limit pollution levels

• Existing sources generally will have up to four years if they need it to comply with the new rule

• EPA said the rules will slash 90% of mercury pollution from coal-fired power plants and will cost almost $10 billion a year

Water Intake Rule • In March 2011, EPA issued proposed regulations that require existing large power plants that

withdraw cooling water from adjacent water bodies to limit the number of aquatic organisms that are killed when they are pinned against the facilities’ intake structures or that are drawn into the facilities’ cooling systems

• The proposed regulations provide that covered facilities are required to meet the impingement standard as soon as possible but no later than eight years after the effective date of the rule

• The final rule is expected to be issued mid-2012

Some of the open issues concerning regulatory developments are Dodd-Frank and FERC 741, according to Mr. Strochak. “These regulations will require significant investments in systems and people to allow companies to remain competitive,” he said. In conclusion, he said that “regulation is not as large a factor as prices but air emission prices are contributing to distress.”

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Q&A Ms. Cross asked the webinar attendees if they had any questions for the panelists, and they asked several poignant ones. One attendee asked the panel about the likelihood of a bubble burst in gas prices. The experts reiterated that “gas-fired plants won’t be distressed” and that “the demand for natural gas will rise due to lower prices.” When Art Stappenbeck was asked if he was to start his own power plant what would he do, he said that he would use gas turbines and only a small amount of land and have access to a high-pressure gas line. Another question asked at the webinar concerned tax benefits. Coal, nukes, and renewables all have applicable tax benefits, but is gas the only area that does not have tax benefits? The answer was yes—yet it still competes well in the market. Mr. Stappenbeck emphasized that despite gas not having tax benefits, the “big positives of natural gas are that it is a clean fuel, there is no waste, it does not require long-term storage, it arrives ready to use, and it is easy to get permits.”

Conclusion TMA’s webinar, “The Spread and Butter of the Power Sector in 2012,” focused on the key issues in the industry today. The expert panelists agreed that:

• As natural gas prices fall, the power market is undergoing significant structural change.

• Coal-fired assets, historically base-load generators, are facing significant competitive pressure from gas-fired assets. The market is expected to continue to trend out of coal assets into gas assets.

• Compounding the market pressure, EPA and congressional regulation is subjecting coal-fired generators to significant uncertainty and additional costs.

• As a result, certain coal-fired generation assets are potentially “distressed:” merchant generators, subject to unfettered competition with gas assets. Highly levered companies, forced to make large debt-service payments, are particularly challenged as are assets with generation contracts expiring in the near term.

About CRA and the Energy & Environment Practice Charles River Associates is a leading global consulting firm that offers litigation and regulatory support, business strategy and planning, market and demand forecasting, policy analysis, and risk management consulting. Founded in 1965, CRA has offices across North America, Europe, Asia, and the Middle East. CRA’s Energy and Environment Practice provides expert economic and business consulting services to a wide range of energy industry clients. With years of industry experience and exceptional strength in analytics, our consultants offer management, regulatory, and economic expertise to all sectors of the power and gas markets—as well as hands-on experience helping clients manage market power, environmental policy, and regulatory issues. We have pioneered techniques and models that have become industry standards, including competitive market designs, efficient bidding mechanisms, creative financial transactions, and methodologies to assess market power. Learn more at www.crai.com/energy.

About Loretta Cross Loretta Cross is a vice president in the Energy & Environment Practice of CRA. She has more than 25 years of experience in corporate strategic, operational, and financial restructuring. She is a recognized expert in the energy industry, and her experience includes all areas of the BTU value chain from

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exploration and production to consumption. She has worked with exploration and production, oilfield services, and power generation companies; trading and marketing entities, pipelines; refineries; and retail energy providers. Clients have varied from small privately held companies to large international enterprises. Her specialties include debt restructuring, business valuation, financial forecasting, forensic analysis, regulatory compliance, litigation support, commercial litigation, damage calculation, litigation consulting, and bankruptcy, among others. She has been a key business advisor to parties in some of the nation’s largest bankruptcies and restructurings and has provided expert testimony in numerous courts on a variety of issues.

Contact Loretta Cross Vice President Houston +1-713-302-5681 lcross@crai.com www.crai.com

The conclusions set forth herein are based on independent research and publicly available material. The views expressed herein are the views and opinions of the authors and do not reflect or represent the views of Charles River Associates or any of the organizations with which the authors are affiliated. Any opinion expressed herein shall not amount to any form of guarantee that the authors or Charles River Associates has determined or predicted future events or circumstances and no such reliance may be inferred or implied. The authors and Charles River Associates accept no duty of care or liability of any kind whatsoever to any party, and no responsibility for damages, if any, suffered by any party as a result of decisions made, or not made, or actions taken, or not taken, based on this paper. If you have questions or require further information regarding this issue of CRA Energy & Environment Memo, please contact the contributor or editor at Charles River Associates. Detailed information about Charles River Associates, a registered trade name of CRA International, Inc., is available at www.crai.com. If you do not wish to receive future updates, e-mail alerts, or invitations to seminars, please let us know by replying to this e-mail and placing “unsubscribe” in the subject line. Copyright 2012 Charles River Associates