CAMBRIDGE, Mass., Nov. 18, 2003 - Uneven deregulation of the North American electric power industry has created an inefficient patchwork of market types and warped some companies' valuations to the extent that a serious gap - or disconnect - has been created between current capital market valuations and industry realities, according to Electric Power Trends 2003, an in-depth study by Cambridge Energy Research Associates (CERA).
Undertaken in collaboration with Accenture, Electric Power Trends 2003 is a comprehensive overview of the industry, and a detailed analysis of emerging industry trends. The 2003 installment of this annual study identifies shifting values among the links in the power business value chain - fuel, generation, trading, transmission, distribution and retail - as the most significant trend to emerge in the industry in recent years.
"Shifting valuations of the links are likely to create a new set of drivers for mergers, acquisitions and divestitures in the coming years," said Lawrence J. Makovich, CERA Senior Director, Americas Gas and Power. "The strategic implication is clear: to develop winning strategies, companies must decipher trends in the power industry value chain and determine which segments or combinations of segments will create the most value for them in the future."
"In the past two years, a number of power companies lost over 90 percent of their equity value," said Etienne Deffarges, global managing partner in Accenture's Utilities industry group. "At the same time, other power companies fared better than the stock market in general. Understanding the forces that underlie these dramatic discrepancies is imperative for business executives, investors and policymakers."
The power business is undergoing profound changes, the scope and depth of which are far greater than anything the industry has undergone in 50 years, according to the report.
Beginning a decade ago, a series of federal and state regulations kicked off a gradual unbundling of the vertically integrated power industry, affecting the entire value chain. In the process, deregulation introduced competitive forces to varying degrees in each business segment, and in each state. Thus, the business landscape - demand growth, supply costs, price volatility, capital intensity, profitability, risk and asset values - can vary considerably from one segment to another.
"After a decade of deregulation, the power industry is, at best, halfway along in the transition from regulation to the marketplace," said Jone-Lin Wang, CERA Director, North American Electric Power. "The process has now stalled, leaving us with an unintended half market-based, half regulated 'hybrid' structure for at least five more years."
The report outlines expected changes in each of six industry segments. These include:
* Natural gas and coal will continue to supply the vast majority of generation growth.
* The increase in gas demand for power generation will continue to shift seasonal demand patterns for gas use, affecting gas storage and withdrawal patterns and transferring gas price volatility to wholesale power prices.
* The capacity overbuild and gas price run-up are reshaping wholesale power price expectations, generation asset values, and merchant generation viability. Oversupply will last at least five years in most regions, and the major financial restructuring that began more than a year ago will continue for the next several years.
* Opportunities are shifting from power plant development to acquisition.
* The continuation of the uncoordinated mix of regulation and market forces will create new distortions, pitfalls and opportunities.
* Industry participants need to right-size trading. Trading is likely to return primarily as a tool for asset optimization and risk management, rather than as a stand-alone business based on speculation.
* Rebuilding the rules and the institutional framework will stabilize the trading business in the future. Liquidity will recover, and the credit positions of market participants will improve.
* The financial penalty that investors impose on companies involved in trading will likely diminish over time with the continuing imposition of proper limitations and controls.
* RTO formation will continue but implementation will take a number of years, and different regions will follow different schedules. Most transmission will remain regulated, with some niche opportunities for merchant projects.
* Higher allowed returns for greater independence in transmission operation is likely to foster additional cases of transmission asset separation and consolidation, though states' reluctance to relinquish control will slow the pace.
* Advanced technologies capable of augmenting the existing grid have been held back due to uncertainties surrounding restructuring and anxiety over the consequences of implementation.
* It is increasingly likely that many states will extend, rather than end, the restructuring transition period - with the associated price caps and rate freezes - and in doing so rely more and more on performance-based rates for distribution services.
* Regulators and managers both are likely to concentrate on distribution cost benchmarking in the years ahead
* Retail choice will stall for several years. No additional states are currently considering retail competition.
A new business segment is emerging - regulated market intermediaries selected through an auction process to serve blocks of retail customers that do not choose electric suppliers.
The dramatic shift in value along the power value chain was confirmed by a CERA analysis of the stock price to earnings per share (P/E) ratios and business segment participation for 61 power industry companies.
Two years ago, regulated retail was out of favor. Many distribution utilities were subject to retail price caps or a retail price freeze, and saddled with "provider of last resort" (POLR) obligations. Escalating wholesale power prices during the first quarter of 2001 caused severe financial hardship for some of these utilities.
Value shifted dramatically over the two years following the first quarter of 2001, noted the study authors. Value shifted away from both competitive generation and trading over the past two years, as the overbuild in generation depressed merchant earnings and low price volatility and scandals stifled trading. Equity values of merchant power and trading companies declined 92 percent during 2002. In the process, value migrated from the merchant power and trading sectors to regulated generation in 2003.
Business Strategy Implications
Experience over the past few years has revealed that Wall Street is slow in recognizing power market developments but quick to adjust valuations, according to Electric Power Trends 2003. Thus equity valuations are often misaligned with market fundamentals until a swift adjustment occurs.
"The most costly mistakes made by power companies were to follow capital market signals and fail to capture opportunities offered by the gap between valuations and business fundamentals during the window of opportunity provided by the valuation adjustment lag," said Makovich.
The report notes that current power company valuations still do not always align with business fundamentals, and that this creates opportunities for those who recognize them:
"Significant shifts in competitive position and thus relative valuations are quite likely in the generation segment during the overbuild workout period. Companies that understand the fundamental trends, risks and rewards in each business link will have an advantage over those who don't. Success will go to companies that can decipher the power industry value chain, understand the trends and drivers of the links, and adjust portfolios to take advantage of the shifting valuations."
About Cambridge Energy Research Associates
Cambridge Energy Research Associates is an advisor to major North American and international companies, financial institutions and organizations, delivering strategic knowledge and independent analysis on energy markets, geopolitics, industry trends and strategy. CERA is headquartered in Cambridge, Mass., and has offices in Beijing, Calgary, Houston, Mexico City, Moscow, Oakland, Oslo, Paris, Sao Paolo, and Washington, D.C.
Accenture is a global management consulting, technology services and outsourcing company. Committed to delivering innovation, Accenture collaborates with its clients to help them become high-performance businesses and governments. With deep industry and business process expertise, broad global resources and a proven track record, Accenture can mobilize the right people, skills, and technologies to help clients improve their performance. With more than 83,000 people in 47 countries, the company generated net revenues of US$11.8 billion for the fiscal year ended Aug. 31, 2003. Its home page is www.accenture.com.