This article first appeared in Power Finance & Risk.
Are Independent Power Producers (IPPs) undervalued as public companies? It’s a common question discussed throughout the industry, particularly as market capitalizations have dipped more than 15 percent in the last two years. PA Consulting Group set out to analyze this question, given a recent spate of single-asset transactions that seemed to indicate strong asset values in certain markets, as well as a mini merchant development boom in the Mid-Atlantic and Northeast U.S. where combined cycle generators are achieving financing at new build costs.
In a fairly simple exercise, PA compared the total enterprise values (TEV) of the primary ‘pure-play’ public IPPs (Calpine, NRG, Dynegy, and Talen) to a high level valuation of the individual generators within each companies’ power generation portfolio (Note: PA made adjustments to account for non-generation business segments, such as competitive retail). Of these companies, Calpine has by far the generation portfolio that is most reliant on natural gas, while Dynegy, NRG, and Talen are comprised of a mix of natural gas, coal, renewable, and oil generators. See Figure 1 below.
Figure 1 – Public IPPs generation asset mix
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As you can see in Figure 2 below, PA’s high level valuation for Calpine is fairly close to its TEV, indicating that the market appears to be giving proper weight to stock whose value is driven by natural gas generation assets. For the other portfolios, it is apparent that the market is not recognizing any value for the coal and nuclear units, as PA’s approach overvalues the portfolios on a $/kW basis unless all value is removed from the coal and nuclear capacity. Given that 1) the short-run profitability of coal and nuclear generators is largely negative to slightly positive, and 2) the equity markets value merchant generation portfolios based on short term earnings expectations (multiples of current EBITDA projections), equity markets end up viewing coal and nuclear capacity as valueless despite the fact that many coal and nuclear generators do have long term value.
Figure 2 – Public IPPs Total Enterprise Value (in $/kW of capacity)
So what does this mean for public IPPs, and for investors in both publicly traded IPPs and generation infrastructure?
1) The value of coal and nuclear is understated in publicly traded IPPs and needs to be evaluated with a longer time horizon. While it is true that some coal plants are not worth the environmental upgrades required to keep them operating, there is value in fuel diversity and some states are demonstrating that they agree. For example, Ohio is debating a proposal that would allow several of its utilities to enter into long-term PPAs with certain non-regulated coal plants. Nuclear plants also provide both fuel diversity as well as zero-emissions power, neither of which they are compensated for currently in competitive power markets. Efforts are underway (such as New York’s recently approved Zero Emissions Credit program), but policy-makers haven’t been able to move quickly enough in some regions (like Illinois) and several reactors are set to shut down in the next several years. Overall, there is unrecognized long term value in the coal and nuclear fleets (as evidenced by over 8 GW of coal capacity transacted in the last two years and the newly announced purchase of FitzPatrick nuclear by Exelon), whether it be from future policy initiatives or a natural gas price rebound.
2) There is likely value left on the table in IPP market valuations, partially due to coal and nuclear but also for gas and other assets that may be undervalued by a portfolio EBITDA approach. Certain assets in a portfolio may be more valuable as single assets than as a piece of the whole, and we’ve seen the realization of this by the IPPs in recent actions. For example, NRG’s recent sale of the Aurora and Rockford I & II facilities to an LS Power affiliate (a private equity firm), Dynegy’s announced sale of its Elwood share to J-POWER (a Japanese publicly-traded firm), as well as Calpine’s sale of South Point to NV Energy (an investor-owned utility). We would expect to see further portfolio rationalization as U.S. publicly-traded IPPs seek to move non-core assets to shore up balance sheets and flagging share prices.
Looking ahead, this brings into question whether or not the publicly-traded model makes sense for U.S. IPPs. Equities investors are generally seeking one or both of two things: either stable and predictable earnings, or the possibility of strong growth. The EBITDA-driven valuations in today’s low commodity price environment mask the fact that many IPP assets have longer term value, which diminishes equity market value while introducing higher levels of share price volatility. Other types of investors, such as private investors, who base valuation on longer term fundamental drivers, are able to take a longer view than equity investors and more appropriately value the growth potential of portfolios of mixed assets. As a result, we may see a continuation of the move towards privatization that started with Talen, which recently announced its sale to Riverstone Holdings after going public just over a year ago.
Salem Esber is an energy markets experts at PA Consulting Group
Note: Ryan Hardy, Matt Mooren, Austin Kesar, Thomas Binet, and Ellyn Green contributed to the development of this article.