In an unregulated environment as the deregulation has been evolved, the basic economic principles that determine the value of the product of an electrical power plant, that is, electricity, are supply and demand, and competition. As demand for electricity increases and the supply of electricity remains constant, the price of electricity increases. But increased profits invite competitors who increase supply.
As a result, supply increases, prices fall, and profits decrease. To manage the unregulated sectors of the market, regional electricity Independent System Operators (“ISO”) coordinate the wholesale generators (electricity supply) and transmission systems with the industrial, commercial, and residential customers (the demand), to ensure that when demand is greatest, the supply is available and provided by the lowest cost plants.
The valuation of an operating electrical plant assumes the transfer of ownership as of a particular date. The transfer price is based on the concept of a willing seller and a willing buyer, neither being forced to participate in the transfer and, also, both being reasonably knowledgeable of the relevant facts associated with the operations and the business. To determine the transfer price or value of the plant, three approaches to value are available to review: the sales comparison approach (based on sales of similar plants), the income approach (based on projected cash flows), and the cost approach (based on the cost of construction less depreciation).
In the sales comparison approach, transactions in the marketplace are used to derive a value for a plant based on the actions of buyers and sellers. Actual sales are analyzed and adjusted to the subject plant. Adjustments to consider include (a) size - the generation capability of the generators; (b) production expenses - compare the cost to produce electricity per kW between
the plants; (c) time - adjust for the economics between the appraisal date and the date when the sale took place; (d) age - compare the age and level of technology; and (e) location - adjust for different economics between the subject’s location and that of the sale; in other words, is the subject in a better or worse location when considering its ability to receive fuel and transmit power to the grid at a profit?
A spark spread or gross margin (revenue per kW less cost of fuel per kW); can be used to adjust for time (market conditions) and location. Several other adjustments can be made depending on the circumstances. When taking into account the purpose of the valuation, any fuel inventories, intangible assets, power purchase agreements (“PPAs”), transmission assets, or other assets should be removed, as necessary, from the transaction price to result in only the price of the tangible plant assets under review.
The sales comparison approach can be a powerful tool when appraising an electricity generating plant, if comparable sales can be found and properly investigated. When the industry began to restructure in some states, many nuclear, coal, and older style steam generating plants were sold in the market. After appropriate adjustments to the subject plant, a sales comparison indicator of value could be derived.
This method is used most frequently by buyers and sellers in the marketplace. But, forecasting the future is difficult because power plants are income-producing assets. Buyers and sellers often use a matrix of income approaches to test their forecasts in as many different ways as possible, thus developing a range of values for use in negotiating sessions. Buyers and sellers also are knowledgeable of plant sales (they often participate in the bidding process for plants) and the cost of new construction and the basic concepts of physical deterioration and obsolescence.
Items to be forecast in the income approach include capacity factor (electricity production), prices of electricity and fuel (energy costs), operating expenses, emission credits, future capital expenditures and sustaining capital requirements, additions to the decommissioning trust fund (for a nuclear plant), and the capitalization or discount rate. Forecasts for prices of electricity are frequently available from various published sources or consulting firms specializing in economic forecasts. Many consultants forecast electricity prices on an hourly basis, based on computer models, and supply and demand relationships.
Electricity production and capacity factors can be forecast by reviewing past performance and the future budgets for the plant. Operating expenses can be projected by reviewing operations over the last three to five years. Future capital expenditures are commonly budgeted by plant management for three-, five-, or ten-year periods. Beyond the budget time period, 2% to 3% of the reproduction cost is necessary for sustaining capital, which is needed to keep the plant in safe operating condition. For nuclear plants, it is especially important to review the decommissioning trust fund and also the decommissioning cost forecast. It is most common to develop a discounted cash flow (“DCF”), rather than just capitalizing one year. Capital expenditure patterns and planned outages vary over multi-year periods such that one year’s data is frequently not stable enough to forecast a normalized income stream, although there can be exceptions. Participants in the market develop after-tax, debt- free cash flow (“free cash flow”) streams that reflect the income level received by equity and debt holders. Depreciation is calculated using the modified accelerated cost recovery system or MACRS tables to reflect the buyer’s new tax basis. Pretax cash flows also can be developed and, at times, can be a meaningful indicator of value.
The discount rate to be applied to the after-tax, debt-free cash flow stream is typically developed utilizing a weighted average cost of capital (“WACC”). This method requires an investigation of publicly traded guideline company stocks to develop a typical capital structure (equity and debt weightings) and beta (volatility or systematic risk inherent in the industry). The capital asset pricing model or the build-up method is used to derive an equity investor’s required return on an investment in the merchant plant electrical power industry.
The equity return must be adjusted for risks inherent in the single plant under valuation and the additional risks of equity ownership, compared with a larger participant in the industry who most likely owns several plants. Additional risk factors, unsystematic risk, must be considered to reflect the additional risks of equity ownership. Because debt cost is also high due to the single plant nature of the investment, higher risk industrial bonds (higher risk but not junk) are utilized. The WACC is then calculated on an after-tax basis and applied to the forecasted cash flow stream.
Caution must be exercised to utilize a capital structure that reflects an investor’s long-term perspective of the industry.
The result of the income analysis is the value of the entire business enterprise associated with the operating plant. To determine the value of the tangible assets alone, a normal level of net working capital is deducted (based on the guideline company analysis, frequently measured as a percent of revenue); in addition, the intangible assets must be valued, then deducted. Intangible assets include, but are not limited to, the trained and assembled workforce and management team, operating manuals and procedures, licenses and permits, PPAs, emission credits, and software. The resulting income indicator of value for the tangible assets includes the real estate comprising land, buildings, and land improvements; and the personal property, both electrical generation equipment units and support assets.
Traditionally, appraisal textbooks describe the sequence of deductions in the cost approach, after deriving the current cost of the subject, as first physical, then functional and economic. If all of the deductions are percentage or dollar deductions, the sequence is immaterial; the resultant cost indicator of value will be the same. However, if the deductions are derived in a manner that is a mix of percentage deductions (typically physical deterioration is calculated as a percentage) and dollar amount deductions (typically operating obsolescence is calculated as a dollar amount because it is the present value of an operating expense differential), the percentage deduction must be made first. Economic obsolescence can be a dollar amount or a percentage amount, depending on how it is derived. Functional obsolescence (“FO”) due to excess capital costs is quantified by subtracting the COR from the RCN. Depending on the type of asset and technological changes within the industry, FO could be positive or negative. Deductions in the cost approach must be developed in a logical manner. Following the traditional sequence of physical, functional, and then economic, can lead to an incorrect indicator of value. The appraiser must analyze how the components of the cost approach are developed and then make the deductions in a logical sequence.
The cost approach is especially useful for unique property where sales do not exist and an income approach is not possible. In this approach, the current cost of the property being valued, less all forms of depreciation and obsolescence, plus land value, is developed. One problem, however, is that the appraiser must be knowledgeable of the industry’s economics and technology. Preparing a complete and detailed cost indicator of value is very time consuming, but the cost approach can produce the most subject-specific detail of any of the three indicators of value. Unless they are inserted in the cost indicator of value, working capital and intangible asset values are not included.
Current Valaution Challenges
From gas-fired power plants to co-generation facilities, lignite coal plants to Powder River Basin coal plants, and nuclear power plants to wind farms, we have the expertise to navigate the industry and arrive at an accurate market value.
Government policies and a constantly changing regulatory environment make electric generation appraisal a complex field. EPA standards for coal-fired plants, government subsidies for wind and solar generation, safety standards for nuclear power, and the price of natural gas all relate to the valuation process for electric generation facilities.
Our expert research, inspection, and analysis account for each of these factors to ensure a defensible value. How do you assess a co-generation facility whose by-product of steam is used in a chemical plant? How do EPA emission standards or the low price of alternative fuels affect economic obsolescence for a coal-fired power plant? How do you account for government subsidies for wind farms? Many coal-fired plants are planning to close in the near future because of high costs associated with new emission control standards. Like the foreclosure market’s effect on housing, we anticipate plant closures and distressed sales to affect the market value of modern coal-fired plants as well as those that expend the capital to meet the new standards.
Meanwhile, heavily-subsidized wind/solr farms are allowed rapid recapture of investment. Their generation curves do not match the electrical demand curves, so how will new super battery storage facilities affect their value? We can help.
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