Energy Assets Don't Always Mix

 | Apr 07, 2014 | 5:03 PM EDT  | Comments
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The best way to understand energy assets is isolate them. In the old days, energy companies had a tendency to link assets together. This approach appealed to state regulators as they attempted to solve energy, environmental and economic development challenges.

In the era of deregulation, it is a different story. Investors want to cherry-pick assets. They seek the highest returns. They want to fund one component at a time. The least impressive assets are deferred.

A desalination plant is a good example. Apparently, California wants to make freshwater out of saltwater. The conversion process requires a lot of electricity. For many, it seems that building a power plant in conjunction with the desalination plant makes sense. When systems are combined, the overall operating costs decline.

It turns out that the combination does not always work. Advocates may not realize that they could be asking investors in a power plant to subsidize the desalination plant. Why would any investor want to subsidize some else's project?

Power-plant investors would happily build a dedicated facility. They would do it only if they could earn more revenue than the alternative. Accordingly, the plant must sell its production to the desalination plant at above-market prices. If it cannot, it will simply sell its power into the market.

The alternative is also true. The managers of the desalination plant have an obligation to seek the lowest possible costs for their power. They are unmotivated to subsidize a power plant unless it will produce cheaper power than what is available in the power markets.

A second issue is the reliability factor. When two independent machines are lashed together, then if either component fails, the entire system fails. In this case, the probability of system failure is about double the probability of any single component failing (assuming individual probabilities are the same).

Energy companies learned this lesson years ago in co-generation. Co-generation is when a power plant's output is dedicated to a third party or host. Sometimes it is a utility such as Consolidated Edison (ED), which sells steam to large buildings. More typically, the host is a refinery, chemical processing or manufacturing facility.

An example is the Midland Cogeneration Venture. Years ago, CMS Energy (CMS) was a nuclear powerhouse. It met with Dow Chemical (DOW) to see how it could help deliver 4 million pounds per hour of industrial steam to Dow's Midland facility. A CMS subsidiary, Consumers Energy, decided to work with Dow and build a large co-generation facility.

To meet their steam needs, Consumers Energy decided to build a two unit nuclear power plants adjacent to Dow's facilities. One reactor would produce industrial steam. The other would produce power for utility customers. They named the nuclear facility Midland Nuclear Power Plant. Construction was nearly complete when the utility ran out of financing.

After spending over $4 billion, Consumers Energy was forced to abandon its nuclear plant, and the project struggled with financial challenges. After negotiating with involved parties, investors decided to replace Consumers' nuclear plant with a combined cycle gas turbine. Today, Midland is owned by a Canadian investment group, which is part of the Ontario retirement system. It is now one of the largest gas-fired cogeneration power plants in the nation. It produces 1,600 megawatts of power and 1.5 million pounds per hour of steam.

The co-generation project was a disaster for Consumers. It was not alone. Several other projects became complete failures. Investors lost fortunes in co-generation facilities, particularly when multiple parties were involved.

The industry learned hard lessons about risk. Companies realized that there is physical risk of component failure. There is additional risk when multiple parties are involved, even bankable parties.

Because of bundled projects like Midland, the energy and financial industries adopted a new rule that required developers to separate assets physically and financially. They also required separate risk assessments on each asset.

Today, wind and solar developers are facing this same rule. As such, it is difficult for them to consider combining large batteries with solar or wind assets. Batteries have to make sense on a standalone basis. So do wind turbines and solar panels. If they do not pass muster, they will not likely be financed.

Investors need to follow the industry's example. While coupling assets may sound elegant, coupled projects are difficult to finance. When a company proposes coupling disparate assets, view the plan with caution.

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