Academic journal article The McKinsey Quarterly

Finding the Balance of Power

Academic journal article The McKinsey Quarterly

Finding the Balance of Power

Article excerpt

Deregulation has given rise to a new breed of highly profitable US power generators and electricity traders, but the industry faces a shakeout as supply catches up with demand.

Recent US power shortages have left the Bush administration scrambling to develop a national energy policy and Californians sitting through brownouts. Yet for a power industry emerging from deregulation, the fundamental shortage of electricity has contributed to an unexpected success story: a new breed of power generation and electricity wholesale-trading companies. Many of these "upstream" companies, often created when utilities floated their deregulated generation businesses, have become stock market favorites. They are riding high on soaring prices coupled with the appetite of the capital markets for high-growth companies in the old economy.

Even as NASDAQ fell by 45 percent in the 12 months leading up to May 2001, the S&P 500 electric utility index rose by 37 percent. Traditional integrated utilities--especially those with strong upstream businesses--made substantial gains, but pure-play companies that focused on the upstream business performed better still: the stock price of power generators such as NRG Energy and Calpine and of wholesale traders such as Dynegy rose by anything from 80 percent to more than 130 percent (Exhibit 1). With annual earnings projected to grow by 20 to 35 percent, the leading companies in this emerging upstream power industry enjoy price-to-earnings multiples in the 20 to 30 range.

Power companies now face the challenge of meeting the growth expectations of the capital markets, even as supply catches up with demand. For while the timing will vary from region to region, supply will indeed catch up. In fact, we believe that many regions could have excess capacity within four years.

Savoring the sweet spot

During the 1990s, new generating capacity failed to keep up with steady-to-brisk growth in demand. Traditional utilities became reluctant to build new power plants as that era of regulation, when utilities were assured of recovering their costs, drew to an end amid uncertainty about what deregulation would entail (see sidebar, "A market in transition," on the next spread).

The result, in many parts of the United States, has been a fundamental shortage of electricity, followed in turn by rising prices: summer peak consumption increased by 96 gigawatts from 1994 to 1999, while new generating capacity increased by only 15 gigawatts (Exhibit 2). Strong demand and high prices for the natural gas that fuels many power plants have contributed to extreme volatility in several markets. California is the most extreme example. From about $33 per megawatt-hour in the summer of 1999, wholesale summer prices in that state rose on average to more than $140 per megawatt-hour in the summer of 2000. In December 2000, prices, at a little over $300 per megawatt-hour, were more than nine times the 1999 level. [1]

Leading power generators and electricity traders have been quick to exploit the sweet spot. Five companies--Aquila, Mirant, NRG, Orion Power, and Reliant--successfully spun off generation and wholesale-trading businesses in late 2000 and early 2001. Several others intend to follow suit, and many more have ambitious growth plans: Mirant, NRG, and Orion, for example, have moved quickly to buy assets and to add capacity Calpine, a company focused on building new, efficient power plants, has announced a target capacity of 70 gigawatts by 2005--which would entail a compound annual growth rate of more than 60 percent over five years. Dynegy, which entered the electricity business only in the mid-1990s, envisions owning or controlling 75 gigawatts of capacity within three or four years.

If the announced projects are completed as planned and electricity demand follows recent trends, by 2005 reserve margins will reach or exceed the 15 percent needed to ensure reliable supply when demand is at its peak in 10 out of 12 regional US markets (Exhibit 3, on the next page). …

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