Monday, December 16, 2013

Sun King* – Star Island: Where History and the Future Meet – Part 2

At Franklin Pierce University we offer an MBA in Energy and Sustainability Studies. In this program we provide students with all the business basics that are taught in traditional MBA programs such as marketing, finance, business leadership, etc but we also provide them the opportunity to focus 25% of their studies specifically into energy and sustainability studies. In these energy focused courses, students are required to submit a final project on an energy related topic of their choice. These projects are usually of very high quality and I end up learning a great deal from them myself.

This week I bring you Part 2 of a great project that was submitted by Chris Moore, one of the students in the Energy and Sustainability Program, who wrote about a New Hampshire focused project in the GM550: The Future of Energy, Business and Society course this past Spring.  You can find Part 1 here.

Star Island:  Where History and the Future Meeting – Part 2. Authored by Chris Moore for GM550: The Future of Energy, Business and Society at Franklin Pierce University

In Part 1, the energy challenges for a Star Island and its resort hotel, located off the coast of New Hampshire were described. All the energy for the island was provided by old diesel fueled generators that would soon be out of compliance and energy costs were high. For all those reasons and more, a Request For Proposal (RFP) was released by the Star Island Corporation (SIC) to find a solution to the Island’s energy problem.  SIC received several proposals from highly qualified bidders for this project, however  there was one innovative bid that captured their attention. It was the genius of Clay Mitchell and the talented team at his alternative-energy company, Revolution Energy, that won over the SIC Board of Directors.

Green Solutions by Clay Mitchell and Revolution Energy, LLC:

”Solar was the only logical solution”, Clay commented during our conversation of how he and his team chose the generating source.  He continued, “There is not enough wind out there in the summer time when the Island is at peak demand; wind was never really a serious option”.

His solution is simple in concept - photovoltaic solar panels with propane gas backup - yet incorporates the latest in electrical controls and solar technology to maximize all efficiencies from the system.  The most recognizable part of the system will be a nearly one-acre solar array made up of six or seven individual panels and situated on a relatively remote part of the Island. See the figure below. 

Because the Island sees its peak energy demand during the summer season and has very little demand in the winter, the solar arrays are able to be positioned at a 10 degree angle which optimizes for the path of the summer sun.  This nearly flat positioning was also most acceptable to the historical committees of SIC and the town of Rye, NH because it did not detract, visually, from any of the Island’s historical landmarks.  These solar voltaic panels along with two new ultra-efficient and quiet propane backup generators will feed into a large battery bank which will be housed where the old diesel generators are currently located.

The 200 kW solar arrays will produce approximately 52% of the annual kilowatt hour energy demand during the operating season and the remaining demand will be satisfied by two new ultra-efficient propane generators.  The chart below shows the Island’s demand curve against the solar array’s power-generation curve for the operating season of the Island. It is worth noting that the kilowatt hours calculated for the Island’s energy demand incorporates a reduction of nearly 25%.  This reduction is the result of various energy efficiency upgrades within the buildings on Star that would be part of the Island’s energy overhaul with this project. According to Clay Mitchell, those energy savings will be accomplished using a variety of approaches; including ratcheting back on the operation of the energy intensive reverse osmosis unit the island uses to generate drinking water. In the future, drinking water will be supplied by treating water from a roof collection system and bringing in fresh water directly from the mainland more frequently. Other energy savings actions will include upgrading all kitchen equipment with high efficiency units, upgrading lighting units, as well as operational changes and, in the future, equipment changes to the wastewater treatment operation.

The two new ultra-efficient propane generators will be fully synchronous and controlled by a charge controller to help replenish the battery banks when they dip below a certain level of discharge, ensuring high quality electricity is always available when demanded. The generators will operate at a far higher efficiency when charging the batteries than they would if following the load of the island as the current diesel generators do.

Propane was chosen as a backup fuel source for two reasons; one, modern propane generators are quiet and extremely efficient, and two, because of the ease and relative safety of transportation of this fuel-type out to the Island.  Star Island will now be able to self-transport propane tanks to and from the island by way of their own maintenance boat, allowing for an increased level of energy independence. Of course, the risk associated with land or water based oil spills is also eliminated.

The generators will also be capable of bypassing the batteries altogether and will be able to provide the entirety of the demanded load in the unlikely event of failure in the battery bank.  Redundancies such as this are planned-in throughout the entire system to ensure the continuity of operations for the island. 

Financing a green endeavor:

Engineering the most efficient solar power generating system was a top priority of Clay Mitchell and Revolution Energy LLC, however he knew that this project was dead in the water if adequate financing was not available for SIC.  The financing solution proposed to Star Island Corporation that will allow them to move forward with the project involves two key features; 1) a Power Purchase Agreement (PPA), and 2) a means to utilize the federal government’s 30% alternative energy tax incentive by offering buy-in by outside investors.  A PPA was a logical route for Star to take because they have little to no flexibility from their Board-voted annual operating budget for capital expenditures, this project would be far too costly to undertake on their own.  Secondly, being a non-profit organization, Star Island Corporation is ineligible to directly benefit from the alternative energy tax incentives offered by the federal government. This fact opens up a prospective funding source for the project by courting capital investments from outside investors who can benefit from these potential tax incentives.

The proposal by Revolution Energy LLC involves the development of a secondary project-LLC named “Revolution Energy Star Island LLC”.  Revolution Energy Star Island LLC will own all equipment of the project, it will be the party responsible for implementing and managing the PPA and it will also be the entity that investors can participate in to receive the available tax credits and other project revenues as determined by the LLC operating agreement.  By approaching the project in this way, Star Island has no upfront costs with the design and installation of the system; they will essentially purchase power that the solar arrays generate from Revolution Energy Star Island LLC at a far lower rate than what they are paying with the current diesel generators.   As the owners of the installation, Revolution Energy Star Island LLC (and their investors) will be able to utilize the alternative energy tax incentives afforded by the federal government, without which this project would not be economically feasible.

There are several different avenues that Revolution Energy LLC could take to finance the final project package.  In the end, the package will likely be a blend of available finance options. Construction financing and long-term financing may be held by two different entities. Construction financing will likely be financed through Revolution Energy LLC’s pre-existing lines of credit with Provident Bank and Bank of America. Long-term debt may be held in part by individuals investing in the project to receive the available tax incentives.

Looking forward; a process of continuing improvement:

Replacing the existing diesel generators with a clean renewable power source on Star Island is merely the beginning of a laundry list of capital projects slated for their next three to five year strategic plan.  Jack Farrell, Star Island’s manager and strategic planner, mentions some projects to tackle after the power generation is in order, “finding a solution to replacing our antiquated wastewater treatment facility and managing our potable water systems are two on the very top of the list”. He adds, “what we came to realize very quickly was that all the systems out there are completely interdependent.  A change in our electricity supply will have an effect on all systems; the same is true for the drinking water system, the wastewater system…you name it, they are all connected.”

As it currently stands (at the time of this posting), the financial details and funding sources for the project are still being developed.  “It is hard to get tax equity investors right now at this level, sadly”, Clay laments when asked about the future of the project.  At this time the project is not a sure thing and shovels have yet to hit the ground, but Clay and his team at Revolution Energy have remained resolute and dedicated to bringing this much needed solution to Star.  The challenges of implementing a new power generation system at a unique setting such as Star Island is a formidable undertaking, but the potential pay-offs for the Island are tremendous.  Star Island will benefit greatly from harnessing the quiet power of the summer sun to operate their facilities and provide their guests with desired amenities.  Star Island is committed to a simple, sustainable and low impact existence; these ideals were established by necessity several hundred years ago and are the soul of Star Island’s way of life today.

Chris Moore
Franklin Pierce University

(*Sun King: Pure unadulterated headbanging joy from The Cult, a 1980’s post-punk heavy metal group from the UK. These guys clearly spent a lot of time listening to their parents’ Black Sabbath and Deep Purple albums.  Turn up the volume and enjoy)

Tuesday, December 3, 2013

Big Star* – Star Island: Where History and the Future Meet – Part 1

At Franklin Pierce University we offer an MBA in Energy and Sustainability Studies. In this program we provide students with all the business basics that are taught in traditional MBA programs such as marketing, finance, business leadership, etc. but we also provide them the opportunity to focus 25% of their studies specifically in the subject areas of energy and sustainability. In the energy focused courses, students are required to submit a final project on an energy related topic of their choice. These final reports from these projects are usually very good and I end up learning a great deal from the  reports myself.

This week I thought I would share with you a great project that was submitted by Chris Moore, one of the students in the Energy and Sustainability Program, who wrote about a New Hampshire focused project in the GM550: The Future of Energy, Business and Society course this past Spring. I found it fascinating and I am sure you will too. Enjoy. 

Star Island: Where History and the Future Meeting – Part 1.

Authored by Chris Moore for GM550: The Future of Energy, Business and Society at Franklin Pierce University

An Introduction and History:

All it takes is one short visit to New Hampshire's Star Island to fall in love with its timeless charm, rich history, abundant wildlife and welcoming family of staff and visitors. At 46 acres, Star is the second largest Island of the Isles of Shoals chain, which is a grouping of nine islands and rock outcroppings nearly ten miles southeast of the mouth of the famed Piscataqua River.

Due to their location off the coast of New Hampshire and Maine, the Shoals are divided in half by the states' lines. The main islands of the Shoals, Appledore Island, Smuttynose Island and Cedar Island are all located on the Maine side and Star Island is on the New Hampshire side. Star Island is located within the borders of the town of Rye, NH and is the only island routinely served by a commercial boat from the mainland.

Fishermen are believed to have stopped in the islands long before John Smith arrived in 1614; however Smith's visit is known to be the first written documentation of the Isles. Denis Robinson in his capsule history of the Isles of Shoals reports that the captain happened upon the Isles while on his expedition of mapping the eastern seacoast. So taken was Captain John Smith with the abundance of fish off what is now known as the Isles of Shoals, he named these "Remarkablest Isles" after himself, "Smythe's Isles". Robinson notes: "According to his original 1614 map and account, fewer than two dozen men were able to catch 60,000 fish in a month." In reference to "Smythe's Isles" and New England, Smith wrote, "...of all the foure parts of the world that I have yet seene not inhabited, could I have but means to transport a colonie, I would rather live here."

The Isles of Shoals became the busiest commercial port on this side of the ocean. It dominated the fish market, setting the commodity price for a century and a half. The collective success of the fishing industry on Smythe's Isles likely led to the eventual name change to the "Isles of Shoals", derived from the term for the "shoaling" or schooling of fish. Settlers began arriving on Star Island from New Hampshire during the late 1600's. The island had a boom in settlers until the Revolutionary War when residents left for the mainland out of fear British soldiers would take them captive. The islands, including Star Island, cycled through several periods of settlement booms followed by eras of abandonment. 

In 1873 the Oceanic, a grand hotel, was built on Star Island to cater to a growing tourism market and attracted such notable artists and writers as Childe Hassam and Nathaniel Hawthorne. In 1916 a Unitarian-Universalism nonprofit organization called Star Island Corporation (SIC), bought the island and all of its buildings and to this very day has been providing affordable individual and family retreats. While Star Island is founded on the liberal spiritual ideals of Unitarian-Universalism and the United Church of Christ, people representing a wide variety of beliefs attend conferences regularly and day-visitors journey out to enjoy the island all summer long. (Stevens, 2010)

During the summer, the island hosts a number of week-long and shorter conferences which can accommodate up to 200 guests who make use of the historic Oceanic Hotel, the 150-year-old stone chapel, and several other buildings dating back to the original village. Day visitors are also warmly welcomed to the island to discover the historic structures and explore the unique island ecology by way of a 2-mile perimeter walking path. The only transportation available to the public out to Star is provided by two commercial boat companies, Isles of Shoals Steamship Company ("M/V Thomas Laighton") and Island Cruises ("Uncle Oscar"). (Star Island Corporation, 2013). 


Transformation towards Energy Sustainability:

Equally as grand as the character, history and beauty of Star Island, so too are the momentous challenges that the Island's management faces in keeping all of the various systems and buildings in working order. Jack Farrell, Star Island's manager and strategic planner explains, "we are disconnected from everything out there. We produce our own energy, make our own water, import all of our food and manage all of our waste. Out there on Star we are like the world in miniature".

As the guests are enjoying the warm summer sea breeze and quaint old-time charm of the Island, Jack is behind the scene feverishly maintaining the three large antiquated diesel-powered generators that provide 100% of the Island's power, checking on the reverse osmosis units that provides the island with much of its potable water, monitoring the waste water treatment facility that serves the majority of the island, managing the island's solid waste streams and seeing to any repair that any of the 100+ year old buildings may require. The term "Jack of all trades" seems too obvious to ignore and rather inadequate!

The realities of operating and maintaining all of these individual systems is not only a mechanical challenge for Jack Farrell, but is a crippling financial strain on the SIC annual budget. Star Island Corporation's 13-member Board of Directors have long recognized that finding an alternative (fossil-fuel free) solution to the three large diesel-powered generators is high on the list of capital investments on the island. In the summer of 2008, SIC utilized a grant received through the Island Institute (a membership-based community development organization based in the Gulf of Maine) to implement an extensive energy audit conducted on Star Island. The results of this audit provided the Board with indisputable data on the state of the Island's power generation and energy use and further strengthened the argument for the immediate need of an alternative source of electricity for the island.

The energy audit was a comprehensive look at all the buildings on the Island, and the goal was to specifically map where the island was consuming electricity and in exactly what quantities. The audit's results estimated the peak power demand was between 90 and 100kW and its average daily load was 65-70kW. It was found that the kitchen used roughly 29.4% of the electrical power, followed by the wastewater plant at 21.3%, the reverse osmosis machine at 18.4%, and all other outlets (lighting, plug-load, etc.) was 30.9%. The assessment also documented that for the year of 2008, 154,000 kWh of electricity were consumed, of which 110,000 kWh were used during the summer conference season operations. The figure below is the energy audit's results of the average weekly electricity demand on Star Island. The bottom of the graph depicts the demand from individual circuits and the top of the chart (in blue) shows the overall collective demand that must be met by the diesel generators. 

Renewable Power Generation; Priority #1:

The results of the energy audit conducted on Star Island only strengthened the argument for what the overwhelming majority of the Board of Directors knew needed to be done; replace the three diesel generators with an alternative power source. The following are some of the major reasons cited for pursuing this capital intensive project:

  • Cost: As the table alongside reveals, SIC spends nearly $120K annually on the diesel fuel to generate electricity on the island. The cost of electricity for this type of generation is calculated to be $0.78/kWhr (as compared to $0.12-$0.18 kWhr on mainland). This cost is increasing annually due to the rising prices of diesel fuel and transportation to the island.

  • Fuel Security: There is only one remaining company (out of Portland, ME) that is capable of transporting the diesel fuel out to Star Island. If this company should become insolvent or refuse delivery, Star Island would be without any source of power generation and therefore operations would stop.
  • Environmental: Star Island has a passionate commitment to sustainability. The generation of the Island's power using a dirty fossil-fuel source was seen as a black eye to their sincere efforts of "green" operations. In addition to their harmful emissions, these generators are tremendously noisy which disrupts the serenity of the Island.
  • Liabilities: Transporting diesel fuel from a tanker ship to the on-island storage tanks is a challenging process that presents a considerable risk of fuel spills both on land and in the water. Clean-up costs of such spills can reach into the tens of thousands of dollars, depending on size, location, and conditions.
  • Regulations: The diesel generators on Star do not meet EPA's Tier 4 air-quality standards for non-emergency generator engines. All generators are required by law to meet these standards by 2012. To continue operating these generators, Star will be required to spend considerable amounts of money to retrofit them with air-quality devices in order to meet the standards.

For all these reasons and more, a Request For Proposal (RFP) was released by the Star Island Corporation to find a solution to the Island's energy problem. SIC received several proposals from highly qualified bidders for this project, however there was one innovative bid that captured their attention. 

Part 2: To follow in next post 

Chris Moore
Franklin Pierce University

(*Big Star – A 1970's group that never really broke through but they have been cited as a major influence on the 1980's and 1990's alternative rock movement and REM in particular. Big Star themselves were heavily influenced by the Beatles and the Byrds. Here is a fabulous tune "Thirteen" by Big Star. Very evocative of those simple early teenage days.)

Monday, November 18, 2013

Walking on the Wild Side* - Stranded Costs and Picking up the Tab for the PSNH Power Plants

In my recent blog post, Options, I discussed the four options that will be considered as regulators and legislators deliberate over the fate of the PSNH power plants. One of these options is to compel PSNH to sell their generating assets and to complete the process of electricity deregulation in NH that was started in 1996. This would make the electricity supply market in NH a fully competitive one. In this post, I examine how this might be done, what the consequences will be for the PSNH customers, and how they will end up picking up the tab for the PSNH power plants. 

As laid out in the discussion of the public utility regulatory compact in an earlier post, a State provides an electrical utility with a monopoly to provide service in a specific area so that it can make the large-scale investments it needs to provide us with safe, reliable and reasonably priced power. Once they do so, they are entitled to recover the cost of the investment and earn a guaranteed return on those investments over the life of the projects - which can some range from 20 to 30 years, and even longer in the case of nuclear power plants.

Consider the following highly simplified example by way of illustration. If an electrical utility agrees to invest $1 billion in a new power plant and receives approval from the Public Utilities Commission (PUC), they would go out and borrow the $1 billion, perhaps at a cost of 5%. Then, once the plant is built, the utility would, over time, recover the $1 billion through a depreciation charge and they would assess a return on their investment. This return would, of course, be higher than the 5% which is their cost of borrowing. Let's assume the plant has a 25-year life, so the depreciation amount would be $40 million per year ($1 billion divided by 25), which would be passed on to the ratepayers as part of the price for electricity supply. Moreover, the utility would also be entitled to earn a return on its investment. Assuming the public utility regulators agree to a 11% return (which is close to what PSNH presently earns), that first year the utility would earn $110 million (11% of $1 billion) which they would recover as a rate base charge that is a component of the all-in costs for electricity paid by their customers.

In Year 2, the depreciation from the first year is subtracted, leaving $960 million ($1000 million - $40 million) of undepreciated value which then becomes the basis for the 11% return on the rate base in the second year. In this year the return would be $960 million x 11% or $106 million. With this approach, the utility recovers its initial outlay via a depreciation charge over the life of the power plant, and it earns a return on its investment via the rate base charge.

It is important to realize that the utility's return on the rate base is not all gravy and it doesn't all go to its shareholders. The utility borrowed that $1 billion and it needs to pay its lenders their annual interest rate, which we assumed to be 5%, so the utility's net return on the invested capital will be 6%.

On top of these depreciation and rate base returns, the utility charges their customer for the cost of fuel – natural gas, coal or oil – as well as the operating and maintenance costs, the salaries for the workers, the property taxes and all other small charges associated with running an operation generating electricity. All these charges are summed and then divided by the number of kilowatt hours (kWh) of electricity produced. This yields a price per kWh for electricity which, after review and approval by the PUC, becomes the rate that the utility charges its customer for electricity supply.

In my last post, I shared a chart which showed the various costs components, including depreciation charges and rate base returns, for the 2012 electricity supply from PSNH. Electricity rate setting is an intriguing topic and it is perhaps something we could cover in a future post.

But, let's now return to the topic at hand: what will happen should PSNH be compelled to sell off their generating assets? The key numbers in this case are shown in the figure below, which breaks out the various values that will be considered in this matter. The top number, $674 million, is the total book or undepreciated value of PSNH assets as of 2012. The original value before the depreciation charges was $1.1 billion according to the Northeast Utilities 2012 balance sheet. My assessment of the book value is that it consists of $422 million associated with the mercury scrubber installed on the Merrimack power plant a few years ago and the remainder, $252 million, is the undepreciated value for the rest of the generating assets A list of these generating assets, which include coal-fired, oil-fired and hydro operations, was provided in my last post.

From the book value of $674 million, I have subtracted the value that PSNH might realize from the sale of their various power plants. I have optimistically assumed a value of $200 million - which leaves us with approximately $474 million of what are termed "stranded costs".

These costs are termed "stranded" as they represent the value of the assets on which PSNH can no longer earn a return nor can they recover their investment via depreciation charges due to utility regulation changes. Nevertheless, PSNH is still responsible for interest payments and paying down the debt they incurred when they purchased and installed the assets many years ago.

I had also noted previously that there is presently a prudency review underway that will determine if PSNH should have spent $422 million on the mercury scrubber at the Merrimack plant when the original budget was $250 million. If it is determined that PSNH was unwise in spending that amount of money, the New Hampshire PUC will make a determination that only part of those costs should be part of the book value for PSNH generating assets and the stranded costs will decrease commensurately.

It is unlikely that PSNH would agree with such a decision. We should not forget that PSNH, through its parent, Northeast Utilities, is a for-profit publically traded company that has an obligation to its shareholders to ensure steady dividend returns and an increasing share value and it is only to be expected that they will mount a legal challenge to the NHPUC scrubber value determinations as any write-off of assets would have a significant effect on their profits and lead to a bunch of unhappy shareholders. In the legal battle will that will ensue, the NH Courts may end up determining the final value of the Merrimack scrubber project. In the process, millions will be spent on lawyers, consultants and expert witnesses, time will drag on, rates for PSNH energy supply customers will continue to be high and the value of the coal-fired power plants will continue to diminish. From my perspective, this seems rather inefficient compared to getting everybody involved around a table for a few days to hammer out a compromise: things might get done faster, a great deal of money would be saved and the PSNH ratepayers would be better served.

Let's assume, for the sake of illustration, that a determination is made that the scrubber project is only worth the original $250 million. PSNH would have to take a haircut of $172 million and write down the value of the assets. In this case, the numbers would be those shown in the diagram below.
Now the total book or accounting value would be $502 million, which would consist of $250 million for the value of the scrubber and $252 million of undepreciated value for the rest of the generating assets. From this, we subtract the $200 million that PSNH might realize from the sale of the assets which leaves us with approximately $302 million. This will be the amount due to PSNH for their stranded costs. The question now becomes: Who writes that check? As it turns out, the unpleasant answer is that all PSNH customers will end up paying for the stranded costs, as will become clear in the explanation that follows.

PSNH has approximately 500,000 customers and, for the purposes of simplification and illustration, let's assume they are all equal. That means each rate payer would have to send PSNH a check for $604 to cover their portion of the stranded costs. PSNH will want that money as soon as possible so that they can invest the $302 million into another project to start earning a return or return the money to its shareholders. It is unlikely that PSNH customers are going to be rushing for their check books to write a $604 check payable to PSNH. One alternative would be for PSNH customers to pay down this amount over time through their electricity charges and also pay PSNH their expected 11% interest. Essentially PSNH would be lending the $604 to each of their rate payers, and they would expect to earn a return on that loan. If we assume the payments are spread over 10 years, this means that each rate payer would be paying an extra $8.32 per month to PSNH for the next 10 years to cover the stranded costs. In kilowatt hour terms, and taking into account that PSNH distributed 7821 Gigawatt hours of electricity in 2012, this would equate to surcharge of ~0.6 cents for every kWh of electricity distributed by PSNH.

In these days of low, single-figure interest rates, 11% is a very high interest rate to pay on a loan. Many of you might be asking whether is it not possible to refinance this amount at a lower interest rate, just as we would do on our home mortgages?

Well, this is exactly what would happen should the regulators and legislators steer PSNH ratepayers down this road. There are many financial institutions that would be willing to lend PSNH customers the $302 million at a lower interest rate, especially if they can be assured, by law, that PSNH ratepayers are obligated to pay down the debt over a fixed time period and that there is no way to avoid the obligation.
This refinancing of the stranded costs is done through a process called securitization, which is a series of financial deals in which debt obligations, such as mortgages, are sold to another party and are pooled with similar obligations. This pool of obligations is then sliced and diced and sold to a new set of investors who pay for the pieces in order to earn a return on their investment that would, in this example, come from principle and interest payments that each homeowner with a mortgage makes every month.

The key aspects of securitization are
  • The transference of risk from the original party that held the obligation to a new group of investors.
  • The original party gets their money back right away so they can invest it in new projects.
The way that securitization would work with stranded costs is via the following steps:

Step 1: The regulators, with legislative approval, would establish a financing order which will give PSNH the right to impose, bill and collect stranded costs from its ratepayers. The stranded costs become an asset on the PSNH balance sheet which replaces the $674 million for the generating assets.

Step 2: A new financial company, called a special purpose enterprise (SPE), is set up.

Step 3: PSNH sells its right to collect stranded costs from PSNH ratepayers to the SPE.

Step 4: The SPE funds the purchase of stranded cost obligations from PSNH by selling bonds to investors such as banks, insurance companies and other financial institutions. For those not financially inclined, a bond is essentially an IOU agreement that is set up between two parties. One party lends an agreed amount of money and the other commits to pay back the borrowed amount at some time in the future but also to pay a fixed interest rate every year. In this case, the security for the IOU would be the stranded costs obligations that PSNH can, by law, collect from its ratepayers.

Step 5: Using the revenue from selling these bonds, the SPE will pay PSNH for the stranded costs so PSNH gets a cash payment, it no longer has the asset on its books and it can take the money and return it to its investors.

Step 6: Every month the stranded costs payments from the individual rate payers will be passed through PSNH to the SPE, which will use these payments to pay the interest on the bonds and eventually the principal amount back to the bond holders.

This securitization process accomplishes two objectives: PSNH gets its money right away and it can return the funds it to its shareholders or use it for new projects, and the risk associated with the stranded costs is passed onto a new group – the bondholders in the SPE.

The risk issue is an important one and, quite frankly, this is not a very risky investment for the bond holders. PSNH customers will be mandated by law to pay for the stranded costs so the risk of 500,000 ratepayers not paying up is low. (There is, however, the possibility that future lawmakers in NH would not feel constrained by these obligations and could choose to overturn them, but this is little different from the risks that lenders to public utilities are presently exposed to.)

With a steady stream of monthly payments from a large group of customers that are mandated by law to pay for the stranded costs through their electricity rates, this is indeed a low risk investment and, as a result, the bond investors would be willing to accept a much lower interest rate than the 11% PSNH would expect. In our present low-interest environment, I believe investors in these bonds would be willing to accept interests rates of 5% or perhaps even lower. Costs for funding would also be significantly reduced by the fact that interest on debt is tax deductible, exactly like your mortgage, which further reduces the cost of borrowing.

What we would then have done through securitization is refinanced that $302 million obligation to PSNH, which carried an interest rate of 11%, to one with a 5% interest rate. In the process, the monthly payments for PSNH ratepayers will drop from $8.37/month to $6.41, or from 0.6 to 0.5 cents per kWh, which is a 23% reduction in the monthly stranded cost obligation for all PSNH ratepayers. So by issuing lower interest rate bonds through the SPE, stranded cost recovery amounts charged to PSNH ratepayers will have decreased – hence the name: rate reduction bonds. In reality, these rate reduction bonds will actually result in additional tariffs on all PSNH ratepayers, but the amount is lower due to refinancing. It is important to note that the numbers I have calculated are presented for illustration of these concepts only and that the final numbers could be quite different depending on the outcome of the prudency review, the final stranded costs tally and the market for securitization of these costs in a year or two.

Now some readers might be thinking that this is pretty wild and crazy financial stuff and that we are clearly walking on the wild side*, financially speaking. Well, that would not be correct. Securitization is a long standing tool that is used extensively in the mortgage industry, and it is, in fact, one of the reasons we have such a robust home lending market in the US. It very likely that after receiving your mortgage for your home, your obligation was sold to another party who pooled your mortgage together with several thousand similar mortgages via a SPE. Bonds in the SPE were sold and bond holders were promised regular interest payments based on the monthly payments from that pool of mortgages. As my Financial Management students in the Energy and Sustainability MBA program at Franklin Pierce University learn, securitization and the unchecked transference of risk played a large role in the 2008/2009 housing crisis and recession. Moreover, securitization for stranded costs payments has been done before here in New Hampshire: PSNH ratepayers are presently assessed a stranded cost recovery charges associated with the Seabrook power plant as part of their monthly electricity rates.

One of the questions we should be asking ourselves with respect to stranded cost recovery is - which customers of PSNH will be obligated to pay these charges? The answer  – I believe – is that all PSNH distribution customers will be assessed these charges, including those getting their electricity provided by competitive suppliers. The key to stranded costs recovery is the establishment of the financing order by the NH PUC that will give PSNH the right to impose and collect stranded costs from its customers. However one of the most critical aspects of this financing order will be that these charges are non-bypassable. In other words, PSNH customers will not be able to avoid them by going to other electricity suppliers. Without this provision, the issuance of rate reduction bonds is unlikely to happen as bond investors would view it a particularly risky investment if ratepayers could escape their obligations.

Now, if you live in the PSNH franchise area and are buying your electricity from a competitive supplier, you are likely whipping yourself up into a froth of indignation at the unfairness that you should be assessed charges related to PSNH's generating operations. However, do take into account that many of these obligations were likely incurred when you were a PSNH electricity supply customer and present PSNH customers might consider it unfair that you could walk away from your obligations. A greater unfairness probably occurs when someone new moves from out of state into the PSNH franchise area and is assessed stranded costs recovery charges they had absolutely nothing to do with.

There is, of course, the possibility that things will play out differently in the legislative and legal deliberations that will occur over the next year or two, but this is where I am placing my bet. If you are angry with stranded cost recovery charges that might be assessed, the very best way for you to show your indignation and to challenge PSNH is remarkably simple - use less electricity. Show PSNH that you mean business by investing in energy savings projects. Put in more insulation, upgrade your windows and heating systems and install low-energy lighting and solar heating systems.

And, of course, remember to turn off the lights when you leave the room.

Mike Mooiman
Franklin Pierce University

(*Walk on the Wild Side – Probably the best known song by the late and very great Lou Reed who just passed away last month at the age of 71. I remember listening to this song as a young teenager and having very little idea at that time what I was singing about as I accompanied Lou Reed on vocals. Fortunately, neither did my mom. Even if I didn't understand the lyrics, the arrangement, the "Doo, doo, doo" chorus and the very prominent bass line appealed to me.)

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Monday, November 4, 2013

Options* - PSNH Generating Assets – The Choices

With the advent of retail choice for electricity supply in New Hampshire, there has been a great deal of migration away from PSNH. Fixed costs associated with their generating operations are high and, with a smaller customer base to spread them over, their electricity supply prices have increased. This vicious spiral of higher prices causing more migration, followed by higher prices for the remaining PSNH customers is plainly unsustainable. As a result, there has been a great deal of discussion by regulators and legislators in New Hampshire about this problem.

The NH Public Utilities Commission released a staff report dealing with this matter in June. The Legislative Oversight Committee on Electric Utility Restructuring has been meeting since the summer and much of their discussion and debate revolves around whether the State should complete the process of electricity deregulation and compel PSNH to divest themselves of their generating assets. It is anticipated by some that this would reduce PSNH rates and allow them to be more competitive. In my last blog, "Should I Stay or Should I Go?", I laid out the arguments for and against divestiture. In this post, I examine the options that are available with respect to the PSNH power plants.

But before we look at the options, allow me to share with you the story of the Brayton Point coal-fired power plant which is located very close to Fall River in Southeast Massachusetts. This is a large coal-burning plant with a generating capacity of 1535 MW from four turbines. It is situated on the water's edge at the top of Mount Hope Bay and is visible when crossing over the Braga Bridge on I-195 into the Fall River area. It is now even more noticeable due to the recent erection of two enormous 500 ft tall cooling towers.

Photo Source: Dominion

The plant had for many years been owned by Pacific Gas and Electric, a California utility. In 2005, the Brayton Point power plant and the coal-burning plant on Salem harbor in Massachusetts were sold to Dominion Resources. In order to continue to operate the power plant, Dominion was required to install the two cooling towers shown in the photo above at a cost of $500 million. The cooling towers were necessary to comply with an EPA edict to reduce the amount of single-pass cooling water from the operations. Prior to the cooling towers, the plant was cooled by simply pumping water from Mount Hope Bay through the power plant to get rid of the waste heat and then returning the water right back into the bay. In the process, water treatment chemicals were added, any aquatic life was shredded in the pass through the cooling operations, and a large volume of warm water was discharged which impacted the marine ecosystem in the bay.
After investing over $1 billion dollars into the operations to ensure environmental compliance, in March this year, Dominion Resources sold the Brayton Point power plant to a private equity group, Energy Capital Partners, along with one gas-fired and one coal-fired plant in Illinois. After owning the plant for just six months, in October this year, Energy Capital Partners announced that they were shutting down the plant in 2017. Their original plan had been to convert the plant to a gas-fired operation but they said that low electricity prices, reduced capacity payments (created by a surplus of natural gas prices), large investments required to meet environmental regulations, and the costs to operate and maintain an older plant did not warrant keeping the operations running. I tend to be somewhat skeptical that they only figured this out after their purchase. These private equity organizations do a great deal of due diligence and financial analysis beforehand and they hire the best experts to advise them. I think it more likely that they took into account beforehand that they might need to shutter the plant and the Brayton Point operation just became the ugly bruised apple in the package that they discarded as soon as it was prudent.
So what lessons do we draw from Brayton Point? Consider the following:
  • Old aging coal-fired power plants in New England have little, if any, value in a sale in the present low-priced natural gas period.
  • This does not bode well for future sales of coal-fired power plants in New England: if the plants are sold it is likely going to be for pennies on the dollar, if they are even sold at all.
  • Enormous investments are necessary to ensure environmental compliance of these operations and, even after these investments, there is no assurance that these costs can be recovered. Dominion Resource squandered an enormous amount of shareholder value in environmental compliance and on those huge cooling towers which, just one year after their construction, were of little value to the new owners.
  • Converting coal-fired operations to natural gas-fired operation does not seem to be an obvious solution, even when you have two new cooling towers at your disposal.
  • Sometimes retiring an old coal-fired power plant is the best solution.

With the background of that sobering story in our mind, let us now return to PSNH and consider the options available as NH legislators, regulators and PSNH scuffle over the fate of PSNH's generating assets.
The options* are:
  1. Do nothing.
  2. Spread costs associated with generating assets over larger number of customers.
  3. Move the generating assets into a separate company and become a competitive electricity supplier.
  4. Sell generating assets.  
Let's explore each of these.
Option 1: Do Nothing
Well, this is pretty much what has been happening since 2001 when the process of deregulation and the sale of PSNH generating assets were halted by the NH legislature. But, as we know, retail choice for electricity supply has resulted in the exodus of a large number of customers to competitive suppliers. In 2012, only 26% of the electricity supplied to PSNH customers was generated by PSNH itself. The rest came from competitive suppliers and from PSNH purchases of electricity from independent power producers and the open market. PSNH rates are higher because it is distributing fixed costs over a dwindling customer base. This has been referred to by many as the "PSNH death spiral" and is a well known financial concern in businesses with high fixed costs. The cost components for PSNH-supplied electricity in 2012 are shown in the pie chart below. Almost 50% of the costs - operations, maintenance, taxes, depreciation and return on assets - are fixed in nature, with the rest being more variable (but likely with some fixed cost components).
 Data Source: NHPUC: DE 13-108

When challenged about the death spiral concerns, the PSNH response has been that this problem has been caused by poor policy and the fact that generation expenses can only be recovered from PSNH electricity supply customers and not from all PSNH's distribution customers. At the time this policy was formulated, it probably seemed reasonable and prudent that PSNH electricity service customers should bear the cost of PSNH's generating operations. But, in hindsight, I think this migration and climbing cost issue might have been anticipated.
Option 2: Spread Costs Over a Larger Group of PSNH Customers
It is important to realize that PSNH has two types of customers within its franchise area. The first group is all electricity users within PSNH area which are all distribution customers of PSNH. Their electricity, regardless of who their contracted supplier might be, is transmitted, distributed and delivered by PSNH. As noted in my last post, PSNH has a monopoly on the transmission and distribution – the wire side - of the electricity business. In 2012, PSNH had just over 500,000 distribution customers (residential, industrial and commercial) within its area of operation and it delivered a total of 7821 gigawatt hours (GWh) of electricity.
The second and smaller set of customers are the energy supply customers. These are the customers that are using PSNH as their supplier of electricity as well. It should be noted that customers within the PSNH service area have retail choice – they can choose to have their electricity supplied by another company and, as noted in "Should I Stay or Should I Go?", there are now many such companies in NH willing to supply electricity. In 2012, PSNH had ~450,000 energy supply customers (residential, industrial and commercial) within its area of operation and it delivered approximately 4600 GWh of electricity.
When we compare distribution and energy supply customers, we note that PSNH only supplies 59% of the electricity within its service area. Since the advent of retail choice, or being able to choose your electricity supplier, this number continues to shrink. This, of course, is the cause of concern as PSNH has high fixed costs and is distributing those costs over a smaller and smaller customer base.
It has been suggested that it might be a better idea to distribute the fixed costs over a larger group of customers, i.e., all PSNH's distribution customers, because all the decisions regarding PSNH present operations and investment in generating facilities were made when those customers were captive energy supply customers of PSNH. As such, they could be viewed as having an obligation to share the costs of those generating facilities. Some have suggested that it is unfair that a customer that migrates to a competitive supplier can walk away from their commitments and leave a larger obligation on the shoulders of the remaining energy service customers.
I am not sure how much "fairness" plays into it, but this does seem to go counter to the spirit of retail choice and competition. Distributing the costs of the PSNH power plants over all PSNH distribution customers would, in essence,  involve placing a PSNH surcharge on the electricity service provided by a competitive supplier. Ultimately, this is what we might indirectly end up with, as I note in the discussion of stranded costs in Option 4 below, but in this case there is absolutely no incentive for PSNH to act competitively by improving operating efficiency, reducing costs, and working with smaller profit margins. The only reason for considering this option would be if the regulators and legislators felt that is critically important for New Hampshire's energy future that PSNH hold onto its own generating fleet and they wanted to counter the exodus of customers from PSNH.
Option 3: Move Generating Assets into a Separate PSNH Company and Become a Competitive Electricity Supplier
One of the arguments that has been made by the folks at PSNH is that the generating assets of PSNH are critical to NH's energy future and that the diversity of supply, offered by the coal-burning operations is a valuable attribute that should not be discarded. It this is indeed the case, another option is to move the electricity-generating assets into a separate PSNH- or Northeast Utilities-owned company and to make that new company a non-regulated competitive energy supply company that would have the opportunity to compete on the same terms as the other energy suppliers now operating in the State.
Under these circumstances, the new entity, perhaps called "PSNH Homegrown Power", would no longer be entitled to a guaranteed return on assets. It would have to make its money by the traditional business approach, which is by assuring that the costs for electricity generation are lower than the revenue obtained from selling electricity. Of course, the concern is that the fixed costs for the coal-fired gas plants are high—the cost of the main fuel, coal, is higher than that of natural gas (on an energy content basis) for most of the year and the only time PSNH can successfully sell electricity into the grid is when electricity prices are high due to demand. Moreover, there is also the looming issue of the discharge of cooling water from the Merrimack plant that I alluded to in Sixteen Tons. Due to the new wastewater permit for the operation, it is likely that the installation of large cooling towers, such as those at the Brayton Point plant and costing well over $100 million, will be required.
Running an operation such as this will be rather challenging: PSNH and its parent company, Northeast Utilities, would have to be willing to invest additional capital into the generating operations as well as deal with years of negative financial returns until such time that natural gas prices rise and coal becomes competitive again. This would indeed be a long-term view and one that might be difficult to sell to the shareholders of Northeast Utilities. It certainly did not work out for the folks who owned the Brayton Point plant.
Option 4: Sell Generating Assets
The final option for PSNH is simply to sell off their assets. This is being extensively debated  by legislators and regulators at this time, as I discussed in my last post. On one hand, this seems like the most straightforward option, as it completes the process of electricity deregulation in New Hampshire. On the other hand, it is also the most challenging to implement and it is the option that will have a financial impact on all PSNH customers.
The generating assets of PSNH include ~1200 MW of generating capability, as shown in the table below. 

These generating assets are listed on the PSNH financial statements at $1.1 billion but with a net depreciated value of $674 million. PSNH is allowed to earn a return of 11.05% on this $674 million of assets, which, in 2012 (along with some other charges), was approximately $83 million. PSNH also recovers their investment via a depreciation charge. The depreciation is typically 2.5% per year so the depreciation expense is ~ $17 million. Of course, the dollar value of the return decreases every year as depreciation whittles away slowly at the book value of the assets.
The bulk of this $674 million value for the generating assets is the $422 million recently spent on the scrubber that was installed at the Merrimack plant to reduce mercury emissions from the burning of coal. The original budget for the scrubber was a "not to exceed" figure of $250 million but, by the time it was completed, the price had skyrocketed to $422 million. A study is presently underway at NHPUC to determine whether it was prudent for PSNH to spend $422 million for a scrubber on an aging coal plant. The outcome of this prudency review, and the court battles that are likely to follow, will be very important to the rate payers in the PSNH franchise area as they will determine future rates for electricity supply and distribution.
If PSNH is compelled to sell off their generating assets, it is highly unlikely that the sale will raise $674 million. The gas- and wood-fired plants in Newington and Schiller might attract some attention but they are old plants. The most attractive assets of PSNH are the hydroelectric plants, which are likely to draw a great deal of interest from operations that specialize in running hydroelectric operations, such as Brookfield Energy Partners. In this coal-unfriendly and low-priced natural gas environment, the Merrimack and Schiller coal-fired plants will likely be the most problematic to sell, particularly in the wake of the Brayton Point plant experience. If the plants are sold, it is not going to be for very much if they are even sold at all. The coal-based plants could even be viewed as having a negative value. If they are not sold and are simply shut down, there will be significant costs associated with the cleanup of the sites as well as ongoing monitoring and maintenance. They simply cannot be abandoned and cleanup could be costly, especially considering PSNH has been operating on these sites for over 50 years.
A recent NHPUC report that considered the sale of PSNH generating assets, indicated that PSNH might realize between $100 million to $300 million for the sale of its generating assets. A detailed follow-up study, due early next year, has been commissioned.
The diagram below breaks out the various values that will be considered in this matter. We have the book value, $674 million, of PSNH assets, which are comprised of $422 million,  the value of the scrubber, and approximately $252 million of undepreciated value for the rest of the generating assets. From this, we subtract the value that PSNH might realize from the sale of the assets – I have optimistically assumed a value of $200 million - which leaves us with approximately $474 million of what are termed "stranded costs". By law, PSNH is eligible to recover these stranded costs from its ratepayers. Of course, if the outcome of the prudency review is that the book value of the scrubber is less than $422 million, PSNH will have to write down the value of these assets and then the stranded cost amount will be less.
These stranded costs are a very large sum of money that the PSNH customers are going to be responsible for and are one of the definite downsides that come from having a regulated public utility which can, by law, recover investments made uneconomic by policy changes. Stranded costs will likely be recovered by allocating a surcharge on all PSNH customers, even if their electricity is not supplied by PSNH. In this way it becomes very similar to Option 2. At least with the divestiture and stranded costs realization option, the obligations of the rate payers become fixed and, over time, the obligation to PSNH will be paid down.That is not the case with Option 2 which is an open-ended obligation with no fixed amount and no end in sight.
So there you have the options that the regulators and legislators in NH are grappling with. A final determination regarding PSNH's generating assets might be made next year but I would not hold my breath. Instead save it for the numerous legal battles that are sure to ensue as soon as final determination is made. In my next post, I will examine the concept of stranded costs in more detail, how they will be funded and how the cost of funding might be reduced through a financial tool called securitization.
Until next time – remember to turn off the lights when you leave the room. Leaving them on just gives energy suppliers an opportunity to distribute their fixed costs over even more kilowatt hours of electricity.

Mike Mooiman
Franklin Pierce University
(Options* - A catchy tune by the highly underrated group, Gomez. The band originally started in the UK but most of the members seem have found their way to the US. The group is known for their well constructed, clever and very catchy tunes. Their album How We Operate is a great introduction to their work.)

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