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.
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.
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.
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.
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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:
- Do nothing.
- Spread costs associated with generating assets over larger number of customers.
- Move the generating assets into a separate company and become a competitive electricity supplier.
- 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.
(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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