Power Plant Search Fund
October 23, 2023
by an member from University of California, Berkeley - Haas School of Business in Berkeley, CA, USA
Has anyone ever considered searching for a small power plant to buy since they typically have a guaranteed rate of return? Just an idea that I had. I'd appreciate any insight you may have.
from University of Texas at Austin in New York, NY, USA
Depending on what state you are in, you can be in a "regulated" or "unregulated" market. This is confusing terminology, because in every state the utilities are regulated as described above. This distinction specifically refers to whether power plants are allowed to be owned by the regulated utility (and thus part of the capital that they get a quasi-guaranteed return of ~10% on), or if the power plants have to be owned by someone else. The general way to think about it is that in a regulated state, the utilities typically (though not always) own the power plants and earn a "guaranteed" return on the amount that they cost to build. In unregulated states, someone else owns the power plants, and there is a central coordinator that manages the supply and demand of power in the market. In the US, the major unregulated markets are basically the Northeast, Texas and California.
In unregulated markets, uncontracted power plant owners "bid" into the market and then receive the market clearing price for every moment of the day that they were selected to generate power (the bidding mechanisms are extremely complex, with a mixture of day ahead and real time bidding, as well as ancillary services to maintain grid stability such as being able to start in a highly flexible manner). These power plants are called "merchant" plants because they do not have a contract, and capture the market-clearing power price. In unregulated markets, the power price can fluctuate significantly, depending on actual power demands at the time, and the availability and cost of the fuel for the least efficient unit that is needed at any given moment. In most scenarios, power prices are set based on the cost of natural gas because that tends to be the "marginal unit." To understand how much this variation can matter, take a look at what happened in Texas a few years ago, or California in the early 2000s.
There are also, sometimes, power plants that have contracts (typically called power purchase agreements, or PPAs) - historically PPAs were put in place prior to the construction of a power plant to facilitate financing the construction of the plant. In practice, today it is pretty rare to find a natural gas plant (or coal plant) that has a PPA still on it, and most PPAs are for renewable power sources installed over the last decade (solar or wind).
Okay, so why does this all matter? Well, for regulated markets, there is no attractive opportunity to buy a power plant because the utility can get a "guaranteed" 10% return owning the plant themselves, unless you're willing to pay a price that is higher than what they would value the plant at based on the 10% return (meaning you're accepting less than a 10% equity return) and sign a PPA that basically provides them power at the price they were already realizing (they have to make sure the plant will be there to fulfill their reliability requirements). In unregulated markets, if you're buying a merchant power plant, you're taking a ton of risk on the realized power price, which is itself a function of other commodities and the relative merit order of plants in the system. You also need to manage your bidding strategy (depending on the efficiency of the plant) to try and capture the most lucrative dispatch hours while avoiding less lucrative hours, but not accidentally missing on the big wins. And you also need to take risk on the maintenance and upkeep costs of the plant itself (which is true for the version where you buy a plant from a regulated utility also). Finally, if you buy a plant with a PPA on it, that does dramatically reduce your risk, but the result is that there are buyers in the market willing to buy those plants at a 10% equity return, which should not be nearly attractive enough for a search fund investor.
There are way more nuances that I left out in the above, but the long and short of it is that it would be extremely risky to buy a merchant plant with no experience in the business, and contracted plants do not trade at return levels that should be attractive to a searcher.
from University of Virginia in Phoenix, AZ, USA