In the aftermath of the crisis, attention is turning to Texas’ deregulated power market. A deregulated market means Texas’ power is not produced by regulated utilities, but by unregulated power producers. There are different types of power producers in the Texas market, but this analysis will focus on the implications for high yield integrated power producers (IPPs), which could see leverage increase depending on direct exposure to the retail market. In short, while we believe IPPs will survive this crisis, we don’t see any short-term winners.
A Flexible Business Model, but Not Without Risks
Before we dive into our assessment of high yield IPPs, it’s important to understand the concept of an integrated business model and how it might be impacted by extreme weather events.
WHAT IS AN INTEGRATED POWER PRODUCER?
IPPs are unregulated power producers that sell power directly into the open market or, if they own a retail outfit (i.e., sells power to commercial, industrial and retail customers), IPPs can use their generation assets to supply their own load demand. IPPs may choose a combination of the two approaches.
WHAT ARE THE BENEFITS OF AN INTEGRATED MODEL?
The integrated model creates a natural hedging strategy for IPPs and reduces exposure to market price volatility. By engaging in a contract with a retail customer, the IPP knows what it can charge and has a rough estimate of what that retail customer might consume. If spot power prices fall to a level where the $/MWh1 is less than what it costs to produce power with its own assets, the IPP may opt to procure power in the open market to supply its retail customers, thereby widening its energy margins. Alternatively, if spot power prices surge (due to extreme weather events), the generator uses its own assets to serve its retail load, thereby preserving energy margins. The integrated model has worked almost flawlessly over the last few years, through summer scarcity events and the economic impact created from the COVID-19 pandemic.
WHAT IS THE RISK TO THE INTEGRATED MODEL?
Certain high yield IPPs may opt to have an overweight retail position, which means its generation capabilities are not sufficient to support its retail load. In this case, the IPP may rely on procuring its shortfall from other power producers (perhaps a solar plant or wind farm) or the open market, or it may engage in financial or physical hedging contracts. An IPP may opt to have an overweight retail position because it has a bearish outlook on power prices. As cheap institutional money helps drive renewable development to all-time highs, a well-capitalized IPP can engage in a long-term power purchase agreement with a solar developer at attractive pricing. This can be a cheap alternative to building, owning and operating generation assets. The risk here is if those renewable generating assets become unavailable. Or even worse, those renewable assets are not available during an extreme weather event, such as a heat wave or a polar vortex.
The Power Crisis: A Breakdown of What Happened
The polar vortex and the unseasonably cold weather it brought to Texas last week certainly qualifies as an extreme weather event. The frigid weather caused a surge in power demand. As seen in the table below, peak demand shattered the previous winter record. The extreme cold weather constrained gas supplies in the region (supply was reprioritized for home heating), coal piles and turbine blades froze, and the sun didn’t shine. One unit at the South Texas Project nuclear plant even tripped offline due to the loss of a feedwater pump. It was a perfect storm that forced 45% of Texas’ power sources to come offline at a time when power was most needed. On February 16, the Energy Reliability Council of Texas (ERCOT), which manages the power system in Texas, stated that 185 generating plants were offline, which equated to a total of 45 gigawatts (GW), including 30 GW of gas, coal, and nuclear energy as well as 15 GW of renewable energy.
However, even as temperatures started to creep above freezing, significant portions of Texas remained without power. We suspect this may have been because ERCOT had challenges balancing the system after imposing rolling blackouts in an attempt to maintain reliability rather than generation assets being unavailable.
The imbalance of supply and demand pushed power prices to their administrative cap of $9,000/MWh. The table below highlights peak power prices in ERCOT (Houston hub) throughout the crisis. To put these power prices in perspective, the average peak power price in Houston from February 1, 2021, through February 5, 2021, was $24.50/MWh.
The Potential Near-Term Impact of the Crisis on High Yield IPPs
For IPPs that were forced to procure power in the open market because of a lack of self-generation supply, the costs could be substantial. Even those IPPs that do not have a retail arm may have missed a lucrative opportunity if their generation assets were unavailable during this period. For example, suppose an IPP is short 1GW of power. Procuring that power in the open market at the $9,000/MWh price cap would cost $216 million for a single day (see math in table below). Scarcity pricing was in play for seven days. Pure-play retailers that are entirely dependent upon procuring power in the open market may face dire consequences because of the events of last week. We know of one pure-play retailer in the state that was actually paying customers to leave and seek alternative providers.
Though there could be short-term financial pain, we believe major high yield IPPs will survive the Texas energy crisis given their generally strong balance sheets and large liquidity facilities. In fact, certain integrated power producers may have yielded a substantial windfall during this unfortunate event. The latter could result in a "winner’s curse," as the optics of having benefited from the public’s misfortune could create backlash among angry customers and politicians in Texas. Other IPPs whose generating assets went idle may have been forced to tap their liquidity facilities to make open market purchases. This event could delay the timeline to investment grade well beyond what was originally anticipated by investors. Following this crisis, the rating agencies are likely to reassess their view of the Texas power market, which has long been viewed as one of the strongest power markets in the United States due largely to steady population growth.
We don’t think it’s all bad news, though. IPPs may see a migration of new customers from poorly capitalized pure-play retailers that do not survive. Additionally, IPPs were likely to layer in hedges during the events of last week for 2022 and 2023 at attractive rates (see table below). More integrated power producers have relatively large open positions in February for the subsequent year. Favorable hedges that were executed last week will likely stabilize and enhance cash flows. It’s worth highlighting that forward pricing in ERCOT suggests the market is expecting more supply (notably solar) to enter the market.
How Does Texas Prevent this Problem from Occurring Again?
The Northeast power market (known as ISO-New England) seems to operate just fine in sub-freezing temperatures so it begs the question—what makes Texas different? It largely comes down to regulation, or in Texas’ case, deregulation. As we mentioned earlier, Texas is a deregulated power market. Instead of regulated utilities, the state’s power is produced by unregulated power producers. These entities could be public or could be owned by private equity firms. Unlike the IPPs, regulated utilities are typically incentivized to spend as much as possible as quickly as possible to help drive earnings growth. A benefit to the regulated utility customer is that the utility’s equipment is generally top of the line and no cost is spared to ensure reliability. On the other hand, in Texas, power producers are typically incentivized to minimize costs while also seeking to ensure reliability. A benefit to the Texas customer is that power prices are typically substantially less. In fact, according to S&P, the deregulated ERCOT market has saved customers billions since 2012.
In other power markets such as the Pennsylvania-New Jersey-Maryland Interconnect or ISO-New England, the system operator runs a capacity market. Capacity markets can create cash incentives for generation asset owners to keep their plants available for reliability purposes. Additionally, if the grid calls upon a capacity market participant, and that plant is unavailable, there are steep penalties imposed. Capacity markets often keep old plants alive that would have otherwise retired, and that can be costly to rate payers and challenge decarburization plans. On the other hand, there is generally no shortage of power generation in capacity markets.
Would a capacity market in Texas have prevented the crisis over the last week? We would say it’s unlikely. For power producers, the biggest obstacle during the crisis was a shortage of gas supply so it likely wouldn’t have mattered how many GWs of gas plants were available. Rather than imposing a capacity market, we think Texas is more likely to legislate action that forces IPPs to winterize assets, just as generators prepare their assets for extreme Texas heat waves. We expect this cost would be socialized and customer bills would likely increase.
A Silver Lining for IPPs?
The Texas power crisis could have a silver lining for IPPs. If legislators take action to make IPPs upgrade their equipment, we suspect IPPs will be compensated in some way for those investments. We believe lawmakers in Texas will likely be more cautious of letting IPPs retire uneconomic base load coal generation in anticipation of becoming more dependent upon intermittent resources such as solar energy. Therefore, IPPs are likely to see some form of compensation to keep base load assets alive. California, one of the most progressive states in the US for renewable portfolio standards, implemented a resource adequacy program that provides compensation to keep gas-fired generation operators online, helping to ensure a smooth transition to a predominantly renewable-powered economy. Once commercial storage becomes readily available, we will likely see less demand for traditional base load thermal generation. Unfortunately, the economics and technology of storage would need to improve before it could become mainstream.
In the long run, IPPs are likely to benefit from new customers seeking dependable retailers with a good brand, even if that comes at a premium cost. As important, we believe the IPPs could realize a new source of income as an incentive to keep assets alive for reliability purposes. Rate payers are likely to see their bills increase, but could also benefit from enhanced reliability to keep the economic engine of Texas running smoothly.
Endnotes
1MWh = megawatt hour. A megawatt-hour (MWh) is a unit of measure of electric energy. It is the amount of electricity generated by a one megawatt electric generator operating or producing electricity for one hour.
Sources
S&P Global Market Intelligence.
Electric Reliability Council of Texas (ERCOT).
Loomis Sayles analysis.
Disclosure
This paper is provided for informational purposes only and should not be construed as investment advice. Opinions or forecasts contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Loomis, Sayles & Company, L.P. Other industry analysts and investment personnel may have different views and opinions. Investment recommendations may be inconsistent with these opinions. There is no assurance that developments will transpire as forecasted, and actual results will be different. The charts presented above are shown for illustrative purposes only and used with permission from Bloomberg Finance L.P. Data and analysis does not represent the actual or expected future performance of any investment product. We believe the information, including that obtained from outside sources, to be correct, but we cannot guarantee its accuracy. The information is subject to change at any time without notice. Indices are unmanaged and do not incur fees. It is not possible to invest directly in an index.
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