Long opinion on the energy problem in ca capstone and competitors are talked about
Perry
Industry Note
United States
Power Technology
California Crisis Helps Drive Electrical Eq./Power Tech Opportunities California Crisis Helps Drive Electrical Eq./Power Tech Opportunities California Crisis Helps Drive Electrical Eq./Power Tech Opportunities California Crisis Helps Drive Electrical Eq./Power Tech Opportunities
January 24, 2001
Jeffrey Sprague
David Smith
SUMMARY
➤ The escalating power crises in California highlights the significant under
investment which has been made in power assets over the past several years.
➤ We believe the crisis opens up the opportunity for passage of interconnection
standards which would help accelerate the adoption of DG technologies.
➤ The crisis is leading companies to the conclusion that they have to take
proactive steps to protect their business, which should also drive more
traditional power and power quality investments in the form of back-up
generators and UPS systems.
➤ On the large cap side, GE and Emerson are our favorite plays. Among the
emerging company’s all should benefit from news flow out of California but
we see Capstone (CPST) as having the most immediate opportunity to benefit.
Hydrogenics (HYGS) should benefit from accelerating fuel cell test and
development expenditures.
OPINION
The BANANA Republic Creates Electrical Equipment/Power Technology Investment
Opportunities
In recent years the concept of NIMBY (not in my back yard) in California has been replaced
by BANANA (build absolutely nothing anywhere near anyone), which has contributed to
severe power system supply shortages. These shortages have been severely aggravated by
an ill-conceived “deregulation” plan which ignores the supply and demand tenets of
Economics 101. The irony is that California is beginning to look like the stereotypical
Banana Republic with the population starved for electricity. Now California is in a bind
which will probably take many years to fully recover from, but creates numerous investment
opportunities among our traditional Electrical Equipment group and among the emerging
Power Technology companies.
Clearly investment in traditional power generating equipment and infrastructure will have to
increase in California and the rest of the nation. However, with General Electric’s (GE; 1L,
$48.69) backlog full through 2003 and orders being taken as far out as 2005, gas turbines are
in tight supply. We expect GE’s business to remain strong as it works to squeeze more units
out of its factories, but GE is not adding capacity. GE’s power service business which is
aimed at uprating (getting more our of old turbines) should also accelerate. GE’s broad
product offering in mini-turbines, rated at 1 megawatt and up, should also continue seeing
strong demand. These machines are attractive as back-up or baseload generators and should
be faster to deploy than large central generating stations. These machines would benefit
significantly if widespread interconnection standards (discussed below) are established.
We expect Emerson’s (EMR; 1M, $73.75) power quality business to remain very strong as
business leaders react to the potential damage to their franchises if they sustain continued
power outages. Simply put, it is clear to users of electricity that they cannot depend on the
incumbent supplier infrastructure to protect their mission critical applications. We believe
orders at Emerson’s flagship Liebert division (Uninterruptible Power Systems (UPS)) were
up well over 30% in Q4 and expect this business to remain strong throughout 2001.
Interconnection Standards Should Facilitate DG Adoption
Following several Stage 3 emergency energy alerts (and three subsequently imposed rolling
black-outs) in California within the past two weeks, combined with the likelihood for many
more as the power grid remains stretched, we believe that grid interconnectivity standards
for Distributed Generation (DG) technologies in California and other states may be just
around the corner. The State of California’s Energy Security and Reliability Act of 2000
already passed rules forbidding incumbents from inhibiting free adoption of DG
technologies.
As state politicians seek ways to reduce pressure on the electricity infrastructure, distributed
generation technologies could not only benefit from California’s current misfortunes, but
also other states that have increasing power loads and may be near critical reserve margins.
In particular, several West Coast states other than California have indicated in past weeks
that they are unable to sell excess power supply to California due to reduced hydro
generating capacity and their own rising state demand and similar reliability concerns. We
believe smart, or frightened, regulators and politicians in other states are likely to take steps
to keep the debacle in California from happening in their states.
Note that these power shortages come at a time when several manufacturing industries
companies have scaled back operations (and are therefore using less power than in 2000) in a
slowing U.S. economy. Shortages are also happening in the winter when electricity demand
is typically lower (less air conditioning demand). Should the economy experience a soft
landing and post a recovery later in the year (and experience higher electricity demand from
sectors that have already slowed) when warm weather stretches grid capacity, California’s
current power grid woes may only be the tip of the iceberg. Moreover, while California’s
grid reserve margins dipped below 1.5% several times this past month, we get the sense that
other surrounding states could be nearing this level. While accurate reserve margins by state
are not published on a timely basis, reduced hydroelectric capacity caused by low rainfall
levels in the past year have caused surrounding West Coast states to think twice before
selling excess reserves this past month. Given the increased awareness that has arisen as a
result of deregulation, the best near term solution appears to be to allow DG technologies to
connect to the grid to relieve system stress.
While Capstone Turbine (CPST #; 1H, $37.19) has received interconnectivity approval for
its microturbines in New York state and Texas, the largest near term opportunity could be to
relieve the stretched Californian power grid. In this context, Capstone’s new 60 kW
microturbine can operate either stand-alone or in tandem with the existing infrastructure.
Accordingly, given that up to 10 units can be stacked together to provide 600 kW of power,
we think that the company is extremely well positioned to provide clean and reliable
electricity to commercial and light industrial customers that wish to generate their own
electric power. A survey we came across recently indicated that if given the chance, 52% of
the commercial and industrial businesses in California would switch to self-generation while
remaining attached to the power grid. This would not only relieve customer reliability
concerns, but also allow the states to purchase power from these independent producers
(through a process termed ‘grid metering’) when excess capacity is available, in effect
having a double impact in taking a significant load away from the current electrical
infrastructure, and widening existing reserve margins.
Interestingly, most of the problem that has arisen in California has been driven by ‘partial’
deregulation that has missed the mark. Specifically, while the state deregulated its power
infrastructure in 1996, three points in particular have led to most of the problem today. First,
the state decided to compensate power generation companies for stranded assets built before
deregulation, yet required new incoming competitors to bear part of the cost to recover
generous payments made by the state for those assets. The end result is that the cost to build
new facilities makes it very difficult for new entrants to compete on price given a hefty fixed
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cost structure, and no new power generating facilities have been built in more than 10 years.
Secondly, the California legislature required that utilities enter into only short-term energy
supply contracts, thereby making them unable to hedge against rising prices through
derivatives. As a result, these companies are much more exposed to wholesale energy price
volatility. Lastly, state legislators required that consumer prices remain capped, while
wholesale pricing could be determined by market pricing. Again, this left the utilities highly
exposed if prices rise, while giving very little incentive to consumers to pull back on energy
usage even if wholesale prices rose significantly.
While we view the issues occurring in California today as primarily two separate events
caused by capacity shortages and rising natural gas prices, they are indirectly linked in that
the utilities must sell power at prices well below cost. Due to this scenario, the utilities have
come under a cash crunch. Separately, a capacity shortage caused by required system
maintenance and a secular rise in demand (state consumption has increased
disproportionately due to feeding the digital economy, compared to the U.S. 3% average
demand growth seen in the past three years) has forced California to rely on borrowing
power generation capacity from its neighboring states in the past year. Given liquidity issues
that have evolved from selling below cost, these neighbors now are unwilling to sell to the
state, that has come to rely heavily on its neighbors. Accordingly, we firmly believe that
distributed generation offers a possible near-term solution to California’s power problems.
Given the sorry state of California’s electric power system, we think that it and other states
could view the current debacle as an opportunity to change existing laws to encourage new
forms of power generation. While this could be proactive on a macro basis, the ‘not in my
backyard’ mentality that has been so prevalent in the past decade (due to California’s
heightened environmental awareness) would curtail the likelihood of major new generating
assets (i.e. large hydroelectric projects or even nuclear plants). The more likely scenario
would be to build more smaller gas-fired turbines. However, backlogs delivery times remain
lengthy, and the solution still does not circumvent the ‘not in my backyard’ issue. As such,
we think that the ideal solution would be to allow (and even provide incentives for)
alternative energy solutions such as microturbines, wind, solar power and eventually fuel
cells. This solution would enable the states to increase capacity and ensure consumers
reliability at reasonable rates.
While we believe that consumers, politicians and utilities realize the benefits of a
deregulated electricity market, the fastest solution likely will be establishing interconnection
standards for distributed generation given that additional centralized power generating
facilities continue to face resistance and supply shortages. In this context, we think that
alternative technologies are set to benefit in deregulated power markets, which includes
diesel and reciprocating generators in the near term, and further out fuel cells and wind
power. We should note, however, that microturbines are particularly well positioned given
that many states have imposed limitations on running diesel-fired power generation due to
emissions concerns. Microturbines typically emit well below 50 ppm of NOx, while diesel
gensets generate more like 500 ppm of NOx, significantly higher CO2 and particulate matter
(soot), that has been proven to be carcinogenic.
We expect that a practical solutions to power shortages will have to move forward sooner
rather than later, given that capacity utilization issues likely will be exacerbated by the
summer and could be even further magnified by a soft landing in the economy. Moreover,
already tight supplies in neighboring coastal states could lead to geographically extended
rolling black-outs and unexpected brown-outs that are both intolerable from an operating and
an economic standpoint in the digital economy.
Accordingly, we think that the microturbine companies with commercial product today
including Capstone Turbine and Honeywell (HON; 1L, $47.88) are well positioned to
benefit from declining state reserve margins and needs for alternate sources of energy to
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lessen the strain on the power grid. Additionally, GE, which has a full line of what we call
mini-turbines (1mW and up) should also see strong demand from businesses looking to
improve back-up abilities and/or self generate. Those companies that have commercial
product today should benefit in robust incoming orders. While we think that other emerging
technologies could benefit in the long term, remember that commercialization of several of
these DG solutions are at a minimum 18-24 months out, and would be more cautious on
some of these names at the present time. However, a primary near-term beneficiary could be
Hydrogenics (HYGS #; 1S, $6.69) as many fuel cell companies rush to complete testing and
product development and populate production lines with commercial production equipment
in order to get operational units out into the field. |
