From MoneyCentral Investor January 28, 2001 Hugh Holman Energy technologies and
services analyst, CIBC World Markets
4 'power tech' picks to play the energy crisis Hugh Holman of CIBC World Markets sees four
bright spots in California's deregulation debacle: AES Corp., Calpine, Dynegy and Enron are
what he calls 'power techs' -- companies that can profit from shaking up the utilities market.
By Eneida Guzman
California continues its slow-motion train wreck as the energy crisis worsens. But through
the chaos of this deregulatory debacle, some see a few eventual winners.
Forget the old-line companies. Hugh Holman, CIBC World Markets' energy technologies and
services analyst, spots tremendous opportunity among up-and-coming companies that can
bring new efficiencies to the power industry.
Holman calls these new players "power techs" -- innovators that can shake up a stodgy
public utilities market with new business models and aggressive strategies. But he says none
of it could happen without deregulation.
"Economists have found that the benefits of deregulation generally exceed their predictions.
These benefits include lower prices, expanded output and better service," Holman says.
And he's optimistic that will be the case here, even amid another painfully dim week for
California's electric utilities. The Washington, D.C.-based expert talked about the evolution
and outlook for the energy crisis and even offered names of four power-tech companies he
believes are poised to unseat the old guys.
The deregulation of the power supply in California is now seen as one of the most botched
public-policy initiatives in a long time. How do you view it? I would agree with that. They
built into their market some very confining, rigid rules that tied the hands of the utilities.
Because of these rules, the utilities were not in a position to make long-term purchases of
power from a variety of suppliers. They were forced, in essence, to buy power on a spot
basis in one market, the California Power Exchange. And, as a consequence, they entered
this period of high gas prices and high electricity demand really unprepared...unhedged, as it
were.
The result is what we see: much higher prices, a lot of volatility and ultimately, perhaps,
even the bankruptcy of some of these companies.
Now, a lot of other states are going through this process. About half the states have now
committed, in some form, to deregulation and none of them are having the problems that
California is having. In some of the markets, such as Pennsylvania, the transition thus far
has been relatively mild. There have been some problems in New York, but Pennsylvania has
worked very well. So this suggests that a lot of what is going on in California is self-inflicted.
Why not lower prices? Power prices in California are at three to five times their 1999 levels.
Over time, deregulation usually brings about lower prices. Why hasn't this happened in
California's market? Well, there's an explanation for that. What people have to understand is
that average prices will decline in an industry that is deregulating. They decline over time
because competition does good things. Competition brings efficiencies. Competition rewards
innovation and new technology. Competition rewards the companies that are lean and cut
costs and so forth. So all of that, historically, at least in industries that have gone through
the process of deregulation, has led to price reduction.
Having said that, in electricity, we have had flat rates. The utility commissions, in setting
prices, don't allow utilities to charge you for peak power, power that you may use at the
moment of greatest use. That power may be very expensive for the utility to provide, but
what the utility commissions do is take those peak prices, fold them in and create an
average cost. Consumers get a bill based on this leveled average cost.
One of the things that happens in a deregulated environment is that the utilities no longer
flatten out those peak prices. They are, in fact, passing them right along to consumers. So
if you go home on a Friday afternoon in August and turn on the air conditioner and the fans
and the TV at the moment when everybody else in your neighborhood is doing the same
thing, suddenly, it costs $1,000 a megawatt hour to supply power to you as opposed to
$100 a megawatt hour. That's what happened in San Diego this past year. Consumers for
the first time were seeing what it costs to supply power at these peak times. So, on
average, prices will go down, but you're going to see higher prices at certain times of day,
at certain times of year when power is most in demand.
Deregulation in many industries -- from natural gas to airlines and long-distance
telecommunications -- has created efficiencies and benefits for consumers. Do you expect
this to happen in California power-supply market in the next few years? We hope so. We
would hate to see backsliding. The worst thing that can happen is for the industry to get
caught between a regulated monopoly market and an open competitive market.
The analogy that I use: It's kind of what's going on in eastern Europe, where the former
Soviet republics are trying to make the transition from centrally planned economies to
market-based economies. It's a rough transition. You can get caught in the middle and
sometimes you can end up worse off than you were in the regulated, centrally planned
format. So we hope that the industry will get back on track and maybe make some
transitional adjustments that get them through this near-term crisis but ultimately don't
cause them to stray too far from the goal -- which is bringing competition to the power
industry.
What will it take for things to start to turn around? In the near term, California has to do
something to relieve the financial stress on the utilities and to begin to get supply and
demand in better balance. There's no instant Band-Aid, but over a period of years they can
recover. They can take steps to encourage more power plants to be built. They can take
steps to improve the transmission grid in California, which right now, is in a bottleneck in
south-to-north transmission. For example, last week where there were shortages in northern
California, there was power for sale in southern California. They just couldn't get it into the
market in the north because of these transmission constraints. So there are these things
that the state can do over a three- to five-year period that will bring a more permanent
solution.
The "recipe for pain" There's talk that Pacific Gas & Electric has hired bankruptcy counsel.
Do you expect a major power company to announce bankruptcy in the near future? I don't
follow PG & E (PCG, news, msgs) or Southern Cal Edison (the primary subsidiary of Edison
International (EIX, news, msgs) ), so I am not the best person to answer that. But what
both companies have said is that they have sufficient cash only to get them through the
end of this month, so I don't think we'll see a bankruptcy announcement in a month's time.
We're talking about something that may happen very, very quickly if the crisis isn't resolved.
Right now, the problem for Edison and PG&E is that they are still required to sell to
consumers at set rates that were negotiated several years back when they mapped out the
deregulation program. So the utilities are buying power in the open competitive market at
$500 a megawatt hour and selling it to their customers at $50 a megawatt hour. That's a
recipe for pain.
Components of CBIC's Power Tech Index Company (Ticker) Company (Ticker) Active Power
(AMSC, news, msgs) H Power (HPOW, news, msgs) AstroPower (APWR, news, msgs)
Hydrogenics (HYGS, news, msgs) Ballard Power Systems (BLDP, news, msgs) Itron (ITRI,
news, msgs) Beacon Power (BCON, news, msgs) KFX (KFX, news, msgs) Capstone Turbine
(CPST, news, msgs) Mechanical Technology (MKTY, news, msgs) Energy Conservation
Devices (ENER, news, msgs) Plug Power (PLUG, news, msgs) Evergreen Solar (ESLR, news,
msgs) Proton Energy Systems (PRTN, news, msgs) FuelCell Energy (FCEL, news, msgs)
SatCon Technology (SATC, news, msgs)
Now, if suddenly we were in a world in which we had to pay the market price, that would
create the incentive for us to begin to conserve and begin to think about distributed
generation; begin to think about adding some solar to our home; begin to think about smart
appliances or other energy-saving alternatives. So, it's very important to get people to
conserve and do the smart thing, but you have to give them the signals through prices.
They're not getting the right signals at the moment.
The state of California has just granted $400 million in relief funds to the power supply crisis.
Is that enough to make a significant impact on the situation? It's putting a Band-Aid on a
wound that needs a tourniquet.
Look for new entrants, new business models You believe the winners of deregulation are
generally the new entrants and not the incumbents. When I first started studying the issues
surrounding deregulation, one of the things that I realized is that the incumbents in an
industry that is deregulating are, by definition, losers. Let's take a very simple illustration.
Local utilities that are regulated are monopolies. They have 100% market share. So, once
they deregulate, they can only lose market share -- just like AT & T (T, news, msgs) in the
long-distance telecommunications market. Deregulation in that industry opens up
opportunities for the newcomers, like the MCIs (now WorldCom (WCOM, news, msgs) ) of
the world. So, from an investment perspective, I don't mean this to be an absolute rule but
generally, you would want to avoid investing in the incumbents. Investors should look for
new entrants who bring different business models and more aggressive cultures.
What are your favorite new entrants to the space? The ones that we focus on are often
called the independent power producers. I call them the "new power companies." We cover
four of these companies, and they all are rated "buy" or "strong buy." They are AES Corp .
(AES, news, msgs), Calpine (CPN, news, msgs), Dynegy (DYN, news, msgs) and Enron (ENE,
news, msgs). All four stocks have been extraordinary performers in the past two years.
AES is a company that began in the early 1980s. They focused on the U.S. market and then,
when U.S. opportunities dried up, they went abroad. The company became one of the
largest international developers of power projects, taking advantage of deregulation abroad
but also taking advantage of another huge phenomenon that is sweeping through the global
power industry -- and that is privatization. For many countries, the power industry has been
a government agency, in effect. And, over the last 20 years, a lot of countries have decided
that isn't the best way to do it. They decided they should allow private companies to be
power providers. Companies like AES and Enron have been very active in pursuing those
kinds of opportunities.
With deregulation, AES has kind of come back and started buying -- largely buying power
plants, as opposed to building them, in the United States. So they are just a large global
power company.
Calpine just announced that it will be building an 800-megawatt power plant in Augusta, Ga.
How aggressive are its capacity expansion plans? Calpine is the leading builder of new power
plants in the United States. The company plans to build about 45,000 megawatts of
capacity over the next four or five years. It's very active in California. It has some existing
assets in California, but all the power plants are natural gas. They are very efficient, very
clean, low-cost producers of power.
Dynegy comes out of the natural-gas side of the business. It still has natural gas and
natural-gas liquids businesses, but it has been buying power plants. It also merged with a
utility called Illinova (parent of Illinois Power, which distributes electricity and natural gas)
last year. Its goal is to become one of the dominant new players in the power industry. It
also has power plants in California that it owns with NRG Energy (NRG, news, msgs).
Enron also started off in the traditional "old" energy business. Enron and Dynegy are both
headquartered in Houston. Enron has built a massive trading operation and is the leading
wholesale trader, buyer and seller of power in North America and Europe.
So both Dynegy and Enron are companies that saw the deregulation opportunities of the
natural-gas industry and brought all their skills and trading capabilities to bear on these new
opportunities in power.
The Dow Jones Utilities Index ($UTIL) was up 45% last year. And the Power Tech Index,
CIBC's index that measures the new entrants to the space, was up 85% last year. What are
your expectations for the overall sector in 2001? What we saw last year was a flight from
technology to safe harbors. And this year, the Dow Utilities Index as of January 23 is down
12% and our power tech company index is up 24%.
Are near-term concerns in the power industry shaping your long-term outlook for the power
tech stocks? Near term, we're very concerned about the dampening effect of what's
happening in California on opportunities for both the new power companies, as well as for
some of these power technology companies. Long term, we are profoundly bullish. We think
that deregulation is going to have an enormously positive impact on the power industry.
Power is, by some accounts, the third-largest industry in the United States, so whatever we
do to make it more efficient and more competitive is going to create enormous investment
opportunities. And that's what we're focused on: finding those new technologies and new
companies that are going to take advantage of those opportunities.
At the time of publication, Eneida Guzman did not own or control shares in any of the
equities mentioned in this column.
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