By Jeffrey W. Schroeter

The electric industry in the United States today is undergoing the most rapid development of new resources in a generation, with deregulation and technology acting as the drivers of this revolution.

For most of the past century, our country saw declining electric production costs in real terms until the early 1970s. Then, to extract further efficiencies, only very large and, at the time, exotic assets became the order of the day. Nuclear power, with its huge regulation-mandated safety systems, and coal-fired power, with its increasing air pollution controls, were the only viable ways to obtain reasonable energy production costs. It didn't matter that this capacity was wildly expensive, since under the old "regulatory compact" the utilities would be allowed to raise rates and recover all their costs from the ratepayers.

The 1980s saw the advent of two new factors: State regulators began to disallow recovery of excessive plant investment that was deemed imprudent, and combustion turbine technology became more efficient and reliable. Never mind that the U.S. Fuel Use Act of 1978, which was intended to prevent a pending shortage of natural gas, actually prevented using natural gas for new power generation. There never really was a gas shortage—just overregulation of production.

The restrictions of the law led turbine manufacturers to develop larger, more efficient, and more reliable units. The move to a market-oriented business of power generation has been made practical by the continuing efforts of combustion turbine manufacturers to advance metallurgy, design, and reliability. Many of the advances were aeroderivative.

In the early 1980s, a few years before restrictions were lifted altogether, the government started to approve applications to build natural gas-fired cogeneration plants, as long as they were coal-capable. The current merchant power movement needed a few more developments.

Congress passed the Public Utility Regulatory Policy Act of 1978, an update of the Federal Power Act that established government regulation of the power industry in the 1930s. PURPA, as the new law was known, encouraged cogeneration—the combined production of useful thermal and electrical energy—and encouraged independent power production for the first time. PURPA also allowed cogenerators to sell electricity to the utility or at retail to the thermal host—that is, the customer that was already using the plant's heat output.

Duke/Fluor Daniel is building a 1,000-MW combined-cycle merchant plant near San Antonio, for Texas Independent Energy. It's expected to start up in December.

The Federal Energy Regulatory Commission's Order 636 in 1986 deregulated natural gas production, and separated it from the operation of pipelines, which remain under federal regulation.

The Energy Policy Act of 1992 created exempt wholesale generators (that is, exempt from significant Federal Power Act regulation). The cogeneration requirement was relaxed. The exempt generator could sell electricity to the wholesale market.

In 1995, FERC Order 888 allowed open access to the electrical transmission system, which allowed independent power producers a method of shipping their power to market.

The final push was the retail deregulation movement—a backlash to the high capital recovery of those utility plants built decades before. With retail deregulation the question became, "Why can't ratepayers choose their generator?"

What really is a merchant power plant? The simplest definition is "one that produces power as a commodity." Another, more accurate definition is "a generator that has only the marketplace to assure a long-term income stream." Merchant plants have no one sales contract for the term of their project debt. At first blush, this seems terribly risky—to build a long-lived, high-capital-cost asset that has no assurance of income.

But there is a good analogy. Take a new Boeing 747-400 at a cost of some $180 million. An airline or aircraft lessor, when it buys a plane, has no assurance that passengers will buy tickets for the next 20 years. But mountains of data say people want to travel. And, by the way, the cost of a Boeing 747-400 is roughly equivalent to the cost of a current model 500-megawatt combined-cycle merchant power project.

What project sponsors like Panda Energy must do is develop a project assuring their investors that they will see their capital recovered and also see a return on their investment.

Is how we do it alchemy? Or is it a trade secret? The simple truth is that it is really just the free marketplace at work. Our responsibility to the investment community, if we want its backing, is to produce a project that, under the worst possible market scenario, will assure repayment of the project's debt. As a sponsor, I risk my own equity in the venture.

How we select markets is indeed a trade secret. However, the elements of the process are very easy to understand. Look for a marketplace that promises good revenue, a location with access to customers, and community acceptance. The not-in-my-backyard mentality often convinces a developer that life is just too short to force development where it is not wanted.

Development of a power generation merchant plant is somewhat akin to large commercial real estate development. If you wanted to build a new large shopping mall, where would you put it? You'd put it where there were adequate customers, who had an unserved need to buy as well as the income to purchase goods. The merchant power generation phenomenon is very similar.

Revenues must support the new resource. The earliest land rush of merchant project development was the stampede of 1997 to the Northeast Power Coordinating Council region, the Northeast Power Pool, which comprises New York, New England, Quebec, and Ontario. Of the 10 North American Electric Reliability Council regions, its power marginal prices—the actual prices bid for electricity—were the highest. The region's rates, after many years of regulated monopoly, included substantial charges for the recovery of large capital investments.

Also, until recently, the choices for fuel in the Northeast were limited to hydro, nuclear, and oil or coal, in Rankine-cycle steam plants that generally operate with a high overhead. When merchant generators entered the region, they all proposed gas-fired, combined-cycle plants, in anticipation of new fuel supplies.

When natural gas producers were heavily regulated, none of them had an incentive to look for gas off the shore of Nova Scotia, or to build more pipes from western Canada. But with the new market in the Northeast, both of these developments are in the works.

By last year, merchant power's land rush yielded requests for electrical interconnection for some 30,000 MW of new capacity in the region. One downside to this market is that load growth, the increase in electrical demand, is not as robust as in the rest of the country. The Northeast is currently considered to be development saturated for the power industry, and only 8,000 MW of capacity, a little more than a quarter of the total proposed, is under construction. Many companies decided too late in the game that they would not be able to compete and be early to market.

Texas Independent Energy, a joint venture of Public Service Electric & Gas Co. of New Jersey and Panda Energy, has a 1,040-MW plant under construction.

The next rush was in Texas or, more specifically, the Electric Reliability Council of Texas region, which covers most of the state. The ERCOT service area, because it does not have synchronous connections with the rest of the United States, is essentially an island. There are two high-voltage dc ties with a total capacity of about 820 MW, but they are really insignificant in a 56,000-MW market. Load growth is still good in Texas and more importantly gas-fired generation is on the price margin—that is, setting a profitable price—some 95 percent of the time. The existing fleet of about 30,000 MW of gas-fired generation has an average efficiency of about 31 percent, while new combined-cycle plants have efficiencies of 50 percent.

Is it any wonder that ERCOT has requests for more than 27,000 MW of new plants to interconnect with the system? What is really going on in ERCOT is a replacement of the fleet and some building for load growth. Where are the incumbent utilities in this fight? Sitting happily on the sidelines—for now. A retail deregulation bill was signed by Gov. George W. Bush in June last year, assuring stranded cost recovery for their nuclear assets—basically to make the utilities whole for their prior investment in those expensive plants.

The ERCOT region now is also reaching development saturation, and the saturation will continue at least until the load catches up with resources. Economists call this the boom-bust cycle. In Texas, we'd use the analogy of a rodent being eaten by a snake: It kind of has to digest its way down for a while.

Where are the future merchant markets? California and Arizona are hot for now, with combined-cycle development occurring near load centers. Markets heavily dominated by baseload solid fuel generation, such as the Midwest, are beginning to see combustion turbine peaking units installed.

There are eight more North American Electric Reliability Council regions. Each has the same elements to weigh for merchant plant development. It's a matter of when, and not if, merchant plants will enter in a given region. Even in states like Florida, where there is no significant retail deregulation effort afoot, it's just a matter of time.

Efficient technology, especially combined-cycle designs, has lowered the cost of producing electrical energy. Deregulation has introduced a commercial incentive to deploy that technology rapidly. The electricity consumers of the United States are the real winners. They will see stable or decreasing energy costs in real terms for at least the next decade.

Beyond that, who can predict what the next wave of this industry will be? In 1990, no one would have predicted that within a decade some 200,000 MW of merchant plants would be proposed for development by independents, with almost all of that power fueled by natural gas.


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