by Roger Feldman -- Bingham, Dana and Gould, P.C.
This almost Newtonian certainty of how the world works also is to be found in analysis of the current acquisition boom triggered by deregulation, i.e. it is all interpreted as bidder match-ups of present value cash stream analysis to corporate strategy. Sales of assets are driven by regulatory compliance or core business focus. Purchasers are drawn of assets by one of three basic approaches: economics of scale, initially through the fuel supply chain; asset backed trading of retail and wholesale energy services and operational efficiencies based on improved management of specific sites. Power strategies are thus characterized as all about alternative appraisals of cash flow potential; different cost of capital hurdle rates and different forward price curves for the regional markets into which the particular auction is being carved.
Arguments about regulatory public policy in this Newtonian DCF would therefore proceed from the question: are proposed contractual or institutional relationships likely to promote the continued creative clash of competing strategies? The ultimate criterion for blindfolded public policy becomes: is the playing field really flattened? If it is, the presumption is that the economic results of the marketplace will serve the public interest best in terms of service and price.
It turns out, however, that "rational" businessmen participating in power auctions and greenfields investment decisions increasingly may be thinking about their investments, in a different dimension than the regulators assume. The challenging inference of this conclusion is that policy makers need to re-examine whether the policies they establish really will elicit from competitors the response from them best for the public. Space constraints permit only the outlining of the new valuation private-public point-counterpoint in this column. It may, in fact, result in a new regulatory policy dialectic.
Private Point: Strategy is viewed increasingly not as a static event, validated by checking the DCF numbers. Each decision is viewed in terms of the options over time it creates; and the quantitative valuation of a series of such options. Strategy is not static; it involves the contemplation of the creation of a series of such options. There have been two recent complementary articles in the Harvard Business Review which explain this far more lucidly than can I, "Investment Opportunities Real Options: Getting Started in the Numbers: (July-August 1995) and "Strategy as a Portfolio of Real Options" (July-August 1998).
In the latter, the author, Timothy Luehrman, introduces the notion of a very special garden plot called "option space" defined by two metrics associated with the value of the option of being able to defer an investment: The first is an old friend Net Present Value (NPV) enhanced by the value of the ability to defer an investment, i.e. NPVq. (in effect, a value to cost metric). The latter is a volatility metric, i.e. how much things can change before an investment must finally be made (in effect, the impact of deferral on what NPV may be realized). Of this garden plot, Luehrman says: "Option space can help address the issues an active gardener will care about: whether to invest or not (that is whether to pick or not to pick), when to invest, and what to do in the meantime." (It certainly appears that our beloved power market is really just one subset of this "garden plot".) For us as businessmen, while the further reasoning is complex and dense, the goal is clear: to maximize profit.
Public Counterpoint: For policy makers, this thinking on the part of private investors logically should be related to the deregulation policies they should follow. Should regulators think in terms of maximization for the private sector of option space? Or, should they fear that the pursuit of option space may be contrary to reliable supply or equitable prices? Is it desirable for too few parties to hold too much option space? Should regulatory focus be on market volatility reduction and/or expedition of private decision-making even at the price of option space reduction? Should it be on preventing the gaming of option space (as, for example, in the transmission field)?
As merchant power men, we buy time and we bet on time. Policy makers historically have sought public satisfaction at virtually every instant as time passes; now the current vogue is to seek "ultimate" satisfaction through free market stabilization. Neither analytic approach seems wholly appropriate. As option space economics succeeds NPV as the actual basis for private decision-making, it behooves public policy makers to factor this fact into their decision making also.
The new energy policy dialectic, just like the old song: sitting at the auction policy dock, buying time.
ROGER FELDMAN, Co-Chair of Andrews Kurth LLP Climate Change and Carbon Markets Group has practiced law related to the finance of environmental and energy projects and companies for 40 years. In particular, he has analyzed and executed a wide variety and substantial value of project financings. He chairs the American Bar Association’s Committee on Carbon Trading and Finance, serves on the Board of the American Council for Renewable Energy, and has been a senior official in the Federal Energy Administration. He is a graduate of Brown University, Yale Law School and Harvard Business School.