Energy Sample Interview Question 1: Valuing a Power Plant

“How would you structure the analysis for a power plant investment?” 

This open-ended, tell-me-what-you-know type of question is something you could run into in a corporate finance, investment banking, investment management, or even a strategy job interview.  You might hear this question in many forms:  “Do you know how to value a power plant?”   “Do you think the sale of Company X’s assets was overpriced?”   “Does Generation Company Ypresent a good investment opportunity?”  A finance professional needs to answer these questions routinely – when a company or investor is involved in developing a new generation facility, bidding on plants being sold at auction, pricing assets for divestiture, or valuing an asset-owning business. 

Principals of valuation apply to all types of assets, so if you can talk about power plant investing in an interview, you can also comment intelligently on investment issues for pipelines, oil rigs, and the like. 

You may not be asked to go in-depth with specific numbers in your interview. Nonetheless, in order to answer this question successfully, you do need to understand a fair bit about what’s involved in building and operating a generic power plant.  We can look at specific cost figures for a gas-fired combined cycle power plant, which is the most common type of new power plant built in the U.S.  Agood rule of thumb to keep in mind is that new capacity costs about $600 per kW.  Due to significant economies of scale, a 250MWplant might cost more than $150 million (250x1000x600), and a 1000MWplant might come in at something under $600 million (1000x1000x600).  Turbine costs are a significant percentage of overall cost, and are thus carefully negotiated with vendor companies, many of which offer a bundled “EPC” (engineering, procurement, construction) contract for the facility construction and turbines. 

Operating a power plant profitably is all about running it during hours when electricity prices are higher than fuel prices, and hoping that hourly operating margin (revenue minus variable cost) adds up to enough over the hours you run during the year to cover all of your fixed costs-and also contribute something to paying back the capital invested to build the plant in the first place.  In our example, we assume the following representative figures: 

•  Electricity prices average $40/MWh during the hours our plant is dispatched, which is 80% of the 8760 hours in the year (40 x 500 x 8760 x 80% = $140m). 

•  Fuel (gas) averages $3 / MMBtu during those same hours, and our plant converts fuel to electricity at a very efficient heat rate of 6500 Btu/kWh. (3 x 6500 x 500MWx 8760hours x 80% = $68m). 

•  Other variable costs add up to $0.50/MWh (0.5 x 500 x 8760 x 80% = $2m).  These are primarily fees paid to the host community for use and discharge of water to cool the plant, which can be some 100,000 gallons per day. 

•  Fixed costs are $100/kW-year (100 x 500 x 1000 = $50m).  Nearly half of these costs are for labor and administration.  Well over a third of fixed expenditures are typically for regular annual maintenance (a plant is often shut down for a week for its annual overhaul) and for funding the “major” maintenance reserve (major portions of the plant must periodically be replaced due to wear-and-tear). 

So, how do you actually answer the question in the interview?  You probably don’t walk through the cost figures laid out above, which are here primarily for your background knowledge.  Remember, the interviewer is likely not trying to test your ability to manipulate numbers in your head without a calculator – rather, s/he is trying to see if you understand valuation on a conceptual level.  Thus, you need to frame your analysis but not actually execute it.  Generally, you will want to communicate your grasp of three basic aspects of valuation: 

1.  Discounted cash flow valuation methodology.  You need to demonstrate that you know how to do a basic, textbook DCF valuation:  Take revenues, subtract variable costs, fixed costs, taxes, change in net working capital and capital expenditures to yield free cash flow for each year; calculate a Net Present Value (discount the FCF stream back to the investment year using the firm’s cost of capital valuation, add the initial capital cost); conduct sensitivity analysis on the major assumptions. 

2.  Back-of-the-envelope valuation methodology.  Perhaps more importantly, you also need to demonstrate that you can assess a project’s 

value intuitively, without any fancy Excel-based analysis.   With just four numbers – expected energy price, fuel price, heat rate and capacity factor – you can easily comment on the financial viability of a plant:  

•  Expected energy price minus variable cost (expected fuel price x heat rate) is your expected hourly operating margin.  

•  Multiply that by the expected hours run (hours in a year x capacity factor), and you have the annual operating margin.  

•  Ask your interviewer what the plant’s fixed costs are.  If they are less than your annual gross operating margin, then you know the plant can be expected to at least break even.  

On an even more qualitative level, one can reasonably comment on the financial viability of a prospective new gas plant with even just one 

number – the heat rate: 

•  The lower a plant’s heat rate is, the lower its variable (fuel) costs are.  

•  Power plants are generally dispatched in ascending order of bid prices (variable costs): the lower the bid, the more the plant will be called to run.  

•  However, market prices are set by the highest bid, so if your costs are substantially lower than the most expensive dispatched 

plant, you stand to make money by virtue of receiving a higher price for your output than it costs you to produce it.  

•  Thus, if the plant in question has a heat rate substantially lower than the plants which are generally the most expensive ones dispatched (and you can observe this by looking at a graph of the market’s “stack” of available plants), you know by definition that the plant will make money. 

3. “Pro forma” numbers vs. actual results.  Asset valuations can be done with varying levels of detail and with more or fewer simplifying 

assumptions, depending on the stage of the project and the purpose of the analysis.  If you do a rough valuation for a proposed new development, you may have 20 line items in a 1 megabyte Excel file.  On the other hand, if you prepare a valuation to support a $100 million loan for an existing plant, you may have 200 line items in a 3 megabyte model.  You will want to demonstrate awareness that assumptions like “annual average hourly electricity price” and “annual average fuel price” do not reflect the complexity of actual operations.  In practice, a power plant may earn revenue from ancillary services, payments for capacity availability, and additional income from power marketer transactions. Much of its output sales (and its fuel purchases) may occur through long-term contracts rather than the daily commodity market.  The heat rate is not a constant, but varies with on/off cycling of the plant and with the temperature outside.  As forecasters are fond of saying, any model of the future is almost certainly wrong.