Category Archives: valuation

Is wholesale power trading as profitable a line of business as they say?

EDF Trading

Gregory Meyer, in today’s Financial Times, reports that banks are scaling back their trading in U.S. wholesale electric power markets. In his companion article, he quotes me saying that

The banks had the balance sheet, but the reality was it was the taxpayers that were giving them the balance sheet. It’s not clear we want the taxpayer subsidising proprietary trading in electricity or even hedging in electricity.

I am very circumspect about whether power trading operations are as profitable as they are often advertised to be. Here’s one reason why.

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Griffin’s Risk Management Superpower

 

The third installment of the feature film series Men in Black features the alien Griffin. Griffin possesses the critical ArcNet shield that can protect the earth against the impending Boglodite invasion. Griffin also possesses an amazing superpower: he can see the many possible futures in store for us. The movie’s writers, director and the actor playing Griffin, Michael Stuhlbarg, exploit this superpower to great comedic effect, first in a scene that takes place in 1969 at Andy Warhol’s Factory, and then later at Shea Stadium where Griffin visualize’s the Miracle Mets’ entirely improbable victory in the World Series later that year. Griffin’s superpower goes an important step further, and this is a key to how the comedy is written. Not only does he see the wide array of possible futures, but he understands, too, which futures are consistent with events as they play out, and which futures are suddenly ruled out by current events. He sees what mathematician’s call the filtration.

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The cost and value of variability in electricity generation

The Bloomberg terminal offers an LCOE function provided by its New Energy Finance unit. The function calculates the levelized cost of electricity for a number of generation technologies. The LCOE is the discounted lifetime cost of a generating one unit of electricity from a particular plant type taking into account all capital and operating costs. Shown here are the results for solar thermal, offshore win, solar PV, biomass and municipal waste incineration, geothermal, wind onshore, coal fired, natural gas combined cycle, and landfill gas:

But just because you can crunch the formula doesn’t mean the results are meaningful. Average cost is interesting, but it ignores two things that are critical to properly evaluating different generation technologies. Continue reading

Shoot the messenger?

Something about yesterday’s earnings announcement by JPMorgan has folks rattled:

Third-quarter results included the following significant items:$1.9 billion pretax ($0.29 per share after-tax) benefit from debit valuation adjustment (“DVA”) gains in the Investment Bank, resulting from widening of the Firm’s credit spreads…

The market is pricing JPMorgan’s outstanding debt with higher spreads, i.e., at a lower value, so JPMorgan books a GAIN equal to the creditors’ market value losses.

Commentators on JPMorgan’s announcement are troubled by the paradoxical result that a higher probability of default–or some other cause of higher spreads–produces an earnings gain. Readers can find commentary on this here, here and here, among many other places.

If assets and liabilities are going to be accounted for using any version of market value, then there is no way to get around the fact that a drop in the market value of a liability must be a gain to the company. The problem arises not from the market valuation of JPMorgan’s debt, but from a failure to see how this one item fits into the larger picture of the company’s earnings and valuation. If the market’s assessment of the company’s future is driving down the value of the company’s debt, that’s not good news for the company as a whole. If the company’s future is less secure, then the multiple that’s applied to its regular earnings should be much less. Properly assessed, this bad news will always swamp the bump in value from the market valuation of liabilities. In the case of JPMorgan, that means the “value” of its other long-term earnings has declined by a lot more than the $1.9 billion pretax bump from the debt valuation adjustment. It’s that decline that analysts ought to be discussing.

By the way, it’s not just bank accounting statements that occasionally exhibit this paradoxical result. It strikes non-financial companies, too. Here’s some text from Constellation Energy’s FY 2007 10K, as that company began to adopt SFAS No. 157, Fair Value Measurement:

SFAS No. 157 requires us to record all liabilities measured at fair value including the effect of our own credit risk. As a result, we will apply a credit spread adjustment in order to reflect our own credit risk in determining fair value for these liabilities which will reduce the recorded amount of these liabilities as of the date of adoption. As a result of this change, we expect to record a pre-tax gain in earnings of a range of approximately $10-$15 million in the first quarter of 2008.

But for most non-financials, the scale of the valuation adjustments in liabilities on the books at market value are usually much smaller than they are for financials.

Risk free rates and value: Dealing with historically low risk free rates

Aswath Damodaran, at NYU, has a nice post on the right and wrong ways to implement valuations in the light of the historically low interest rates on Treasuries and other sovereign debt. The trick is to think through the consequences on all elements of the valuation.

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