Strategic Overview

 

 

POWER

Our power generation platform includes wind, hydro, gas cogeneration, biomass and solar facilities across Canada, totalling 505 megawatts of installed capacity, of which Capstone’s net share is 461 megawatts. We are also developing a pipeline of wind power projects totalling an expected 85 megawatts of capacity, or 65 megawatts net to Capstone.

Cardinal operates under a non-utility generator agreement with the Independent Electricity System Operator, whereby the facility is activated at peak times when power prices provide a financial incentive to do so. Whitecourt sells power into the Alberta power pool and has a fuel supply agreement with Millar Western Forest Products Ltd. The balance of Capstone’s operating and development projects have power purchase agreements with creditworthy counterparties (see Figure 1).

The key performance drivers for Capstone’s power segment in 2015 are:

1. Achieve consistently high availability to help maximize revenue (see Figure 2).
   
2. Maintain or improve the quality of each facility by focusing on routine, predictive and major maintenance and implementing technological and  operational enhancements (see Figure 3).
3. Efficiently manage operating costs at each facility.
4. Complete the Goulais wind power development project on time and on budget.
5. Advance the mid-term projects through permitting and approvals.
6. Start construction on projects with REA approvals.
7. Operate facilities safely with a goal of zero lost-time injuries.

 

In 2014, Erie Shores installed Turbine Pitch Optimization technology to maximize the amount of energy captured by the blades, thereby enhancing revenue. TPO can potentially extract an additional 1% to 2% performance from turbines.

 

 

 

 

UTILITIES

Capstone’s utilities platform includes interests in a district heating company and a regulated water system.

District Heating
We hold a 33.3% equity interest in Värmevärden, a district heating business in Sweden serving individual, multi-residential, municipal and industrial customers in 10 communities.

Our key performance drivers for 2015

1. Manage fuel costs, Värmevärden’s, largest operating expense, by using cost-effective fuels.
2. Maintain strong customer relationships by providing highly reliable, quality service to customers, thereby increasing potential for customer contract attraction and retention.
3. Ensure high plant availability and operational efficiency, which helps to maximize revenue potential while minimizing the use of more expensive peak fuel.

 

Bristol Water
Capstone is the largest shareowner in Bristol Water, a regulated water utility in the United Kingdom that provides 240 million litres of water daily to more than 1.2 million people. Bristol Water is a high-quality, perpetual asset with a history dating back almost 170 years and excellent prospects for sustained future growth from an increasing local population and expanded business activity in the region.

The Water Services Regulation Authority (Ofwat) is the economic regulator with oversight of Bristol Water and every other water and sewage treatment utility in the United Kingdom. Every five years, Ofwat approves the pricing model and business plan (known as the Asset Management Plan, or AMP) that applies to each of these utilities, in a process called the price review (PR). In 2014, Capstone was closely involved in the PR14 process through which the pricing model and business plan for the five-year period from April 1, 2015 to March 31, 2020, or AMP6, were determined by Ofwat.

The PR14 process was extensive, involving more than a year of submissions, revisions, direct negotiations, expert analysis and customer input. Capstone management worked with Bristol Water’s team during this time and provided regular updates to stakeholders throughout the process.

We believe the plan ultimately submitted to Ofwat:

• reflected the priorities of customers;
• was designed to deliver the right outcomes for current and future customers and the environment;
• ensured Bristol Water met its statutory obligations;
• represented the right balance of risk and reward between customers, investors and other stakeholders;
• was affordable and soundly financed.

 

On December 12, 2014 Ofwat delivered a final determination on the business plan for AMP6 that fell short of expectations. There were several major points of difference between Bristol Water’s proposed business plan and Ofwat’s final determination.

Bristol Water proposed wholesale expenditure of £500 million (£541M with a new reservoir)

• reduced household bills by £9 to £188 (4.5%);
• had broad customer support (92%);
• invested in the system but at a lower level than current AMP;
• £41 million to start Cheddar 2 reservoir, which would spread the expense over successive regulatory periods and potentially reduce overall costs;
• weighted average cost of capital of 4.4%, including recognition of higher embedded debt costs.
• no Cheddar 2 reservoir.

 

Ofwat set allowable total wholesale expenditure of £409 million

• average household bill falls to £164 in first year, then to £152 (20%);
• allowable cost of capital (WACC) of 3.6% (real);
• no small company premium; adjusted penalties; slim maintenance capex;

 

Bristol Water’s Board of Directors resolved on February 5, 2015 to formally reject Ofwat’s final determination. This triggered a process whereby Ofwat was compelled to refer the AMP6 business plan to the Competition and Markets Authority (CMA), the UK agency responsible for considering regulatory references and appeals.

The CMA will now review submissions from Ofwat and Bristol Water regarding the AMP6 business case. It should be noted that Bristol Water went through a similar process in 2010, when the Board rejected Ofwat’s final determination for the 2010 to 2015 period and the matter was referred to the CMA’s predecessor (the Competition Commission), with the result that a more acceptable business plan was set in place.

Pending the outcome of the CMA review, Bristol Water will operate in the meantime under the Ofwat final determination, starting April 1, 2015. It is expected that the CMA will render its final determination on the AMP6 review in August 2015. Any adjustments arising from the CMA’s decision would come into effect on April 1, 2016.

Plans have been prepared to manage Bristol Water efficiently under a range of potential CMA outcomes. However, it remains the case that the inherent value of this water system and its long-term growth profile make it a compelling investment regardless of short-term regulatory challenges.

Other Performance Measures
Aside from the CMA review, standard operations are continuing at Bristol Water.

Key performance drivers for 2015 are:

1. Provide safe, reliable drinking water that is cost-effective for customers.
2. Operate in compliance with all regulatory and environmental requirements.
3. Operate efficiently to manage costs.
4. Complete capital expenditures under AMP5 business plan by March 31, 2015.
5. Operate in accordance with AMP6 final determination through CMA review process.

 

 

GROWTH PROSPECTS IN INFRASTRUCTURE

Infrastructure offers unique investment characteristics because of its essential role in serving the needs of people, communities and the demands of the global economy. Governments traditionally provided the funding for projects like roads, power plants, hospitals and utilities, but constrained budgets have led to decades of underinvestment in this area.

Private capital has increasingly flowed into infrastructure to fill the public funding gap, attracted by the long duration, high barriers to entry, stable cash flows, inflation protection and dominant market position of these assets.

Today, the competition for infrastructure investments is intense. This has somewhat narrowed the selection of high-quality assets, and made the patient and disciplined analysis of any potential acquisition more critical than ever.

Power Sector
The renewable energy sector has been among the most active in the infrastructure space. The general attractiveness of the asset class – amid climate change concerns, government incentives and regulations, and rapidly improving technology – is one factor driving this change. Canada saw a rapid expansion of renewable energy supply driven by public policy, though this initial surge has now tapered off.

The other factor is the emergence of yield companies, or “yieldcos,” which enable investors to participate in renewable energy without many of the risks associated with construction or research and development. Wind, solar, thermal and hydro facilities are structured into yieldcos, generating predictable cash flows that are passed on to shareholders as dividends. These companies have an enormous demand for acquiring operating assets, which has often driven valuations higher and returns lower.

Capstone is well positioned with a steady development pipeline enabling us to build out new wind projects using our internal capabilities. We also evaluate potential acquisitions in renewable power facilities, though in today’s frothy market, we apply a rigorous diligence process to ensure they serve the best long-term interests of shareholders.

Utilities
Utility companies that transmit and distribute power, natural gas and water have long been associated with providing reliable, perpetual infrastructure returns. That picture is evolving, along with the investment opportunity utilities present.

Electricity
The transmission and distribution of electrical power is changing. The local distribution company model, or LDC, has long been the standard delivery method, but there are inherent inefficiencies to running a patchwork of small utilities to serve modern, sophisticated economies. A report in 2014 from Ontario’s Advisory Council on Government Assets recommended consolidation of the "excess number of small players" in Ontario's electricity distribution sector; other jurisdictions are contemplating similar moves.

Meanwhile, the rapid adoption to new technologies, like rooftop solar, light industrial wind turbines and “inside the fence” on-site power plants, has disrupted the traditional dominance of electricity utilities everywhere as customers go off the grid. Industry dislocations of this scale often present investment potential; at this stage, we are paying close attention to the unfolding opportunities and risks in this area. We expect to see more clarity over the next 18 months as governments formalize the consolidation framework, the possible role of the private sector becomes defined, and new technologies transform the business model for power distribution.

Water Utilities
Water is frequently referred to as the petroleum of the next century because of the world’s growing population, scarcity of fresh water and climate change-induced drought. Ownership of regulated water utilities is the most direct way to harness this trend.

As with other infrastructure assets, the US$460 billion worldwide water market has garnered considerable attention from large institutional investors, global banks and specialist water utility companies. There is significant interest in the best assets.

Capstone’s 50% ownership of Bristol Water gives us a foothold in this coveted sector, as well as direct experience with the regulatory environment around water utilities. Our association with water multinational Grupo Agbar (a part of Suez Environnement), one of our ownership partners in Bristol Water, has the potential to create additional investment opportunities once the short-term regulatory issues at Bristol are settled.

Natural Gas
The investment possibilities in natural gas involve local distribution, storage, and transportation over long distances via pipelines. Natural gas is in wide use globally, often because it is a cleaner fossil fuel alternative to coal or oil, which is being phased out in many markets. We have experience with natural gas as a fuel source at Cardinal, and there is considerable potential to invest in a utility that carries this resource.

Other Pillars
Public-private Partnerships
The Canadian P3 market is among the most established and highly regarded in the world, as provincial and federal governments have come to understand the benefits of having the private sector assume a major share of the risks of financing, construction, performance and maintenance of public infrastructure. The US and other markets are steadily increasing their use of the P3 model.

Bidding for new P3 projects and seeing them through development and completion involves a considerable financial commitment and a degree of risk, but also carries a potential for high return on investment. Operating P3s, which have already been built and are functioning as they should, generally produce attractive, yet more modest, returns. For the past year, Capstone has retained a leading P3 expert to advise on potential acquisitions that can offer predictable, government-backed cash flow with limited volatility. The market remains competitive for P3 assets, and identifying a suitable project or acquisition will take time.

Transportation
Capstone’s management team has direct experience in developing and managing transport infrastructure including roads, public transit and shipping ports. These assets, along with railways and airports, tend to represent larger acquisitions that Capstone would likely pursue in partnership with other parties. For the time being, expansion into this area is a lower priority for the company.

The management team at Capstone understands the importance of growing the company, with the corresponding recognition that today’s competitive infrastructure market requires a creative approach to sourcing accretive transactions that carry long-term positive outcomes for all stakeholders.