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  • Electric Power Industry and Stocks

    Posted by Carl from Chicago on November 10th, 2007 (All posts by )

    One of the most intelligent guys in the power industry is named Wayne Leonard. I was told that he started in the plant accounting department at Public Service of Indiana (not usually the starting point for CEO’s) and then PSI merged with Cincinnati Gas and Electric to form Cinergy which was then bought by Duke power. Wayne left when they were still Cinergy and went to Entergy, which is a big southern utility based out of shattered New Orleans. I remember seeing presentations by business unit when I was at Cinergy and Wayne’s stuff was over my head while the other divisions were essentially mouth-breathers. I would always recommend watching Mr. Leonard’s actions to see where the industry is heading.

    In parallel, readers of this blog have seen my heckling of Exelon for pretending that their local distribution company was a separate entity from their massively profitable power generation entity, such as this post. Readers have also seen my post recommending that the State of Illinois seize the nuclear power plants from Exelon here at this post (I realize that this is odd coming from a libertarian, but there is a method to this madness) – if you are interested just go to LITGM and type “Exelon” in the search box to see more.

    The underlying issue is that power companies should be viewed as two main entities 1) distribution companies that purchase power from someone else and serve cities 2) generating companies that make power and sell this power to distribution companies. The value of #2 electricity companies is ALMOST INFINITE – meaning that since no one is creating new base load plants while demand increases, you can sell power for the highest price the market will bear indefinitely. The only blips on the horizon are the fact that at some point you bleed the distribution companies so badly that they go bankrupt and the states start to look around for more desperate solutions (like seizing the assets, the assets that rate payers paid for originally). The value for #1, however, is negligible – they usually make a return on capital and this return is being hacked away by local politicians and governments because more money is going to the generating companies and they don’t want to raise rates. Usually they received about a 10% return on equity and this is going down into the single digits, around 8%. And this 8% isn’t without risk, either.

    The investment issue is that many companies are a mix of #1, highly valuable plants, and #2, virtually worthless distribution companies. As integrated entities, you can’t get the value for #1 because the governing authorities make you give a lot of it back by not letting #2 go bankrupt.

    What to do? Watch Mr. Leonard. He is proposing spinning off the super-valuable nuclear plants from Entergy to form a separate company (which raised the stock price about 5%). Current share holders will receive shares of this new entity (called Spin-co for now) and this will be their reward, since these shares are expected to be richly valued by the market (and this value will fall to current share holders).

    One item of note in these recent generating companies is that they aren’t even pretending that they’ll reinvest in NEW generating assets, like TXU tried to do before NIMBY’s rioted. This is essentially just a financial play to put these assets in a separate company to maximize their value…

    What is left? A distribution company hostage to limited generation capacity and reduced to begging for relief and handouts from the local government. Not a happy place to be, I’ll bet.

    Once this happens, you can imagine that other companies will follow. Exelon probably will give up their ruse that their distribution company is a separate entity and just spin off their generating assets and then, truly, the distribution company will have to go hat-in-hand, begging for money to survive (like they are pretending to do now).

    If you are an investor in the utility industry, you should get ahead of this trend and look for companies with generating assets that they can spin-off and consider purchasing their stock. The market isn’t dumb, however, and probably a lot of this has been built into their stocks. And don’t look at the “electricity industry” as one industry; there are RICH providers of generation and POOR buyers of electricity. Combining them together is like combining gold mines with retailers that sell gold jewelry on a table on the street.

    From a policy standpoint, this is the saddest outcome. Now our failed electricity plans have come full circle, and the last chance to put together the vertical industry model is dead. The vertically integrated model had horrible flaws, but we have nothing to take its place, except for an even more desperate public model (see the Illinois Power Agency).

    If you own one of these stocks that splits, enjoy the power side, and stare with worry at the distribution side. For one the future is limitless, and for the other the future is bleak. Of course, this may be priced into the shares, but when you see the relative value of the shares you will note how the market values them. Some analysts at one point were saying that if the distribution side of Exelon went bankrupt (i.e. had ZERO value) it wouldn’t impact the value of Exelon stock overall, since so much of the value is in the generation side.

    Cross posted at LITGM

     

    5 Responses to “Electric Power Industry and Stocks”

    1. david foster Says:

      I wonder how these economics might be changed by the growth of alternative energy, driven by subsidies as well as improving economics.

      Suppose that in a particuar region we get up to 20% wind/solar. This output will be fairly unpreditable, as winds fluctuate and clouds move across the sun, and the more conventional generating sources will have very spikey demands to make up for these fluctuations. If this results in a worsened average-to-peak load profile for the conventional power, then it seems like the generating businesses in the best position will be those that have reasonably low capital costs, even at the expense of some increase in fuel costs…thus, maybe in this scenario gas-fired is better than coal-fired is better than nuclear.

    2. Shannon Love Says:

      We’ve really got to develop a property system that can handle the network effect. Having part of the grid free-market and part of the grid regulated begs for some variant of the tragedy of the commons.

      Even so, the Texas ECOT system seems to work well. It even has an accounting gimmick by which people can buy “green” energy and still keep the lights on even when sun goes down and the wind stops blowing.

    3. Robert Schwartz Says:

      Clearly the problem is NIMBYism, and its bastard step-child, environmentalism.

      Voltaire wanted to see the last noble strangled with the intestines of the last priest. I want to see the last environmentalist strangled with the intestines of the last lawyer.

    4. Shannon Love Says:

      Robert Schwartz,

      I want to see the last environmentalist strangled with the intestines of the last lawyer.

      I’m thrilled to learn that is even an option.

    5. David Moelling Says:

      The problem with your thesis is that for a long, long time generation was the dog. It had the bulk of the capital investment, the highest risk and for 20 years since the Carter era was in surplus.

      Only in the last 5-6 years was it in shortage, and the current high profitability of the nuclear plants is all due to high gas prices and sunk capital costs.

      In areas where the consumer was less sheltered from these changes, the discos have done OK. The real issue for the operators is getting out of regulatory areas like Illinois and Maryland where the local pols have taken complete control.

      I have long thought a scheme to offer shares in a new nuclear LLC that include a lifetime discount on power to the shareholder would do well. Even selling 50 MW in small shares would build a real constituency for deregulated power.