Exelon's Acquisition of Pepco Faces Tough Regulatory Challenges

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Written by John Egan for Industrial Info Resources (Sugar Land, Texas)--Exelon Corporation (NYSE:EXC) (Chicago, Illinois) agreed to pay $6.8 billion in cash to acquire Pepco Holdings Incorporated (NYSE:POM) (Washington, D.C.) to rebalance its business by lessening its reliance on unregulated nuclear power generation and increasing the role of regulated, monopoly electric and gas distribution. Exelon will keep its position as one of the largest power companies in the U.S. with this transaction, announced April 30. But for the deal to become effective, it will need to pass muster with numerous state and federal regulatory bodies. Assent is by no means assured.

Exelon has a longstanding and deep commitment to nuclear generation: it operates 23 nuclear units at 14 plants in Illinois, Maryland, Nebraska, New Jersey, New York and Pennsylvania. Except for the Nebraska unit, all operate as merchant plants that sell power at market prices. Unlike generators operating in traditionally regulated power markets, merchant generators have no guarantee over the price or dispatch of their electricity. High power prices can mean big profits to low-cost generators. Exelon also generates electricity from 32 fossil-fueled plants throughout North America.

Exelon's nuclear merchant strategy worked well for a number of years, particularly when gas prices were high. But Exelon's merchant fleet of nuclear generators has fared poorly against gas-fired generation in recent years, partly because the shale gas revolution has dramatically increased gas supplies and lowered gas prices. Natural gas prices for electric generation hit a recent peak of about $12.50 per thousand cubic feet in late 2008, but fell steadily to about $4 per thousand cubic feet in 2012, before recovering to its current level of about $8 per thousand cubic feet, according to the U.S. Energy Information Administration (EIA) (Washington, D.C.), the independent statistical branch of the U.S. Department of Energy (DoE) (Washington, D.C.).

Some companies owning merchant nuclear generators, including Dominion Resources Incorporated (NYSE:D) (Richmond, Virginia) and Entergy Corporation (NYSE:ETR) (New Orleans, Louisiana), have closed plants that were unable to compete in gas-dominated wholesale power markets. For more on that trend, see October 8, 2013, article - North America's 'Nuclear Renaissance' Grinds to Halt as Plant Development Projects Stalled, Cancelled; and July 9, 2013, article - U.S. Nuclear Renaissance Now Further Away and More Expensive.

In announcing the transaction April 30, Exelon said the addition of Pepco's 2 million customers in three states and Washington, D.C., would bring its total customer count to about 10 million. Part of the strategic rationale for the deal was that it would "further expand Exelon's regulated holdings, ensuring a balanced earnings mix as power prices recover," the statement said.

In a statement, Exelon President and CEO Chris Crane said, "Exelon and Pepco Holdings have a compelling strategic rationale for merging, given our geographic proximity and similar utility business models."

Exelon's merchant generation fleet exceeds 35,000 megawatts (MW) of generation capacity. The utility holding company also operates regulated electric distribution networks serving about 6.6 million customers in Illinois, Maryland and Pennsylvania. Exelon said it would divest up to $1 billion of assets, though it would not say whether those assets were nuclear generators, coal-fired power plants or something else.

The transaction must be approved by several state and federal regulatory bodies. In some previous deals, regulators have either vetoed transactions outright or imposed conditions on deals that caused the parties to walk away. Examples of failed deals include Exelon's attempt in 2004 to acquire Public Service Enterprise Group Incorporated (NYSE:PEG) (Newark, New Jersey); NextEra Energy Incorporated's (NYSE:NEE) (Miami, Florida) attempt in 2000 to acquire Entergy; and a 2005 deal where NextEra Energy tried to buy Constellation Energy Group (Baltimore, Maryland). But some utility deals have been approved, including Exelon's 2011 acquisition of Constellation Energy Group (Baltimore, Maryland); the 2010 acquisition of NStar (Boston, Massachusetts) by Northeast Utilities (NYSE:NU) (Springfield, Massachusetts); and the merger of Duke Energy Corporation (NYSE:DUK) (Charlotte, North Carolina) with Progress Energy (Raleigh, North Carolina), which closed in 2012.

In his statement announcing the Exelon-Pepco transaction, Joseph M. Rigby, Pepco's chairman, president and chief executive, said, "Exelon is one of the most respected energy companies in the country, and it is committed to building on the progress our team has made over the last few years to improve system reliability and customer satisfaction."

Pepco is working its way through a host of operational, reliability and public-relations problems caused by severe weather. Prolonged power outages following the "Snowmegeddon" of 2010, Hurricane Irene in 2011, SuperStorm Sandy in 2012, and a derecho storm in 2012 led to a sharp increase in customer complaints against Pepco, triggering increased outlays to improve system reliability.

An investigation by The Washington Post concluded that Pepco's reliability was among the worst in the nation, and that the company ranked at or near the bottom nationally among electric utilities in keeping power on and restoring lights once electricity goes out. The Post also reported the average Pepco customer experienced 70% more outages than customers of other big-city utilities. And the lights stayed out, on average, more than twice as long.

On a conference call with reporters announcing the transaction April 30, Exelon's Crane expressed confidence that the companies could win approval from regulators, citing Exelon's experience with the acquisition of Constellation. "We have a skilled regulatory team," he said. "We'll work closely with the regulator. We would not do this if we could not see a path toward closure."

Not everyone was as confident. Neil Kalton, a senior analyst at Wells Fargo & Company (NYSE:WFC), cautioned investors that "the regulatory approval process would likely be thorny, as [Pepco] has four jurisdictions that are considered to be relatively tough."

With its eye on Pepco's regulatory and reliability problems of recent years, Exelon earmarked up to $100 million in a customer investment fund, to be utilized across Pepco's service territories in Maryland, New Jersey, Delaware and Washington, D.C., as each state's and D.C.'s public service commission deems appropriate. The fund could go to bill credits, assistance for low income customers, and energy-efficiency measures.

"This is a creative transaction that could produce a merged company with a lower blended risk profile and bigger profits--if energy markets cooperate," said Brock Ramey, research manager for Industrial Info's North American Power service. "The deal would unite a leader in merchant power that has been bloodied by low gas prices with a regulated utility still working its way through regulatory and reliability problems. I think closing this deal will require more time and more financial concessions than Exelon has put on the table. But this is not their first rodeo. If regulators push too hard, Exelon has shown it will walk away from a transaction that no longer makes sense."

Industrial Info Resources (IIR), with global headquarters in Sugar Land, Texas, three offices in North America and 10 international offices, is the leading provider of global market intelligence specializing in the industrial process, heavy manufacturing and energy markets. Industrial Info's quality-assurance philosophy, the Living Forward Reporting Principle™, provides up-to-the-minute intelligence on what's happening now, while constantly keeping track of future opportunities.