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There are two items which we expect to drive the performance of bonds issued by electric utilities in the next 12 to 18 months. The first factor will be how issuers capitalize on the changing regulatory environment, which is the focus of this article. The second issue, which will continue to drive performance, is the flight to quality trade. Should market volatility be greater than it has been historically, the electric sector and its constituents will likely outperform. Issues from electric utilities operating in relatively healthy regulated jurisdictions are considered a safe alternative in a turbulent investing environment. Conversely, if progress is made at solving the European issues (achieving austerity measure targets, avoiding potential sovereign defaults, circumventing the European banks’ need for substantial write downs of investments, etc.) and the domestic economy improves, the electric utility sector will likely underperform, as wider spread sectors outperform as shown in Exhibit 1. 

The following will provide detail on the issuers we believe will be positively affected by the changing regulatory environment, including Exelon Generation Company LLC (GenCo) and PSEG Power LLC (Power). Additionally, we identify the three pieces of regulation currently drawing the most interest of electric utilities, which are: The Maximum Achievable Control Technology for Hazardous Air Particles (MACT); Cross-State Air Pollution Rule (CSARP); and Greenhouse Gas Standards (GHG).

Generating Companies Will Likely Capitalize on the Going Green Initiative

We believe that GenCo and Power currently offer an appealing risk adjusted return opportunity given their aligned interests with the EPA, the size and quality of their generation assets, the region in which they operate, the strength of their credit profile, and the “unregulated discount” each issuer is currently receiving. One of the EPA’s current initiatives, which will be addressed in detail later, is to limit hazardous air pollutants (mercury, sulfur dioxide, oxides of nitrogen and other acid gases) from coal based generation. We believe that both GenCo and Power have generation fleets that are situated well to meet the proposed rules. Exhibit 2 is a comparison of the generation fleets of GenCo and Power with other utilities. Because GenCo and Power have less coal fired capacity than their peers each will have less environmental related capital spending and will not have to retire coal plants to meet the upcoming regulations.

In addition to the relatively low amount of coal-fired generation subject to increased costly environmental related upgrades, both GenCo and Power should benefit from having a large amount of generation capacity that emits relatively low amounts of hazardous air particles. Exhibit 3 compares the non-coal fired generation capacity of the companies in the electric utility sector. Both GenCo and Power fare well in this appraisal.

We have a favorable view of where both GenCo and Power operate and sell their electricity due to our expectation that capacity in those markets will contract in the next several years. Exhibit 4 below details an estimate of industry wide coal-fired plant closures due to the regulations expected to be implemented by 2015. These industry wide expected closures corroborates well with company specific estimates (e.g., American Electric Power Inc. (AEP), Calpine Corporation, Duke Energy Corporation, Exelon Corporation, PPL Corporation, Southern Company, Brattle Group). The table shows that the Regional Transmission Organization that is most affected by the likely regulations is the PJM (combined east and west – See Exhibit 5 map for states in PJM) with more than 16,000 Megawatts of capacity at risk. We expect GenCo and Power to capitalize on this shrinking supply, as both sell almost all of their cleaner, low-cost output in the PJM.

Exhibits 6 and 7 demonstrate the financial strength of both GenCo and Power. While both charts depict Last Twelve Months (LTM) results, the three-year average results show similar relative strength for each credit. Given that both of these operating companies are unregulated, they carry more operating risk and therefore maintain lower financial risk. From a purely financial perspective, GenCo and Power are among the best companies in the electric utility sector.

We believe the risk profiles of GenCo and Power are among the best in the utility space based on the size, quality and location of their assets, their lowly levered balance sheet and consistently strong free cash flow. Moreover, we believe that credit profiles for each of these issuers could very well improve relative to their peers given how they are positioned to capitalize on the proposed regulations from the EPA. Interestingly, in this risk averse environment, unregulated operating companies, such as GenCo and Power have underperformed their regulated peers with the GenCo notes maturing in 2020 at +221 basis points and the Power notes maturing in 2021 at +208 basis points (spread to the curve, adjusted for dollar price and maturity). As a result, potential risk adjusted returns for these unregulated operating companies are as compelling as they were in June 2009.

While we have a constructive opinion of GenCo and Power, we believe that security selection in the utility sector is especially important in the current environment. The Electric Utility Option Adjusted Spread (OAS) is trading 33 basis points inside of its five year average and it is trading at its tightest level relative to Industrials since the mid-point of the Great Recession. Given the questionable fundamental backdrop (lower demand for electricity, greater environmental related expenditures, potential retirement of assets, greater regulatory risk), we have considered moving to Unattractive on the sector. However, as we stated initially, strong demand for electric utility paper during volatile economic conditions often mitigates these fundamental concerns. As a result, our relative value opinion of the sector remains Fair.

New Regulations Will be Costly

We agree with Kermit the Frog. He famously crooned, “It’s not easy bein’ green,” and that is especially true for those utilities that own coal-fired electric generation plants. Adhering to statutes and regulations overseen by the EPA is very expensive, time consuming and disruptive to some existing business models. The following provides details on the three key pieces of regulation currently drawing the most interest in the electric utility sector: The Maximum Achievable Control Technology for Hazardous Air Particles (MACT); Cross-State Air Pollution Rule (CSAPR); and Greenhouse Gas Standards (GGS). Collectively, the regulations will have a profound affect on the industry due to the considerable costs to comply with the rules and the changed composition of how electricity is generated. While Exhibit 3 listed the estimated retired plants by region, Exhibit 8 details the announced coal plant closings to date by company and capacity in the PJM.

Maximum Achievable Control Technology (MACT)

On May 3, 2011, the EPA proposed national emission standards for hazardous air pollutants from both new and existing coal electric generating units. The proposed rule would create national standards that require all coal electric generating units to achieve the maximum degree of reductions in emissions of hazardous air pollutants. This standard for setting emissions reductions standards commonly is referred to as the Maximum Achievable Control Technology or MACT standard.

The proposed MACT standard is the first time that the EPA would regulate hazardous air pollutants emissions from electric utility steam generating units. The regulation sets limits for mercury and acid gases and the proposed emission standards must be met within three years of the date when the regulations become effective. MACT rule compliance for existing facilities would begin in 2015 under this proposal.

Several coal-focused utilities have complained that the EPA is being very aggressive with this piece of regulation. Specifically, representatives from AEP and Southern believe the abbreviated period to provide feedback was unnecessarily short (90 days versus typical 150 days). Additionally, these representatives claim the EPA developed the thresholds for the measurements without any operator consultation, which is unusual.

Cross-State Air Pollution Rule (CSAPR)

On July 6, 2011, the EPA finalized the Cross-State Air Pollution Rule (formerly known as The Transport Rule; replacing the 2005 Clean Air Interstate rule ordered by the U.S. Court of Appeals). The final rule of CSAPR requires 27 states to reduce power plant emissions that contribute to cross-border air pollution. In a controversial decision in this final rule, Texas was added to the list of the states that must comply, which obviously upset companies there with coal-fired generation assets (e.g., AEP and Luminant). CSAPR requires coal fired plants to meet emission caps of sulfur dioxide (SO2) and oxides of nitrogen (NOx) beginning January 2012. According to several coal-focused utilities such as AEP, Duke and Southern, CSAPR is more restrictive and the compliance periods are more aggressive than originally proposed.

Greenhouse Gas Standards (GHG)

On December 23, 2010, the EPA proposed establishing greenhouse gas (GHG) pollution standards under the Clean Air Act. Under the agreement, the EPA proposed standards for power plants in July 2011 and for refineries in December 2011 and will issue final standards in May 2012 and November 2012, respectively. Compliance with the EPA based GHG standards would begin in 2015.

Recall that the regulation of carbon dioxide was mandated by the U.S. Supreme Court. In Massachusetts vs. the EPA from April 2007, the Supreme Court determined that greenhouse gases are “air pollutants” under the Clean Air Act and that carbon dioxide emissions can be regulated (A 5 to 4 decision with Justice Anthony M. Kennedy casting the deciding vote). In addition, the Court opined that in the face of uncertainty, but increasingly potent data, the U.S. EPA had to provide better reasons for refusing to regulate carbon dioxide (CO2).

The carbon dioxide emission regulation via the EPA comes on the heels of the failed and highly controversial legislation known as “American Clean Energy and Security Act of 2009″ authored by Representatives Waxman and Markey. The Waxman-Markey bill would have provided carbon emission credits for free to utilities and merchant generators. In effect, Waxman-Markey’s cap and trade system was a targeted tax on gasoline, diesel and jet fuel to subsidize the research and development efforts of utilities to sequester carbon dioxide.

Conclusion

We believe compliance with these upcoming regulations and companies’ ability to capitalize on the new standards will be the fundamental factors which determine performance in the next several years. We believe that those companies that have generation fleets with relatively little exposure to coal fired generation will benefit in the future. This is particularly true for those companies operating in the PJM such as GenCo and Power where a substantial amount of coal capacity will likely be retired in the next three years.

Written by:
Patrick McGeever
Vice President, Corporate Credit

For the entire document (with exhibits) and important disclosures associated with its content, view original document (PDF)