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Goodbye Safe Haven?

Risk avoidance drives utility stock performance.

Fortnightly Magazine - March 2009

end of 2008, there were approximately 17 companies in the portfolio with market-to-book ratios under 1.0, 3 the bellwether mark describing whether companies are creating or destroying value. This list includes a variety of company types—power generation companies such as Reliant Energy, Dynegy, and NRG Energy; integrated gas and electric companies such as Ameren, Duke Energy, CMS Energy, and DTE; and integrated gas companies such as Williams and Southern Union Gas.

These companies all might bounce back on their own, depending on the focus of their management teams and their ability to grow earnings and improve balance sheets and income statements; or they might be acquisition targets by companies that maintained higher market-to-book ratios ( e.g., Exelon with its 2.0 end-of-year market-to-book, targeting NRG Energy with its 1.0 market-to-book).

Companies with strong balance sheets: The gas distribution and energy delivery success stories of 2008 might continue on into 2009. Given low interest rates and the potential for a continued recession, these companies—with their stable income streams and conservative management philosophies—might look attractive to investors and even provide growth opportunities if they choose to leverage their balance sheets through mergers or acquisitions.

Beneficiaries of new energy policy: The Obama administration has indicated energy policy will rank among its top priorities, with a focus on clean energy and energy independence. So the question then becomes, which utilities are best positioned to take advantage of changes in policy?

A national renewable portfolio standard (RPS) will have little impact on many utilities in California and the Northeast, as their existing state RPS requirements likely will exceed any national RPS requirements. However, utility affiliates with strong renewable development capabilities— e.g., FPL, with its focus on unregulated wind and solar development—could benefit through the additional requirements thrust upon utilities in many states.

While the creation of a national carbon policy is expected, the requirements inherent to such a policy are much less clear, other than that a cap-and-trade system likely will be implemented. Companies with significant coal-fired generating assets and carbon emissions ( e.g., AEP and Southern Company) will be impacted by: (1) the timing of any carbon-policy implementation, (2) whether existing coal-plant owners receive (or must pay for) their initial allocation of allowances, and (3) the associated regulatory recovery constructs for carbon control investments on regulated generation assets. Additionally, once a carbon policy is instituted, companies with coal-heavy generation portfolios operating in competitive generation markets ( e.g., Reliant and Allegheny) may be less profitable as their costs increase, or their units are displaced with lower carbon-emitting (and thus cheaper) generation.

Companies with large nuclear portfolios (such as Exelon and Entergy) may be able to leverage their clean energy focus. In the medium term, carbon policy may result in a higher marginal cost for energy in competitive markets, resulting in increased profitability (higher prices at the same cost) for those companies owning unregulated nuclear assets. In the longer term, the administration’s stance on new nuclear development will be important, as the industry will need to add new, clean base-load resources.