Exelon Corp.'s $7.9 billion bid to buy Constellation Energy builds on a series of recent deals meant to create profitable electric power companies that burn less coal, use more natural gas and combine existing nuclear fleets.
Early yesterday, Chicago-based Exelon and Baltimore-based Constellation proposed a merger that would combine the nation's largest operator of nuclear power plants with a large marketer of electricity along the East Coast. The deal envisions shedding a significant slice of coal-fired power in Constellation's energy mix, and it would create a $52 billion company dominated by "clean energy" in the form of nuclear power, natural gas and renewable energy.
"The importance of electric utilities as clean energy investors cannot be overstated," said Ralph Cavanagh, co-director of the Natural Resources Defense Council's energy program.
The pace of consolidation in the electric power sector has been picking up, and analysts said the Exelon-Constellation deal just underscores the need for utilities to get bigger to handle emerging challenges, including cutting greenhouse gas emissions. Hotter on their plate is the need to upgrade or replace older coal-fired generators that could be a drag on their balance sheets once environmental regulations factor in the costs of pollution and climate change.
In January, Duke Energy Corp. proposed a $13 billion merger with Progress Energy Inc., both based in North Carolina. At the time, Duke's chairman and CEO, Jim Rogers, cited a "tsunami of capital costs" that called for greater consolidation in the industry.
In the past six months, U.S. utilities have proposed nearly $30 billion in mergers. They also include Northeast Utilities' deal to buy Boston's NStar. Wholesale power giant AES Corp., based in Arlington, Va., has offered to buy out Dayton Power & Light in central Ohio.
"The electric industry as a whole has a capital budget of $1.5 to $2 trillion over the next 20 years," Cavanagh said. "The allocation of that capital is critical going forward."
Exelon has long been in a better position than most utilities to handle regulations tied to the burning of coal. It has openly supported climate legislation that would reward its fleet of zero-emissions nuclear plants. Constellation has investments in renewable energy, but it has also resisted calls by Maryland state officials to buy power from offshore wind projects proposed off the Northeast coast.
Nearly 90 percent of the combined energy portfolio would be nuclear, gas and renewable energy -- a portfolio that could align with an energy policy envisioned by the White House and that could bring Republicans on board. In his State of the Union address, President Obama discussed a clean energy standard, and he left nuclear and natural gas on the table as sources of low-carbon electricity that could count as "clean energy" under a broad federal mandate.
Keeping an eye on regulators
Financial analysts said the merger makes sense. A note put out by Citigroup on Wednesday, as rumors of the deal circulated, said a merger would strengthen Constellation's balance sheet and asset base. Doing so could open the door for Constellation to tap $2 billion in cash it keeps on hand. "This capital should be partially freed if merged with an entity with excess physical generation assets, like Exelon's," equity analyst Brian Chin wrote.
Mergers in the electric power sector can face withering scrutiny from state regulators. Power producers and distributors looking to combine forces also face tougher scrutiny from the Justice Department and the Federal Energy Regulatory Commission over their ability to control electricity prices. For their part, Exelon and Constellation have butted heads with regulators in New Jersey and Maryland in the past five years over proposed mergers and acquisitions.
In 2006, Exelon dropped a proposal to take over Public Service Enterprise Group Inc. (PSE&G), after 18 months of negotiations with the New Jersey Board of Public Utilities failed to get the go-ahead from a state regulator pressing hard for rate concessions. In 2009, NRG Energy forced Exelon to drop a hostile takeover attempt that would have created the nation's largest power generation company.
Christine Tezak, an energy analyst with Robert W. Baird and Co., told her clients in a note yesterday that the merger "will require deft management of regulatory hurdles." With DOJ and the Federal Trade Commission changing their merger requirements, she said, the landscape has changed since Exelon's deal with PSE&G and could mean a tougher road meeting federal anti-monopoly standards.
"Under the new guidelines," she asserted, "the agencies will focus less on the raw increases of market concentration and focus more on the impacts on the consumer."
Further, she said, "significant ratepayer concessions" could emerge out of negotiations with regulators in Illinois and Maryland. About five years ago, with electricity prices going up, Maryland regulators blocked a bid by NextEra Energy Inc. to buy Constellation. Wrangling over electricity prices, the potential re-regulation of Maryland's power generation and fights over nuclear and wind power in the Northeast have muddied up Constellation's relationship with Maryland's governor and utility regulators.
"We will participate actively in those proceedings to ensure that the transaction is in the best interest of Maryland ratepayers," Maryland Gov. Martin O'Malley (D) said in a statement.
To grease the wheels some, Constellation said it would offer customers of its subsidiary Baltimore Gas & Electric a $100 credit within 90 days of closing the deal with Exelon.
One energy attorney, who did not want to be named, said the deal could run into antitrust problems due to the combined-cycle natural gas plants. Regulators could see too much price-setting potential through a concentration of gas-fired generation, and force the companies to sell off some of those assets.
Exelon operates the utilities Commonwealth Edison in Illinois and PECO in Pennsylvania. Exelon and Constellation have significant assets in the mid-Atlantic region and throughout the PJM Interconnection regional market. PJM operates electricity markets stretching from Illinois, across northeastern Rust Belt states, to the mid-Atlantic states and as far south as North Carolina.
The future is gas
"These are the two biggest proponents of consolidation in the industry," said Doug Green, an antitrust and power sector attorney with Steptoe & Johnson LLC. "[Exelon] has clearly thought it was a beneficial strategy to augment their generation fleet in PJM."
The proposed merger fits into the vision laid out by Exelon CEO John Rowe, said Green and other sources.
Rowe grabbed the spotlight in March when he told a Washington audience that burning natural gas to produce electricity is a more realistic approach to cutting pollution and greenhouse gas emissions than building an expensive fleet of nuclear power plants. He called the U.S. onshore gas supply a "genuine elixir" for at least a decade, as gas prices remain near historic lows and power generators replace their oldest and dirtiest coal-fired plants with gas.
"We think long-run value lies in being greener and cleaner," Rowe said during a conference call with analysts yesterday. Constellation's interests in solar power fit Exelon's broader strategy of further distancing itself from coal and expanding the zero-carbon emissions corners of its fleet, he said. "We want to have a presence marketing those things."
Putting aside the significant assets and interests in nuclear power, natural gas gets a nod in the merger. Constellation plans to sell off about 2,600 megawatts of coal-fired generation once the deal closes. Doing so would shrink the combined company's coal-fired power to 6 percent, with one-quarter of its power coming from firing up gas plants. The majority, 55 percent, would be nuclear power.
"Anybody who has coal units has to look at their economic viability in light of political pressure," said Steptoe & Johnson's Green.
"No one in their right mind is going to build nuclear plants right now," he said. Gas prices are so low that they're competitive on price with generation from coal. "He's right about that," Green said of Rowe's comments on gas. Still, he said, natural gas prices won't be low forever, and profit margins for both nuclear and gas will be tighter in time.
"If you were plotting strategy for a utility and you want it to grow, positioning yourself as a greener company certainly seems like a sensible strategy," Green said. "You can build political support, and that's always important so you can build projects in this industry."
On the New York Stock Exchange, Constellation gained 5.7 percent to end the day at $36.26 a share. Exelon gained 1.6 percent to close at $42.18.