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posted on 30 December 2015

Merchant Power Gets Unplugged

by Richard Stavros

Investing Daily Article of the Week

Shares of merchant power producers have been hit hard over the past month, as the continued decline in natural gas prices, along with weak power demand and competition from renewables are expected to further erode earnings next year.

Of course, these market dynamics are affecting the utility space as a whole, not just independent power producers. Indeed, we've covered these trends extensively in recent years.

And our view has long been that regulated utilities are superior to merchants in this environment because the stability afforded by regulated rates gives the industry time to respond to these changes.

The market would seem to agree. Some merchant power stocks have sold off by as much as 18% this month, while their regulated peers have largely held their value.

Ratings agencies are also urging caution on the merchant sector.

Moody's Investors Service revised its industry outlook for competitive power producers to negative, citing declining prices for power and natural gas. At the same time, Moody's announced a stable industry outlook for U.S. regulated utilities, underpinned by a continued expectation of a supportive regulatory environment.

Unregulated utilities with coal and nuclear plants are under additional stress, as falling power and gas prices will impact their operating cash flow.

The rating agency predicted utilities with mostly gas-fired plants will fare better, as fuel costs fall with revenue, but the entire market is hampered by weaker demand growth due to energy conservation efforts and a tepid economy.

And the agency noted that regulated utilities have taken a credit-positive step in working with regulators to revamp their rate design and remain ahead of the potential industry transformation from widespread adoption of wind, solar power and other renewables.

Turning the Tables

Over the years, there were a number of merchant players that embraced new technologies, such as renewables and energy storage, more aggressively than their regulated peers. And that raised the possibility that the merchants might become the disruptors themselves.

But the regulated utility sector has managed to beat the merchants at their own game by creating more competition and limiting the size of the market.

The difficulties facing the merchant sector are underscored by the fact that regulated utilities themselves are shedding merchant assets left and right, such as PPL Corp.'s (NYSE: PPL) spinoff of Talen Energy. This trend has created more competition in the merchant space.

Meanwhile, these same utilities have been bringing more assets into the regulated space, further limiting the potential market for merchants.

Utilities such as Duke Energy Corp. (NYSE: DUK) have started initiatives to establish regulated rates of return on renewables, such as rooftop solar, which helps protect their regulated service territories from disruption by new entrants.

Even in competitive markets such as Ohio, the formerly regulated incumbents still found a way to preserve their market share. Last week, American Electric Power Co. Inc. (NYSE: AEP) managed to reach a deal with state regulators for power-purchase agreements that allow it to earn quasi-regulated rates for the next eight years from a portion of its Ohio generation fleet.

In the absence of such a deal, AEP would have likely sold these plants into a competitive market where they would not have been as valuable as they were previously when they were fully regulated.

The merchant operator Dynegy Inc. (NYSE: DYN) has challenged the settlement, arguing that it's bad for consumers because it limits competition.

Nevertheless, the deal illustrates regulated utilities' power of incumbency. And it reaffirms our view that regulated utilities are best positioned to continue providing stable income in an increasingly volatile and disruptive environment.

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