Not All Utilities Are Alike

 | Nov 29, 2013 | 2:00 PM EST
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When it comes to investing, it is important to appreciate that not all utilities are created equally. In fact, some investors might be surprised to learn that some well-known utility names are engaged in remarkably diverse activities.

To help sort it out, I've broken down the utility industry into six major types:

  • Type 1 companies are mainstream utilities. Examples include Xcel Energy (XEL), Southern (SO), Duke Energy (DUK) and Dominion Resources (D). They are state-regulated integrated enterprises. They have been granted a monopoly to exclusively generate and distribute their own energy to their own consumers. They operate on a cost-plus arrangement. Their respective state governments assume the financial risks associated with capital investments, including risks associated with power plants.

  • Type 2 companies are distribution utilities. Examples include Pepco Holdings (POM), Consolidated Edison (ED) and Northeast Utilities (NU). These companies are regulated by their respective state governments. Because states will not allow them to pass on the costs of generation to their customers, these utilities often deliver other people's power to their customers. They typically operate on a cost-plus arrangement, and their respective state governments assume most financial risks associated with the utility's capital investments.

  • Type 3 companies are transmission-line utilities. Examples include ITC Holdings (ITC) and American Transmission Company LLC. These companies are engaged in interstate commerce and are regulated by the federal government through the Federal Energy Regulatory Commission. State regulators have no jurisdiction over these companies' rates or economics. Like Type 2 companies, these enterprises move other people's power to other utilities on a cost-plus arrangement. Type 3 companies never sell power to consumers.

  • Type 4 companies are generators, or independent power producers. Examples are Calpine (CPN), NRG Energy (NRG), Dynegy (DYN) and Atlantic Power (AT). When it comes to economics, these companies are largely unregulated by state or federal governments. Unlike Types 1, 2 and 3, most Type 4 companies own market-facing assets. They are not financially hedged by federal or state governments.

  • Type 5 companies are regional transmission organizations (RTOs). Sometimes called independent system operators (ISOs), RTOs are federally regulated public companies. They coordinate the movement of wholesale electricity within a region, often a multi-state region. Examples are ISO New England, PJM Interconnection, Midcontinent ISO, Electric Reliability Council of Texas and California ISO.

  • Type 6 companies are marketers. These companies are third-party utilities. They own the energy but not necessarily the wires or pipes. They move their energy over transmission and distribution lines to deliver their product to a particular location. They own the contractual rights to use utility assets, such as transmission lines, pipelines, distribution systems and meters. They often engage in sophisticated financial transactions. Constellation Energy, a division of Exelon (EXC) is a leader in this segment. Another leader is Centrica (British), which will soon take over Hess' (HES) energy markets. Integrys Energy (TEG) and EnerNOC (ENOC) also have a major marketing presence with specialties.

Among the six types, pure plays do exist. For example, Southern is almost a pure play for Type 1. Pepco Holdings and Con Ed are almost pure plays for Type 2. ITC is a pure play for Type 3. Calpine, Dynegy and Atlantic Power are a pure plays for Type 4. EnerNOC is a pure play for Type 6.

Nevertheless, most utility holding companies are a mixture, with one type dominating. Exelon is a good example. Technically, Exelon is a Type 5 utility with a Type 4 subsidiary dominating 60% of its top line. Exelon owns three Type 2 companies in Illinois, Maryland and Pennsylvania. Exelon is a dominant player in Type 6, which allows it to hedge some of its Type 4 assets.

Another is American Electric Power (AEP). It owns several Type 1 integrated utility companies. It owns Type 2 distribution companies operating in Ohio and Texas. It is one of the nation's largest Type 3 transmission line utility companies, which move wholesale power in 38 states and eastern Canada. AEP owns a large fleet of power plants, many of which are operating in Type 1 subsidiaries; others are operating in Type 4 independent power producer subsidiaries. American Electric Power is also involved in Type 6 utility marketing operations.

Exelon and AEP are unique utilities. Each represents a federation of utility companies. Often, it is difficult to argue which subsidiary dominates. Together, they form a sophisticated portfolio of internally hedged operations.

Nevertheless, different utility types are engaged in completely different businesses. Investors should be cautious when analysts compare and contrast investment opportunities among utility types. It does make sense to own ITC and Calpine. It does not make sense to assume they are equivalent or that they somehow compete in any meaningful way. ITC and Calpine are completely different businesses, they have different top lines and different risk profiles, and they are completely different investments.

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