Trouble Lurks on Some Utilities' Balance Sheets

 | Dec 17, 2012 | 5:00 PM EST
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Another power-generating company is struggling to survive. According to Reuters, "Edison Mission Energy, a power company that operates in more than a dozen U.S. states, is preparing a possible bankruptcy filing as it tries to restructure about $5 billion in debt."

Edison Mission Energy produces and sells wholesale electricity in the power markets. It is distinct from its parent, the California utility Edison International (EIX). Its subsidiaries and affiliates have interest in 43 operating power plants with an aggregate capacity of 10,379 megawatts. These facilities include fossil-fuel power plants in California, Illinois, Pennsylvania, West Virginia and Doga, Turkey, a biomass facility in New York and a large portfolio of wind energy projects in Illinois, Iowa, Minnesota, Nebraska, New Mexico, Oklahoma, Pennsylvania, Texas, Utah and Wyoming.

Edison's problem appears to be prices for wholesale power. Edison operates five power plants in the Midwest, where bulk power prices have occasionally passed zero. It turns out that these plants are merchant plants, which are not sold under long-term contracts. Most of these plants' output is sold into the PJM Interconnection, commonly referred to as the PJM marketplace, and they are financially unhedged.

Selling power into the markets without long-term agreements is called "going naked." It is the riskiest position any utility can undertake. If market prices remain strong, owners can make a killing. If power prices sink, it's curtains. In Edison's case, it went naked, and power prices sank.

Edison is not alone. As previously reported, Exelon (EXC) has been experiencing similar challenges with its fleet of nuclear power plants. Its fleet is expected to remain profitable, but it may not produce enough margins to maintain healthy payout ratios. As such, Exelon's management warns that the company may be forced to cut its dividends.

While some investors are focused on these companies' profitability, a new issue is emerging on their balance sheets. Independent power producers such as Edison, Exelon, Dynegy (DYN), Calpine (CPN), NRG Energy (NRG) and Atlantic Power (AT) are carrying generating assets at book value. But mark-to-market values may be something entirely different.

Look Skeptically at Balance Sheets

Plants that cannot produce power economically are not an asset, they are a liability. Idle plants cost money. The power-generating company has to pay overhead expenses, a standby staff, insurance, taxes, interest, depreciation, property taxes, amortization, utilities and so on. Without revenue or gross margins, these expenses create losses.

If there is likelihood that expenses will exceed revenue for the foreseeable future, the present value of the facility's cash flows becomes zero or negative.

Dominion Resources (D) makes the case. The company analyzed its operations at Kewaunee Nuclear Station, concluded it was no longer economic and decided to retire the plant 20 years early. From its Securities and Exchange Commission 10-Q filing, investors learn how Dominion wrote off their asset:

"In April 2011, Dominion announced it would pursue a sale of Kewaunee. Dominion but has been unable to find a buyer for the facility. Dominion expected that it would permanently cease generation operations at Kewaunee in 2013 and commence decommissioning of the facility. The decision to decommission Kewaunee was approved by Dominion's BOD on October 2012 after consideration of the factors that made it uneconomic for Kewaunee to continue operations.

"Dominion evaluated Kewaunee for impairment since it would be retired before the end of its useful life. As Dominion was not aware of any recent market transactions for comparable assets with sufficient transparency to develop a market approach to fair value, Dominion used discounted cash flows to estimate the fair value of Kewaunee's long-lived assets.

"As a result, Dominion recorded impairment and other charges of $435 million. In addition to these charges, Dominion anticipates recording additional charges related to the exit plan of approximately $50 million."

Because Dominion's exposure to the Midwest power market is relatively small, its write-off is manageable. The same is true with the generating fleets owned by NRG Energy and Calpine. But it is a different story for Exelon.

Dominion's analysis warns that competitors' assets in the same region may be overvalued. Analysts can use Kewaunee as a mark-to-market reference or discounted cash flows to value generating assets. Of course, any change in valuation will change stockholders' equity.

Exelon's second-quarter 10-Q allocates $17.7 billion for Exelon Generation Company's Property Plant and Equipment (net), or about 41% of Exelon's enterprise value of $43.6 billion. This percentage represents substantial exposure.

Only five of Edison's plants are merchant plants exposed to the Midwest power market. Its fleet is geographically diverse, and it uses a variety of fuels. It would not be surprising if Edison's bondholders follow Dominion's lead and retire some of their Midwest plants. That decision, should it come, could be good news for Exelon's nuclear fleet.

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