Exelon Is Perfectly Positioned

 | Dec 17, 2013 | 9:34 AM EST
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For Exelon (EXC), the good news may be on the horizon. Market fundamentals are changing, and the company is changing for the good. If all goes to plan, the company can expect to see improved top-line revenues and bottom-line earnings. Of course, other traditional power producers like Calpine (CPN), Dynegy (DYN) and Atlantic Power (AT) will also benefit. But it is unlikely they will benefit as much as Exelon.

Investors may recall that Exelon bought Constellation Energy Group in 2012. For the last two years, Exelon has been busy realigning internal operations to accommodate the acquisition. That realignment has been difficult as its merger coincided with a sudden and surprising slowdown in the wholesale power industry.

Today, Exelon operates the nation's largest fleet of commercial nuclear power plants. About 55% of its generating capacity of 34,700 megawatts is nuclear power. The balance is natural gas (28%), hydroelectric (6%), wind and solar (4%), coal (4%) and oil (3%).

Market fundamentals are beginning to shift. While some may be caught by surprise, Exelon is ready. It pared its operations, positioned its assets and adjusted its portfolios all in the preparation of a helpful shift in fundamentals.

Market changes will cause Exelon's top lines to improve beginning in the third quarter of 2014. They will improve again in the third quarter of 2015 and again in 2016.

One big change is the revenue Exelon expects to earn from the capacity markets. In the PJM Interconnection, auction results are already booked for 2014-2015, 2015-2016 and beyond. There is no debate. PJM capacity auctions will deliver higher revenues for all market participants, including Exelon. (PJM's 2016-2017 produced lower prices, but those prices are still higher than current prices.)

The shift is not limited to PJM. Capacity fundamentals are changing elsewhere. While not all results are in, a trend is developing. Other regional transmission operators are adjusting their capacity auctions to maintain their grid's reserve margins. To attract generating assets, the other grids must find ways to improve generators' revenues. Capacity is on the top of most policymakers' lists.

Exelon has a large footprint in PJM. They also have a presence in ISO New England, the Midcontinent Independent System Operator (MISO) and the Electric Reliability Council of Texas (ERCOT). All three are considering programs that could improve capacity payments for generators. Obviously, if only one delivers with improves revenues, Exelon's shareholders win.

Keep in mind, the biggest winners in capacity auctions are nuclear and base-loaded coal plants. Unlike renewable energy, peaking and other intermittent sources, nuclear and coal are entitled to the full capacity payment, whether or not they produce power (solar and wind only earn a fraction, if any). In addition, because Exelon's plants are physically large, their capacity payments can be substantial.

PJM is an example. For year 2012-2013, PJM paid $16.46 per megawatt-day for capacity only. For a 1,000-megawatt plant, this payment amounts to slightly over $6 million per year per plant.

In 2014-2015, PJM's RTO-wide capacity payment jumps to $125.99. That $6 million payment Exelon received in 2012 now jumps to approximately $45 million. Multiply that revenue by the number of plants Exelon has participating in PJM's auction and their top revenues suddenly looks healthier.

It gets better. In 2015-2016, PJM's RTO-wide capacity increases again. While not as big a jump, it reaches $136.00 or almost $50 million for each 1,000-megawatt plant.

Capacity auctions are only part of the picture. In Exelon's market, tens of thousands of megawatts of coal-fired power plants will exit the capacity and energy markets. Utilities have already announced that approximately 60,000 megawatts of power plants will be permanently retired by 2016. Some believe that number will grow to 70,000 megawatts. When supplies evaporate and demand remains fixed, prices for capacity and energy should move up.

That leads to the second change in fundamentals: energy prices. With fixed demand declining supplies, energy prices should start moving upward. Even with new demand-response programs coming on line, generators should see increased revenues for energy.

At the same time coal plants are exiting the market, grids like PJM, MISO and ISO New England are spending billions to upgrade their transmission lines. The grids' objective is to reduce constraints and avoid bottlenecks.

Reducing bottlenecks leads to the third change in fundamentals. With constraints removed, Exelon's power plants can now reach new markets. In particular, their Midwestern plants will be able to deliver power to previously unreachable eastern markets.

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