The two-year battle over Exelon’s bid to acquire Pepco is finally over. In March, Washington, D.C. regulators approved the Chicago-based utility company’s $6.8 billion plan to scoop up Pepco’s three mid-Atlantic electric and gas utilities, giving it a bigger base of regulated revenue to offset the financial uncertainty in its unregulated generation business.
To win the deal, however, Exelon agreed to D.C. regulators’ demands to provide ratepayer rebates, energy-efficiency programs and smart grid pilots, as well as commitments to support solar power projects in the nation’s capital. And while the utility is hoping to bring out new solar and microgrid projects as part of its new regulated businesses, Exelon will also be required to open those opportunities to third-party competition.
The Exelon-Pepco deal is noteworthy for its size, creating the biggest utility in the country, with 10 million customers. It also indicates a new wave of consolidation in the North American utility sector, ranging from multibillion-dollar mergers to forays into new business lines, according to Matt Mooren, energy and utilities advisor at PA Consulting.
These drivers can be broadly separated into two categories, noted Mooren. First, there are the cyclical trends of low energy prices and financial struggles for the unregulated, independent power producer (IPP) portion of the North American utility sector. Second, there are the once-in-a-lifetime changes -- the rise of utility-scale renewable energy, distributed energy resources and technology-driven customer energy empowerment.
In this environment, companies are seeking stable revenues and rates of return inherent in regulated utilities, as Exelon has done with Pepco. But they’re also seeking out opportunities in the emerging businesses of wind and solar power, distributed energy management and customer energy services -- areas where regulated utilities are facing their own challenges.
“It’s a more progressive and innovative approach,” said Mooren. “People are in position to play both offense and defense, in terms of the distributed energy trends and the customer energy technology trends.”
The cyclical trends
Let’s start with the cyclical trends and a bit of history to explain how we’ve come to where we are today.
“In the mid-1990s, there was basically one business model -- the vertically integrated electric utility,” Mooren explained. Then came the rise of independent grid operators, and the splitting of the utility business model into competitive retail energy providers, independent wholesale power producers, and transmission and distribution utilities, which in turn led to a lot of consolidation across those fields, he said.
But after a wave of boom-bust for the unregulated side of the utility business, along with the current trend of low natural-gas prices and thus low marginal electricity prices, “Wall Street and shareholders have been penalizing electric utilities in particular, and utilities in general, for any non-regulated investment," said Mooren.
While publicly traded independent power producers such as Dynegy, NRG Energy and the bankrupt Energy Future Holdings have lost more than half of their market value over the past several years, regulated utilities have generally held steady or gone up.
“So you’re in a place where utilities are searching for growth, and that growth is very hard to accomplish with any sort of non-regulated investment that doesn’t fit trends that would be accretive to the regulated side of the business,” he said.
These trends are behind controversial proposals like the Exelon-Pepco merger, or NextEra’s $4.3 billion bid for Hawaiian Electric Industries. They’re also the driver of lower-profile deals, like Algonquin Power’s $2.4 billion acquisition of Empire District Electric, or a U.S.-Canadian investor group’s $4.7 billion purchase of Louisiana’s Cleco.
“Look at Exelon’s earnings and shareholder value,” he said. “Several years ago, they were substantially dependent on the non-regulated portion of the business -- either their generation business or their competitive retail business. And those earnings are pretty volatile.”
With Pepco’s electric and gas distribution utilities, “They’ve changed their investment profile to one that’s less risky for people who are looking for more secure investment.”
In some ways, this trend is a reversal of the move toward consolidation in unregulated lines of the energy business from the previous decade, he said. But that’s not always possible in the complex, state-by-state regulatory regimes that govern utilities. Take the example of FirstEnergy and AEP, which have recently seen federal regulators put a hold on a plan, approved by Ohio regulators, to allow the two utilities to rate-base power-purchase agreements from some of their struggling power plants.
But there are still options for diversifying, said Mooren. “You could acquire natural gas utilities,” both to diversify into a different set of customers and to provide some control over the fuel for much of the industry’s generation assets, he said. That kind of hedging can also be accomplished by buying natural gas reserves, as NextEra subsidiary Florida Power & Light has done (although that project has run into its own troubles).
Rob Rains, an energy analyst with Washington Analysis, noted that each utility M&A deal has its own quirks. “In general, I think for the better part of this year so far, investors have identified the utility space as a good defensive position” amidst more general market volatility.
And then there’s the fundamental challenge for utilities seeking growth in an era of generally flat energy sales. “If you’re not growing in terms of sales, it’s a good time to look for acquisitions,” he said. That may be driving the investments made by Canadian utilities into U.S. distribution and generation utilities, said Rains -- there isn’t a lot of growth potential in Canada, after all.
Investing in the new utility business models
But there are yet more options available for managing the current environment. “The M&A activity in the utility space has accelerated because of the availability of cheap capital, obviously, and the urge to identify strategic businesses as a regulated utility,” Rains said. But along with that, “regulated utilities are identifying renewables as an opportunity for rate-based growth.”
Duke Energy is also planning to double or triple its renewable portfolio over the next several years, for example. Southern Company, the giant Southeast utility, is adding several hundred megawatts of renewables as part of its last integrated resource plan, and Xcel Energy is expected to seek investment for infrastructure to support more renewables growth in its coming multi-year rate case in Minnesota, said Rains.
Important M&A activity in this field includes the creation of Duke Energy Renewables, the utility giant’s new business created by the acquisition of California solar installer REC Solar and energy management company Phoenix Energy Technologies, he said. Other utility moves into commercial solar include NextEra's acquisition of Smart Energy Capital, and Edison International's purchase of SoCore.
“I think distributed energy resources are clear avenues to growth for distribution utilities, because they don’t have generation that will be hindered by that distributed energy growth,” said Mooren. But these acquisitions aren’t just about taking a stake in the growth of renewable energy, he noted. They’re also about making connections to the broader realm of supplying energy services to commercial and industrial customers.
Distribution utilities, including those in vertically integrated markets, have long offered different products and services for their larger customers, noted Mooren. “The major difference now, compared to what they’ve been doing for quite some time, is moving away from the physical delivery of energy, and getting into more of the digital and societal transitions that are occurring, particularly in certain jurisdictions.”
One good example of this is Southern Company’s $431 million purchase of PowerSecure, he said. The North Carolina-based company controls some 1,500 megawatts -- mostly backup generators, along with some cutting-edge solar-battery integrations -- that help hospitals, data centers, grocery stores, food-processing plants and other big commercial-industrial customers ride through blackouts and shave peak power costs.
In a similar vein, Edison International has spent about $100 million to acquire a stable of companies -- Eneractive Solutions, Delta Energy Services and Altenex -- to form the core of its new energy services business, Edison Energy, launched in March.
“There is the opportunity to turn non-regulated investments into regulated products and services down the line,” explained Mooren. “They could own it, or expand their regulated business model around the knowledge, skills and products that come from those non-regulated investments, and improve their stance with regulators.”
This is all part of a broader recognition by the utility sector that the rise of distributed and renewable energy is threatening their underlying business model, according to a leaked 2016 planning document from the Edison Electrical Institute. "If it doesn't fit into clean energy, grid modernization or a focus on the customer, we're not doing it anymore," Brian Wolff, EEI's executive vice president for public policy, said in a recent interview.