Perspective
The Man Who Would
Be King
Exelon Chairman, President, and CEO John W.
Rowe, on the proposed merger that would create
the largest utility in the United States.
May 2005
By Richard Stavros
There are utility chief executive officers (CEOs) and then there is the utility chief executive officer, or the captain of all captains.
Exelon CEO John W. Rowe would head the largest utility in the industry, if a proposed merger with PSEG goes through. By creating a $40 billion market-capitalization utility, the newly formed company would be 60 percent larger than its nearest market-cap peer, and would have total assets of approximately $79 billion, with almost $25 billion in annual revenues and $3.2 billion in annual net income.
The combined company would be the nation's largest power generator and a leading U.S. wholesale power marketer, with a generation portfolio of approximately 52,000 MW of domestic capacity, including about 20,000 MW of nuclear generation.
Not surprisingly, a planned merger of such magnitude has ignited a debate over the ideal size, scope, and scale of a modern utility. While some espouse economies of scale and greater balance-sheet benefits, others are unsure of the value of larger U.S. utilities. Critics point to European utilities-some
that are twice the size of the entity that Exelon proposes-as oligopolies that have stifled electric competition on the Continent. Consumer advocacy
groups have raised similar concerns in respect to the Exelon-PSEG merger. The Federal Energy Regulatory Commission is reviewing the merger for market-power issues, and it is widely believed that the new company will have to divest some of its generation to preserve competitive wholesale markets.
Moreover, others have asked whether the nation's regulatory agencies are adequately equipped to regulate companies of this size, and what the implications would be for regulation if similar-sized utilities were to consolidate.
What is the best course of action?
Is this the beginning of a consolidation wave? Is Exelon-PSEG going to be the first of many $40 billion utilities?
In an exclusive interview, I cover these issues and talk to the man whose company dares to be bigger, and some say, better than all the rest.
Public Utilities Fortnightly: What is the value of the merger between Exelon-PSEG? What can you do by owning PSEG that you couldn't do alone?
John W. Rowe: There are both short- and long-term opportunities. The biggest short-term opportunity is to improve our value of our share of the Salem and Hope Creek nuclear fleet by running it better, while we also improve their value in both Salem and Hope Creek. In the longer term, they seem to be able to get better distribution and reliability than we do, with somewhat less money being spent. [That] is an area where we can learn something from them. We can increase the geographic diversity of both our generation and delivery systems. We can increase the regulatory diversity of the company, and we can provide greater overall scale at an affordable price.
I think everybody in the industry agrees that scale has value, it's just that
it doesn't have unlimited value. So the issue is always, can you find a deal that will give you that scale which the cost synergies will pay for? We have found such a transaction.
Fortnightly: In corporate America today, some media companies have actually been scaling down and spinning off unprofitable subsidiaries from their extensive acquisition sprees during the late 1990s. How will you avoid the inefficiencies that can come from being a larger company?
J.W.R: Well, scale brings efficiencies and inefficiencies. I am quite confident that in the electricity industry there is vastly more efficiency to be had. For one thing, when you consider the cost of things like new generating plants, particularly in a market-based regime, there are only a few companies big enough to have the equity to be able
to afford to build the new generation plant. That's just one example.
Fortnightly: But five years from now, will we be having a discussion about how Wall Street thinks you have too many disparate type of companies under one holding company umbrella, and how the answer is a spinoff of the regulated or unregulated businesses?
J.W.R: Well, I think that is always possible, [but] that is certainly not our strategy. The key thing is that we learned the lessons that everybody else did in the late 1990s, and the first couple years of this decade, which is that utilities are not organizations that are very good at going into dramatically different businesses. We have spent the last three years shrinking down to our core businesses, which are generation, energy marketing, transmission, and delivery. So I don't think we are guilty of "conglomerate fever."
At the present time, the balance of risks that comes from having both a regulated, relatively predictable delivery business and a more commodity-cycle generation business is a good mix.
But the gods are always bigger than
I am. If the world should evolve in the most market-based regions in a way that encourages a split between the regulated and unregulated businesses, obviously you are better off to be large enough so that the resulting companies are big enough to have some meaning. We don't think that's the direction things are going to go. We think the whole California experience militates very strongly against that sort of breakup between the two businesses. But it is always plan B, I guess. Plan A is very clear-to try to get as much value as we can out of having companies of both kinds in the corporate family, but to be very careful that we obey the [federal] and state rules in terms as to how those operations work together.
Fortnightly: How do you propose to allay regulators' concerns that Exelon will not become too big to regulate?
J.W.R: Well we work very hard in Illinois and Pennsylvania to be responsive to the state regulators. You don't hear us say, "You can't have that kind of information," or, "We don't have to follow public policy." We worked very hard in Pennsylvania when they adopted their alternative energy portfolio standard to help with that. We worked on similar things in Illinois. I think it is a matter of the management remembering that you are not bigger than the states that you serve and that the regulated delivery business[es] are still interests with very special public trusts.
Remember, as the world of big corporations goes, three or four states is not a lot. It would be hard to name another business that has the capital and technological responsibilities of the electric utility industry [but] that only functions in three or four states. These are big states. These are very important states. They have very parallel public policies. They are all pro-competition and they are pro-environment. It's our job to find a way to make certain that our state responsibilities implement public policy rather than fight with it.
I have spent a career doing it, and it has gotten to be quite a long career now.
Fortnightly: There has been discussion that public policy more than anything else is driving the utility business model. What do you read into the public policy tea leaves as far as how a utility should be structured and what its primary mission should be?
J.W.R: Public policy on that question is split across the country. Right now there are three models for what a utility should be and what it should look like. There is the model that tends to prevail in New York, New Jersey, New England, Pennsylvania, Illinois, and Texas (perhaps Maryland, Ohio and Michigan), that says you should have a very active competitive wholesale power market. You should have very effective regional transmission organizations. You should have choice that is open to retail customers and you should have regulated safety-net service provided by the retail companies. That's one model.
You have another model that is perhaps best typified by the Southeast companies. The Southern Co., but also Progress Energy and the Florida companies, which still tend largely to be fully integrated, [with] some wholesale competition (but not as much as the Northeast), relatively little retail choice, [and] with at least a rebuttable presumption that new generation would be rate based. That also prevails to some extent in the Northwest, but that is where it is, of course, heavily influenced by public power participants. Then you have California and some other states that appear to be drifting from a competitive model back to some sort of integrated resource management model where the utility is required to make long-term commitments to buy generation from other people. I think over the next five to 10 years we are going to see some slow blending of those models, but I don't think that anyone has a clear picture what one surviving model will be.
I just think, as more and more new generation is needed, these questions of competition versus regulated procurement will be considered anew. For me, one of the cynical advantages of old age is that when people in my industry are quick to say competition didn't work and it won't build new coal or nuclear power plants, [that] gas is expensive [and] therefore we have to go back to rate base, I say, "beware," based on my New England experience. You may not get rate base; you may get integrated resource management, and that was a process that drove the cost up rather than down. I think we are dealing with a bunch of models, all of which have some history of failure, and the issue is how you make them work.
Fortnightly: Why do you think you failed in your acquisition of Illinois Power? What did you learn from the experience? What is different this time around?
J.W.R: We learned several things. First thing we learned is that there was not a clear consensus in Illinois that it was good for Illinois that we get bigger in the state. One of the issues is, do people want you to be a very large hometown company, or do they want more competition? At the time, there was at least some preponderance of a view that they wanted to increase the emphasis on competition even beyond that inherent in the statutory structure. We weren't really turned down at Illinois Power-we were turned down on the fundamental proposal that we have a four-year continuing rate agreement with an all-requirements supply between Com Ed and Exelon generation. The alternative to that-which most of the parties before the Illinois Commission have worked out over the last year-is to adapt the New Jersey [retail supply auction] as a way to make certain that a competitive wholesale price is available to the retail consumer who doesn't shop. To some extent PSEG is a bigger, better deal for us. It's clear that it can stand on its own economics a little more easily. But to some extent the PSEG transaction is a response to the fact that in turning down our proposal on Illinois Power, the Illinois legislature was pushing an increasingly competitive framework.
Fortnightly: There has been much discussion and concern in the investment community over a possible "earnings cliff"-the possibility that Exelon will earn less in a post-2006 Illinois rate environment. Were your proposed Illinois Power and PSEG acquisitions part of a solution to that issue?
J.W.R: The "earnings cliff" issue has been fundamentally answered by rising wholesale prices for power. The Illinois Power transaction was intended as a way to give both the company's shareholders and its consumers a sense of
stability and certainty; to reassure shareholders that there wasn't a big cliff issue, on the one hand, to reassure consumers that they didn't have open-ended exposure to wholesale price volatility on the other hand. But the issue now is not, how do we avoid a cliff? The issue is, how do we manage what may be looked at by some as too much good news in the wholesale markets so that we provide a reasonably stable price
to our customers?
The market price for power has come up substantially in the last 18 months. I think the issue now is how we make certain on the one hand that we get a fair market price for Exelon generation's power and also for the power that Com Ed has to procure from other people for its customers.
On the other hand, the issue is managing that all with a delivery rate requirement so we don't have double-digit increases for Illinois consumers.
Fortnightly: But some still say the greatest risk to Exelon earnings is falling commodity prices in the interim between now and when a retail supply auction scheme is implemented.
How do you propose to allay these
concerns?
J.W.R: I think we are more concerned at the present time that the commodity price will be too high rather than it will be too low. Given the prices that we have seen in PJM East and PJM West in the last year, Exelon Generation is very well situated to make money. We are hard at work at making sure that Exelon Generation gets that market value, but also that Com Ed's customers have a rate structure that has sufficient stability so that the advantages Com
Ed customers have seen since the Illinois legislation eight years ago are significantly preserved. In other words, Chicago used to be a high-rate city compared to many others. Now, Chicago is relatively low-rate for a major city. So, we would like to see Com Ed and Exelon Gen get what they are entitled to, but that general position of relative advantage be sustained to
the extent possible.
That will mean interesting negotiations with the Citizens Utility Board and other parties to the proceeding in Illinois, trying to come up with a package that people think first meets the statutory requirements; second, is attractive to us; third, is attractive to our customers; and fourth, allows a market price to exist that will encourage new generation. Because if the market price were artificially constrained, the market would not provide new generation. But we are not worried about a near-term collapse. The combination of shrinking capacity margins and rising natural gas prices has pretty much removed the problem of price collapse.
Fortnightly: Given the recent revelation of alleged falsification of scientific records at the Department of Energy in the feasibility analysis of Yucca Mountain, do you think the process toward making it a repository is stalling, despite licensing? Furthermore, is the impasse over Yucca Mountain a roadblock to the development of new nuclear power?
J.W.R: I think it is the single largest issue that needs to be resolved, and it doesn't have to be any one solution. There are other ways to solve it. But I, at least, am of the view I would not want to order a new generation of plants (except possibly the demonstration facilities for the advanced design) until there is not just public promise, which there has been for 50 years, but a real public expectation of a place to store this spent fuel. My own view is that Yucca Mountain is the right plan and the best plan, except … Yucca Mountain should be used … with the idea that the spent fuel can be retrieved someday for some kind of advanced reprocessing. There is too much value in those fuel rods to treat that as junk.
I think … the single most important thing to the future of nuclear energy [is] more nuclear plant; [the industry] needs them for base-load power. It needs them to avoid excess dependence on natural gas. It needs them to deal with climate change. But I could not commit myself to a new fleet of nuclear plant until first, the need for base-load power is more established; and second, until I'm sure there is going to be a publicly acceptable solution to the spent fuel problem.
I'm not going to go out and tell my
customers we are building a lot of plants and we don't know where this stuff is going to go.
Fortnightly: What is your view of stock buybacks? Some have said this is typically done when an industry has no investment or growth ideas. Is there a dearth of growth ideas in the industry? Are mergers the only growth strategy available?
J.W.R: I think returning capital to your shareholders should always be one of your options. I think it is very clear that this is a low-growth industry. In a low-growth industry, merger or consolidation is almost always the most obvious way to grow. But also you have to be very careful in how you do it. Our investors are very clear that they will only support merger and acquisition activity if it is accretive on a basis such that cost synergies [savings] pay the merger premium.
We were able to negotiate the PSEG transaction on terms of that nature, thanks in significant part to the mutual advantage that the two companies get from improved nuclear operation. But you can't go about doing acquisitions
in some sort of willy-nilly way. For us,
the PSEG merger is the best way we have to continue to provide earnings growth over the next four or five years, like we have been able to do over the past four or five years. This is basically a cost and consolidation play. It's a conservative play. It requires keen attention to your cost synergies. It requires working those regulatory and public policy issues so that people know you will do your best to meet the need of each state. It requires a high commitment to maintaining regulatory and governmental respect and trust.
We in Illinois have spent $3 billion improving the T&D [transmission and distribution] system since 2001. That is a best investment in our customers and public trust. We do similar things in Pennsylvania. It is very important that one remembers this is a low-growth industry and there is nothing wrong with returning capital to our shareholders. Now, we did some major stock buybacks at the time of the PECO-Com Ed merger. Over the last year, we did
some very minor stock buyback. But
we have increased our dividend from something like $0.845 to $1.60 over the last several years.
Thanks to President Bush's fairer treatment of the dividend and the majority in Congress that passed it, you now have a tax treatment of dividend that makes traditional utility dividends at least as attractive as share buybacks in many ways. When you look at the current stock price for us as well as for a great many utilities, that's as much a dividend multiple as it is an earnings multiple.
Fortnightly: Yes, but will this type of growth through mergers satisfy investors down the line? As former Southern Co. CEO Allen Franklin once remarked to me, the larger the company becomes, the more difficult it will be to grow earnings.
J.W.R: And Allen was nearly always right, including that time. It's true that unless you come up with a totally new product or service, you can't deliver double-digit growth for very long. And we have been striving to keep a profile of better than 5 percent growth. We have done it for the past four years since our last merger. I think the new one will help us do it for several more years, but fundamentally this is not a high-growth industry. In the competitive states, the generation side is the commodity cycle. It's very attractively priced now and probably will be for the next several years. But no one should just predict that these prices would
simply continue to grow.
Fortnightly: Is there anything that you'd like to add?
J.W.R: I think you got at the key thing, particularly when you started asking about ideas on growth and ideas on the structure of the industry. This is in many ways an old-fashioned industry with very substantial economic issues and opportunities and very substantial public responsibility. We are constantly groping for a better model on how to reshape or restructure this industry. I've indicated that there are three models out there. What's really interesting is to see how those states that are competitive make some competition and regulation really serve the public interest. You can turn that around and ask the same question in another way: How will the competitive states finance the building of generation plant when they need it? That's an obvious question and a hard one. But you can ask virtually the same question in many of the integrated regulated states. Are they really going to do
it by rate base like we used to do it in the 1970s and 1980s? Are they going to run the risk in those states of a replay of the regulatory reactions to the cost of new plants that existed in the 1980s?
The great virtue of having done
this work for 21 years is not that it has taught me to know the future, but it has at least taught me what is wrong with the past. The virtue of having some sort of competitive marketplace
is that it gives the public assurance that the price they pay for new generation isn't the result of the competence
or incompetence of any one
management.
Richard Stavros is executive editor of
Public Utilities Fortnightly. Contact him
at stavros@pur.com.
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