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Merchants of Power Could Be in Trouble

By Reuben Gregg Brewer – Feb 28, 2014 at 10:16AM

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The peak-to-average electricity demand ratio is rising, suggesting a tougher outlook for merchant power players—that's a problem some utilities are already working to solve.

According to the U.S. Energy Information Administration (EIA), the spread between average electricity demand and peak use is widening. That's one of the reasons why regulated utilities have been shedding merchant power operations. It's also why you might want to avoid the merchant power sector, too.

Normal and peak
Two important metrics in the utility sector are the average amount of power used and the peak amount. The average is what power companies have to be ready to produce every day. Meeting peak demand is something that utilities have to be able to do, with an added margin of safety, but only when needed. When this energy isn't needed power plants sit idle or run below capacity.

According to the EIA, "decreasing average utilization levels for generators" has led to a widening of the spread between peak and average use. This trend has been most pronounced in New England where, "in 2012 peak-hour demand had risen to 78% above the hourly average level." That's up from 53% about 20 years ago.

Historically some larger utilities have had both a regulated arm and a merchant power division. Shifting consumption dynamics is changing that, since "decreasing average utilization" means lower sales, and brief peak periods aren't enough to make up for it.

Getting out
Dominion Resources (D -1.40%), for example, has been shifting away from merchant power to focus on its regulated businesses. It's been an expensive shift; the utility bought Brayton Point power station in 2005, spent $1.1 billion on upgrades, and then sold it and two other plants for just $650 million.

While that may sting over the near-term, it's probably a good move for Dominion over the long haul. For example, merchant power player Atlantic Power (AT) has seen its shares plummet over the past year from over $10 a share to under $3 as weak power markets led to a big dividend cut. Worse, Atlantic Power recently hinted that another dividend cut could be coming as it struggles to deal with a heavy debt load.

Another giant jumps ship
But it isn't just small fry like Atlantic Power that are feeling the pinch. Utility giant Duke Energy (DUK -0.68%) plans to exit its Midwest merchant business. According to Duke CEO Lynn Good, "Our merchant power plants have delivered volatile returns in the challenging competitive market in the Midwest. This earnings profile is not a strategic fit for Duke Energy..."

If you are a conservative investor you might might want to follow the lead of Duke and Dominion and shift out of the merchant power market. That includes Exelon (EXC -0.57%), one of the biggest players in the space. Weak power markets led to a dividend cut in the middle of last year.

Perhaps more troubling, CEO Christopher Crane noted in Exelon's fourth quarter conference call that, "...despite our best ever year in generation some of our nuclear units are unprofitable at this point in the current environment due to the low prices and bad energy policy that we are living with." Exelon is considering closing some of the nuclear reactors that were once hailed as its crown jewels.

Entergy (ETR -0.39%) is another merchant player that's looking to get out, but has found its options limited. Thus, it's taking a plant by plant approach as it tries to limit the risks in this increasingly volatile business. That could lead to a higher risk profile than conservative investors may want.

Keep it simple
It's obvious that big utilities are shifting gears in an effort to get back to basics, that includes Duke and Dominion. Entergy is going down the same path, but it still has notable merchant issues to address. That's a core problem for Exelon and Atlantic Power.

This isn't to suggest that merchant power is a bad business, but there are industry changes taking place that notably increase the risks. If you prefer regular dividend checks, avoid merchant power and stick to regulated utilities.

This isn't the only trend impacting utilities...

Reuben Brewer has a position in Atlantic Power. The Motley Fool recommends Dominion Resources and Exelon. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Exelon Stock Quote
Exelon
EXC
$40.00 (-0.57%) $0.23
Duke Energy Stock Quote
Duke Energy
DUK
$97.94 (-0.68%) $0.67
Entergy Stock Quote
Entergy
ETR
$112.81 (-0.39%) $0.44
Dominion Energy, Inc Stock Quote
Dominion Energy, Inc
D
$59.77 (-1.40%) $0.85
Atlantic Power Stock Quote
Atlantic Power
AT

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