Energy - Utility Development Exelon believes it can profit, ease market power through 'virtual divestiture' of PJM nuclear capacity March 14, 2006 2:57 PM
Exelon Corp. and Public Service Enterprise Group Inc. believe that retaining ownership of their nuclear plants in New Jerseyand Pennsylvania while selling the rights to the output of the plants will be a smart business move.
As a concession to critics of the companies' proposed merger, Exelon and PSEG have agreed to sell the rights to 2,600 MW of baseload capacity from their nuclear plants in a plan they call "virtual divestiture."
Among the beneficiaries of such a plan, Exelon has said, are potential bidders in New Jersey's annual auction for basic generation service. By purchasing some of the nuclear plant output, a basic generation service provider can better manage its price risk, Exelon says.
The New Jersey Board of Public Utilities, the last remaining major regulatory body to act on Exelon's proposed acquisition of PSEG, has extended hearings on the merger to March 27. The New Jersey regulators had previously been expected to make a decision by May 15 on the merger application, which, if approved, would place management of the state's only remaining locally headquartered utility, PSEG subsidiary Public Service Electric and Gas Co., with a company headquartered out of state. Exelon and PSEG expect the merger to close sometime in the third quarter of 2006.
The companies' virtual divestiture proposal is separate from a plan to sell intermediate and peaking power plants totaling about 4,000 MW of capacity. That, in combination with the virtual divestiture of nuclear capacity, is being done to ease market power concerns in the PJM East region of PJM Interconnection LLC, where Exelon and PSEG own and/or control about 40,000 MW of capacity.
Under virtual divestiture, Exelon and PSEG have promised to deliver output from the nuclear plants into the PJM market. The companies' nuclear plants include PSEG's Salem and Hope Creek plants in southern New Jersey; Exelon's Limerick plant, located west of Philadelphia; and the Peach Bottom plant in southwestern Pennsylvania, in which the two companies currently share ownership. Additionally, an Exelon affiliate, AmerGen Energy Co. LLC, owns the Three Mile Island plant in Pennsylvania and Oyster Creek plant, near the Jersey Shore.
Exelon does not want to sell the nuclear plants — it also owns six in Illinois — because, as the company said in filings with state and federal regulators in February 2005 seeking approval of the merger, it believes it can bring "the benefits to the marketplace of enhancing the operation of the nuclear fleet by applying Exelon's nuclear operating expertise." Exelon has already taken over the management of PSEG's Salem and Hope Creek plants.
For some critics of the proposed merger, virtual divestiture is not divestiture. Instead, it is just the companies' "attempt to equate firm contracts for sale of energy with the divestiture of assets," said a neighboring utility, PPL Corp., which filed protests with FERC in April and May of 2005 over the proposed merger.
There have been other objections from other companies over the virtual divestiture proposal: Would Exelon and PSEG be able to withhold power from the market at times of their choosing for routine outages, sending prices up? What will be the effectiveness of a market monitor? What is the legality of the virtual divestiture?
The protests were rejected by FERC when it approved the merger, including the plans for virtual divestiture. Commissioner Suedeen Kelly commented specifically on Exelon's reputation for operating nuclear plants.
Alberta used a type of virtual divestiture in its restructuring
The Canadian province of Alberta, which began a restructuring of its electricity markets in the late 1990s, used a variation of Exelon's virtual divestiture proposal to evaluate stranded costs related to generation assets and promote competition in the wholesale energy market.
"I think it [virtual divestiture] worked very well, knowing the problem it was designed to solve," said Martin Merritt, Alberta's electricity market surveillance administrator.
Six years ago in Alberta, most of the electricity supply came from three vertically integrated and regulated companies —
ATCO Group, EPCOR Utilities Inc. and TransAlta Corp. — which together held roughly 6,400 MW out of a total capacity of 7,300 MW in the province. Of the three utilities, TransAlta held the lion's share of the generation, about 3,670 MW.
Desiring more competition in the marketplace, the province decided to sell all the megawatt capacity of the province's 13 generators, including the big three, under contracts that were called power purchase arrangements, or PPAs.
The scheme was "a little bit of a Rube Goldberg," Merritt said, where a middleman was introduced into the power system who sold the power to another party that would deliver it to end users. Merritt said the plan "worked like a charm. We wanted to redistribute the dispatch service and Alberta went from [having] three big gorillas" to bringing many more companies into the wholesale marketplace.
The duration of the power purchase arrangements was 20 years, to the year 2020, at which time, if the plant were still in service, the capacity would be returned to its original owner.
The auction was held for 6,395 MW of capacity from coal and gas plants, and there were five bidders: Engage Energy; ENMAX Corp.; Enron Corp.; EPCOR; and TransCanada Corp. However, bids only came in for 4,249 MW; one glitch was that 2,146 MW went unsold. Looking at the need to sell this power, the Alberta Balancing Pool, a provincial agency created to handle the financial aspects of the province's restructuring, was given control of those megawatts.
The Balancing Pool shortened the duration of the power purchase arrangements and lowered the bundled amount of megawatts that could be sold. This proved to be the key to selling the previously unsold output of three plants.
Today the Balancing Pool handles the rights to capacity of only one plant, the 762-MW coal-fired Genesee plant. Final bids were due March 10. The bids can be for either the entire capacity or strip contracts from 25 MW to 600 MW, or two strips of 81 MW of capacity that can be sold as either energy or ancillary services. The terms offered are for three, five or 10 years and to Dec. 31, 2020. Any strips will be awarded by April 1, with the transfer of control of the PPA scheduled for May 1.
"The power purchase arrangements separated plant ownership from the right to market output," said Larry Charach, an energy policy consultant with Strategic Results Consulting of Edmonton, Alberta, who led Alberta's restructuring. "Utilities were paid their costs and they must provide power" under the PPAs, which set the amount utilities are paid for operations and maintenance and liabilities.
The PPAs "had good elements and bad elements," ATCO Power Vice President for Finance Brian Milne said. "Generally, the perception is that we got a fair deal" in the sale of ATCO's power.
An independent assessment team looked at the cost structure of the plant. "The team determined [operations and maintenance] money, rate of return, taxes, and so forth," Milne said.
"There were discussions with the team and then the new Energy Utilities Board approved the plan. There was not a huge change [for the utility] because we were regulated at that time," Milne said.
Did the purchasers get fair value? "Probably not," he said. "In the early days of the PPAs, prices were high for electricity. Everyone knew deregulation was coming since the government had announced that was what they planned to do in 1996," he said.
"So from 1996 to 2001, when the first auction was held, no new plants were built because we didn't know what the rules were going to be under deregulation. So then, the province got overbuilt with plants and market power rates dropped," Milne said.
Today, six years later, the price is "probably not far off" the true market price, Milne said.
Virtual divestiture, as a tool for bringing competition into Alberta, has worked. More generators have moved in and generation capacity since 1998 has increased by 3,200 MW.
'Auction design matters'
For Exelon, the objective of virtual divestiture is not to bring competition into the marketplace; rules for that are already in place. Instead, virtual divestiture is meant to assuage concerns about potential market power that the merged company could have in the PJM market. Exelon gets to keep its assets and make some money through efficiencies of operation while the purchaser of capacity has a chance to make money — or lose it — in selling power.
Critical to the success of the auction is its design.
In Alberta, the simultaneous ascending auction that was used was designed by Market Design Inc. of College Park, Md., and Charles River Associates Inc. of Boston, now CRA International. The auction is called "simultaneous" because all the power
purchase arrangements are bid at the same time, and it is called "ascending" because new bids are higher than old ones, Charach said.
Exelon has selected MDI to design its auction, and CRA will be the independent adviser of the auction.
"Auction design matters," MDI and Charles River Associates said in a December 1999 report to the Alberta Department of Resource Development. "Design failures can result in distorted values, lost revenues, inefficient outcomes, other unsatisfied goals and regulatory and public criticism. The rules of the auction must be complete, consistent and without loopholes."
In addition to good auction design, "the items being auctioned must be properly defined and characterized, and reflect the underlying values of the items within the context intended by the seller of the items," the report said.
"Bidders and their investors must have sufficient information about the items and the auction process to be able to properly evaluate their participation in the auction," the report said. The auction itself "must be administered correctly following the design with its rules, rights and obligations enforced strictly."
Exelon plans to use a simultaneous ascending clock auction, which is a variation of the simultaneous ascending auction. In the clock auction, the auctioneer paces the price and bidders bid quantities.
MDI was selected by Exelon because of its experience with clock auctions and the auctions the company has designed and implemented for French utility Electricite de France (EdF). The EdF auctions, which Exelon has said are similar to what it has in mind, are for 6,000 MW of capacity under contracts for periods of between three and 36 months.
Winning a contract at auction is not without risks. Besides changes in energy prices, there can be changes in environmental regulations which affect profit, potential regulatory tweaking of market design, and unforeseen outages.
"No contract is perfect or without some ambiguity," said David Salant of ERS Group, who has designed spectrum auctions and assisted in the initial design of New Jersey's basic generation service auction. "The force majeure provisions offer some wiggle room."
Exelon said in comments e-mailed in response to SNL Energy that it will deliver energy around the clock and "if EE&G [Exelon Electric & Gas, the name Exelon and PSEG will adopt once the merger is complete] fails to deliver, a buyer will receive the positive difference, if any, between the market price and the price paid by the buyer to EE&G for the energy."
Exelon said, "The only exception will be when force majeure, as that term is defined in industry standard enabling agreements [which EE&G will use], applies." Failure to deliver could be excused only "by truly cataclysmic events," the company said.
Of the 2,600 MW that Exelon promises to place for auction, 2,400 MW would be for delivery in PJM East at the Nuclear Generation Aggregate, consisting of the buses at Exelon and PSEG's nuclear units located in PJM East. The remaining 200 MW would be for delivery at the PJM West Hub or any other delivery point in PJM as it was configured before 2004 (before six new members joined) that had been agreed to by EE&G, Exelon said.
Exelon has said it will not sell more than half the nuclear capacity to a single buyer. The energy will be sold in 25-MW blocks with one, two and three-year terms.
A 15-year contract is also an option, though Exelon anticipates there will be little interest in a long-term product since "it is unlikely that any market participant will be willing to take the price risk associated with committing to a 15-year deal," Exelon said. The contracts will begin on June 1 and end May 31 the following year, a period that coincides with the dates used by PJM.
The price set by the auctioneer will take into account the cost of operating and managing the nuclear plants, allowing EE&G to make money by improving the productivity of the nuclear plants.
"A key business driver for the merger is the synergies resulting from application of the Exelon management model to operation of PSEG's nuclear plants as well as its existing fleet," Exelon said. "The virtual divestiture removes any incentive or ability to profit from the nuclear plants through higher market prices."
Exelon boasts of "world class nuclear operating expertise" and nuclear plants producing at least at 92% of capacity, but the PSEG plants have had poorer production rates. This should leave room for improvement. Exelon has already entered into a management arrangement with PSEG, placing a team of Exelon managers at Salem and Hope Creek, where it says it has seen performance improvements in the past year. The Salem and Hope Creek nuclear facilities have been troubled plants for years over environmental concerns and worker safety and poor morale.
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