Exelon's Carbon Advantage

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imageForbes.com

Exelon's John Rowe has been planning for expensive carbon for a decade. Now it's time to push for the payoff.

On a cold December Chicago afternoon John Rowe stands at a window in his office, a dim, quiet, three-room suite lined with history books and sprinkled with objets d'art, including a stone horse from the Tang Dynasty and an Egyptian sarcophagus. From his 54th floor perch he is looking north to the high-rises of the Gold Coast below and the frigid waters of Lake Michigan shimmering with weak, fading winter light beyond. "You can't sit up here in the afternoon and see the lights come on and not love this job," he says.

Spoken like a true utility man. Rowe, 64, the longest-serving utility executive in the industry and chief executive of Exelon ( EXC - news - people ), the country's most valuable utility by market value, is indeed in the catbird seat. While Exelon and the rest of the utility industry has been battered by a weak economy and suddenly low electricity demand and prices, Exelon has a lot to look forward to. Soon after Rowe created Exelon in 2000 with the merger of the Chicago utility Unicom (parent of Commonwealth Edison) and the Philadelphia utility Peco, he sold off most of the company's coal plants and focused the company on nuclear. He created a generation subsidiary that sells the power produced by 17 reactors, by far the largest nuclear fleet in the nation and the third biggest in the world (after those of Electricité de France and Russia's Energoatom).

The gas that billows out of those iconic nuclear plant cooling towers is water vapor. Exelon's nukes turn out 130 billion kilowatt-hours of electricity every year and not a single metric ton of carbon dioxide, the most important greenhouse gas. That's a nice place to be now that it appears that Washington--helped along by Rowe's lobbying--is going to impose a price on carbon, either through a cap-and-trade bill that has passed the House of Representatives or through Environmental Protection Agency regulations. While its carbon-heavy competitors would have to raise prices, Exelon would benefit greatly. Under the House bill, estimates Bernstein Research's Hugh Wynne, the present value of Exelon's earnings stream would increase by $14 a share, or 28%.

Exelon's happy position is not all just good luck, though there is some of that. Rowe sold off those coal plants after the merger in part because he didn't have the money to shape up both a fleet of underperforming coal plants and underperforming nuclear plants. But he decided to jettison coal because he suspected a price on carbon was coming from dealings he had as chief executive of New England Electric (now National Grid) in the early 1990s. "I thought climate legislation would come sooner or later and that I'd rather have my money in the nuke fleet," Rowe says of his decision of a decade ago.

Exelon needs that legislation to happen sooner rather than later. Without a carbon price of some sort, Exelon's fortunes aren't so bright. Exelon is financially sound today. This year it is on track to make $2.7 billion in profit on $17 billion in sales. Its return on capital, at 11.2%, is the best in the utility industry. Since the company was formed in 2000 it has returned 130% to shareholders, compared with a 64% return for all utilities and negative 6% for the s&p 500.

But Exelon is a commodity company: Its profits depend on power prices. Prices are set at the margin, and in this industry the marginal energy comes from natural gas, which is cheap now. When gas prices were at $14 per million Btu Exelon's shares traded at $92. Now, with prices at $5, Exelon trades at $50.Gas prices may stay low for a while. Imaginative drilling techniques have recently created a bountiful supply of gas from U.S. shale formations. Subsidized wind energy could put another competitor at Exelon's doorstep. No one really needs that extra capacity now, but many states and perhaps soon the federal government are mandating greater use of renewable power (see related story, "Clean Energy or Bust"). Wind power has its weak point (a tendency to be more plentiful at night), but that weakness is counteracted by pairing it with quick-start gas plants, not with sluggish nukes.

Rowe hasn't been able to grow by acquisition, either. Three times since 2003 Exelon has tried to acquire a smaller rival, and three times Rowe has been unable to close the deal. "The conundrums are real," Rowe acknowledges. "There's nothing that's going to drive Exelon's profit in the next couple of years wildly. It just isn't going to happen."

Except, of course, carbon legislation. And because of that, the company views spending on lobbying for legislation almost like a capital expense. William Von Hoene, a cowboy-boot-wearing former criminal defender who heads the finance and legal departments for Exelon and is a possible successor to Rowe, thinks of carbon legislation as Exelon's big growth opportunity. "It's an investment we are making that will result in substantial shareholder value," he says.

So lately Rowe spends more time wearing out shoe leather in Washington than he does gazing at the sparkling lights of downtown Chicago. He has emerged as a lobbyist for cap and trade, a scheme that would limit carbon emissions to the amount spelled out in tradable carbon permits. If such a scheme is enacted, utilities without the need to buy permits will be at a competitive advantage to utilities that need to have them.

It doesn't hurt that, while Rowe is a Republican, Exelon has very deep ties to the Obama Administration. Frank M. Clark, who runs ComEd, helped advise Obama before he ran for President and is one of Obama's largest fundraisers. Obama's chief political strategist, David Axelrod, worked as a consultant to Exelon. Obama's chief of staff, Rahm Emanuel, helped create Exelon. Emanuel was hired by Rowe to help broker the $8.2 billion deal between Unicom and Peco when Emanuel was at the investment bank Wasserstein Perella (now Dresdner Kleinwort). In his two-year career there Emanuel earned $16.2 million, according to congressional disclosures. His biggest deal was the Exelon merger.

Emanuel e-mailed Rowe on the eve of the House vote on global warming legislation and asked that he reach out to some uncommitted Democrats. "We are proud to be the President's utility," says Elizabeth Moler, Exelon's chief lobbyist. "It's nice for John to be able to go to the White House and they know his name."

Exelon argues that even without the hometown ties, Rowe is a credible voice on climate-change legislation. He first argued for a carbon price in 1992, long before he was sitting on a giant fleet of carbon-free nukes. He served as cochairman of the star-studded National Commission on Energy Policy. Rowe made a splash in September when Exelon quit the U.S. Chamber of Commerce because the group opposed greenhouse-gas regulation.

Rowe is a history buff who reads voraciously, going on binges during which he reads as much as he can about a specific era. (Lately it's been medieval history.) He clearly enjoys being a voice on a contentious issue of the day. "I wouldn't use Al Gore's apocalyptic terms," he says. "But how a growing world population copes with environmental forces is very important to what kind of life we have on this Earth."

It is not lost on anyone that Rowe stands to gain a lot from this legislation. Exelon discloses that it expects a revenue boost of $1.1 billion a year if carbon is priced at $15 a ton. Exelon would gain simply because a price on carbon would raise the cost of production for fossil-fuel-powered electricity. Most of that would be passed on to customers, raising the wholesale price of power. Exelon's revenues would rise, but its costs wouldn't.

Luckily for Exelon the industry position is the same as his: Utilities vastly prefer the certainty and the market-based approach of a cap-and-trade program to direct regulation by the EPA. Exelon also invented a scheme (included in the House bill) that softens the financial blow to ratepayers by giving the utility industry's portion of free emission allowances to electricity retailers instead of generators. State public utilities commissions would then ensure that the retailers pass on savings from the sale of those allowances (electricity retailers aren't emitters) to their customers. Exelon's retail subsidiaries, ComEd and Peco, would get allowances, but Exelon's power generation subsidiary wouldn't get any. Exelon would still benefit, though indirectly. Competitors with big fossil fuel fleets would have to raise electricity prices to cover the cost of emissions permits. Exelon would benefit from higher power prices without having to buy permits. The scheme prevents Exelon from getting a big windfall, but it makes for a bill that's easier for politicians to pass.

"You can look at it either as statesmanship or simple prudence," Rowe says. "If this kind of program costs customers too much it will blow up all over us, and it won't last." And Rowe knows if one company gets too fat too fast on a piece of legislation, it would be all too easy for legislators to draw up a windfall tax. "The government has innumerable ways to take money from us if they really want to."

The Senate, prodded by Senators John Kerry, Lindsey Graham and Joe Lieberman, is expected to take up climate legislation next spring and vote on a plan later in the year, with or without the help of international agreements coming out of the Copenhagen talks. Rowe puts the probability of passage in 2010 at "less than 50-50 but better than one in four."

Rowe's pragmatism was bred on the dairy farm in Wisconsin where he grew up. He went to a one-room schoolhouse before heading to Madison for both undergraduate and law degrees. He has funded two chairs in history there and is in the process of funding one in virology. "The University of Wisconsin is the only thing I am truly chauvinistic about," he says. While working for a Chicago law firm he helped represent nuclear plant owners. In 1984 he landed the top job at tiny Central Maine Power. He later moved on to New England Electric and then Unicom.

For all of his Washington lobbying and connections, Exelon is powerful today because the company learned to make its nukes run well. In the years before Exelon was formed its reactors ran at below 50% of capacity, worse than the industry's 70% average. Now Exelon's reactors run between 93% and 94%, better than the industry's 90%. Nuclear reactors run all day and night until they need to be refueled every 18 or 24 months, depending on the type of reactor. Refueling takes the industry an average of 40 days. Exelon does it in 27. "You have to give them credit for building and acquiring that fleet, and you have to give them credit for running it in a league-leading fashion," says Bernstein's Wynne. "It sometimes goes overlooked that they are superior operators."

The exacting business procedures were developed for the nuclear business but have since been extended to other parts of the business like the fossil-fuel fleet and legal and finance departments. Hundreds or even thousands of documents are drawn that codify how to do a given task. In the case of a nuclear refueling outage, it's 7,000 to 9,000 tasks, says Ron J. DeGregorio, who runs Exelon's nuclear operations. The model helps him choreograph a shutdown to the minute, like a Nascar pit stop that goes on all day and all night for two weeks. He compiles a record of the best times for each set of routine tasks. Put together, it gives him a target: 13 days, 17 hours. Almost always the reactor goes through other maintenance and upgrades during a shutdown, so more time is added for those.

DeGregorio's staff starts planning a refueling outage two years in advance. For an upcoming refueling they need to inspect sections of steel inside a pressure-suppression compartment during the shutdown and coat the steel with a protective paint. They are spending $10 million to develop a robot that will be able to do it for them faster and prevent exposing workers to extra radiation.

As the refueling gets closer, the number of plant workers, usually 800, grows to 2,000. Workers go through safety training and rehearsals during which they walk through the refueling to try to figure out if they have been overly optimistic or missed obvious ways to save time. The workers rewinding a generator, for example, could get started faster if the people building the scaffolding to reach the generator started on the left side instead of the right. "The people responsible for task 374 will be ready and waiting while 373 is finishing up," says DeGregorio.

As each task is completed, managers report what went wrong and what can be done better. At the end of a refueling cycle as many as 3,000 lessons learned are logged into the management model, says DeGregorio.

Exelon runs such a tight ship that it makes growing from where it is difficult--and maybe impossible--in a tight economy with low power prices. But Rowe has a few plans. He is planning to spend $4.4 billion to add 1.3 to 1.5 gigawatts of capacity to his existing nuclear fleet through what is known as "uprating" the reactors. New components, controls and turbines are added to the nukes to allow them to produce more power. The way Exelon looks at it, the company is adding the equivalent of a big new nuclear reactor for about half the cost and no extra overhead. Von Hoene argues that despite a handful of plans around the nation to build new nuclear reactors, none will be built by 2017 when Exelon finishes its program. "No other company in the country can do what we can do," he says. "We will be ahead of everyone in the country in increasing nuclear capacity."

(Rowe would love to build a new nuclear plant, too, but they are so expensive he would want an expanded federal loan-guarantee program and much higher gas prices before he commits to one.)

Rowe thinks there's money to be made in transmission, too. This year he formed a transmission subsidiary to capitalize on the increase in transmission construction planned to move renewable power around the country. It's also a defensive move. If lots of wind power is coming to Chicago, Exelon wants it to keep it moving east to higher demand pockets and collect as it passes through.

But another avenue for growth that Rowe would like to take has been difficult for him. In 2003 he tried to buy Illinois Power but was blocked by regulators. A two-year battle for New Jersey's PSEG ended in 2006 when regulators demanded price concessions Exelon couldn't swallow. This year Exelon's hostile bid for NRG Energy failed when Exelon refused to raise its offer price and NRG shareholders rejected the bid. Rowe's still on the hunt, either for entire companies or for power plants that owners might be willing to sell. His recent track record might make it harder to do, despite Exelon's high market cap.

Rowe is unapologetic. What others call a failure to close, he calls a hard-headed dedication to shareholder value. "I'd love to be a visionary," he says. "I've got some wonderful Constantine coins where he's looking up at the stars. But Constantine's a good model. He was basically tough and present-value-oriented. I'm paid to make practical decisions with other people's money while I keep the lights on and keep my nukes safe."

The President's Utility
Ties are tight between Exelon and the Obama Administration:

President Obama. Frank Clark, chief executive of Exelon's ComEd, is a big Obama fundraiser, helping him launch his run for President.

Rahm Emanuel. John Rowe hired Emanuel (Obama's chief of staff, then at an investment bank) for advice on the 2000 merger that created Exelon.

David Axelrod. His consulting firm helped concoct a public ComEd campaign for rate increases (before he became Obama's chief political strategist).

 


 

Comments

The Best Stocks for 2010: Exelon

The Money TimesWith the S&P 500 index up nearly 70% from its March low, the number of companies coming up on my stock screens is dwindling. But one company that recently came up was nuclear power generator

Exelon (NYSE: EXC). I like Exelon because it's a relatively low-risk company, has a huge cost advantage over most competitors, pays a stable 4.3% dividend, and is pretty cheap. Owning Exelon shares is also a free option on any climate-change legislation that introduces a cap-and-trade system.

Exelon is an electric utility company that operates the largest fleet of nuclear power plants in the United States. It has 20% of all nuclear power generating capacity in the United States. Exelon also operates natural gas, oil, coal, and hydro plants, but 75% of its output is nuclear. Nuclear power's advantage is that, along with hydro, it has the lowest operational cost, and it is used as base-load power.

Combine a 90% plus utilization rate with low costs and you get high, predictable cash flows -- and who doesn't like cash? It's no accident that Warren Buffett's Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) has invested so much in its Mid-American subsidiary.

The nuclear advantage goes to companies that have existing plant capacity. No new nuclear plants have been started in the United States since the 1970s, although some were completed and brought online in the 1990s. Today, capital cost is the main reason why new plants have not been started.

There are approved plans for new plants, but without significant government guarantees on debt, I think it will be some time before any are built in the United States. And even then, it will take years to complete them.

Exelon owns two public utility companies: Commonwealth Edison (ComEd) in Illinois and PECO in Pennsylvania. ComEd serves 3.8 million customers, and PECO 1.6 million electricity and 491,000 natural gas customers. Utilities are highly regulated, and profit margins are much lower than power generation; however, the profits are fairly consistent and could be boosted by lower price constraints.

The value in power
In any economic downturn, demand for power is reduced, and Exelon has accordingly experienced diminished demand. But this won't last forever, and of course, it brings the share price down to value territory. Opportunities for accelerated growth are limited barring acquisitions, but at less than $50 per share, the market is pricing in less than 2% growth. With an eventual rebound in the economy, I estimate mid- to low-single-digit organic growth over the next 10 years, which puts the value around $70.

Just as important to me is how management allocates its
considerable cash flows. Over the last five years, dividends per share have grown annually at a 13.6% average pace. The next priority is growth opportunities, but management has demonstrated that it will only invest when it sees a good economic return. The company has shelved plans to build two new nuclear plants, based on cost and current demand.

Exelon will acquire significant power companies, but only if the price is right. Earlier this year, Exelon offered to buy NRG Energy (NYSE: NRG) but was rebuffed by NRG shareholders. Exelon management refused to raise its offer. Any cash that is in excess of investment is used to buy back shares, which at today's price is a good deal.

Foolish bottom line
Exelon affords good protection to the downside -- even
in the March lows, the share price only dipped below $40 for two days. Exelon will never be a high-flying stock, but just like Icarus, highfliers can crash and burn. For 2010, the market is starting at a high altitude. You'll do much better to keep your feet on the ground with a potential 40% to 50% upside and a 4.2% dividend while you wait.

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