New Law Bodes Well for Utilities

Here at Morningstar, we have been tracking the progress of the Energy Policy Act for some time. This blockbuster legislation, which was signed into law this week after years of delays, contains a smorgasbord of tax breaks, subsidies, and policy changes that will have an impact on a wide range of industry groups we cover at Morningstar. However, utilities are one of the most-affected groups.

While it is too early to fully quantify the effect of the bill on utility stocks, that doesn't prevent us from attempting to read the tea leaves and think through possible impacts on our stocks down the road. Two caveats apply to what follows. First, the devil is in the details. Despite the mammoth size of the bill (1,724 pages) a number of its provisions have been painted with broad strokes. This means that the implementation of these provisions will be critical in determining the law's impact on specific stocks.

Second, while the new rules are overwhelmingly positive for utilities, all legislation has the potential to create winners and losers. For example, the bill grants the Federal Energy Regulatory Commission (FERC) backstop authority to site new electric transmission facilities. While this provision should generally help utilities by increasing the level of transmission investments, it could also harm specific companies that rely on the difficulty of putting new transmission lines into place as a barrier to entry, helping to keep local power prices high.

That said, there is an awful lot to like in this bill for utility investors:

Regulatory: Repeal of PUHCA
On the regulatory front, the Energy Policy Act commits to a major utility regulation overhaul. First and foremost, it repeals the Public Utilities Holding Company Act (PUHCA) of 1935. That bill had forced utilities with service territories in multiple states to register with and be regulated by the SEC. Eliminating this requirement has the potential to reduce the filing and compliance costs of currently proposed mergers between  Duke (DUK) and  Cinergy ,  Exelon (EXC) and  PSEG (PEG), and  Scottish Power's  PacifiCorp with the MidAmerican unit of Warren Buffet's  Berkshire Hathaway (BRK.B). In addition, PUHCA's repeal helps to fast-track these mergers by eliminating the need for merger partners to prove that they constitute a single integrated electrical system. The elimination of this provision also lifts a cloud hanging over  American Electric Power  (AEP), which recently faced court challenges to its 2000 merger with Central and South West on a strict reading of this requirement.

The repeal of PUHCA has received lots of attention by Wall Street, as its elimination is seen as a catalyst for increased merger and acquisition activity in the sector. While increased M&A activity will no doubt lead to higher Wall Street bonuses, we are not necessarily convinced that it will lead to big increases in shareholder value. Among other problems with utility M&A is the fact that merger partners are frequently required to share a large part of merger cost savings with rate-payers to win the blessings of state regulators, something which reduces the value that accrues to shareholders.

Regulatory: Revision of PURPA
The Energy Policy Act also revises utility purchase requirements under the Public Utility Regulatory Policies Act of 1978 (PURPA). Under PURPA, utilities are required to make mandatory energy purchases from certain outside generators called qualifying facilities. These mandatory purchases limit the ability of regulated utilities to grow earnings by expanding regulated generation assets. The bill allows utilities to either restructure or eliminate these contracts under certain conditions, something that paves the way for additional regulated generation investments. Potential beneficiaries of this modification include  PG&E (PCG) and  Edison International (EIX), both of which derive a large amount of power from qualifying-facility generators.

Nuclear Power
The bill contains a number of incentives for nuclear power. To kick-start the construction of new nuclear power plants--none have been built in the U.S. for decades--the law underwrites a hefty production tax credit of $18 per megawatt-hour for new nuclear power plants. The credit is good for up to $125 million per year per plant, and extends over the first eight years of a plant's life. Major beneficiaries of this credit include Exelon,  Entergy (ETR),  FPL Group  ,  Progress ,  Southern (SO), Duke, and  Constellation --all of which have joined a consortium committed to building a new advanced-design nuclear reactor. In addition, the bill enhances the liability protection of current nuclear operators by extending the Price-Anderson Act to 2025. This act provides more than $10 billion in public liability claims in the case of nuclear incident.

Coal Power
The bill creates incentives to build coal gasification (or "clean coal") technology in new power plants. Under the relevant provisions, coal gasification plants larger than 400 MW qualify for federal loan guarantees. Utilities that could benefit from the proposal include AEP and Cinergy, both of which have gasification facilities planned in the Midwest. However projects only qualify if they are operated as merchant plants, selling power on the open market.

Similar loan guarantees are provided to the first five builders of solid petcoke gasification facilities, which gasify a refinery waste product (petcoke) rather than coal.  Cleco , which has proposed a $1 billion 600 MW petcoke gasification facility in Louisiana, could be a major beneficiary of this provision.

Utilities also benefit from federal cost-sharing for any innovation in coal-fired plants that either substantially advances the unit's thermal efficiency or results in environmental performance above and beyond current clean air standards. A whole range of coal-heavy utilities in the Midwest and South potentially stand to benefit from such a provision--including  FirstEnergy (FE), Cinergy,  DPL  ,  Consumers (CMS), Duke, and Southern, among others.

Hydroelectric Power:
Hydroelectric power benefits from several bill provisions. Non-federal utilities can recoup up to 10% of capital costs for investments resulting in efficiency gains in existing dams. The bill also creates production incentives for turbine investments on existing dams. Possible beneficiaries include utilities that already have extensive hydrological assets in place, such as PG&E, Edison International,  Avista (AVA),  PPL  (PPL), Duke, and  ENEL (EN).

Demand for Renewables
Renewable energy receives several different types of subsidies. The bill encourages the use of renewables by forcing the federal government to increase renewable-generated electricity purchases (solar, wind, hydro, biomass) beginning at 3% in 2007 and growing to 7.5% by 2013. Also, the bill contains provisions to extend the wind-production tax credit by two years. An obvious beneficiary of the wind credit is FPL, currently the largest provider of wind in the U.S. The extension could also benefit utilities with plans on the table to expand existing wind capacity, including  AES  (AES),  Xcel (XEL),  Aliant (LNT),  Sempra (SRE) and PG&E.

In short, the Energy Policy Act seems to have something for everyone. We will wait to see how the utilities in our stock universe respond to the incentives laid out by Congress in the months ahead.