Duke Energy (NYSE:DUK), one of North America’s largest electric utility companies, intends to divest its Midwest electricity generation business as it seeks to reduce its exposure to the volatile wholesale electricity market. The company’s Midwestern assets have been facing some headwinds of late on the back of low wholesale electricity prices as well as the rejection of the company’s recent request to Ohio regulators for a rate increase. Overall, we see the move to sell the assets as being positive for Duke since it should bring about greater earnings stability as well as a possibility of better margins. However, we will be closely watching the price that the company is able to realize on the divestiture.
Details of the Divestiture
- Earnings Review: Lower Maintenance Costs Help Duke Post A Profit
- Earnings Preview: Spotlight On The Future As Duke’s Revenue Growth Stalls
- What’s Driving Duke’s Regulated Utilities Revenue Growth?
- What Has Driven Duke’s EPS Growth In The Last Four Years?
- Duke’s Q1 Earnings Decline By 8% On Special Items, Unfavorable Weather Conditions
- How Has Duke Energy’s Revenue Composition Changed In The Last Five Years?
Duke’s Midwestern generation assets are part of the company’s commercial power division and account for a bulk of the division’s revenues and generation capacity. The assets up for divestiture include 13 natural gas-, coal- and oil-fired power plants with a total generation capacity of around 6.6 gigawatts (GW). ((Duke Energy to begin process to exit its Midwest generation business, Duke Energy, February 2014)) Following the sale, which is expected to be completed within the next 18 months, the commercial power division will primarily consist of the company’s solar and wind generation assets. The company could net about $2 billion from the sale, according to Sanford C. Bernstein & Co. 
Volatile Earnings And Recent Regulatory Setback Are Likely Motives Behind The Decision
Unlike the retail market, where electricity is sold directly to end consumers, wholesale power is sold to parties such as large consumers or retailers who in turn supply to end consumers. Electricity prices in the retail market are relatively stable since utility companies often have a monopoly in the regions that they operate in, with rates regulated by the government. The wholesale market, on the other hand, is open to a much broader set of participants, including traders who buy and sell electricity. Wholesale electricity prices vary with supply and demand, and the price fluctuations may be very wide at times.
Prices on the PJM Interconnection market, on which Duke’s Midwestern generation assets sell their output, have seen particularly high volatility. Wholesale prices on the Interconnection have dropped by nearly 50% since 2008 due to weaker industrial demand as well as plummeting natural gas prices.  This had led to relatively volatile results for the company’s commercial power business. For instance, the segment’s adjusted earnings stood at around $6 million in Q1 2013 after which it swung to a loss of around $3 million in Q2. In Q3 2013, the segment’s adjusted earnings stood at around $15 million.  Duke filed a request with Ohio regulators to allow it to collect a capacity charge of around $768 million from its customers in order to meet the shortfall between wholesale electricity prices and the cost of operating its power plants. However, this request was turned down by regulators last week and is likely to have been a factor in the company’s decision to sell the assets. 
Overall, we see the planned divestiture as being positive for the company due to two reasons. Firstly, it could make the stock more attractive to typical utility investors, who tend to prefer companies with a lower earnings volatility. Secondly, the company expects the reinvestment of the sales proceeds to be accretive to its earnings.Notes: