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FERC decision seen as more detrimental to FirstEnergy than AEP

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Essential Energy Insights - September 17, 2020

Essential Energy Insights September 2020

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FERC decision seen as more detrimental to FirstEnergy than AEP

FERC'sdecision to revokewaivers of affiliate power sales restrictions for andFirstEnergy Corp.subsidiaries was met with stock downgrades and disappointment. The news isexpected to have a much bigger financial impact on FirstEnergy than AEP, whichhas announced it will either sellits generation assets or pursue re-regulation in Ohio.

JefferiesLLC and RBC Capital Markets LLC both downgraded FirstEnergy's stock April 28 onthe heels of FERC's decision late April 27 to grant complaints that the salesagreements will force captive customers "to " of AEP andFirstEnergy's competitive subsidiaries AEPGeneration Resources and FirstEnergySolutions Corp. (EL16-33 and EL16-34)

Thecomplaints were filed in anticipation of the Public Utilities Commission ofOhio approval of power purchase agreements for nearly 6,000 MW of primarilycoal-fired generation that is bid into PJMInterconnection LLC capacity markets. PUCO voted unanimously March31 to approvemodified eight-year PPA plans for the generation, under which customers willreceive rate credits or charges to offset power purchase costs.

FERCfound that the non-bypassable charges associated with the PPAs is a reportablechange in circumstances from the conditions under which the commission agreedto waive the affiliate restrictions. FERC acknowledged that Ohio ratepayers havethe ability to choose retail suppliers, but said AEP's and FirstEnergy's Ohioretail ratepayers are nonetheless captive because they have no choice but topay the non-bypassable generation-related charges incurred under the PPAsirrespective of their retail provider.

Ifthe companies want to proceed to make sales under the PPAs, they will have tobe filed at FERC, which would then review them under its Edgar and Alleghenystandards in a process that could take several months to complete.

AEPChairman, President and CEO Nicholas Akins told investors and analysts April 28on the company's first-quarter earnings call that the company has "nointerest in getting involved in a protracted FERC-state jurisdictional debate."

AEP shares closed at $63.06 on April 28, down less than 2%from the $63.93 close on April 27. FirstEnergy's shares closed at$32.47 on April 28, down approximately 10% from the $36.05 close on April 27,the day of the company's earnings call.

FirstEnergy executives seemed confident that FERC woulddeny the complainttied to its subsidy plan.

FirstEnergy downgraded

Standard& Poor's Ratings Services on April 28 revised its outlook on FirstEnergyand its subsidiaries to negative from stable based on FERC's ruling.

"FirstEnergyhas minimal cushion at its present rating level, reflecting financial measuresthat are at the very low end for the current rating," S&P said in itsreport, noting that the negative outlook "reflects the increasedprobability that we could downgrade FirstEnergy and its subsidiaries one notchwithin the next 12-24 months."

Moody'salso revised its outlook on FirstEnergy and its subsidiaries to negative fromstable given the "lengthy, unpredictable timeline" and "uncertainty"around PPA approval, state regulatory measures and equity issuance.

CreditSights analysts said they "believe the rejectionof [FirstEnergy]'s PPA has serious implications for FirstEnergy's creditprofile, bond spreads, and only remaining investment grade rating from Moody's."

"We believe bonds at FE parent and FES will pull backon PPA rejection news," analysts wrote in an April 27 report. "[W]emay even hear the conversation shift to how can FE exit the merchant generationbusiness."

Onthe equity side, Jefferies downgraded FirstEnergy shares to "hold"from "buy" and RBC downgraded the stock to "sector perform"from "outperform." Analyst Anthony Crowdell lowered hisestimates "to reflect the loss of PPA earnings" and account for potentially$2 billion in equity issuances to support FirstEnergy's balance sheet andcredit metrics.

"Webelieve it is unlikely the PPA will be approved upon review given FERC'sinterpretation of captive customers," Crowdell wrote.

RBCand Morgan Stanley Research also believe FirstEnergy will have to issueapproximately $2 billion of equity.

FirstEnergy Corp. may seek FERC approval for its income guarantee for the 2,210-MW W.H. Sammis coal plant.

Source: FirstEnergy Corp.

"Webelieve FirstEnergy may likely challenge this order through the court system,"RBC analyst Shelby Tucker wrote. "However, we expect a prolonged processwith even a potential ultimate benefit not impacting the company's financialsfor at least a year or two."

MorganStanley has held the view that FERC was likely to rescind the affiliate waivers and invalidatethe PPAs under the Edgar standard of review.

MorganStanley said it values FirstEnergy at $41 per share with the PPA agreement, but$34 per share without it.

GuggenheimSecurities LLC has said it believed that the PPAs would not only be approved byPUCO, but withstand a FERCchallenge since the PPAs "do not preclude customer's abilityto shop."

Guggenheimanalyst Shahriar Pourreza in an April 27 report called FERC's ruling a "reallydisappointing surprise for AEP, [FirstEnergy], and our overall thesis on Ohio."

Options

FirstEnergyis still evaluating options for its 2,210-MW W.H. Sammis coal plant and 908-MW nuclear plant,which include seeking a rehearing of FERC's order and submitting the PPA forreview.

"It'salways been our position that the PPA will satisfy the FERC's criteria for anaffiliate contract," FirstEnergy spokesman Doug Colafella said.

"Inaddition, FirstEnergy will consider both short-term and long-term legislativeand regulatory solutions in Ohio to preserve the benefits associated with … PPAfor the customers of the Ohio Companies," the company said in a Form 8-K.

Analystshave suggested FirstEnergy could join AEP's push for re-regulation in Ohio.

"Bottomline, ultimate FERC rejection is not the end of the line as re-regulation wouldpresumably remove FERC review entirely, with an exit from wholesale marketoversight altogether," UBS Securities LLC analyst Julien Dumoulin-Smithwrote in an April 28 report.

"We believe success on this front is possible, butcaution that the costs may be prohibitive and timing is uncertain," MorganStanley analyst Stephen Byrd wrote in an April 29 report.

Morgan Stanley said FirstEnergy will either need to acquireadditional generation, likely natural gas, or enter into PPAs to meet its powerneeds.

American Electric Power Co. Inc. is exploring the sale of its interests in the 1,800-MW Cardinal coal-fired power plant and three other assets after FERC halted its Ohio generation subsidy plan.

Source: American Electric Power Co. Inc.

"Interestingly,under this approach, we see [DynegyInc.] as a major beneficiary given its large low-cost fleet withinOhio, which we would expect to be highly competitive in any PPA process,"Byrd wrote.

AEP impact

MorganStanley said the FERC outcome is "much less meaningful for AEP" thanfor FirstEnergy, noting that net present value of the PPA cash flows isapproximately $1 per share with an earnings benefit of 10 cents per share to 15cents per share.

Outsideof an income guarantee, AEP will likely sell its interests in the , , and coal plants.

"We think a complete generation sale would be quicker,avoiding dragging out the uncertainty on a small portion of the business, whichwe believe is distorting a very attractive regulated utility story," Byrdwrote.

Guggenheiminitially said the ruling is "more agnostic" for AEP since the companywould likely just include the assets in the PPA in its ongoing process. AEP onApril 28 indicated it would pursue a separate sale process for the PPA units,which Pourreza later wrote "complicates the process."

Hesaid potential bidders are "not likely interested in the PPA assets giventheir obvious more uneconomical status." Guggenheim valued a sale of theentire Midwest competitive portfolio, approximately 8,000 MW, at $3.5 billionwith the PPA assets valued at approximately $900 million and the othergeneration valued at $2.6 billion.

AEPOhio is the trade name of OhioPower Co.

Standard & Poor's RatingsServices and S&P Global Market Intelligence are owned by S&P Global Inc.