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All eyes on FERC: Wall Street says PUCO decision on generation subsidies expected

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All eyes on FERC: Wall Street says PUCO decision on generation subsidies expected

and FirstEnergy Corp.lobbied for nearly two years for Ohio regulators to approve their incomeguarantees for "vital"power plants that face economic challenges. Wall Street analysts also kept aclose eye on the decision and its impact on company shares.

Butwhen the Public Utilities Commission of Ohio voted unanimously March 31 to approve modified subsidiesfor the nearly 6,000 MW of primarily coal-fired generation, stock reactionseemed muted — closing up 18 cents for FirstEnergy at $35.97 and 38 cents forAEP at $66.40 — with analysts and investors not surprised by the decision. WallStreet and opponents, such as the Alliance for Energy Choice, contend theutilities "got virtually everything they asked for."

Theattention seems to have shifted to how FERC will rule on complaints looking tooverturn the power purchase agreements and protect power suppliers incompetitive markets.

"Itwas relatively broadly expected that the Ohio commission would approve [theseplans]. That's been investor consensus throughout the process," MorganStanley Research analyst Stephen Byrd said April 1. "The key issue thatthe investor is thinking about is FERC."

Powersuppliers argue the agreements will force captive customers "to " ofAEP and FirstEnergy's competitive subsidiaries andFirstEnergy Solutions Corp.They want FERC to rescind certain waivers it previously granted to AEP andFirstEnergy's subsidiaries tied to affiliate power sales restrictions. (EL16-33and EL16-34)

Byrdreiterated Morgan Stanley's view that there is a "very significant risk"that FERC reviews and ultimately rejectsthe PPAs despite the Ohio commission's approval.

FirstEnergyand AEP's argument is that since Ohio is a retail competition state, FERC hasheld that customers are not captive and affiliate PPAs are allowed.

"Theproblem with that argument, potentially, is … this PPA is nonbypassable,"Byrd said. "Customers can't choose to accept it or go with anothersupplier. They must pay these costs."

Theanalyst said he expects FERC to rule on the waiver this month prior to the nextPJM Interconnection LLCcapacity auction. However, it could take months for FERC to review thecontracts.

"However,unless a stay of the PPA order is filed for and granted by PUCO (which we viewas unlikely), FE and AEP can put the PPAs in effect regardless of the pendingFERC complaint, and the margin generated will be retained by the companies(i.e. these margins are not subject to refund)," Morgan Stanley said in anApril 1 research report.

Suppliersalso have filed a complaint urging FERC to protect PJM capacity markets from price suppressions byextending PJM's minimum offer price rule, or MOPR, to existing resources toensure they aren't receiving above-market revenues. (EL16-49)

GuggenheimSecurities LLC said in a March 31 report that it does not believe FERC willside with the suppliers in either case.

"Acaptive customer is a customer who cannot shop for retail generation andsupply. The PPAs have a rider that would be a distribution charge, which isalso under state and NOT FERC jurisdiction," Guggenheim analyst ShahriarPourreza wrote. "Since the PPA is setting a distribution charge on allcustomers, it is non-bypassable. This does not interfere with the 'captivecustomer' definition, as PPAs do not preclude customer's ability to shop."

Pourrezaadded that while FERC could change the MOPR structure, it is "unlikelyFERC would do so in order for it to apply specifically to AEP and FE's plants."

Risk/reward

MorganStanley said the implications of the PPA and its potential rejection by FERC "shouldbe limited for AEP, but fairly meaningful for [FirstEnergy]."

FirstEnergy'sproposal involves approximately 3,200 MW of generation with the PPA providing a"valuation uplift" of approximately $7 per share.Without the PPA, Morgan Stanley said it values FirstEnergy at $34 per share,which is modestly below where the stock was trading at the time of the report.

"Whilere-regulation of Ohio (in some form) is a possibility if FERC rejects theproposed PPA, such a path could take significant time, and in the interim[FirstEnergy] may well need to stabilize its credit position," the reportstated.

"Fortunately,from a shareholder's point of view, it's not as if at this price FE shares havea lot of downside," Byrd said. "Markets effectively, in our view,[are] only willing to bake in a fairly low probability of these PPAswithstanding legal challenge."

AEP'splan involves approximately 2,700 MW of generation with the PPA "modestlypositive for earnings, but not a major driver," according to the report.

MorganStanley said the net present value of the PPA cash flows is approximately $1per share.

Landmark ruling?

GlenrockAssociates LLC analyst Paul Patterson said while PUCO's ruling may beconsidered substantial from a state commission standpoint, it is "not thatrare."

"It'san acknowledgement — at least it appears to be in my opinion — a regulatoryacknowledgement they want energy policy, electric power policy not to be solelydictated by the wholesale market," he said. "This isn't all thatunusual to me. The thing that's sort of noteworthy about it, though, is that it'slarge, it's happening in the middle of PJM and it's a rather dramatic move, butnot one that's all that different than what we've seen with other states."

Theruling, however, "doesn't bode well for merchant generators" and is "onemore threat to profitability," Patterson said.

"Itdoes place the merchant power plants at something of a potential disadvantage,insofar as they don't have those contracts," he said. "That meansthat you're probably going to have capacity that's going to be around longerthan it otherwise would be. I think that's what the fear is. And the pricingbehavior might be different as well."

Therevised PPA for AEP Ohio, the trade name of Ohio Power Co., includes a 10.38% ROE and will beginJune 1, 2016, and end May 31, 2024. It will guarantee income for the capacity,energy and ancillary service output of its ownership share in two coalplants, as well as Cardinalunit 1, Conesvilleunits 4 through 6, J.M.Stuart units 1 through 4 and W.H. Zimmer unit 1. (Case Nos. 14-1693-EL-RDR,14-1694-EL-AAM)

Despitethe PUCO ruling in favor of the PPAs, AEP has indicated it will file forrehearing to "address some of the modifications" made to thestipulated agreementand clarify some of the language in the order.

"Forexample, it is disappointing that the PUCO rejected cost recovery for theinitial co-firing of Conesville Units 5 & 6 with natural gas, which willprovide environmental benefits during the transition," AEP spokeswomanMelissa McHenry said in an email.

Aspart of its settlement, FirstEnergy agreedto reduce its proposed income guarantee for the 2,210 MW coal plant and908-MW Davis-Bessenuclear plant to eight years from 15 years and cut its ROE to 10.38%. It alsopromised at least $100 million in customer credits. The retail rate stabilityrider runs from June 1, 2016, through May 31, 2024. (Case No. 14-1297-EL-SSO)