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April 18, 2001

Are TBusinesses Superfluous for Trading Operations?

by Will McNamara 
Director, Electric Industry Analysis

[News item from Power Finance & Risk] Vertically integrated power company 
Dynegy is likely to sell its electricity distribution business within the 
next few years to focus on its more profitable energy generation and trading 
activities, predict analysts familiar with the company. Anatol Feygin, senior 
equity analyst at J.P Morgan in New York, says a sale of Dynegy's 
transmission and distribution assets could fetch the company close to $1 
billion. 

Analysis: There are two different ways to evaluate the speculation that 
Dynegy may be looking to sell its transmission and distribution (T&D) 
business. From a company-specific perspective, such a strategy would make 
sense for Dynegy, as it would allow the company to focus more exclusively on 
its trading and marketing operation, which has experienced truly spectacular 
growth over the last year. Although Dynegy has refused to deny or confirm 
reports that it is planning to sell its Tassets, the company's financial 
numbers clearly build a case for such a move. In addition, Dynegy's potential 
restructuring could very well be part of a larger trend in which those 
companies that place a high priority on their generation business see little 
value in remaining in the highly regulated and low-profit Tmarket. 

To be clear, Dynegy's Tsubsidiary is Illinois Power, based in Decatur, Ill., 
which serves more than 650,000 natural-gas and electric utility customers in 
a 15,000-square-mile area across Illinois. Dynegy acquired Illinois Power 
when it completed its merger with Illinova in February 2000. At the time, 
Dynegy maintained that a primary value of the acquisition was Illinois 
Power's Toperations and the fact that they would allow Dynegy to gain a 
foothold in the Illinois market. Of course, Dynegy also gained approximately 
4,929 MW of generation that Illinois Power had previously structured in an 
unregulated subsidiary. Nevertheless, if Dynegy is planning to sell its 
Toperation, the sale would include Illinois Power and would represent a 
dramatic strategy turnaround for the company. 

Let's look at the unique reasons why Dynegy might be considering such a move. 
It's rather apropos that word begins to circulate of a sale of the company's 
Tbusiness at the same time that Dynegy releases its 1Q 2001 report, in which 
its earnings more than doubled. As it has in the past few quarters, Dynegy 
reported remarkable numbers, including a 73-percent increase in its earnings 
that resulted primarily from wholesale natural gas and electricity sales. 
Dynegy's recurring net income in the first quarter rose to $137.5 million or 
41 cents per diluted share from $79.4 million or 26 cents in 1Q 2000. 
First-quarter revenues rose to $14.2 billion from $5.3 billion. Dynegy 
reportedly produced and sold 26.1 million megawatt hours of electricity in 1Q 
2001, which represented a 19-percent increase over the same period in 2000.  

Dynegy continues to discount the role that California sales played in its 
earnings, despite the fact that it owns about 2,800 MW of capacity in the 
state (including joint ventures). Due to its presence in the state, Dynegy 
(along with a handful of other power suppliers) continues to be singled out 
as having gained a financial windfall from the California energy crisis. Yet 
even without California, cold weather in the Midwest during 1Q 2001 also 
benefited Dynegy (along with other natural gas and power producers such as 
Enron and Duke). Looking nationally, Dynegy has ownership stakes in about 
13,000 MW of generating capacity and is on its way toward the goal of owning 
or controlling 70,000 MW by 2005. 

Consequently, it seems fairly clear that wholesale marketing and trading is 
where Dynegy is making most of its money. It only makes sense that the 
company would want to invest its existing capital resources (and any funds 
gained from selling its Tassets) into growing this part of its business. In 
contrast, in general Toperations typically only bring a return of equity of 
about 10 percent, given the fact that they are still heavily regulated by 
FERC. When 73 percent of its earnings are coming from wholesale operations, 
it is a no-brainer that Dynegy would move further and further into this 
market. Moving forward, Dynegy's business most likely will become more about 
managing its power sales and exchanges on its still-new trading platform 
(Dynegydirect), and less about operating a distribution system.  

As noted, I think Dynegy's business model fits into what appears to be a 
growing trend among companies heavily focused on generation and trading. 
First, over the last year there has been a slew of companies that have 
divided or are planning to divide their regulated and non-regulated 
businesses (AEP, UtiliCorp, Southern Company, Reliant and NRG, to name a 
few). The operations are being split not only to attract two different sets 
of investors, but also to allow a high-growth business such as independent 
power production or wholesale trading to grow independently from regulated 
operations.  

Second, I think we can look to AEP as a company that is charting what may 
become a more common path. Last fall, after completing its acquisition of 
CSW, AEP announced an extensive corporate restructuring that includes an 
exclusive focus on generation assets, wholesale marketing and trading. The 
company has no plans to expand its distribution assets, either domestically 
or internationally. AEP has not released its 1Q 2001 earnings report yet, but 
for year-end 2000 wholesale margins at the company were 41 cents per share 
higher than in 1999. AEP presently controls a generation portfolio of 38,000 
MW and is a top 10 power marketer and top 20 natural gas trader in North 
America. Nevertheless, AEP's restructuring could take more than a year to 
accomplish, especially considering that the company may have pooling of 
interests restrictions related to its merger with CSW and other conditions 
that fall under PUHCA. 

Thus, it's evident why the power marketing and generation business is so 
appealing. In addition, it is also becoming clear that transmission and 
distribution businesses might be something to avoid unless a company only 
wants to remain in this heavily regulated side of the energy industry. I've 
already mentioned the low average return on equity associated with 
Toperations (also referred to as &wires businesses8 in some states). In 
addition, FERC continues to monitor interstate transmission activity, and 
oftentimes the policies affixed onto separate transmission systems can be 
divergent and extremely complicated. A company that owns or operates 
Tassets, especially ones that transcend regional boundaries, may find that 
the business causes an excessive amount of operational headaches that simply 
cannot be justified by its minimal profit opportunities. Siting is also a 
problem, as even when communities can be convinced of the need for new 
Tcapacity, they typically do not want it within their own view. 

As a result, the wires business is presently considered to be rather 
lethargic, considering its low risk / low rate of return characteristics. 
According to Reuters, electricity demand over the next 10 years is expected 
to increase by 20 to 25 percent. In contrast, transmission line capacity is 
expected to increase by only about 4 percent. The reasons for this disparity 
are that many companies are avoiding further investment in transmission 
capacity due to the inherent disadvantages associated with this business. 
Further, companies that presently own or operate transmission lines are 
impacted by FERC Order 2000, which mandates a plan for forming or joining a 
regional transmission organization (RTO) by Dec. 15 of this year. While RTO 
plans continue to remain a high priority, the siting or expansion of 
Tcapacity has become a secondary concern. 

Considering these many downsides to the wires business, Dynegy and other 
companies that look to sell their Tbusinesses may not have such an easy time 
with the divestiture. As noted, the business is heavily regulated and any 
potential sale would have to be approved by several layers of regulatory 
agencies. In addition, a company looking to purchase Tassets, assuming that 
the company is aware of all the risks involved, would most likely be a 
company that is only interested in Tand is not an active participant in the 
generation business.  

There are companies with this kind of business model. National Grid comes to 
mind as a leading example. The U.K. company is one of the world's largest 
independent transmission companies and for over a year has been attempting to 
establish a major presence in the transmission and distribution sectors of 
the industry, primarily in the United States. National Grid has acquired 
Niagara Mohawk, New England Electric System (NEES) and Eastern Utilities 
Associates (EAU), all Toperations located in the Northeastern United States. 
Dynegy's assets are located in the Midwest and do not seem consistent with 
National Grid's regional focus. However, the point to be made is that there 
are companies active in the United States that are aggressively pursuing 
Toperations, despite the seemingly obvious risks associated with this 
business. 

An archive list of previous IssueAlerts is available at
www.scientech.com




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