Constellation power shift

THE BALTIMORE SUN

When Constellation Energy Group Inc. splits from Baltimore Gas and Electric Co., planned for the end of the year, it will begin life as a $6 billion electricity supplier with a powerful advantage: 10 BGE electric plants, including the nation's only relicensed nuclear station.

Constellation didn't pay billions of dollars to buy the valuable assets on the open market or risk losing out to a higher bidder. Instead, it got the plants as part of the plan to deregulate electricity in the Baltimore region.

It's a deal that boosts new Constellation's arsenal of electricity to sell nationwide, enhancing its chances of becoming a major player in an extremely competitive, high-risk and, it hopes, lucrative merchant power business.

But the same deal leaves a highly leveraged BGE with $2 billion in debt, less cash and a limited ability to grow.

To serve its 1.1 million residential customers, the utility will have to pay for the electricity it once produced - about $1 billion a year. BGE has locked in supplies until 2006 through fixed-rate contracts.

State regulators signed off on the plant transfers months before Constellation Chairman and Chief Executive Officer Christian H. Poindexter announced the ambitious plan to split into two independent companies: Constellation Energy and BGE Corp., in which BGE will be a subsidiary.

Company officials maintain the proposed separation plan is good for customers, shareholders and Baltimore, which will be home to both companies.

Critics contend the deal is too favorable to the new Constellation, while more neutral observers say it's the new Constellation that bears more of the risk.

But regulators worry that a financially weakened BGE, cut off from the deep pockets of its powerful corporate parent, could falter.

So concerned was the Maryland Public Service Commission that it held four days of hearings that concluded last month, during which its chairman wondered aloud whether the asset transfer "was premised on faulty facts."

And just 10 days ago, the state People's Counsel recommended that the commission delay the separation until Constellation provides firm commitments to restore BGE's capital structure.

"At the time of the asset transfer, this commission was very wary of the debt that would be left with BGE," PSC Chairman Catherine I. Riley told top company executives during the hearing.

"It was committed to that you guys would restore BGE's equity ratio within four or five years. When that commitment was made, did anyone envision that this separation would occur? Is there any reason why we [the PSC] should have anticipated separation?"

The PSC is expected to issue a decision next month.

Company officials vehemently deny that new Constellation is coming into being at BGE's expense. "We are very confident that BGE will be in a very strong position financially," said Paul J. Allen, Constellation vice president of corporate affairs.

And credit-rating agencies have reacted favorably, reflecting the view that a distribution company like BGE is less risky than a merchant power company like new Constellation. After announcement of the pending split, Standard & Poor's placed BGE on credit watch "with positive implications to reflect that once its ties to Constellation's generation business have been severed, BGE's business profile will improve."

Company officials say they have gone out of their way to minimize BGE's risks. Just last month, BGE entered into long-term, multimillion-dollar contracts with affiliate Constellation Power Source and Allegheny Energy Supply Co. LLC to lock in wholesale power supplies for residential customers at current prices through July 1, 2006.

Company officials said the new contracts eliminate the threat that the utility could be caught in a squeeze between a rise in power costs and a rate freeze in effect until that date.

But while Constellation will continue cooperating with the PSC review, company officials maintain that the agency has no authority over the separation.

The crucial decision faced by the PSC comes as it attempts to maintain control over BGE's future and ensure the region's power supply under deregulation.

It is a scenario being played out across the country. Once-staid utilities are evolving at a dizzying pace under deregulation and as a result, industry experts say, regulators - let alone consumers - are struggling to understand and keep up with critical changes.

In Constellation's case, said one expert, the beneficiary of the changes is clear.

The transfer of the plants on July 1, 2000, was "a very sweet deal for Constellation, no question," said Stephen G. Hill, a consultant hired by the state People's Counsel to examine the split.

"The concept that BGE had nothing to do with the new company's future is a fiction that company executives want you to believe. But for years, BGE was a fully integrated utility that owned plants built with ratepayer dollars. The utility was the cash cow.

"There is no return"

"Those money-making assets now reside in Constellation, not BGE," Hill said. "The separation is the finalization of the company's plan, but the risk was realized at the time of the asset transfer. The two are intertwined. And once it happens, there is no return."

The 10 power plants aren't the only assets Constellation is getting from BGE, according to a review of financial reports, regulatory filings, public documents and testimony of company executives at the PSC hearing.

Under the plan:

Constellation is assuming only a fraction of the debt associated with BGE power plants. Along with the plants, Constellation received $109 million in working capital, which includes material and supplies, fuel stocks and working funds.

Constellation stands to receive 90 percent the $528 million in "stranded" costs BGE is being allowed to collect from ratepayers to cover the expense of building the plants.

Although Calvert Cliffs Nuclear Power Plant will be owned by Constellation, BGE customers will continue to pay into the decommissioning trust fund required by the federal government to ensure the safe closing of the plant. They also would be liable for any shortfall in the trust fund.

Company officials maintain that the actions taken - most with PSC approval - are fair. Just last month, the PSC approved the accounting for the asset transfer.

While there was no exchange of money when BGE transferred the plants at a net book value of $2.4 billion (original cost minus accumulated depreciation and deferred taxes) as specified by its deregulation settlement agreement, company officials said new Constellation will have assumed or paid more than $1.1 billion in debt to BGE and its new parent, BGE Corp., after the split.

"I don't think a balanced look at this would bear out the idea that Constellation drained the utility. The commission looked very carefully at all of this. They are a real watchdog and wouldn't let that happen," said Robert S. Fleishman, Constellation's general counsel, who will assume that post at BGE Corp.

He said the company has filed extensive public documents with various state and federal agencies that disclosed all the company's plans, adding, "This has been as open and up front, and above board ... as anything I've seen."

Certainly, Maryland's 1999 deregulation law, spurred by Congress, fundamentally changed the rules that governed the utility business. Up to that point, utilities were guaranteed their cost of producing power, including the construction of power plants, plus a specified rate of return.

In exchange, they had to get regulators' permission to build plants and to change rates. In enacting deregulation, the General Assembly hoped to create a competitive market with high incentives to increase efficiency and lower costs - improvements they hoped would result in lower prices.

Looking at future

To spur that competition, legislators required Maryland utilities to "transfer, sell, lease, assign, mortgage, or otherwise dispose or encumber some or all" of its power plants to either affiliated or nonaffiliated entities.

Fleishman, the Constellation general counsel, said the company chose to transfer the plants because it wanted to be in the generation business. "We were looking at the future and saying one of the things we do well is generation. So we wanted to transfer [the plants] to an affiliate," he said.

Washington-based Potomac Electric Power Co., which serves Montgomery and Prince George's counties, made a different choice.

Deciding to focus on delivering electricity to customers, it sold its four plants for $2.75 billion - about twice book value. As part of its agreement with the PSC, Pepco recently started sharing that gain with its customers by issuing substantial credits to businesses and residents. Residential users in Maryland got an average of seven weeks of free electricity.

In other states, some utilities sold their plants for as much as seven times book value.

"In transferring the plants, [BGE] may have missed that profit opportunity," said H. Sterling Burnett, a senior analyst at the National Center for Policy Analysis, a nonprofit group in Dallas that supports deregulation and competition.

A study by the Florida Municipal Electric Association this year concluded that transferring power plants from utilities to affiliated spinoffs at book value offered companies huge windfalls.

The FMEA study argued that the sale of plants could fetch on average about 2.5 times book value, a gain that could be returned to customers in rate relief.

"When the assets are transferred, the gain-on-sale issue goes away," said Barry Moline, executive director of the FMEA. "Boom. The company keeps it all. It's fleecing the ratepayers. And, you give the hometown guys a head start over the competition."

While company officials agree that the transfer gives new Constellation an edge, they rejected the idea that it comes at the expense of customers, who received a six-year rate reduction as part of the deregulation settlement.

"The settlement agreement involved a lot of parties. ... It was a process of trade-offs that included very significant rate reductions and a rate freeze," said Allen, the Constellation vice president.

In any case, transferring BGE's power plants to Constellation had an immediate effect. Constellation's merchant power business overnight became the company's main source of profit, generating 60 percent of the company's earnings in 2000 (although the transfer covered only the last six months of that year ) vs. 16 percent in all of 1999, according to the company's 2000 annual report.

The 10 plants and BGE's partial ownership in three other plants allow Constellation to produce enough electricity for about 6.2 million homes. They produce about 61 percent of Constellation's generating capacity of 10,100 megawatts.

But Constellation wants to have a capacity of 30,000 megawatts by 2005, enough for 30 million homes - a goal that means buying more power plants or building them.

That requires raising hundreds of millions of dollars and lowering its liabilities as much as possible to give the new company the flexibility it needs to grow.

"The lower the debt, the higher the credit rating, the stronger the balance sheet, and the more you can attract new capital as needed," said David B. Burks, utilities analyst for J.J.B. Hilliard, W.L. Lyons Inc., an investment brokerage in Louisville, Ky. "And of course, if you have lower debt, you'd have lower interest expense. In theory, that could help the bottom line.

"From a credit perspective, I think it's fair to say there's a bit more volatility [in the utilities industry] now going forward than there has been historically" as a result of deregulation efforts across the United States, Burks said.

'No economic sense'

At the PSC hearings, company executives vehemently denied that they had put BGE at risk to give Constellation an edge.

When BGE becomes the largest subsidiary in the new $5.5 billion BGE Corp., the utility will be strong enough to help its parent grow by 4 percent to 5 percent a year, a typical growth rate for comparable, low-risk electric delivery companies, executives said.

"It makes no economic sense for BGE Corp., myself or for the board of directors for BGE Corp. to manage BGE in a way that is detrimental to BGE, because that would also be detrimental to BGE Corp.," said Constellation Vice Chairman Edward A. Crooke, who will become chairman and chief executive of BGE Corp.

"It makes all economic and management sense for us to ensure the financial viability of our premier asset," Crooke said.

Constellation's plunge into the merchant energy business was not a spur-of-the moment decision, but a strategy that began developing well before the advent of deregulation.

In an interview last year, Poindexter said he knew in the early 1990s, when Congress began pushing electric deregulation, that BGE would have to make important changes "to be in the top 10" power companies nationwide.

In an attempt to achieve that, Poindexter announced a merger with Pepco in September 1995. The merger collapsed two years later, on Dec. 22, 1997, after state regulators demanded rate reductions and protections for consumers that the companies were unwilling to accept.

During the two-year struggle to get the Pepco merger approved, BGE started shifting gears.

In February 1997, BGE formed a partnership with Goldman Sachs & Co. to sell energy and related services to other U.S. utilities and municipalities. A year later, Goldman Sachs and BGE, in a joint venture, formed Orion Power Holdings Inc., a company focused solely on generating and selling electricity. Constellation retains about 18 percent of Orion - a stake that will go to BGE Corp. after the split.

But BGE's regulated status in Maryland prevented company officials from using the utility as leverage to raise capital and issue debt to help finance nonregulated power projects.

So in 1998, the company started aggressively lobbying lawmakers to allow it to form a holding company. After the General Assembly failed to vote on the proposal, BGE threatened to move its headquarters to Delaware.

In the 1999 Assembly session, the company succeeded in making the issue a test of the business climate in Maryland, and the bill sailed through. On April 30 that year, a holding company was created, Constellation Energy Group Inc., with BGE as a subsidiary.

The parent company immediately began to reap the benefit, collecting $316.6 million from BGE and its subsidiaries in the last three quarters of 1999, according to annual and quarterly reports.

Of that, $188.4 million was passed on to common shareholders as dividends, but Constellation retained $128.2 million, according to company filings.

In the first half of 2000, Constellation collected $188.5 million, from BGE and its subsidiaries, and kept $62.9 million while passing $125.6 million on to shareholders.

The $191.1 million that Constellation retained was most likely used for capital improvements, continuing expenses and new power projects, company officials said in an interview.

Constellation stopped requiring BGE to pay it a distribution when the plants were transferred, allowing the utility to retain cash to pay off debt.

Besides the holding company legislation, the 1999 General Assembly enacted electric deregulation, and Constellation turned its focus to achieving a favorable deregulation settlement.

In closed-door negotiations, the company argued vociferously that its nuclear power plant was a huge liability, according to participants.

Indeed, at the time nuclear facilities were selling for far less than book value, industry experts said. The company would have to absorb an unnecessary loss were it to sell the Calvert Cliffs nuclear plant, company officials argued.

BGE's claim that it could not sell Calvert Cliffs for anything close to its $1 billion book value was the No. 1 reason that it was allowed to collect stranded costs - the amount a utility has spent to build power plants that it has yet to recover from customers.

BGE said it deserved $1 billion in stranded costs. The other parties in the settlement talks, including a trade group of power suppliers and the People's Counsel, maintained that BGE deserved none.

After contentious discussions, the parties agreed to a compromise allowing BGE to collect $528 million. It became part of the settlement approved by the PSC.

The trade-off: BGE agreed to a 6.5 percent rate reduction for residential customers that's frozen through mid-2006 - a rate cut that saves residential customers an average of $54 million a year, the company says.

"They sold the farm for the rate cut," said Thomas W. Kinnane, an attorney representing the Mid-Atlantic Power Supply Association (MAPSA), a group of out-of-state electricity suppliers that sued over BGE's settlement agreement and the asset transfer. The case is winding its way through the appeals courts.

"They allowed BGE to undervalue Calvert Cliffs too much. We argued that the nuclear plant was incredibly valuable and would become more so after the relicensing."

The trade association's warning was prescient.

Having foreseen the country's renewed interest in nuclear-fueled generating plants - later bolstered by Vice President Dick Cheney's support - Constellation announced a month after the settlement agreement that it would buy majority ownership of a New York nuclear plant for about $815 million, including fuel stocks.

Four months after the settlement agreement, Calvert Cliffs became the first nuclear power plant in the country to win license renewal, keeping it operational into the 2030s and boosting its value, experts said.

"Nuclear power plants are more valuable now," said John J. Reed, executive director of Navigant Consulting, which helped sell the New York plant to Constellation. He added that relicensing would help increase a plant's value.

"I know it's worth a whole lot more," said Hill, the consultant to the People's Counsel. "Calvert Cliffs will run a whole bunch more years and it will run cheaply. It's very valuable to them. It's a moneymaker for them and worth way more than what they got it for, which was nothing."

SEC disclosure

What regulators didn't know until this summer was that, with the transfer of BGE's power plants, company executives had allocated 90 percent - about $475 million - of the stranded-costs authorization to Calvert Cliffs Nuclear Power Plant. The remaining 10 percent remained with BGE.

The 90 percent allocation was disclosed by Constellation in a filing with the Securities and Exchange Commission on July 7, 2000, just days after the asset transfer took place, but was never included in any filings to the PSC.

In fact, commissioners didn't know that the bulk of stranded costs would be handed over to new Constellation until this summer's hearings.

A clearly vexed Riley asked Constellation officials at one of the hearings why that money wasn't earmarked for the $2 billion debt left behind with BGE, a level that changed its capital structure to 70 percent debt. Constellation officials replied that it had not occurred to them.

The agreement also provides that BGE customers will pay $18.7 million a year through 2006 into the decommissioning trust fund, even though new Constellation will own Calvert Cliffs and take charge of the fund.

If, when time to close down the plant, the fund falls short of the equivalent of $520 million 1993 dollars, BGE customers will have to make up the difference - a possibility that worried the PSC and other state officials.

In testimony, Poindexter assured the PSC that there will be no shortfall because the fund is closely monitored by the U.S. Nuclear Regulatory Commission.

On the other hand, if the trust fund is managed well and produces more than the $520 million in inflation-adjusted dollars, customers are entitled to a refund. In a brief filed with the PSC, the People's Counsel recommended that the company should maintain cash, liquid securities, or some acceptable bond or surety to assure that funds will be available to BGE customers.

People's Counsel Michael J. Travieso, whose office serves as the consumers' advocate in utility matters, said that despite these concerns, consumers still got a good deal from the settlement agreement.

"MAPSA is in the 'I told you so' camp," he said. "But the case was settled for $528 million because everybody thought, all the parties thought, that there was a significant risk in that if we litigated the case, we would not have achieved what we got in the settlement.

"Instead, we got six years of a rate freeze and a rate reduction, which was a substantial amount of money for our ratepayers," Travieso said. "We believe that, in the short term, we got an incredibly good deal for our customers."

Regulators, however, are looking for assurances that the deal they approved - including the plant transfers - will still look good after the companies split.

"When the asset transfer happened, it wasn't an important issue what was going to happen with the capital structure of BGE since it still had the support of Constellation," Hill said.

When Constellation received permission to transfer the power plants, the company pledged to restore BGE's pre-split capital structure by absorbing $1.1 billion in debt associated with the plants.

But Constellation officials said BGE was unable to transfer that debt because of a ruling by the Internal Revenue Service.

In a change of plans, company officials said, two Constellation subsidiaries issued $366 million in promissory notes to BGE and also assumed $278 million in tax-exempt pollution-control debt, the cheapest debt on BGE's books.

Company officials also told the PSC that about $470 million in debt associated with two other subsidiaries - Constellation Investments Inc. and Constellation Real Estate Group Inc. - will be assumed by the new Constellation after the split.

Those two subsidiaries will join parent BGE Corp. debt-free but the transaction will not lower the utility's debt, the company conceded.

BGE's capital structure, company officials told the PSC, will be restored within a five-year period, using a variety of methods including paying dividends out of its nonregulated affiliates, raising capital by BGE Corp. and liquidating nonregulated assets to pay off BGE debt.

"The specific methods used will depend on a variety of factors that are either unknown or uncertain at this time," Crooke said in testimony filed with the PSC. "What we have demonstrated is that we have a plan which consists of various options to allow us to re-capitalize BGE. We are not dependent on a single option."

The company's plan to return BGE to a healthy capital structure will most likely work if it is carried through and there are no unexpected problems, said consultants hired by the various Maryland agencies examining the plan.

"In the long term, the picture is kind of murky," said Hill, the consultant to the PSC. "The fact is BGE simply won't be the company it used to be. It will be smaller, it will have less equity and it will have more debt. Things can go wrong. Can a weakened BGE handle unexpected problems?

"Constellation definitely got that asset transfer in under the radar," Hill said.

In voicing that fear at the hearings, Riley asked, "How do you close the barn door once the horse is already out?"

It's impossible, industry experts say.

But Calvin Timmerman, the PSC's chief economist, advised the agency that it was not too late to ensure that the risks are minimized.

If the PSC is still not satisfied with the separation plan after its intensive review, the agency can demand certain conditions and written agreements from the company before the split to safeguard BGE's future, he said.

"You can say to the company, 'Looking down the road, we started you out right, you're going to stay that way,'" Timmerman said.

"We have some opportunity right now to shield BGE in the future. This commission has some authority over this situation."

Transformation of BGE

1992: The federal Energy Policy Act is enacted. It directs states to adopt policies leading to increased competition between power suppliers and transmitters. Sept. 25, 1995: BGE announces that it will merge with Washington-based Potomac Electric Power Co. to create the nation's ninth-largest power company. Feb. 25, 1997: BGE announces a partnership with Goldman Sachs & Co. to form a power-marketing subsidiary, Constellation Power Source Inc., to sell energy and related services nationwide. Dec. 22, 1997: BGE and Pepco abandon their merger plan after a two-year battle against rate cuts imposed by regulators and a union challenge in court. March 7, 1998: BGE announces plan to restructure company into three parts: utility, power generation and unregulated subsidiaries.

March 11, 1998: BGE pairs with Goldman Sachs again to start a national merchant energy company, Orion Power Holdings Inc. BGE owns stock in Orion.

April 1998: BGE fails to get holding company legislation to begin restructuring passed in Annapolis.

Feb. 2, 1999: General Assembly approves holding company legislation after BGE threatens to move headquarters out of state.

April 8, 1999: General Assembly passes electric deregulation law.

April 30, 1999: Constellation Energy Group Inc. becomes the holding company.

Nov. 10, 1999: Public Service Commission approves BGE deregulation settlement agreement.

December 1999: Opponents of the deregulation settlement file court appeals.

March 23, 2000: Calvert Cliffs Nuclear Power Plant becomes first nuclear plant in the nation to receive a relicensing permit.

July 1, 2000: Ten power plants are transferred from BGE to two unregulated affiliates, Constellation Power Source and Calvert Cliffs Nuclear Power Plant, with PSC approval. Beginning of deregulation in the Baltimore plan is delayed by court order.

Aug. 4, 2000: Deregulation begins in Baltimore region after court stay is lifted.

Oct. 23, 2000: Constellation announces plans to separate into two companies: Constellation Energy Group, a high-risk power generator that sells electricity nationwide and BGE Corp., a regional electric company that includes utility BGE. Shareholders will receive a share in each for every share they hold. The company also says Goldman Sachs will invest $250 million in new Constellation and that it will cut its dividend 71 percent.

Feb. 2, 2001: Constellation declares a quarterly dividend of 12 cents a share, down from 42 cents a share.

July 31 - Aug. 3: PSC holds hearings on the impact of Constellation's plan.

Aug. 14: PSC approves the accounting of the BGE plants transfer.

Aug. 31: Office of People's Counsel files a brief recommending that PSC delay approval of the separation until Constellation provides firm commitments to restore BGE's capital structure. Briefs from the PSC staff and the Maryland Energy Administration also recommend that the separation should continue, but not without firm commitments from Constellation.

BGE plants transferred to Constellation

Plant Original cost Net book value* Capacity(megawatts)

Calvert Cliffs $1.63 billion $1.06 billion 1,685

Brandon Shores 1.4 billion 820.7 million 1,300

Wagner 349.3 million 190.8 million 1,020

Crane 225.6 million 16.5 million 399

Riverside 46.9 million 25.0 million 251

Gould Street 27.0 million 3.6 million 104

Westport 13.1 million 7.0 million 121

Philadelphia Road 8.1 million 2.4 million 64

Perryman 117.1 million 76.9 million 350

Notch Cliff 16.0 million 4.1 million 128

Keystone ** 114.9 million 70.7 million 359

Conemaugh ** 97.1 million 48.9 million 181

Safe Harbor ** - 53 million 278

TOTAL $4.0 billion $2.4 billion 6,240

* Value at which plants were transferred

** Partial ownership of Pennsylvania plants

SOURCE: BGE Public Service Commission filing

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