With almost 26,000MW of generating capacity, Dynegy (NYSE:DYN) has one of the largest electric generating fleets in the country. Almost half of this capacity is coal based, and with low natural gas prices and tightening environmental regulations, the challenges with this fuel have led to a difficult year for Dynegy stockholders. While these are challenges for DYN, the company has been actively responding to keep their plants open. Their coal plants are all compliant with the MATS regulations, and they are working to address some of the other tightening rules out there such as coal combustion residuals and 316(b). Dynegy does not currently provide environmental information through the Carbon Disclosure Project (CDP), but there are other ways to learn about their environmental activities. DYN’s last investor day presentation discusses many of the ways they are meeting tighter environmental standards, and there are over 15 pages discussing environmental issues in their last 10K.

Dynegy’s latest response to the challenges facing coal took place in November when they announced plans to retire the 465MW coal fired Wood River power plant. This plant is located in southern Illinois and consists of two units, one that has been running since 1954 and the other since 1964. This plant is one of the smaller units in their Illinois generating fleet.

Exhibit 1

Source: SNL, Dynegy, and Garnet Research, LLC

 

Dynegy estimates that closure of the plant will provide $80-100M in savings to the company over the next few years. DYN blamed the MISO (Midcontinent Independent System Operator) capacity auction process for the decision on Wood River. At first blush, blaming the MISO auction sounds surprising because in the most recent MISO auction the clearing price in Zone 4 (where Wood River is located) was far higher than elsewhere in the system.

Exhibit 2

Source: MISO

Based on this information it appears that Wood River would be in good shape, but the problem is that only 553MW of Dynegy’s MISO capacity actually cleared that auction, compared to 3,000MW of eligible capacity that did not clear.

 

Exhibit 3

Source: Dynegy Q1 2015 Earnings Slides

 

Dynegy says that the problem is the current structure of the MISO capacity auction rules leaves them at a disadvantage. This has only become an issue for the auction in Zone 4 because it is the only zone in MISO that is not fully regulated. Power plants in MISO that already recover their costs through their regulated rate mechanisms don’t need the capacity revenue to maintain plant profitability. These plants can bid in at minimal amounts to insure that their plant clears the auction. 

An Examination MISO’s 2015-2016 PRA Detailed Report (PRA stands for Planning Resource Auction) shows that this is exactly what happened. 5,700MW of the 8,000MW that cleared the auction bid in at a price of $0/MW-day. Another 540MW bid in at a price of one penny.

Plotting out this information you can see that little capacity was bid at the higher prices.

Exhibit 4

Source: MISO 2015-16 PRA Detailed Report and Garnet Research, LLC

The MISO report does not say which plants made which bids, but it makes sense that regulated owners would follow this strategy. While regulated generation owners end up having their plants clear the auction, it won’t create a giant windfall for them. It turns out their customers are the biggest beneficiary. For instance, Ameren (NYSE:AEE), which owns close to 2,000MW of capacity in Illinois, has to return 95 percent of any revenues resulting from the capacity auction back to customers. Even though AEE doesn’t get to keep much, it is still worth their while to participate because it helps keep customer rates lower, and lower rates help keep customers happy. There are also municipal utilities with generation in Zone 4 that will benefit customers if they have their capacity clear in the auction. Dynegy can’t bid zero in these auctions because if the auction cleared at a minimal price they would be stuck with a money losing plant with no way to recover their costs.

Potential changes to the auction would likely require some type of minimal bid, or different type of treatment for assets that already have some type of cost recovery through a regulated mechanism. This would allow the Dynegy plants to compete on a more even playing field with fully regulated plants, and likely have more plants clear the auction. MISO has acknowledged the need for auction reforms, but when and how changes would be implemented are still unknown.

Of course, the capacity market isn’t the only thing hurting the profitability of Wood River this year. Power prices in Illinois are below 2014 levels. So far in 2015 there have only been two days when the daily around the clock price has been over $50/MWh. In 2014 this happened thirty-six times.

In their Q3 earnings presentation Dynegy presented power plant performance information, and you can see the impact lower prices had on operations.

Exhibit 5

Source: Dynegy Q3 Earnings Presentation

Dynegy’s MISO-Coal plants and their IPH plants are all located in Illinois, and these plants all had a decline in their net capacity factor for the quarter vs. 2014, and they had an increase in the number of uneconomic hours.

Looking at the price duration curve for Q3 it is no surprise to see the increase in uneconomic hours for their plants. At basically all points along the curve the power price in 2014 was higher than in 2015. Exhibit 6 also shows that Q3 2013 power prices were higher than this year’s third quarter as well.

Exhibit 6

Source: SNL and Garnet Research, LLC

A number of the IPH plants seem to be in a worse situation than Wood River. However, there are factors that make Wood River a better retirement choice. The IPH plants were all purchased from Ameren in 2013.  Environmental agreements with regulators have been made with these plants as a portfolio. If Dynegy were to try to retire an individual plant it would potentially open up the need to renegotiate all of these agreements.  The IPH plants also have some debt associated with them that would complicate the retirement of one of these plants.

Wood River did not have these constraints, and there were actually new environmental decisions that made its selection easier. The EPA has been working on new effluent rules for power plants, tightening the standards for what can be in a plant’s wastewater. The EPA wrote the law to apply to smaller plants than originally anticipated, so if Wood River were to remain open it would need additional CAPEX to meet these new standards. The extra spending helped put the plant over the edge for closure.

Dynegy will file a retirement notice with MISO, which will then conduct an analysis to see if the plant is needed for regional reliability purposes. If the plant is not needed to maintain system reliability, it should be shut down by the middle of 2016. If the plant is needed, there would likely be some type of reliability must run (RMR) agreement paying Dynegy to keep the plant open. This wouldn’t be a big windfall, but it would at least stop Wood River from generating losses. This RMR would likely last for a few years until upgrades to the transmission grid can be completed that allow the plant to close without any reliability risks.

 

Companies to Watch:

Obviously Dynegy (NYSE:DYN) is the name most exposed to these developments. Changes in the MISO auction could have a significant impact on the company. If they were able to clear another 1,000MW of capacity through the auction at $150/MW-day it would provide them with almost $55M of additional revenue.

Exelon (NYSE:EXC) is also significantly impacted by these issues. Their 1,069MW Clinton nuclear power plant is located in Zone 4. Exelon has discussed the possibility of closing this plant, but issued a press release last October stating they will defer a decision for at least a year. Changes in the MISO capacity auction could allow this plant to stay open on a more extended basis.

 

Robert Howard is the founder of Garnet Research, LLC, an independent investment research and consulting firm focused on utilities. Prior to forming Garnet Research he spent thirteen years as an investment analyst at a hedge fund. He started his career as a pricing analyst and engineer at Baltimore Gas and Electric over seven years. Rob has a BS in Engineering and a BA in Economics from Swarthmore College, and an MBA with a concentration in Finance from The University of Texas. He is also a CFA charterholder.