Investor Update

Nov 18, 2010

Good day, everyone, and welcome to the Duke Energy Ohio SSO Filings Conference Call. Today's call is being recorded. At this time, for opening remarks, I would like to turn the call over to Mr. Stephen DeMay, Senior Vice President, Treasurer and Head of Investor Relations. Please go ahead, sir. Thank you, Jessica. Good morning, everyone, and thank you for joining us today. Earlier this week, Duke Energy Ohio filed an application with the will replace the company's current electric security plan, which expires at the end of begin today's call with prepared remarks by Jim Rogers, Duke Energy's Chairman, President and CEO and Julie Janssen, who is President of Duke Energy, Ohio. Following those remarks, we will take your questions. Jim and Julie will be joined by Lynn Good, the company's Chief Financial Officer Jim Turner, President and Chief Operating Officer of our regulated business and Keith Trent, Trent, President of our commercial businesses, which includes our Ohio generation. Today's discussion is being webcast and it includes forward looking that could cause future results to differ from this forward looking information. The presentation materials, which include supplemental appendix information can be found on our website. Now let me turn the call over to Jim Rogers. Thank you, Stephen. Over the past several months, we have discussed with you various strategic options related to our non regulated Ohio standard service offer or SSO for generation services to its customers beginning in 2012. Our application request approval of a market rate offer or MRO. It ultimately will will establish market based prices would be determined through an independent competitive auction process. Obviously, this filing represents a change in direction from the ESP type structures we have proposed in the past. Yet, the change is underpinned by several important business considerations. The most important consideration is that the existing ESP structure has evolved into an asymmetrical risk proposition for Duke. Our Ohio generating assets serve as essentially regulated function by being dedicated to retail customers on a first call earn the quasi regulated nature of the ESP ensures that even if market prices were to rise in the the structure restricts our ability to increase our price to the market price when such prices are high. In this lore of negotiated rate or market framework, where our Ohio generation business is generation of our generation business. It has the potential to benefit customers and shareholders over the longer term. To set the stage for this filing, I will first review the history and objectives of deregulation in Ohio. Ohio began transitioning to a deregulated generation model in 1999 with the enactment of of stable prices for continued safe reliable electric service to Ohio customers to protect the operational and financial integrities of the utilities all the while facilitating an environment that provides competitive choices. Or from certified alternative generation providers. At the same time, each utility was required to be the default supplier for customers in the service territories. In an effort to demonstrate clear clear customer benefits, even as utilities and competitive suppliers were gearing up for competition, Senate Bill 3 mandated that during a market development period that could extend until 2,005 or until customer switching commission drew concern that customers would experience rate shock if they went immediately from frozen rates to unfettered market prices. In an effort to minimize the potential for such customer rate rate increases, Duke's rate stabilization plan allowed the company to increase its market based SSO price. Allowed for certain specific components such as fuel, purchase power and environmental compliance to be recovered. It also ensured stable prices for consumers. This regime worked well for both with safe, reliable and economically priced electric service and in maintaining the financial viability of the utility. In 2,008, the Ohio legislature passed Senate Bill 221. It continued many of the pricing mechanisms under the previous legislation. It also reinforced the recognition of emerging competitive electricity markets. Additionally, it established an option to determine customer pricing based upon competitive market prices. Pursuant to these rules, Duke At the time it was negotiated, the ESP rate was comparable to market prices. However, shortly after the ESP was implemented, unprecedented recession in the U. S. And subsequent fall in gas prices resulted in a sharp decline in power prices, leaving the company's negotiated rate above prevailing market prices. This disparity between our ESP rate and market prices has resulted in significant customer switching. It has also served to reinforce the reality that Ohio has become a lower of negotiated rate or market environment in which it will be very difficult to earn consistent and appropriate risk adjusted returns on our generation investment in the state. As you can see on this slide, we have outlined 3 challenges with the ESP structure in Ohio. First of all, the utility is not adequately compensated for its provider of last resort obligation. Under this obligation, the utility is required to provide service to customers that choose to be served at the utility standard service offer price. Also, customers who switch to lower cost providers today have a free option to switch back to the utility if market prices rise above an established SSO price in the future. A second challenge for utilities to invest for the long term in Ohio and be assured of recovery of their investments. As a result As have been bypassed resulting in less than a reasonable return on these investments. And pending environmental regulations have the potential to result in significant future capital expenditures or the closure of our older less efficient plants. The ESP provisions of Senate Bill 221 include an opportunity for recovery of specified environmental bypassable charge. However, this opportunity is only for the life of the generating facility and only if the facility is dedicated to serving the native load. For these and other reasons, the implementation of these Regardless of the form of an SSO, whether ESP or MRO, the company believes that coal ash compliance costs should be recovered from native load customers on a non bypassable basis. We are evaluating the need for legislative clarity on the recovery of these costs. Given the long term capital intensive investments for power generating facilities that are normally made for 30, 40 or even 50 years, we need more long term clarity than short term ESP plans can provide. Finally, Finally, caps the profits that utilities can earn under an ESP. Obviously, this has not been an issue for us over the term of our existing ESP, but it clearly limits the return that a generation owner can earn. Asymmetrical treatment exposes Duke to downside risk, while capping its upside opportunities running counter to the spirit of truly competitive markets. Julie will cover how MRO satisfies the applicable MRO requirements by which the commission will evaluate the filing. Before I turn the call over to Julie, I want to thank the many employees that work hard every day to provide safe and of those who have worked diligently over the past several months to evaluate our options and ultimately finalize and file our MRO application with the Ohio Commission. We still have a significant amount of work ahead of us as we move through the approval process of this application. However, this filing represents a our customers' right to reliable and reasonably priced electricity and our shareholders' need for a reasonable return on their investment. Now let me introduce Julie Janzen. Thank you, Jim. For those of you who do not know me, I'm the President of our Ohio and Kentucky utilities. And in this role, I oversee our efforts deliver safe, reliable and reasonably priced electric and natural gas service to our customers. Our organization is headquartered in Cincinnati, Ohio. I'm pleased to discuss our filing with all of you today. I will spend the next few minutes talking about the various ways to procure generation services we evaluated under Ohio Senate Bill 2 21 and address why we believe 3 available options under Senate Bill 2 21. 1st, an ESP option with pricing determined through negotiation or litigation next, an ESP option very similar to the first, but with pricing determined through a an discuss the strategic advantages of the MRO filing that are important to keep in mind. First, the MRO provisions maintain prices to customers which are fair and competitive as the auction process helps ensure customers are afforded the pricing benefits of competitive market forces. Additionally, the staggered nature of the auctions mitigates customer rate volatility. The MRO provisions continue to give customers the option to switch generation providers, which is a benefit many have exercised over the term of our recent ESP. The MRO filing also removes the asymmetrical risks Duke Energy Ohio has experienced under the ESP structure, which Jim discussed. In particular, after the transition to full market rates under the MRO, the utility is no longer subject to the significantly excessive earnings test. As a result, the MRO provides us more opportunity to capture the upside from market fluctuations rather than just the downside risk we are exposed to today. Under the MRO, after completion of the transition period to market, generation supply for our Ohio load will be secured in competitive markets on an ongoing basis. As I have already mentioned, one of the key components of our MRO filing is the blending period. This slide contains an illustrative example of how pricing is determined during the blending period. The purpose of the blending period is to safeguard customers from rate spikes and to protect the financial integrity of the utility, while customer pricing transitions to full market rates. The duration of the blending period will be determined by the commission, but cannot be less than 2 years or longer than 10 years. The a competitive market price. After year 2, the commission has discretion to alter the blending percentages prospectively in order to mitigate an abrupt or significant change in the utility's price. Our application proposes a blending period from January 1, 1, 2012 to May 31, 2014. As you will recall, effective January 1, 2012, FERC has conditionally approved the transfer of our Ohio and Kentucky transmission to PJM as well as the participation of our regulated generation in proposed the 1st year of the blending period to be 17 months, so our SSO auction periods can match to the PJM planning cycle for its capacity auctions beginning in year 2. All subsequent periods would align with the 12 month PJM in year 1 20% market in year 2 with the remaining component being the most recent ESP price. As we describe in our filing, the most recent ESP price is the price that will exist at the end of 2011. In year 3 and thereafter, pricing would be based on 100% market prices. As outlined in the appendix, our application proposes a competitive competitive auction process is similar in format to the 2 auctions approved by the Ohio Commission and conducted by First Ohio utilities. We are proposing that these descending price clock full requirements auctions are conducted on an annual basis. Once the company fully transitions its customer generation pricing to market rates after the blending period, we believe the competitive marketplace will provide adequate and affordable generation service to our customers. For an MRO filing, the PUCO must determine within 90 days whether that application meets the statutory requirements rather than the 275 days required for approval under an ESP filing. If the MRO requirements are met, the commission must approve such filing. If the commission does not deem the MRO application to be statutorily compliant, it must direct the utility as to how any deficiency may be cured in a timely manner. The commission has established a procedural schedule, which is included in the appendix to this presentation. A technical conference will be held on November 22 with hearings scheduled for January 4. In order to meet the 90 day requirement, we expect a Thank you, Julie. Before I close, I would like to briefly discuss how our generating assets fit into our MRO plans. During the blending period, we expect that Duke will supply generation to the SSO load through its legacy generation and through the competitive auction process. However, no later than the expiration of the blending period, we intend to transfer our generation assets to an affiliate outside of the utility. This request to transfer the assets will be made at a future date separate from this MRO filing. In summary, Duke's proposed MRO meets the applicable requirements. Secondly, it results in competitive rates to customers. Thirdly, it removes some of the significant asymmetrical earnings challenges experienced by the utility under an ESP. And finally, it results in longer term clarity for our generation portfolio. As a result, the MRO provides us more opportunity to capture the upside from market fluctuations rather than just the downside risk we're exposed to today. Taking together these strategic advantages increase our the the initial application has been made, we will focus our efforts on working with the commission staff, our customers and other parties to obtain approval of the filing. We will update you as we progress through this process over the next We'll go first to Greg Gordon with Morgan Stanley. Thank you. Good morning. Good morning. Jim, in the past, the current 1 of your competitors in the state attempted to achieve an MRO and was sort of directed back towards a negotiated ESP. Can you talk about the dynamic there and how what their flexibility actually is under the law and how you might deal with that? Well, my understanding is that FirstEnergy filed twice for MRO. The first time it was rejected and for a variety of different reasons. And obviously, we've studied that rejection And in preparing our current MRO filing, we have addressed those issues appropriately. In their second filing, they really it ended up being an ESP kind of evolved from an MRO into an ESP type of structure. And I think the short answer is, is the commission has been reluctant to address and to approve an MRO, but that was in the past. And I think the today we're in a fundamentally different place than we've been in the past. If I look back over the last 9 years going back to 2 1,000, the market prices have been above the prices to our customers during the frozen rate But it was a period where both the customers benefited and our investors benefited from those arrangements. Our investors benefited from those arrangements. Today, we're in a fundamentally different place. The plummeting price of power in PJM is really what has led to the switching on our system. And consequently, this much different situation in my judgment underpins why the commission will probably look at this in a different light today than it looked at MROs in the past. And as we look forward in PJM, we see the prices to be very low for the next 3 to 4 years. And so obviously, they want to give customers as much access as possible to these lower prices. Another question, Jim, that's somewhat ancillary. I know under the statutory time limit, it looks like the current sitting commission will rule on this decision. But if for some reason it were delayed, do you think that you'll have a significantly different makeup of the commission reviewing this filing if it slips into midyear? Under the law, the commission has to act on this within 90 days. And they can't delay acting beyond that period of time. The current commission in my judgment, there are no commission seats expiring with the exception of 1 of the commissioners in I think it's April. And so the existing commission assuming all the commissioners stay on the commission with the change in administration in the state, assuming they all stay on the commission, they will have to act. It will be this commission that will act on this proposal. Thank you, Jim. Thank you. We'll go next to Daniel Eggers with Credit Suisse. Hi, good morning. Good morning, Daniel. Jim, I guess just question number 1, just trying to marry the comment you said about PJM prices looking low for an extended period of time. Even you're fairly vocal about the idea of the need for the inevitable closure of coal plants and clearly you operate in a market where that would be a major impact. How do you see delivering to the commission the idea that prices are going to stay low while also talking about a fairly meaningful need for change in supply demand fundamentals in the region? I think the important point here is that we're really have been focused on the fact that our customers have a free option in this period where the prices have plummeted. And we're not compensated for anemic recovery we see will anemic recovery we see will it will the economy will come back. It's anybody's guess as to when. The shutdown of 20% to 30% of the coal plants in the United States will in all likelihood significantly affect the Midwest because that's where most of the coal plants are located. And the gas prices remain low. So you've got some factors in the future that are pushing they have the potential to push prices up like the shutdown of coal plants. If shale gas turns out to be real and not a mirage or not blocked because of environmental requirements. You could see excess gas supply, which could put downward pressure on prices in PJM, where roughly 85% of the time gas is on the margin. At least historically that's been the case. So it's my judgment Dan that if I look at the economy, maybe the best way for me to answer is to simply make this observation. When we look at our entire system demand, we it's our judgment that our 2,007 load doesn't return until 2014 or 2015. That basically says the economy is going to be very anemic during this period of time, high unemployment, low GDP growth. So we think power prices are going to be depressed during this period of time. The rules with respect to the shutdown of these plants probably won't take effect until about 2015. So when you put all this together and with the uncertainty, because the EPA will not rule, I don't believe until 2012 on the environmental aspects of shale gas. So it's sort of a wildcard in all this. But we just believe prices will be low in PJM for the foreseeable near term. Term. Okay. Thank you for that Jim. And I guess one other question. As you guys compare the MRO versus the ESP option, as I understand it, there is the option in the MRO transition instead of going at the 3rd year to 100% market, they could phase that in at 10% transition in market rates that you keep the you know, the play a transition in market rates that you keep the risk of prices staying low or going lower. But if prices go up, you get capped on a long run basis by the legacy ESP price. I'm going to ask Keith to address this. Yes, Dan. Certainly, the commission does have discretion in years 3 and beyond to determine what percentage of market versus the prior ESP goes into the pricing. We have testimony that's been filed that talks about that and talks about that beginning in that later period, you start seeing the market converge. And at that point, the customer should be expecting to pay at or near market. And so we think that it's a very reasonable conclusion for the commission But certainly, we recognize that there's some discretion there for the commission to alter that. And it's difficult for us really to speculate what they may or may not do. Okay. And just to clarify on that, I'm sorry, but with the commission when you reach an Almaro agreement, would they commit to at what year you would go fully to market? Or would that be would they have discretionary authority over time to make that decision? Yes. It's our understanding that they would have to make that determination of when we would go fully in the market. Okay. Thank you. Thank you, Dan. We'll go I wanted just to pick up on something you mentioned, Jim, early on. You talked about your view that coal ash compliance costs should be recovered on a non bypassable basis and that you were evaluating I think you said the need for legislative clarity. What how can you just elaborate a little more on this presumably means you're seeking to have legislation to that effect passed? And how would that work? Good question. Jonathan, let me turn this over to Julie, if I may. Hi, Jonathan. This is Julie Janssen. There is currently a statutory provision under the ESP that provides for recovery of certain environmental costs. And as Jim discussed in the script, the issue there is just the limitation around that recovery that those costs be post-eleven oh nine only for the life of the asset and that the assets be of the EDU. So presumably it requires that the assets be in the utility. So that's a pretty limited provision as we see it. And so we think it just certainly makes sense that we would look at the recovery of certain environmental costs such as the coal ash, regardless of whether we're in an ESP or an MRO on a non bypassable basis through some Changing. And then just separately, if I'm not wrong, if you do this blending, there is a provision for the commission to adjust the legacy ESP price for I believe things like fuel etcetera. Is there absent your proposal, 2011 for under any of those mechanisms there are in the CUNY ESP. Jonathan, during the blending period, we have an option to adjust former ESP components that would have been contemplated in the 20 11 ESP price. But what we have proposed is if the commission allows us to go to market over the period that we have set forth that we would agree to freeze those ESP components at the 2011 level. And I'm just looking for clarity on whether absent that offers a freeze that they would be moving up, down, sideways? I think that would be premature for us to talk about. I think it would be an appropriate discussion and negotiation as we go through this, but I don't have any further clarity I'd offer at this point. Thank you very much. Thank you. Thank you. We'll go next to Shar Pourreza with Citigroup. Good morning. When we met at EEI, you mentioned that other failed MRO attempts were really based on technical factors and less than subjective or arbitrary factors. Can you elaborate on what some of those technical factors were? Yes. Shar, I would refer you to slide 11 in the deck, which lays out some of the statutory requirements. And as Jim mentioned in his remarks or to a prior question, the original denial of FE's MRO filing in 2,008 was at a very different market period. And as we've seen the competitive market develop, we've seen successful auctions in the state of Ohio. As we look at these statutory requirements, we believe we can meet them. Okay. Okay, thanks. Thank you. Our next question comes from Paul Patterson with Glenrock Associates. Paul? Mr. Patterson, your line is open. Please check your mute button. Can you hear me? Yes. I'm sorry about that. I'm trying to I guess what I because it seems to be clearly this is being shopping is driving a lot of this. Can you give us a flavor for how much EPS contribution the Ohio Generation and Retail business is giving you guys right now? Paul, I would refer you to the guidance we've given around the Commercial Power segment. That's as much detail as we've given at this point. And as we about a nickel of downward pressure as a result of annualized switching. So that's what I would refer to you at this point. Okay. That hasn't changed, okay. And then when we're talking about the retail load that you have in Ohio, I know that you guys are very aggressive in terms of signing up those contracts. Can you give us a feeling for what the tenure, the timeframe of those contracts are? When they might need to be repriced? Yes. Paul, this is Keith. The tenure of the contracts for the most part have been tied to the term of the ESP. So they basically go through the end of 2011. There are very, very few exceptions to that, but you should think of all those contracts basically ending at 11%. And also that's what we've seen from contracts relating to other suppliers as well. Okay. Thanks a lot. Thank you. We'll go next to Michael Lapides with Goldman Sachs. Hi, guys. How should we think about in terms of the impact of customer switching? I'm just trying to think through the if you get an MRO and the customers that are still under the ESP will still be pricing at a blended rate, but a 10% 1 year or 20% in the next year. So those that stay at that price and we know while lots of customers switch many don't switch will still be priced at a level pretty far above market. Does the MRO effectively enable you to continue to benefit from that for another few years until you fully until every customer effectively fully goes to market in year 3? Yes, Michael, I think that's a fair assumption recognizing that switching is always a variable. But the first 17 months that we proposed would be at a ninety-ten split and then the remaining 12 months at an eighty-twenty. Okay. Thank you. Thank you. We'll go next to Ali Agha with SunTrust Robinson Humphrey. Thank you. Good morning. Good morning. In the past, Jim, you've talked about when you look at Duke as a whole, you look at it as a regulated utility, not really a merchant company or a company with merchant exposure. Obviously, as you go towards the MRO and you get to that 100% level, the generating assets do become merchant like. Has your thinking changed? And if not, should we assume that if you are to get out of the merchant side of the business that would occur once the 100% switch change in MRO has been reached? Is that the way to be thinking about this? I think our focus today is really on the MRO. I think it's premature value proposition is really predicated on the value proposition is really predicated on the dividend and the growth of that dividend and having a stable earnings stream and with minimal volatility is really the key to our value that decision until much further along in the process. But to be clear, you have the your assumption is that the approval to move the generation assets into a separate entity would happen around the same time that you reached a 100 percent MRO time period. Is that right? Yes. That's exactly right. And second question, as you point out, the blending nature obviously protects you to some extent where the forward market curves are, which are obviously much lower. But the fact is if they stay where they are there is downward pressure coming on the earnings side from the generation. Perhaps up beyond that Ohio ends up flat to perhaps up beyond 11% or should we assume that downward earning pressure in 2012, 2013 given where the forward curves are? Yes. Ali, this is Lynn. We do have a rate case plan for the electric T and D business that we would file in 2011. And consistent with what we talked about just a few moments ago, we do think the blending period gives us an opportunity to preserve earnings in the short term, recognizing that switching is always a variable. Right. Just to be clear though, TMD rate case coupled with the blending period, are you looking at Ohio as a whole relatively flat for a couple of years? Or could we assume some downward pressure net net? I don't look at Ohio in quite that way, Ali, and I don't really want to get in a position where we're giving guidance beyond what we've talked about here in 2011 and certainly for the rest of 2010. I think it would be appropriate to explore this a little further as we see where the MRO, how that filing develops. And certainly, we'll give guidance more specifically on 2011 when we come at the February Analyst Meeting. Fair enough. Thank you. Thank you. Our next question comes from Reza Hatifi with Deckade Capital. Thank you very much. The existing shop load that your retail arm has gotten that you said essentially expires at the 20 11. How should we think about the discount those customers are receiving relative to the current ESP price? Yes. Russell, this is Keith. And for competitive reasons, we don't get into specific of the amount of discount that we do have for customers that are on a plan that's a discount to the the ESP. So I really can't give you specific guidance on that. What I would say is that Duke Energy Retail will continue to a very significant part of our strategy as we go out into 2012. It will traditional native customers from Duke Energy Ohio as well as in other service territories in Ohio. Understood. And I guess your earnings CAGR guidance 4% to 6%, I think it was off of a 2,009 base. How should we think about that in relation to this MRO filing? I guess the MRO think about that relationship? We'll give, as I said a moment ago, fuller guidance on 2011 and also expectations around growth in February. We are our growth rate is primarily underpinned by the FENG business, you know, and the significant capital that we're deploying. And I think it is important for us to move through this MRO proceedings, get it to the point of approval before we can give you more specifics on expectations. Okay. Thank you very much. We'll take a follow-up question from Daniel Eggers with utility design, will you guys of the traditional utility design, will you guys prospectively take some sort of impairment or some sort of charge as you move those assets to market in a lower commodity price, lower earnings environment than you would have expected under a traditional cost of service design? I'm not going to answer that. I'm going to let Lynn do that because she's our impairment expert. I'm just delighted to be Dan as you can imagine. It's a fine title, Lynn. I thought you would be pleased with that. As we analyze the value of our assets, we look at a variety of scenarios about the future, particularly as it pertains to this business that's been changing so dramatically. We took an impairment charge during the 3rd quarter related to assets or Q2 related to assets that we saw under pressure from early retirements, etcetera. So this is something we evaluate on an ongoing basis. I'm not anticipating something unique to this filing that would impact valuation. Would you be able to request stranded cost recovery from Ohio as a result of the transition of those assets out of the rate base? I think that's something we'd have to evaluate in the future. Nothing contemplated at this point. And there is nothing in the important point to note here about the composition of Yes. And Jan, I think there's an important point to note here about the composition of these assets. We have about 4,000 megawatts of generation, 850,000 of which is unscrubbed. Those are the assets that we took a write down for in the second quarter just because of planned early retirement. The other the remaining assets are very well positioned for the future in a variety of scenarios. We don't see a of environmental exposure on those. They're fully scrubbed SCRs etcetera. So I think it's important to keep the quality of the assets in mind as you think about how we're positioned for the future. I would add one other thing to Lynn's answer and that is that we're in the process of moving about 3,700 megawatts of combined cycle gas out of from under Duke Energy Ohio and put it into a separate entity. Got it. Okay. Thank you, guys. Thank you. At this time, we have no further questions in the queue. So I would like to turn the call back to Mr. Stephen Demay for any additional or closing remarks. Thank you, Jessica, and thank you everyone for joining us today. As always, the Investor Relations team is available for any questions that you have. Have a great day. This does conclude.