Constellation Energy Group CEO Mayo Shattuck expects the shakeout in the energy marketing and trading business to take up to two years and to bring down several more of Constellation’s competitors in that time period.

“For those that stay, there is a legitimate role for intermediation in this business that can’t go away,” Shattuck told an analysts’ conference in New York City hosted by Deutsche Bank Alex. Brown. “There are people who need power that have to get it, and people who sell power that need to sell it to somebody and they do not want the risk management responsibilities that exist between those two. [Marketing and trading] is here to stay; we just have to get it right and appropriately regulated, and I think the [regulatory and credit rating] agencies will get it there.”

Shattuck said there will be an evolution of industry analysis by the credit ratings agencies, which eventually will break down marketing and trading companies into several categories in which certain trading platforms are evaluated based on their rules and procedures.

The ones that will be successful, he said, are those that were built on the “historic Wall Street platform,” such as Allegheny Energy, which purchased the trading operations of Merrill Lynch and Morgan Stanley, and Constellation because it bought the trading operation of Goldman Sachs last year. “These are platforms that have had 50-60 years of experience running by the rules and procedures and understanding what limits are and the metrics of VAR (value at risk). Whereas I think that the platforms that were not built with that kind of inherent risk management approach are the ones that on the edge perhaps move too aggressively — and traders will always move aggressively to find the spread.”

The ratings agencies will become more comfortable with the industry, Shattuck promised, and eventually they will be able to distinguish between the types of trading activities. “It’s going to be a difficult year or two, particularly with congressional and regulatory oversight and input into this that may well be a bit of an overreaction. We do need more regulation,” he admitted. “Let’s get out there and constructively help the industry shape the best demonstrated practices and the appropriate code of conduct and get it right.”

Shattuck, who took over as CEO last November, said Constellation always has practiced a more conservative marketing and trading method that focuses on structured transactions rather than volume growth. “We’re not trying to be a leading market maker in the volume-oriented trading business. We’re not pursuing any electronic trading platforms. We are not pursuing activities outside of North America. What we have done is to focus on long-term, high-valued sales of energy, capacity and related products for distribution companies. This sub-segment of the wholesale energy market will continue to exist as [transportation and distribution (T&D)] entities must backstop their load requirements. It’s not about high-volume trading and big market positions; it’s about disciplined analysis and customer relationship management. Our team has proven itself to be very good at it over a period of four years.”

He said Constellation focuses on a portfolio of wholesale load-servicing contracts balanced by owned or controlled generation resources. It focuses particularly on regional markets in which end use, rates and supply have been “fully decoupled;” specifically the Northeast, MidAtlantic and Texas. Shattuck estimates that Constellation has an average load servicing market share in those deregulated areas of about 9%.

He added that Constellation also has one of the strongest balance sheets in the industry with a 51% debt to equity ratio, and he expects the company to deliver 10% growth from existing assets over the next three to five years.

The company’s latest acquisition of NewEnergy from AES Corp., announced last Tuesday, will be immediately accretive to earnings and will provide positive cash flow, Shattuck said. NewEnergy serves about 3,000 industrial and commercial customers in 14 states and about 4,000 MW of electric load.

“It is a very good acquisition for us,” he said. “Though small in dollar terms, we think it’s a valuable and strategic business line extension. We already serve wholesale load for high-quality T&D business and deregulated markets across the country. We’ve been gaining experience in serving industrial and commercial customers in our home territory in Maryland… This deal helps us extend our reach nationally.” Shattuck added that Constellation snagged NewEnergy for $176 million after tax and cash considerations or about 15% of expected 2002 revenue and 7.5 times NewEnergy’s 2002 earnings before interest, taxes, depreciation and amortization.

For AES, the sale will boost liquidity and strengthen its balance sheet by releasing credit support in the form of parent guarantees and letters of credit for the retail unit’s operations. AES NewEnergy’s United Kingdom operations are not included in the deal, which is expected to close by the end of the year.

“Recent changes in wholesale electricity markets have created a situation where a national retail energy supply business no longer fits within AES’s business strategy,” said AES COO J. Stuart Ryan. “Over the last few months, AES conducted a comprehensive and deliberate sale process, dealing with several interested parties, and we are pleased with the result… This sale will allow NewEnergy to have access to the credit support it needs, and continue its terrific growth and profitability.”

AES started a major restructuring program earlier in the year under pressure from its share price collapse and downgrades from credit rating agencies particularly related to AES’s financial exposure in Latin America. In February the company cut its 2002 spending plan by more than 40%, announced plans to distance its exposure in Latin America and get out of the power marketing business. AES then sold its electric utility Cilco to Ameren in May for $1.4 billion. In light of continuing political turbulence in much of Latin America and AES’s improving, but still difficult financial position, Standard & Poor’s two weeks ago lowered AES’s corporate credit and senior unsecured debt ratings. S&P said that the downgrade was due primarily to the increasingly challenging environment that AES is facing in managing businesses in Latin America.

AES CFO Barry J. Sharp said the NewEnergy sale would “significantly contribute to improving the strength and flexibility of AES’s balance sheet in keeping with our commitment to improve liquidity. Over the past several months, we have successfully reduced 2002 discretionary capital expenditures by $500 million, while preserving a substantial amount of the long-term value of our construction program, while also identifying over $200 million in annual operating cost savings. Also, with the addition of the sale of NewEnergy, we have signed agreements that represent over $1 billion of additional cash proceeds to AES. These transactions include the announced sale of Cilco, and the completion of non-recourse financings at our contract generation businesses in Puerto Rico and Northern Ireland.”

It’s the second time in the last three months Constellation moved swiftly to take advantage of the financial fallout from the restructuring energy market. In April Constellation Power Source, a subsidiary of Constellation Energy, bought nearly 20,000 retail energy contracts being sold at auction by bankrupt Enron Energy Services, for $22.6 million. The retail contracts cover customers in Texas, Maine and Massachusetts. About 13,500 of the Texas contracts are fixed-price contracts, which represent a total load of 350 MW.

Since the beginning of the year, Constellation has reduced its work force by 900 positions and sold nearly $600 million in assets, and it plans to continue a program of selling off non-core assets while keeping an eye out for attractive properties and companies that fit its strategy. “I think there will be some interesting acquisition [opportunities], but I don’t think in this kind of environment [that] it pays to be overly brave… I think there are lot of companies out there who are very wholesale oriented, very generation oriented. We are trying to build a company that is very balanced.”

Constellation Energy Group is a holding company that includes a group of competitive energy businesses focused mostly on wholesale power marketing, merchant generation, and portfolio management in North America, and the Baltimore Gas and Electric Company (BGE), a regulated gas and electric delivery company serving central Maryland.

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