The path facing Exelon Corp. and Dynegy Inc. to complete a deal announced last Monday under which Exelon will buy Illinois Power from Dynegy will become “longer and harder” for the companies if the Illinois Legislature doesn’t back a legislative proposal in the near future related to the proposed transaction, Exelon CEO John Rowe said last week.

Rowe made his comments following Exelon’s announcement that it has entered into an agreement with Dynegy to acquire substantially all of the operating assets of Illinois utility Illinois Power. The purchase price of $2.225 billion includes the assumption of approximately $1.8 billion of Illinois Power’s debt at closing, a $150 million promissory note from Exelon and approximately $275 million of cash, subject to adjustment for working capital.

Rowe noted that passage of legislation that has been introduced in the Illinois General Assembly is needed to facilitate the acquisition.

Exelon, its Chicago-based subsidiary Commonwealth Edison Co. (ComEd), Dynegy and down-state Illinois Power, based in Decatur, IL, as well as various labor, business and community groups, are supporting the legislation that would, among other things, authorize the Illinois Commerce Commission (ICC) to complete a review of the transaction within nine months. In revised legislation, Exelon recently agreed to extend the ICC review period of the deal from six months to nine months.

Exelon said that the legislation would give the ICC the authority to set rates for four years after the transition period ends in 2006, which would pave the way for stable rates for smaller ComEd and Illinois Power customers through the end of 2010. Even with a modest increase in rates in 2007, ComEd and Illinois Power’s smaller customers would still be paying rates well below those of the early 1990s, the company said.

In a conference call with investors, Rowe was asked whether a failure on the part of the Illinois Legislature to back the legislative proposal is a “dealbreaker.” In such a scenario, the process for completing the transaction “would become two or three regulatory paths and we and Dynegy would have to assess, in that event, whether we can proceed together to do this,” Rowe responded.

“Without enabling legislation that permits the ICC to handle all these issues at once, the road is longer and harder and we’ll have to sit down with Dynegy,” Rowe said.

The legislation was passed by an Illinois Senate committee last Wednesday, according to a Dow Jones report. But a spokesperson for Illinois Senate President Emil Jones told the wire service last week that he won’t call the legislation for a vote on the Senate floor until certain questions related to the proposal are answered.

Talks between Dynegy and Exelon over a possible sale of Illinois Power to Exelon were first disclosed in late September (see NGI, Sept. 29).

Each company’s board of directors approved the acquisition. The transaction also requires the approval of the ICC, the Federal Energy Regulatory Commission, the Securities and Exchange Commission, and other federal agencies. Depending on the timing of these regulatory approvals the transaction is expected to close in the fourth quarter of 2004.

The assets included in the transaction consist of approximately 40,000 miles of electric transmission and distribution lines, more than 750 miles of natural gas transmission pipe and 7,600 miles of natural gas distribution lines. Illinois Power, which has more than 1,800 employees and approximately 590,000 electricity customers and 415,000 natural gas customers across northern, central and southern Illinois, currently comprises Dynegy’s regulated energy delivery reporting segment.

Dynegy noted that the promissory note bears interest at 5% per annum, matures in December 2010 and is subject to mandatory prepayment or extension upon the occurrence of certain events, including those relating to ratings upgrades obtained by Dynegy and contingent environmental liabilities retained by Illinois Power.

“We have briefed the rating agencies and do not expect this transaction to hurt our credit,” said Exelon CFO Bob Shapard during the conference call. “In fact, we believe this transaction will improve our risk profile. The real value of this transaction is more predictable and stable earnings.”

But Standard & Poor’s Ratings Services (S&P) placed its A- corporate credit and other ratings on Exelon and its affiliates on CreditWatch with negative implications as a result of Exelon’s Illinois Power announcement. S&P noted that Exelon has about $8.5 billion in outstanding debt and trust-preferred securities, excluding about $6 billion of outstanding securitized obligations and about $1.1 billion of nonrecourse debt.

“Standard & Poor’s expects to resolve the CreditWatch listings and consolidate the corporate credit ratings of Exelon and the entity that will house the Illinois Power assets at or near the time of the $2.225 billion transaction’s consummation,” said S&P credit analyst Scott Beicke.

S&P noted that Exelon’s financial strength comes from a strong capital structure, which has been enhanced by securitization financings of $5 billion by Exelon subsidiary PECO Energy Co. and $3.4 billion by ComEd, healthy internal cash generation, a low dividend payout ratio and continued cost-control efforts.

But the ratings agency also said that adjusted for off-balance-sheet obligations including, among other things, purchased-power commitments, credit measures are expected to be weak for the current ratings, with adjusted funds from operations (FFO) interest coverage around 4x and adjusted FFO to total debt of roughly 25%.

S&P placed its ‘B’ corporate credit rating on Illinois Power on CreditWatch with positive implications. S&P also affirmed its ‘B’ corporate credit rating on Dynegy. The outlook on Dynegy and its subsidiary Dynegy Holdings Inc. remains negative. S&P said that the affirmation of the remaining Dynegy units reflects S&P’s current assessment of the firm’s business model, risk level and financial profile.

Meanwhile, in a related agreement that is conditioned upon the closing of the transaction, Dynegy has contracted to sell 6,000 MW of generating capacity to an Exelon subsidiary for six years beginning in January 2005. The capacity, which will be provided by Dynegy’s coal-fired baseload facilities in Illinois, natural gas-fired peaking facilities developed by the company throughout the region and one of Dynegy’s tolling contracts, will be used by Exelon to meet its customer demand.

Under this agreement, Exelon will purchase 2,900 MW of capacity and energy from Dynegy’s peaking facilities and the tolling arrangement. Also as part of the agreement, Exelon will purchase 3,100 MW of capacity only from Dynegy’s baseload coal fleet. Dynegy will dispatch and sell the energy from these coal assets into the Illinois wholesale marketplace. It is anticipated that this arrangement will be in place concurrently with the termination of Dynegy’s power purchase agreement with Illinois Power and the closing of the transaction.

Dynegy will use cash proceeds from the transaction to reduce debt. Assuming a fourth quarter 2004 closing, the sale of Illinois Power is expected to be accretive to Dynegy’s liquidity position and cash flow in 2005 and beyond. The company expects to incur a loss resulting from the transaction.

Credit Suisse First Boston acted as the financial advisor to Dynegy in connection with the transaction.

“We believe that this transaction will be good for Exelon’s customers, employees and investors and Illinois Power’s customers and employees,” said Rowe in a prepared statement. “This agreement has the potential to establish long-term, stable and reasonable rates for millions of ComEd and Illinois Power customers, and provide stability for the working men and women of Illinois Power. However, to make this work, we will need additional clarity and certainty after the state-mandated transition period ends on December 31, 2006.”

In the conference call, Rowe was asked to detail the anticipated level of rate increases being proposed for ComEd and Illinois Power customers over the four-year timeframe after 2006.

“The agreement specifies a point at which we could choose to abandon the transaction, but we have not developed the exact shape of the rate increase yet,” Rowe noted. “The most I can say is that it will be probably in two parts. One in 2007 and another in 2009 and that the total will be single digits. In other words, less than half of the rate reduction which was required of us in the 1997 [Illinois] restructuring act.”

Put another way, the prices “will remain more than 10% lower than they were back in the early ’90s,” Rowe said. “The burden is upon us to convince the Illinois Commerce Commission that the proposed increases would be justified both on a market basis with power and on a cost basis for the power, and also justified on the basis of all of the investments in system reliability we have put into the system over the past few years.”

Exelon has invested more than $2 billion over the past five years to improve and maintain ComEd’s electric system. Through any transaction, Exelon’s commitment to reliable electric service would be reflected in investments in Illinois Power’s infrastructure, the company said.

Exelon said that with set rates, customers will be protected against volatile electric bills. If there are spikes in gas and wholesale electric prices, Exelon bears the risk since customers will have the benefit of a stable rate. If gas and wholesale electric prices go down, customers have the option to switch to another electric company and take advantage of lower prices that competitors offer.

The transaction and related legislation has come under fire from the Illinois Citizens Utility Board (CUB). CUB Executive Director Martin Cohen recently said that the proposed transaction boils down to “locking in excessive rates through the end of the decade.”

“We have some history of finding successful outcomes with them in the past,” Rowe said, referring to CUB during the conference call. “We believe that if the legislature puts this into the arms of the commission [ICC], that we will try very hard to find effective ways to negotiate with them again.”

Midwest Generation, an Edison International subsidiary that owns several power plants in Illinois, is also “actively opposing us,” Rowe went on to say. Midwest Generation in 1999 acquired 9,287 MW of generating capacity in Illinois, constituting all of the non-nuclear generating assets of ComEd.

Rowe also noted that there are certain environmental groups “that have been asking that a variety of environmental investments be placed on the bill. We’re always willing to negotiate with them, but as of the moment there isn’t a successful outcome.” However, an Exelon spokesperson recently noted that the revised legislative proposal before Illinois lawmakers adds “a strong environmental component,” including a commitment to renewable energy in the form of a renewable portfolio standard.

Following the approvals required for Exelon’s acquisition, the Illinois Power business will retain its name and will be operated as a separate unit under Exelon’s energy delivery business. In addition, Illinois Power’s 1,800 employees will become part of Exelon.

As for the ability of the companies to close the deal in the fourth quarter of 2004, Rowe appears relatively confident that that goal can be met. “As I’ve said several times, this is step-by-step,” Rowe said. “Within that umbrella of caution, I believe we could get this all done by the end of next year, unless hearings at FERC take longer than that. But I’m quite confident the Illinois proceedings can be done in that kind of timeframe,” Rowe said.

“Again, this is one of the reasons we’re asking for the special legislation. If you have to do the power purchase agreements in one proceeding, and the merger in another proceeding and a future rate structure in yet a third, then there are pieces of this that we might not be able to get decided for a couple of years.”

Illinois Power will also join PJM Interconnection, a regional transmission organization, as a part of the acquisition. ComEd expects to join PJM next spring. ComEd will continue to serve Northern Illinois, and Illinois Power will continue to serve Central and Southern Illinois.

Trans-Elect recently filed suit in the Federal District Court of Northern Illinois (Chicago) against Illinois Power on the grounds that the utility violated the terms of a contract to sell its transmission system to Trans-Elect.

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