Ongoing high prices in PJM capacity auctions and stagnating free cash flow yields could throw a wrench into the recent outperformance of independent power producers, according to Jefferies analysts, though they added that strong demand by datacenter customers for merchant electricity supply should maintain the sector's momentum.
Since Talen Energy Corp. sold a Pennsylvania datacenter campus to Amazon.com Inc. and agreed to provide behind-the-meter power from its 2,494-MW Susquehanna Nuclear plant earlier in 2024, merchant generators' historic "[outsized] volatility" in the stock market has manifested as "gangbuster returns," Jefferies analysts wrote in a Sept. 12 research report launching coverage of the IPP sector.
Even though Jefferies attributes "fairly robust future datacenter value" to Talen, Constellation Energy Corp., Vistra Corp., NRG Energy Inc. and Public Service Enterprise Group Inc., the analysts said the next two PJM capacity auctions — for the 2026/2027 and 2027/2028 delivery years — put "the risk of state supported generation development" into focus following the 2025/2026 auction, which cleared at $269.92/MW-day.
"It is difficult to ignore if there are three back-to-back-to-back high clears with 10%-plus sustained bill increases for customers," the analysts continued. "Here it could be three strikes, and you are out for competitive markets in PJM."
As one way to mitigate customer bill increases, "states could run procurements for new dispatchable generation assets (natural gas) and compensate the local utilities for the power purchased," Jefferies analysts wrote, "keeping a semblance of competitive markets."
But investors may not approve of strategies by public IPPs to develop new generation, either.
"We and most investors look poorly upon large project risk, especially for unregulated projects," Jefferies wrote. "Even regulated projects of a sufficiently large size causes utilities to trade at weaker multiples, all else equal."
Private equity-backed Calpine Corp. recently signaled that it will explore "multiple new locations" throughout PJM to build generation, focusing on Ohio and Pennsylvania, following the auction results.
Free cash flow yield concerns
While IPPs have been repurchasing shares as stock prices continue to make significant gains in 2024, the average free cash flow yield — which compares cash available to investors after capital expenditure to a company's per-unit equity value — has fallen to 11% in early September, from 18% in June 2023, according to the report.
"We and investors are more closely dissecting repurchase actions and announcements for any signs of wavering from a steady repurchase cadence," Jefferies analysts wrote. "Any slowdown in repurchases or signaling of different priorities could lead investors to believing that management has less conviction in the risk/return of the stock."
It could also spur mergers and acquisitions activity if buybacks become a more expensive capital allocation option, Jefferies said.
A wave of utility company divestments from merchant power portfolios in recent years as part of a broader industry strategy to focus on core regulated assets has concentrated large volumes of unregulated generation in the hands of private equity firms.
In 2023 alone, Duke Energy Corp. sold its commercial renewables business to Brookfield Renewable Partners LP for $2.8 billion, while a partnership owned by Blackstone Inc., Invenergy LLC and pension fund manager Caisse de dépôt et placement du Québec acquired American Electric Power Co. Inc.'s unregulated renewables portfolio for $1.5 billion.
"It remains to be seen if private equity sees the current market conditions as ripe to explore exits or monetizations," the analysts wrote. "All the power companies have engaged in M&A in the last 24 months, so we anticipate there would be a willingness to engage."
Nuclear colocation deals on the horizon
Jefferies reassured investors that AEP and Exelon Corp.'s challenge to a proposed interconnection service agreement (ISA) between the Susquehanna plant, PJM and PPL Corp. will not prevent other colocation deals.
"We have now seen zero additional nuclear deals signed in the past six months and elevated uncertainty policy with utility challenges which has created some anxiety amongst investors, but we still expect them to manifest," the analysts said.
"Multi-unit transactions like what Constellation may be contemplating could be more protracted," they added. "With the high profile [Federal Energy Regulatory Commission] challenges and now technical conference, we expect a modest delay but fully anticipate nuclear deals to be announced in 2025."
PJM in June submitted to FERC an additional amendment (ER24-2172) to the ISA with Susquehanna Nuclear and PPL that raises the volume of colocated load under the agreement to 480 MW, from 300 MW previously.
While the filing was made after PJM and PPL concluded that increasing the colocated load to 480 MW would not create any grid stability or reliability issues, AEP and Exelon warned that ratepayers would bear another $58 million to $140 million per year in transmission system costs under the amendment. They also contend the agreement requires the plant to incur system charges from PJM.
FERC in early August issued a deficiency letter calling for more information from PJM before moving forward with the proceeding. PJM on Sept. 3 responded to the deficiency letter, and FERC's response is expected by Nov. 4.
Given AEP and Exelon's concerns, Jefferies expects cost sharing to be an issue for deals involving nuclear plants that customers subsidized with zero-emission credits to prevent from closing.
"Most of [Constellation's] and [Public Service Enterprise Group's] nuclear assets were compensated by ratepayers to prevent the retirement and/or low shareholder returns," the analysts wrote. "If Dominion Energy Inc. seriously pursues a data center at its [Connecticut] merchant Millstone nuclear plant we expect that to be noisy as well."