EXECUTIVE SUMMARY   CHANGES: TURN AND FACE THE STRANGE   AS MARKET CHANGES, REGULATORY PROCESSES, AND TECHNOLOGY EVOLUTION HAVE UNFOLDED, ENERGY AND UTILITY COMPANIES HAVE TO FACE THEM AND ADAPT

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With apologies to David Bowie, we enter 2015 to turn and face the strange and the opportunity of changes—changing market dynamics, regulatory models, and options for the future. Hydrocarbon prices and renewables costs are the lowest they have been in about a decade. New regulatory models are being proposed and tested. New options for the future are moving from design to test—and will be proven one way or the other. Energy utilities are confronting change and creating it, challenging it, and embracing it. There is a saying, “May you live in interesting times.” We do. Some themes that are explored in this edition include Adapting to Changing Market Dynamics

• • Low petroleum prices are having ripple effects through the energy sector, including natural gas, where they are manifesting themselves in low natural gas liquids prices and reduced oil-associated gas production—but for how long?
  • Utilities are adapting to customer and policymaker interest in green energy by instituting renewable energy

tariffs in some jurisdictions

• Also driving interest in renewables is continued progress down the experience curve due to economies of learning and scale

Facing the "Strange" of Regulation

• State approaches to utility regulation are changing, as regulators factor in a mix of policy considerations (renewables, energy efficiency, and microgrids, among others) to traditional cost-plus regulatory constructs. Different jurisdictions are using differing approaches, along a spectrum from commission-orchestrated to marketbased, and utilities are navigating and testing these approaches
• Environmental regulations are being implemented, and utilities are putting implementation plans into motion as a long-awaited rule on coal combustion residuals is finalized and contours of proposed rules governing greenhouse gas emissions from new and existing sources are finalized by the U.S. Environmental Protection Agency
• But uncertainty is high as court challenges loom on several front

Embracing Options for the Future

• Electric vehicles continue to make inroads, and utility and other companies in this sector seek the right charging infrastructure and business models
• In Germany, which has undertaken a historic energy transition from fossil-fired and nuclear energy, reliability has been maintained, although significant capital investment is required for the grid and renewable energy, and incumbents have had to adapt to a rapidly changing business environment. The jury is still out on the long-term effects of the German effort; the situation is more complex than the sound bites and headlines indicate

MERGERS, ACQUISITIONS, AND CORPORATE RESTRUCTURINGS: CHANGING OWNERS AND FORM DESPITE LOW INTEREST RATES, NO MERGER AND ACQUISITION BOOM HAS EMERGED—BUT SOME THEMES ARE EMERGING

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Selected Major Energy and Utility Transaction Announcements (Q3 and Q4 2014) September Announced: Sept. 28 Deal: NiSource spin-off of Columbia Pipeline Group Deal value: TBD (est $800M for 14.6%) Type: Gas Planned IPO in mid-2015 of MLP of 15,000 miles of interstate and gathering pipeline and 300 Bcf storage October Announced: Oct. 20 Acquirer: Macquarie-led investor group Target: Cleco Deal value: $4.7B Type: Electric Utility holding company serving 0.3M retail and wholesale electric customers in LA (mostly) and MS; 3 GW of generation capacity November Announced: Nov. 17 Acquirer: SunEdison Target: First Wind Holdings Deal value: $2.4B Type: Renewable 1.6 GW of pipeline and backlog wind energy projects; 6.4 GW of wind energy project development opportunities Announced: Nov. 30 Deal: E.ON (German utility) proposes split into two Type: Electric German electric utility proposes split into two public companies, one company focused on renewables, the other with conventional generation, energy trading, and E&P December Announced: Dec. 3 Aqcuirer: NextEra Energy Target: Hawaiian Electric Deal value: ~$4B Type: Electric Regulated electric utility serving 0.45M electric customers in HI; 1.6 GW of generation capacity Spinning off Gas Assets and Improving Project Funding

• NiSource, which owns both regulated gas and electric utilities and gas midstream assets, filed to spin off its midstream business, which is poised to invest $12 to $15 billion over the next 10 years
• Dominion Resources also offered midstream assets—principally its Cove Point LNG export project—to the public through an IPO, largely to help fund its construction

Small and Midsize Utility Acquisitions: Cash Flows and Test Beds

• Proposed acquisitions of CLECO Corp., a Louisiana utility holding company, and Hawaiian Electric Industries
• Purchasers are financial investors and non-contiguous utilities, respectively, so analysts perceive limited traditional utility deal cost-savings synergies
• Both purchasers will benefit from steady cash flows, and with NextEra’s renewables bent, the “smart deployment of capital in ways that improve the customer value proposition over time,” including testing new technologies like energy storage and studying impacts of rapid solar deployment

Adjusting to Industry Sea Changes

• As Germany’s power generation portfolio is restructured with much higher levels of renewable resources, E.ON, a major investor-owned utility, is splitting its business into renewable and conventional generation to reflect differences in risk, business outlook, and policy support

REVERSE MLPSARE BEING CONSIDERED BY SOME ENTITIES AS SOME MLPS "MATURE"   UNWINDING KMI—THE MASTER LIMITED PARTNERSHIP (MLP)

• In August 2014, Kinder Morgan Inc. (KMI) announced its plans to acquire all the outstanding equity secu Morgan Management LLC and MLPs Kinder Morgan Energy Partners and El Paso Pipeline Partners
• The deal, valued at $75.6 billion, was finalized on November 26, 2014, reorganizing as a C-corporation

TOO BIG AND OLD TO MLP?

• The rationale for the “reverse MLP” was that traditional tax, cash flow, and dividend benefits were overshadowed by high-incentive distribution rights payments and organizational unwieldiness
• According to one analyst: KMI “breaks the link to the MLP model, where quarterly distribution increases are the norm, providing eventual headroom to walk dividend growth down as the business matures and growth opportunities slow next decade”
• Interestingly, as a C-corporation, KMI’s borrowing costs were lower than as an MLP
• Others potentially in a similar position as KMI include ONEOK and William

DOWN, BUT NOT OUT

• MLPs and yieldcos are still being considered by some, including EQT (midstream gas) and Sempra Energy
• Sempra is debating the two structures for its gas, renewables, and other businesses
• Sempra says the choice of vehicle will be driven by:
  • Strategy and growth initiatives
  • Value creation for shareholders
  • Asset mix flexibility
  • Liquidity and size of investor base
  • Volatility and trading history of existing entities

“WIRES” COMPANIES ARE INCREASINGLY INTERESTED IN REITs AS FINANCING VEHICLES   ARE REITS THE NEW YIELDCOS?

• Some growth investments (renewables, gas generation) have used yieldcos for tax-efficient financing
• REITs are gaining increasing attention as attractive vehicles for projects with more stable, steady, and passive cash flow, especially in transmission
• Like MLPs, qualifying REITs are not subject to corporate income tax (although one must also check state tax laws to ensure equivalent state tax treatment)
• With IRS approval to use REITs for properties like electric transmission, transmission REITs could become a popular investment vehicle in 2015

PERHAPS, BUT THERE ARE LIMITATIONS TO WHAT REITS CAN DO

• Despite IRS approval of a wires REIT, its role must be passive
  • The REIT cannot operate the T&D system—the REIT must lease the T&D system to a lessee/operator
  • Lessee/operator of the T&D system can own only a limited economic interest in the REIT
  • The REIT’s income from the T&D system must be passive rental income; no portion of the rent can be based on the net income or profits of the lessee/operator
  • Substantially all of the property owned by the REIT and leased to the lessee/operator must be "real property"

An electric transmission and distribution system—from the busbar through and including the meters—qualifies as real property since it is “an inherently permanent structure that is not an accessory to the operation of a business” and “the system is a passive conduit that allows electricity created by a generation source to flow through the system to end-users.” -Sharyland Utilities IRS Private Letter Ruling (2007)