Ohio-based power company FirstEnergy Corp plans to buy Pennsylvania's Allegheny Energy Inc for $4.7 billion in stock to create one of the largest U.S. utilities, but regulatory hurdles loom.

The acquisition would give FirstEnergy, the company behind the massive blackout in the U.S. Northeast in 2003, additional generating capacity from newer and more efficient coal-fired plants that meet more stringent pollution requirements.

Congress is debating legislation to limit carbon dioxide emissions that will increase costs for coal-fired generation.

But Allegheny shares rose only 12 percent on the news, far short of the premium of 32 percent that FirstEnergy offered, indicating investor skepticism that the deal can be completed.

In recent years, planned mergers of FPL Group and Constellation Energy Group as well as Exelon and Public Service Enterprise Group
have fallen apart after regulatory problems arose.

Tough requirements from U.S. state regulators, who often oppose large mergers on fears that prices could rise and services could decline, have stymied a long-expected wave of consolidation in the utility sector. State regulators have sought drastic concessions in the form of rate reductions from companies planning to merge.

FirstEnergy expects the deal to close in 12 to 14 months, although that may be optimistic, one analyst said.

I think it takes longer to get the approvals, said Michael Worms, analyst with BMO Capital Markets.

Still, the deal is a good strategic move by FirstEnergy, he said, since Allegheny is cheaper than many peers on a price-to-earnings basis.

The combined company would have a power generation capacity of 24,000 megawatts and serve more than 6.1 million customers at 10 regulated utilities in seven states.

Executives at the companies said they did not foresee problems winning regulatory approval and would likely not have to seek clearance in Ohio, New Jersey or New York. In addition to those states, the merged company would operate in Pennsylvania, West Virginia, Maryland and Virginia.

FirstEnergy CEO Anthony Alexander told a conference call that Maryland and West Virginia would present key regulatory tests, followed by Pennsylvania, where the combined company would be the largest utility with over 2 million customers.

I would say we have very good relationships in those states with the regulators, he said.

But a spokeswoman for the Public Utilities Commission of Ohio said the state might examine the financing issues behind the deal, and a legal expert predicted more scrutiny than the companies expect.

It looks like there's some serious concerns in Ohio, Pennsylvania, Maryland, New York and New Jersey, according to an antitrust expert who asked not to be named. It's going to be looked at closely.

SHARE DEAL

Under the agreement, each Allegheny share would be exchanged for 0.667 share of FirstEnergy common stock. That values Allegheny shares at $27.65.

FirstEnergy will also assume $3.8 billion of Allegheny debt. The deal has been approved by the boards of both companies.

The combined company is going to have significant opportunities for growth and lower risk. It will be accretive to earnings and have a stronger balance sheet, Allegheny Chief Executive Officer Paul Evanson told Reuters.

The companies said they expected cost reductions of $180 million in first year of operations, about half of which would come from combining the generation fleet.

About 21,000 MW of its power plant capacity would be in the wholesale market, with the remainder controlled by its regulated utilities.

After the close of the deal, FirstEnergy shareholders would hold 73 percent of the combined company, and Allegheny shareholders would hold 27 percent.

The company will retain the FirstEnergy name and generate about $16 billion in annual revenue and $1.4 billion in net income.

HISTORY OF PROBLEMS

FirstEnergy has had a history of operational problems, including a transmission line failure that escalated and swept across the power grid and knocked out electricity across eight states and into Canada on August 14, 2003.

It has also suffered several problems at its Davis-Besse nuclear reactor, including a water pump emergency in 1985 and a hole in a reactor pressure vessel head that forced the shutdown of the plant from 2002 to 2004.

The company entered into a deferred prosecution agreement with the U.S. Department of Justice related to the safety violations, and paid a $24 million settlement.

FirstEnergy's Alexander said those problems have been addressed and that FirstEnergy has become one of the most reliable utilities in the nation.

FirstEnergy is a different company today. Those issues have been addressed, the company has moved on from that. It has substantially changed in terms of operations, he told Reuters.

FirstEnergy was advised by Morgan Stanley and Akin Gump Strauss Hauer & Feld LLP. Allegheny was advised by Goldman Sachs and Skadden, Arps, Slate, Meagher & Flow LPP.

(Additional reporting by Michael Erman and Diane Bartz in Washington; Editing by Derek Caney, Dave Zimmerman, John Wallace and Richard Chang)