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for all three segments are nearly identical,
Electric Generating Segment
Risk vs. Concentration of Generating Assets
Median Asset Beta
High Concentration .31
Medium Concentration .29
Low Concentration .31
suggesting that the market does not currently differentiate between the risk characteristics of companies with 70 percent of their assets in generation and those with 70 percent of their assets in distribution. Going forward, the market probably should, or it could get caught again. More important, utilities should employ different asset betas in making capital investment decisions. The trouble is, we cannot directly measure the asset betas, or risk, of the functional utility segments. However, an indirect measurement will point you in the right direction.
We have calculated betas over time for the three industries that arguably can serve as proxies for the three electric utility functions: 1) independent power (for generation), 2) gas pipelines (for electric
Industry Segment Betas
Market Proxies (Medians)
Asset Equity Implied
Industry Beta Beta COE (%)
Independent Power 0.96 1.23 16.9
Gas Transmission 0.44 0.59 12.3
Gas Distribution 0.26 0.37 10.5
transmission), and 3) gas distribution (for electric distribution). Graph 2 shows the betas for these proxy industries over the recent past. The data is instructive. The independent power industry (IPPs), without a franchise, emerges as the riskiest. More interesting, IPPs have become riskier with the sunset of state-mandated contracts. The gas pipeline industry, with its various diversification schemes and vertical integration, was exceedingly risky 15 years ago. However, as that industry has begun serving more of a merchant function, the associated risk has fallen. The gas distribution industry (LDCs) operated in a relatively low-risk environment 15 years ago. Today LDCs carry even less risk, having survived Federal Energy Regulatory Commission Order 636 without much pain. (It is worth noting that a number of studies actually predict an increase in the theoretical COE for the gas distribution industry, since it can no longer count on pipelines as exclusive providers of gas. To date, however, this prediction has not come to pass.)
Table 2 shows the current asset betas and the resultant equity betas and COE for each of these proxy industries.
Taken at face value, this data implies that an electric utility with an 11 percent allowed ROE should not invest in generation, but in distribution. The flipside is even more difficult to stomach; only those companies with ROEs well above the industry average should invest in generation. An exception might exist for an electric utility that holds a very unique fuel or portfolio advantage, which it then can direct to
its generation business and can retain for its shareholders.
The stark reality is sobering: Many an electric company should exit some aspect of the generation business, unless allowed ROEs go up or that company possesses a unique skill set that can help it cut the COE.
But do we conclude that most utilities should simply abandon
a large component of rate base and employee headcount? No, although various intermediate steps can lower a utility's cost of service and COE. In sequence