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Financial News

Fortnightly Magazine - February 1 1995

reached 34.3 percent, reflecting an excess capacity of 12 percent based on a targeted 20% reserve margin at the time. Because electric generating facilities take a long time to build, this initial emergence of excess capacity appears unavoidable.

The important question, however, relates to the speed with which the utilities eliminated the excess capacity. In an unregulated industry, such excess capacity would have forced prices down precipitously. Producers would have quickly ceased adding capacity until the excess disappeared and the price recovered. In the electric industry, however, utilities failed to cut back enough to bring capacity into line with demand, and regulators did not force the issue. Reserve margin remained above 30 percent until 1988. Excess capacity of 10 to 15 percent persisted for 15 years. Construction activity continued to draw powerful support from within the organization. Management did not want to shrink it any more than necessary.

Despite the adverse economic climate, demand growth projections remained excessively high. For instance, as late as 1978, managements in aggregate were forecasting that electric demand would grow 5.2 percent a year between 1978 and 1987, even though demand had grown only 3.2 percent annually over the previous five years. Demand actually grew only 2.2 percent between 1978 and 1987. Utility managers also ignored financial signals telling them to retrench.

Mushrooming capital spending and intense inflationary pressure forced large rate increases. Capital spending spiraled from $17.2 billion in 1974 to $27.1 billion in 1979 and $35.6 billion in 1982. Annual inflation ran 5.5 percent during the late 1970s. These cost pressures forced regulators to boost electric rates 12.8 percent a year between 1974 and 1979. Nonetheless, rate decisions were miserly; return on equity averaged only 11.2 percent during these years. Utility stock price-to-book value ratios came in consistently below 1.0, implying a return on equity below cost. This low ratio clearly called for a cut in construction.

The strongest signal to cut back could be seen by the devastating effects on shareholders. Between 1974 and 1979, sale of common stock increased the number of shares outstanding by 9.5 percent a year, while almost all of the stock was sold below book value. This new equity diluted industry book value by 18 percent from 1974 to 1983. It was obvious that something was very wrong. Yet construction and stock issues continued until the mid-1980s.

We noted the problem in this column in the issue of June 19, 1980 (p. 56): "The initial emergence of excess capacity must be viewed as a product of unforeseeable events. But almost seven years later such an explanation no longer suffices. . . . Managements have . . . failed to be aggressive in slowing down and rescheduling construction . . ." In the March 12, 1981, issue (pp. 40-41), we discussed the likely consequences of the failure to cut reserve margins. The comment again acknowledged that excess capacity was initially unavoidable, but then pointed out:

"Eventually there will come a point, probably not too far away, when the persistence of excess capacity will become widely viewed as avoidable. As such