As regulators continue to investigate industrywide restructuring as an answer to regional electric rate disparities and calls from large consumers for price reductions, the trend of dealing with...
Utility Finance After the TransitionJames T. Doudiet, John Higley, and Patricia Eckert
DOUDIET:Stranded investment has overshadowed other financial issues in the transition to a competitive electric utility industry. For example, what will post-transitional companies look like? Will they attract growth-oriented investors?
Utilities as monopolies enjoyed unparalleled access to the capital markets because price was based on cost. That structure assured the ability to raise funds under any and all circumstances, but it created an atypical industry. Utilities embraced financial strategies (see sidebar) that one doesn't find among unregulated firms. Prices and costs are unrelated in competitive markets; customers are not locked in.
Allow me to propose a financial objective for the post-transitional era: sustainable earnings growth. That idea is getting lost with so much attention paid to transition-period issues. Sustainable earnings growth eventually will drive valuation for utilities, just as in all other businesses. So how does financial strategy translate into value?
In the future, utility managers will find less demand for the skills they've developed (raising capital, investor relations, and the like) in the regulatory era. Other skills will take on greater importance: budgeting, activity-based cost accounting, and cash management.
On the regulatory side the concept of incentive regulation offers a road to sustainable earnings growth, but only if utilities don't lose sight of market share. Incentive regulation rewards business innovation and yet blends in regulatory oversight. It moves away from rewarding a company for a growing investment base (em and toward cost control. The addition of price caps or tolerance bands further distances regulatory oversight from the traditional concept of price based on cost.
I also think we will see a much greater emphasis on outsourcing. In the past, utilities were vertically integrated in more ways than in capital structure. They wanted to do it all themselves. But that desire stifled innovation. Few new ideas arise in monolithic organizations. To compete well demands a constant flow of new ideas from as many sources as possible. Supplier chains can add creativity to any organization.
On the financial side, debt creates an unwelcome fixed cost. So, we might expect tomorrow's electric industry to exhibit a smaller proportion of debt capital. Cash flow will be highly valued, but you need a strategy to use cash wisely. Various uses of cash will complete for management's attention. For example, should managers elect to pay dividends while postponing fixed-cost reduction? Dividend payments should fall as a percentage of earnings only if there emerges a better use for the cash. Such a strategy would appeal to new investors looking for sustainable earnings growth instead of dividends.
In telecommunications, we saw a separation of the business into high-growth and low-growth business segments. Cellular communications are a high-growth example. Almost before cellular had become a business, telephone companies spun off these operations to give aggressive investors a vehicle for rapid growth. We might infer from this that investor preference will influence restructuring in the electric business.
The traditional way utilities have achieved financial growth in the past (em earning a return on a growing asset base (em is just about done. And while cost reduction is essential for the