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Investor Beware: Don?t Overestimate Financial Returns In a Restructured Electric Industry

Fortnightly Magazine - June 1 1998

TODAY THE ELECTRIC UTILITY INDUSTRY HURTLES TOWARD massive restructuring. This fervor is not surprising as it appears society has become convinced that market forces can work better than a centrally planned, regulated environment. This conviction draws strength from deregulation in other industries, such as the airlines, natural gas production and telecommunications.

In the electric utility industry, however, this desire for markets is encouraged by a simple but powerful reality: For several years, the marginal cost of electric production has remained far below the average embedded total cost of production. The ground has been made more fertile by a substantial surplus in electric production capacity, especially in those regions where the greatest desire for restructuring has appeared. Because of this surplus, the risk to electric system reliability inherent in restructuring is perceived as low.

We see the rush toward restructuring most powerfully in California, New England and New York (em the regions where electricity tends to have the highest delivered price. In places where delivered prices are far lower, such as in the South and much of the Midwest, one hears talk of restructuring, but the discussion seems driven more by a need to be politically correct than by any real desire to move as fast as California or the Northeast. Any serious reflection leads quickly to a simple realization: The desire for restructuring directly correlates in intensity with the price of the delivered product.

A deeper investigation of the political, regulatory and social forces that drive restructuring initiatives can reveal some important conclusions about the consumer prices and investment returns that we will likely see in these 'leading edge' regions.

On a macroeconomic plane, investors should consider this question: Will they find any substantial opportunity for reasonably attractive returns on investment?

The Political Backdrop:

Dangers for Long-term Capital

From my experience, the underlying environment (em the events that have led California and the Northeast to acquire the point-position in restructuring (em will almost certainly ensure that investment opportunities will remain poor in the short and intermediate term.

California and the Northeast have been intimately involved in utility planning for the past 20 years. Generally, these states have demanded 20-year forecasts and supply plans to meet those forecasts (em leading to a heavy, state-approved commitment to nuclear power. Why? Supply availability or local environmental regulations virtually precluded base-load generation of any other technology (e.g., coal or natural gas). Electric rates ballooned in these very states when officials mandated huge cogeneration buy-back requirements at above-market rates and enforced other regulatory directives, such as massive expenditures for conservation and load management programs (em even during periods when load growth was flat or negative. The same forces that led to the high costs seen in California and the Northeast are now determined to lower electricity costs through restructuring, even if the costs for past regulatory mandates may not be recovered.

Any investor in a restructured industry would be well advised to consider this political backdrop in weighing the possible large-scale, long-term capital commitments for electric generation. The last 20 years is replete with examples of regulatory

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