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The Fortnightly 100 Revisited: Do Utility Stock Prices Reflect Operational Efficiency?

Fortnightly Magazine - February 15 1999

The numbers say "yes," adding weight to last year's benchmarking survey.

Does productive efficiency help determine an electric utility's prospects in regulated or competitive markets? Is productive efficiency a better marker of real-world success than simple financial attributes, such as cash flow, dividend ratio or operating income?

In unregulated markets, higher productivity translates directly into relative declines in costs and prices, and by extension, greater ability to compete and prosper. In the regulated arena, it improves the utility's earning potential through more favorable regulatory treatment, especially under performance-based ratemaking regimes. Now, however, in financial markets too, there is ample evidence that productive efficiency can secure high marks for a utility.

Prompted by competitive pressures emanating from open access on the one hand and induced by the potential rewards of performance ratemaking on the other hand, in recent years electric utilities have begun to pay increased attention to the efficiency with which they conduct their business. Productive efficiency of U.S. utilities in the production and delivery of electric power was examined in two recent studies, the results of which were published in two issues of Public Utilities Fortnightly.fn1 Using different analytic procedures, these studies produced indices of productive efficiency for about 100 investor-owned utilities, and explored patterns underlying the observed variations in efficiency in terms of geography, utility size, resource composition and other relevant dimensions.

This article serves to extend those studies. It focuses on the implications of efficiency and productivity in terms of a utility's standing in financial markets.fn2 Using the results of operational efficiency rankings developed in the previous studies, in this paper we explore the relationship between productive efficiency and a utility's performance in financial markets. We show that quantitative measures of technical efficiency derived from formal econometric and optimization models are reasonable instruments for capturing technical and operational performance and, arguably, are very useful partial predictors of how a utility's stocks perform.

We begin with a working hypothesis that a utility's market performance depends mainly on a short list of objective characteristics: its demonstrated financial fundamentals, the regulatory and competitive settings in which it does business, resource flexibility and operating efficiency.fn3 In line with modern finance theory, we assume that capital markets work efficiently - that the market price of a utility's stock represents its true asset value. In turn, we assume that the market price reflects all relevant information and provides the necessary clues to what market participants think about corporate actions and their likely impacts on shareholder wealth. Informed either by their own perceptions or guided by the evaluations of rating agencies and other intermediaries, investors show their expectations of the enterprise's current and future levels of risks and returns by "bidding" for its stocks in financial markets.

A large number of factors, both objective and subjective, related to market opportunities, competitive position, perception of risks and operating environment are considered when investors and rating agencies evaluate the worth of a company's stocks. Standard & Poor's, for example, uses a complex set of criteria in its rating method that