[BETA] Fortnightly

Rural Distribution Territories: A Drag On Utility Earnings?

 

The case for selling off the lower-density areas.

The utility industry is restructuring. As companies abandon the old vertically integrated , energy-sufficient model for operation and adopt a differentiated strategy focused on generation, transmission, distribution, or services, they will also move from a stock valuation based upon dividend policy to one based upon return on assets and earnings growth. The regulatory environment is also moving away from the old rate-based mentality to a greater reliance on market forces and, in the future, performance-based distribution rates. If one looks at any other major industry in the United States, it seems clear that there will be fewer major players in the future. Those survivors will be the companies that extract the best financial performance from their assets and get the greatest multiple on their stock price.

For the companies that opt to remain in the distribution business, there will be a fairly radical change in the way they look at distribution as a business. The days of treating distribution districts as cost centers and regarding return on assets as an overall corporate performance measure has to end. Research conducted by our firm, Management Consulting Services, clearly shows that most investor-owned utilities earn an abysmally low return on assets in rural distribution territories. Compounding this problem is the fact that much of this rural territory has very low load growth. In the past, many companies justified moving into sparse rural territory to position themselves for future growth. In many areas of the country, the demographic changes that lead to that historical growth have petered out. We believe that an asset management approach to the distribution business will quickly convince financially driven companies to consider divestiture of this inherently low-return service territory.

The low return on assets in rural territory is driven by several factors which make the cost of serving rural territory substantially higher than the cost of serving dense urban and suburban load. Rural areas require a higher investment in distribution assets and are substantially more expensive to operate. This is compounded by the prevalence of overlapping and duplicative service in rural areas.

In many places outside of the major metropolitan areas, the mix of electric service territories resembles the random drawings of a four year-old. () While the investor-owned utilities and municipal utilities serve most towns and often the thin strips of highway that connect them, rural cooperatives serve everything else. These territorial assignments reflect political decisions made decades ago, not a current analysis of cost of service, return on investment, or growth potential. This vestigial definition of markets creates a huge cost penalty, which is not sustainable in a more competitive utility market. If current management doesn't react to this drag on financial performance, the managers of the companies that acquire them will.

These cost penalties result, in large part, from two inefficiencies. First, because the cooperatives and investor-owned utilities maintain separate substations, and distribution lines, the utilities suffer from a problem of duplication of costly facilities. In the most severe situations, lines