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Frontlines

Electricity rates may be heading skyward sooner than we think.
Fortnightly Magazine - April 2004

expenditures.

While all this may sound rather innocuous, experts say utilities should be concerned as many of the arguments I have outlined are beginning to be used in rate case proceedings. Certainly, shareholders and institutional investors are already concerned about the financial impact to utilities from possible disallowances.

The Return of Rate Cases: Investors May Not Be Impressed

Even as concerns rise over rate creep, so too do the worries of investors and Wall Street financiers, as they eye the growing number of utility rate cases.

An equity research team from Lehman Brothers, headed by Daniel F. Ford, recently released a follow-up to last year's report on rate cases, . This year's report is aptly titled,

Ford reviews 36 rate cases on the calendar for electric utilities over the next 24 months, and rates the regulatory commissions. He believes that these rate cases mark the beginning of a new cycle the likes of which has not been seen in 10 to 20 years. Further, they may well drive stock market performance for the utilities in question.

"Our review of 351 rate cases since 1986 shows that electric utility stocks underperform the group heading into cases." But Ford finds that in an environment like we have today, with long-term interest rates below 5.25 percent (for the 10-year Treasury), that such stocks tend to outperform after the rate case gets going, and recommendations start coming in from the commission staffers and intervenors.

According to Lehman Brothers Economist Ethan Harris, the current low-rate environment could continue through 2005.

"Overall," says, Ford, "we believe rate cases will serve as an overhang for the group in 2004, as 26 rate cases are in sight as we enter the year.

"Specifically, we found that when 10-year Treasuries are below 5.25 percent, electric utilities underperform the group by -8.1 percent prior to filing and in the early stages of discovery. This underperformance is reflected from the period seven weeks prior to a rate case filing to the time when staff and intervenors file positions. In this environment, electric utility stocks reach peak relative outperformance of 8.2 percent about nine months after the staff/intervenor filing. These proposals usually mark the most negative milestone of a rate case because they are made by competing and more consumer-orientated parties."

Furthermore, many companies have not had a full-blown rate case in eight to 10 years. Meanwhile, the industry has invested billions of dollars into infrastructure. Many costs such as post-retirement benefits, pensions, and environmental requirements have changed considerably as well, according to the report.

"While allowed ROEs are attractive in the industry relative to today's interest rate environment, some companies are likely to need to seek recovery of their investment through rate increases or to offset rate reductions," Ford finds.

Lehman does believe that certain utility stocks will trade at a price/book premium in constructive regulatory regions. "Overall, it seems as if the business-orientated Midwest and Southeast trade at the highest valuations, on average, and the more consumer and natural-resource-orientated New England and Southwest regions trade at discounts

"Specifically, the Midwest traded at