Power Measurement

A look at issues that could keep energy executives up at night.

The most common strategic issue depriving utility executives of sleep is the looming clash of investor expectations for steady growth in earnings compared with what utilities can deliver given slow growth in customers and demand. While many dream of assured regulated rates of return, the reality for most utilities is that the 1.5 percent retail growth experienced between 2002 and 2003 will prove unsatisfactory for earnings. Wall Street expects 10 percent growth. Even with improving gross domestic product, the best organic growth we will see is around 3 percent, leaving a gap of 7 percent.

Bridging the Gap

• Ratebase Additions. On average, ratebase growth was slightly more than 5 percent in 2003. While this makes up a significant portion of the growth gap, it still leaves the industry a few percentage points short of the 10 percent target. Utilities looking to add to the ratebase by buying generation at attractive prices have found it difficult to get their state PUCs to allow them to put it into the ratebase unless they go through a competitive procurement process that demonstrates the prudence of the decision. Additionally, utilities that try to acquire assets through an unregulated affiliate face extensive regulatory attention over the affiliated transaction and whether it is sufficiently arms-length to be prudently recovered in rates.
• Rate-of-Return Hits. Utilities seeking rate increases run significant risk that regulators will respond by cutting allowed rates of return given low interest rates, lower cost of capital, lower perceived risk, and low capital investment.

Working off the excess in new generation supply brought on line in the last few years has resulted in very high reserve margins and commensurate low profitability for natural gas-fired generation across many (but not all) markets. These high reserve margins are a significant turnaround from the situation that existed in the late 1990s. Figure 1 shows cumulative load growth and cumulative generation additions since 1990 in North America. Cumulative generation additions fell behind cumulative load growth during the decade of the 1990s.

Illustrated another way, Figure 2 compares the chronology of new capacity additions by fuel since 1950. The figure is notable for two reasons. First, it compares the staggering level of building during the recent building boom to pervious years and, second, it shows that industry has relied almost exclusively on natural gas capacity to meet incremental load growth for the coming years. With this, the path toward fuel diversity for power generation has swerved. It remains to be seen how this development will play out in the market and whether increasing the reliance on natural gas fuel will have long lasting implications for other sectors of the economy.

Acquisitions

Consolidation in the energy industry is coming. Pressure to grow earnings likely will result in some consolidation in the utility and other sectors of the energy industry as investors seeking higher returns and share prices will be affected by the market perception of the growth potential of the stock.

"Back to basics" is not likely to last