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Rate Shock: A Matter of If, or When?

Fortnightly Magazine - January 2006

clear customer benefits to more reliable, renewable and efficient energy, the resulting growth in rate base leads to a higher revenue requirement—and higher rates.

2. Fuel-cost increases . Fuel typically is the largest component of the cost structure of an integrated utility, and more than two-thirds of total U.S. generation is from coal or natural gas. In the past 12 months, the cost of natural gas has more than doubled. 2 Coal prices also have risen substantially—both commodity and transportation—and face continuing pressures on both demand and supply.

3. Labor costs . Wages, health care benefits, and pension costs continue to rise. As the industry struggles with retirements, recruiting, and the growing need for a more skilled and engaged workforce, containing per-employee expenditures has become increasingly difficult. Also, total labor costs may rise as hiring needs related to new capital projects affect the industry’s long term trend of reducing headcount.

4. Market structure and compliance costs . Transmission restructuring costs are increasing, as are compliance costs for Sarbanes Oxley, security, and other regulatory reporting. The costs of Electric Reliability Organizations stipulated in the 2005 Energy Policy Act also will affect consumers. Once in place, these are notoriously difficult to rein in. And as utilities file rate cases, regulatory and legal costs will escalate.

5. Commodity prices other than fuel . Global demand also has increased the price of many commodites used by utilities—everything from steel to gasoline. Improved sourcing and supply chain management has eliminated major costs within the supply chain, but this is being eroded, and in some cases overwhelmed, by higher material costs. This factor will be amplified in the construction cycle now underway.

6. Financial de-leveraging . Through “back-to-basics” strategies, free cash flows are increasingly staying in the core utility. As utilities focus on their core business, while preparing for rate cases that accompany capital investment, they are de-leveraging balance sheets.

The industry has a solid track record of reducing costs, and that will continue. The question is whether opportunities exist for most utilities to reduce costs in the near-term that outweigh the factors driving cost increases.

  • Productivity improvements and strategic sourcing have delivered substantial savings in recent years. Although much of the “low hanging fruit” may have been captured, new outsourcing agreements may be one way to continue improvements in cost and quality.
  • Innovation has the potential for breakthrough cost performance, particularly in areas such as demand response and distributed technologies. To deliver savings, these require regulatory approvals, customer participation and investment. Efficiency programs will also play an important role in the long term, but so far have demonstrated a slow pace of adoption.
  • And in some cases, significant savings are possible through M&A.

Unless these savings outweigh the impact of rising costs, utilities will have no choice but to pursue a regulatory path to significantly increased rates.

A Lost Art

Because of the success of the industry in reducing costs during the past 15 to 20 years, and rate freezes associated with transition periods in many states, rate cases have become a lost art. Utilities no longer