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Avoiding a Train Wreck

Fundamental issues set companies and regulators on a collision course.

Fortnightly Magazine - September 2010

such thing as a free lunch, but customers generally don’t appreciate how cheaply they’ve been served. Underinvestment has kept prices artificially low for too long. In many parts of the country, we’re still running utility infrastructure that outlived its intended life sometime last century. Utilities and regulators understand the real need for replacements and upgrades, but customers don’t understand why costs should rocket upwards for services that have remained substantially unchanged.

Second, the industry’s herd mentality guarantees that virtually every trend becomes a bubble that eventually bursts, often painfully for investors, customers or both. Previous bubbles included nuclear plant construction, and later the gas-fired turbine craze. Now it’s wind and the smart grid. Next, it might be natural gas again, as the industry stampedes toward what seems like the cheapest and easiest solution for adding clean generating capacity. But if shale gas fails to materialize in the volumes expected—or if gas demand rises precipitously, as it must with the power industry’s dash to gas—then that solution won’t look nearly as cheap as it does today.

“I don’t think the market has fully accounted for all the new gas-fired generation that’s being developed,” said Jean Reaves Rollins, managing partner with the C Three Group in Atlanta, which developed the Fortnightly 40 model and provides financial analysis for the report each year. “Well over 10,000 MW of new capacity has been announced or placed into the licensing process in the past 12 months, and we expect more announcements. The more gas-fired plants we install, the more integrated electricity and gas markets become, and the more important it becomes that we understand commodity price trends.”

Third, utility investors have become accustomed to a set of financial metrics whose days might be numbered. Those metrics were developed in a different world, when technology was more static, and the words “utility” and “risk” were strangers. And yet any utility CEO who today might dare pose a contrary strategy—one that might threaten those beloved metrics—will bring on swift punishment from Wall Street, via stock selloffs or credit downgrades.

This isn’t just the fault of utilities; it’s also the fault of a regulatory paradigm that exposes utilities to the risk of having their returns decimated every time they bring a rate case before the state commission. With such a disincentive, it’s no wonder utilities have avoided rate cases for so long. But now, with cap-ex spending likely to rise, utilities logically should be issuing new equity and tightening their dividends, to spread the costs and risks among shareholders and customers. Most companies avoid doing that because they need to maintain status-quo financial metrics, even though those metrics are based on a deferred cap-ex model. It’s a vicious cycle with no clear end in sight.

Compromise Solutions

As anyone on Wall Street knows, uncertainty is the enemy of investment, so the growing conflict poses major challenges for industry leaders. The term “train wreck,” however, implies a bigger catastrophe than we can let happen.

Just as industry precedent portends trouble ahead, it also suggests that, one way or another, we can