THE CEO POWER FORUM
Not all utility CEOs are created equal...We take this to be self-evident after the bankruptcies, ratings downgrades, balance-sheet blowups, and financial debacles that took place in the industry in the last five years.
Those utility CEOs that kept the corporate ship sailing smoothly, growing their companies right through those turbulent times also evidenced this premise.
But while it's easy to judge in hindsight those that took on too much risk, bought too many plants, failed to execute their business plans, or were too ambitious, even a management guru might be hard-pressed to identify tomorrow's successful leaders.
The "back-to-basics" plan so well executed by the utilities in restoring investor confidence (and some executives say they never left back-to-basics) has had the unwanted benefit of once again painting the industry with a broad "plain-vanilla" brush.
While interest rates stay low and economic growth advances at a measured pace, utilities will continue to be the darlings of Wall Street, as a handful of utility indexes show single, and at times, double-digit increases in the last six months.
But some financial experts say such success cannot last forever. The party has to end. The record earnings multiples or price-to-earnings ratios being ascribed to the utility industry cannot last forever, they explain, as interest rates will rise, the economy will grow, and investors will cycle their investments.
Some say more consolidation is the answer. But others say that great leadership is the key to investor satisfaction, and that their companies will continue to enjoy high valuations and investments.
So, who comprises this next generation of leadership in the utilities industry? Who might very well change the industry's investment paradigm?
has endeavored to find the "ultimate" CEOs-those who are blazing a new path for their companies and for the rest of the industry. We chose six CEOs as among the industry's brightest stars;
Mayo A. Shattuck III, CEO, Constellation Energy (Ticker: CEG)
Anthony F. Earley Jr., CEO, DTE Energy (Ticker: DTE)
James E. Rogers, CEO, Cinergy (Ticker: CIN)
C. John Wilder, CEO, TXU Corp. (Ticker: TXU)
Wayne H. Brunetti, CEO, Xcel Energy (Ticker: XEL)
Lewis Hay III, CEO, FPL Group Inc. (Ticker: FPL)
Many of these companies have bucked the industry trend and have pushed into businesses, markets, and practices that had been written off in the overreaction to deregulation. Constellation Energy's Shattuck and TXU Corp.'s Wilder are proving you can run a profitable company in competitive wholesale and retail electricity markets. Shattuck comes from the investment banking world and Wilder originally came from the oil patch, so they offer a new vision-and new language-for the industry.
FPL Group's Lewis Hay not only runs one of the most environmentally conscious companies-FPL is the largest wind-energy operator in the country-but his company is involved virtually in every competitive wholesale energy market around the country. Cinergy's Corp.'s James E. Rogers, whose thoughts on global warming are shaping the industry's view on the environment, has engineered one of the biggest mergers (with Duke Energy) in U.S. history, where he would become chief. DTE Energy's Earley shows how innovative he can be in finding new businesses and new opportunities within the utility industry, while Xcel's Wayne H. Brunetti is developing one of the most innovative technology programs in the industry.
Public Utilities Fortnightly is pleased to present the industry's ultimate CEOs.
Mayo A. Shattuck III
Chairman, President and CEO, Constellation Energy
"Goldman Sachs built the platform. They came from a world of conventional procedures and compliance, and an understanding of rule sets. Almost every other wholesale platform built in Houston and run by cowboys got out of control. "Public Utilities Fortnightly Almost four years ago, in late 2001, on the day you were named CEO, Constellation announced a very dramatic change in the company's strategy. Constellation decided to retain its holding company structure and halt its plan to split its regulated and unregulated businesses. As a result of this decision, Constellation terminated its once highly touted alliance with Goldman Sachs, buying the investment bank out of its interest of the company's joint trading operation for the extraordinary sum of $355 million. Why did Constellation change course so abruptly?
Mayo A. Shattuck III The company was a little bit later than most in respect to splitting into the merchant [business] and regulated utility. And I'd say we were later than most in getting approvals and IRS rulings and so forth. By August of 2001, it [began] to be apparent to the company that it was late in the game and that the merchants were beginning to show some stress fractures-stress fractures that people vividly now see in retrospect. But at the time it was not clear that the merchant model was about to fail. Constellation was beginning to feel those stress fractures and admitted to the [investment community] in July of 2001 that [Constellation] wasn't going to come close to meeting their forecasts.
As it turned out I was retiring from the banking world. I was on the board of Constellation for about a year. I was as a board member beginning to push on the notion of not splitting the company and putting the company at risk. When I was retiring, which was really right around [Sept. 11, 2001], the board then came to me and said, 'Would you consider coming to run Constellation?' And I said that I would do that but on the premise that we do not split the company.
Second, by not splitting it turns out that our alliance with Goldman Sachs was put in a very awkward place and they would end up with an illiquid piece of the company as opposed to the liquid piece of the spun-out company. I felt we had to buy out Goldman Sachs. The number appears to be a lot larger than it really was because part of that payment was essentially an accounts payable. It was something that they had already earned and we had not paid out. So, we paid about three times cash flow for that business. It was a very good acquisition for us. It turned out to be a home run later in the story.
As we did those things, there were three major changes; 1) management changed; 2) we elected not split the company; and 3) [we] bought out Goldman Sachs, just as Enron was about to fail. So, there were a lot of dramatic moments at the end of 2001.
Fortnightly But many prognosticators at the time felt that Constellation's announcement was a signal that the energy company would go back to being a sleepy utility. Why did the company not take that route?
Shattuck Well, we could have gone in several different directions. But with the cards we had been dealt, the generation fleet was in fact by definition merchant at that point. What had happened with deregulation in Maryland was that the plants were going to have to compete in the open market. Baltimore Gas & Electric was going to remain as the regulated utility.
But what was clear from the culture of the place. … I was very much an outsider not just to the company but to the industry. The whole mindset of the industry at the time was making electrons and pushing them on to wires. There was no mindset surrounding the other end of the value chain-the customer end. I noticed even we had a mindset-I call [it] "generation-centric"- [and] they felt that capturing the customer end of the value chain didn't matter because at the end of the day they'd always just be making electrons and someone would buy the electrons. What I did at the time was push the organization to understanding whether it was worthwhile building a model around the customer end of the value chain. By that I mean we had a lot of wholesale customers buying electricity from us in other markets like in New England. Our wholesale platform that had been built with Goldman Sachs was really working pretty well, even though people perceived that part of the business as [similar to] trading like Enron. Ours really was not.
We reduced all directional or proprietary trading and focused the business on essentially structured products for other wholesale customers. So, we would sell power to Central Maine Power and those that, like municipalities, didn't have generation. In that way we were able to build a real business that had a certain element of scale to it. We believed that if we could get big enough region-by-region there would be certain scale advantages to being large. And all of the other companies were then going back-to-basics.
As we started this part of the journey, Williams started going down. Reliant. El Paso. There was a collapse where we were able to get into all of these other regions by virtue of buying contracts from others at ridiculously low prices. So, we decided to essentially go for scale at a time when everyone else was retreating, feeling that not only was it a real business, but a business where the scale advantages would manifest themselves later on.
Fortnightly How were you able to go in this direction given the ratings agency pressures on the utility industry to exit this business?
Shattuck There was some luck involved. There were some timing advantages in the sense that we recognized the failure of the so-called merchant model earlier than others did. So, we quickly re-capitalized the balance sheet.
When I joined we had a $5.5 billion dollar bridge loan on our books, which had we not re-capitalized right away it would have been a disaster. So, we re-capitalized the balance sheet early and finished by the beginning of 2002. We sold off almost $1 billion of non-core assets. We did everything possible. This was our version of back-to-basics, which was, let's just do energy as opposed to real estate, assisted living centers, and leasing deals on airplanes and things. At the time, we used that expression, 'We're going back-to-basics.' But we didn't mean it in the same way that the industry has now coalesced around back-to-basics being back to regulatory routes. We are now 80/20 the other way-non-regulated/regulated. And no one else had taken that course. But we felt that there was going to be a market vacuum. We went to fill the vacuum and everything was cheap, so we could buy our way into our positions pretty quickly and cheaply.
Yes, it was very much contrarian, but we had a lot of confidence in the fact that the wholesale model worked. To the extent that that was working by the middle of 2002 we started thinking, you know what, we should go down to the retail level. Retail was actually a dirty word at the time because people didn't believe that there were retail models that worked. We coined the word from other industries-actually the commercial and industrial business-"competitive supply." So, we went out and bought New Energy in 2002 and decided we would bring this apparatus, this big risk-management enterprise, down a level to compete for large retail and industrial customers. That has been a home run.
Fortnightly But do you think you are coming full circle to reconsidering the decision that you made in 2001? Do you feel you are not getting full credit from investors for the high growth in your unregulated business precisely because it is tied to a low-growth regulated utility?
Shattuck That's a very important question. I've spent my whole life in the capital markets and I felt very strongly that we were not going to chase [price-to-earnings] strategies. If we were chasing P/E strategies we never would have done what we did because everyone essentially felt that so-called trading operations were going to sell at a hugely discounted multiple.
Our view was, first of all, to convince people that it wasn't trading per se. It was a customer-driven structured products business. But it would take a while for people to grasp what that really was. It is a complicated business. It's much more complicated than any other commodities business because of the physical aspects of delivery. Our feeling has been that over time the capital markets will reward us for a unique strategy that is working. We have to build the credibility of making our guidance. It was painful for knowing that the skepticism was high. As you say now, three years later, people understand it, they now give us a premium multiple for it. But at the same time, I'm not inclined to think disgorging our regulated utility is the right thing either. It is prudent, we think, to have a balanced portfolio. I bet we spend a long history debating how balanced that ought to be. But the fact of the matter is, it is a good cash-flow balance to the overall portfolio of businesses.
Fortnightly How do you propose to maintain consistent 10 percent annual growth per share? Many industry analysts believe you have set quite a high standard for yourself.
Shattuck It is a high standard for this industry. It is not really that high a standard for an average American company. So, having come from the world of growth companies in my prior investment banking life, I sort of find it a little bit amusing how challenged I am on that subject. That is why the annual report tries to hit it straight on. The components of growth, we do have a natural organic business where we can build market share against others. We have proven it now for almost four years. The platform is getting bigger and deeper, more regions and more products. Our retail business is now three times larger than the next closest national competitor. The wholesale business is number one in its category (FERC-related volumes). There are certain scale advantages to that, where if you keep lowering your cost structure you are going to be able to drive your penetration. So, that is one-third of the growth. I don't know if it is one-third of the 10 percent. But obviously it was a big contributor to the 17.5 percent [net income] growth rate last year.
Fortnightly There's been lots of talk over the years of what a utility can and cannot do. Why do you think you were able to push ahead into merchant trading, particularly at a time when so many utilities were exiting that business?
Shattuck One of the big advantages that we had was that Goldman Sachs built the platform. They came from a world of conventional procedures and compliance, and an understanding of rule sets. Almost every other wholesale platform built in Houston and run by cowboys got out of control. It got out of control because they didn't have the conventional practices in trading like Goldman had. So, as a consequence, we didn't have a single problem during the California crisis and issues of disclosure. We were very fortunate because of the heritage of the trading platform to be in that position. And I think that had a lot to do with our ability to be a consolidator early because we weren't defending ourselves against prior bad practices.
Fortnightly A lot of people still do not understand how the merchant trading business works. Many view merchant trading as a low-margin business. And the investor community has often highlighted their concern over Constellation maintaining its $3 per MWh margin. Could you explain the way you make money and what the risks are?
Shattuck It's a risk-intermediation business. We are the ones forcing the margins down. We're doing it because we believe the most viable long-term strategy is where our scale provides us with a relative cost advantage to our competitors. We have built a very large platform and essentially what we do is sell power under various formulations, terms, and conditions. Given that position, and I can name 15 different kinds of risks associated with it, we are off-loading the risk of that customer who doesn't want to have to deal with price, weather, load variation, congestion, etc. We are taking all of those risks and absorbing them ourselves. Then, to hedge our positions, we procure the corresponding hedge, which, again, has many elements of sophistication to it. That procurement process actually allows us to garner more margin often because we are also providing a service to the generator who doesn't have any front- end sales competency.
So, if you are a generator and you are sitting on power length, Constellation comes to you and says we can essentially serve as your front-end sales arm. We are going to take all this length and we are going to bid a certain price, say below market, but at the same time the generator is saying, "Good for me. That provides me a service because I don't have to worry about the sales process and hedging techniques."
So, as a consequence, on both ends of the spectrum there are customers. We are simply intermediating. And our ability to manage the book of business as it gets larger and larger is a key skill set that is going to be hard for others to compete against given that fact that, yes, we can compete at lower margins than others because we understand the risks involved and we understand essentially how to manage the book. So margin pressure is something that the market does make noise about or seems concerned about. But at the end of the day, we are managing to a certain level of understanding in this realm.
That is what intermediation is in any trading business. It's fine that people worry about it. Maybe it will keep others out of the business, although frankly, we do want a certain number of people in the business to increase the viability and the liquidity in these markets.
Fortnightly Many utility company CEOs are contemplating mergers in the hopes of achieving greater scale and scope. Are you concerned that such mergers could stifle competitive energy market development and affect your business model?
Shattuck We're probably the only company with a perspective that scale is important in this part of the business. I think most companies are thinking about fleet management more than anything else. For example, buying more plants and being able to manage them more efficiently. I'm sure you've heard the axiom that the Japanese have seven utilities for half of the population of the United States, and we have 100. So, people suppose that consolidation should and will happen, and I fundamentally believe that too, although the regulatory overlay is so constricting that it is not going to be easy.
Also, because of the execution risks, people will be afraid to take that step. But I do think that it will happen over time, like the Exelon-PSEG merger, and it will happen because there are scale advantages in virtually every business that you can think of.
Fortnightly What is your comment on Entergy's recent ICT proposal that introduces RTO-like principals to Southeastern markets? As you know, Entergy's proposal differs greatly from the Midwest and Northeast RTOs in scale and scope.
Shattuck I think that every effort that leads toward opening the markets is a good one, and it is going to come in fits and starts. It's going to come through concessions to FERC and consolidations. And it is going to come from states getting braver again and embarking on what is a very complicated transition. I think the forces will be there. We have to take the little victories as they come. It is not going come in one massive sweep. N
Anthony F. Earley Jr.
Chairman and CEO, DTE Energy
"To enhance that natural utility growth of around 2 percent per year, we want to surround the utilities with a portfolio of non-utility businesses that have higher growth prospects. "Fortnightly In your letter to shareholders, you speak of the company receiving 30 percent of its earnings from non-regulated businesses. Please explain.
Anthony F. Earley Jr. That is our target. Actually in 2004 it was just over 50 percent of our earnings. That was a bit of an anomaly. In 2004 we were working our way through both gas and electric rate cases, so our gas and electric businesses were under-earning. We're through the electric case, and once we get through the gas case and we get back to a more normal year, we expect that our non-utility businesses will be to 30 to 40 percent of our overall net income. Our strategy is really to have a diversified energy company that has a good solid utility base but is augmented by the higher-growth prospects from our non-utility businesses. And we've been successful over the last decade in building that business. It supplied $240 million in net income to us in 2004. And we expect that would grow to $300 million in 2005.
Fortnightly How do you believe your company distinguishes itself from its peers?
Earley We distinguish ourselves because we announced the strategy that we have been following in 1997. And we may be the only company that hasn't changed its approach in the last eight years. You have seen people swing from, "We hate the utility business and we are going to sell everything off," to "Now the back-to-basics, we are going to sell all the non-utility businesses off and go to our utility roots." Our strategy, as we announced in 1997, and we continue to believe in because it has been successful for us, is that you have a strong utility base. We think the utility business is a good solid business to be in. And that type of utility base supports an attractive reliable dividend for our owners. But the utility businesses by its very nature only grows in the order of 2 percent per year, no matter what you do. Back in the 1990s people were saying their utilities were going to grow at eight or 10 percent per year, and we all found out you could only do that with smoke and mirrors.
To enhance that natural utility growth of around 2 percent per year, we want to surround the utilities with a portfolio of non-utility businesses that have higher growth prospects. But we look for several important characteristics in those [non-utility] businesses.
Fortnightly What important characteristics or criteria do you look for before you invest in a non-utility business?
Earley They generally are closely linked to the core skills and assets that we have developed in our utility business. For example, we are a traditional coal-burning utility and a major player in the coal markets. Many of our non-utility businesses relate to the coal business.
Second characteristic: large energy-intensive customers. We are a company that has a tradition of supplying steel companies, auto companies, major users of electricity. So, many of our non-utility businesses are around services to those large energy-intensive customers. Third, we continue to be fairly geographically focused because we do believe that energy markets continue to be regional and not national in scope. We generally focus on the industrial Midwest, though we are starting to branch out a little bit from that East and a little bit down to the industrial South, but [we are] largely focused in the Midwest.
And finally, we are focused on non-utility businesses that have attractive competitive dynamics. By that I mean business lines where there might only be two or three competitors, not 20 or 30 competitors. Back in the day when people were putting power plants on the market, and all of these people were bidding for them, we decided that you are never going to be able to build a business by going out and being the highest bidder on one of these things and trying to make money off of it. For example, we provide energy services to a number of auto companies-compressed air, steam, chilled water-those sorts of energy services that not a lot of people are talking about but can be very lucrative. We did a deal last year. It was a $300-plus million deal with DaimlerChrysler to supply energy services at eight Midwest facilities. So, it is that kind of non-utility business that we are focusing on…
Fortnightly Of the businesses that you have, what are the top three earners, and how do you think that will change in the next five years?
Earley Good question because it is going to change. Around half of our net income comes from our synfuels business. Synfuel is the production of coal fuel from marginal useable coal. It is the stuff that might not be shipped. You mix it with good coal and you process it into charcoal-like briquettes. This is then a very useable fuel. Because of the perceived benefits of using this marginal coal, Congress authorized tax credits for this. We have a number of synfuel facilities that produce synfuels and a large number of tax credits. We use some of the tax credits ourselves. But largely we sell off interest in these plants to companies that can use the tax credits.
Fortnightly The Internal Revenue Service (IRS) has recently placed the synfuel industry under a microscope, questioning the scientific validity as to whether the companies are meeting the criteria to claim tax credits. How did the recent IRS initiative affect DTE Energy?
Earley It didn't affect us at all. As long as you follow the rules, you are entitled to the tax credits. The problems that came up were people that didn't follow the rules. One of the requirements was that you had to have the facility in-service by a certain date. So, if you didn't meet the in-service date, you didn't qualify. Also, you had to make sure that in fact you weren't just taking this marginal coal and the good coal and just kind of throwing them in together. It actually had to be processed into a new form of fuel. There had to be a chemical change in the fuel. As long as your process met this chemical change test, you qualified. Many people were not meeting the chemical change test. Those were the problems that you saw. Those of us that met all of the requirements are entitled to the tax credit. We have been audited by the IRS and they have signed off on our processes.
Fortnightly The other discussion that has taken place in the financial community in terms of synfuel has been what happens when the synfuel program winds down. How do you make up for those earnings?
Earley In 2007 the tax credits end. Some of the cash will continue to come in into 2008. But the way you can look at it is, about $1.6 to $1.7 billion dollars in cash will have been generated for us between now and 2008. Our business challenge is to take that $1.7 billion dollars in cash and reinvest it in our other businesses so that it generates new cash and new earnings for us in the future.
You ask [about] our mix of businesses. That is our largest. In 2008 it's gone, and something else has to take its place. Probably our second largest line of business now, what we call onsite energy services, are energy services for large energy-intensive customers. It's supplying pulverized coal to steel plants, energy services to auto-manufacturing plants, and the like. Last year we bought the energy facilities at eight Daimler-Chrysler plants and [began] selling them compressed air, chilled water, steam, waste-water treatment services, and the like. The pulp and paper industry-we're starting to get into that. That is an intensive energy industry.
Another area that is one of our significant but smaller lines of business right now, is the area of non-conventional gas production. Non-conventional gas production is the production of gas from generally shale formations or coal formations. We produce natural gas out of what is called the Antrium shale formation located in the northern part of the lower peninsula of Michigan. You can think of it as a rock formation that is like a sponge that has natural gas in it. It's not the traditional natural gas bubble that you might drill for in the Texas Gulf coast.
We think there are significant opportunities in newly discovered shale formations, one of which is called the Barnett shale formation in the Dallas/Ft. Worth area. A number of financial commentators have written it up as the next big producing area for natural gas in the United States. We expect that this is a business that could produce between $25 and $50 million in net income for us in the next five years or so. Right now our non-conventional production is in the $20 million range. We would double or triple the size of that business.
Fortnightly Some financial analysts have called on DTE Energy to sell its non-conventional gas production business because of the volatility in that business. Certainly, many other utilities have changed their business plans because of peer pressure from the financial community. What is it that utilities can do? Do you feel pressured to sell that business?
Earley I think utilities have to understand what their core skills and strengths are. And I think we have demonstrated that this unconventional gas production is one of our strengths. We have been in the business through our Michigan Consolidated Gas company, and their former parent MCN, for years and years. This is not something new that we are getting into. We are one of the respected producers in this. So, this is an area we know a lot about. I agree that there are some businesses that utilities shouldn't be in. It takes a really hard examination of what you do well and where you add value and what you don't. We think this is where we add value. The one commentator that has suggested that we sell it is a commentator that has urged a number of companies to have large share buyback programs. They would prefer us to buyback our shares. I don't think that is a growth strategy. That is a very short-term finance strategy. There may be some opportunities to use some of this cash to buyback stock, but we think it is better to reinvest in businesses that will produce income for us over the next 10, 15, 20 years. The nice thing about this unconventional gas area, the gas tends to be produced over a long period of time. It doesn't flow as fast as a traditional gas well. But flows in over a long period of time. I think that fits well with the basic utility structure of stability.
Fortnightly You are one of the few utilities to have sold your transmission system for several times book value. In fact, many were expecting a transmission asset-selling wave, particularly after FERC announced special incentives for this type of transaction. A lot of utilities out there probably want to know; how you felt about the sale? What did you do with the money? And, why don't you think other transmission systems have sold?
Earley We're thrilled with the sale. You're right, we got over two times book for it. Anytime you can do that that's a pretty attractive deal. It was in part prompted by the incentives at FERC. It was also prompted by our own strategic review. Given the geography of Michigan, we didn't see growth opportunities in transmission. We got a nice return from that business. But we thought we could deploy the money in better ways in the future. So, we're thrilled to get two times book. That money has gone to things like continuing to strengthen out balance sheet and investing in the types of businesses that I talked about. Why haven't more transmission businesses sold? As you may know, FERC got involved and proposed a very extensive change in transmission rules. That got hung up over a lot of regional opposition from the Northwest and South. I think that lack of clarity about what the requirements were going to be for transmission systems have slowed any efforts for people to buy systems.
Fortnightly What is your view of retail competition?
Earley Retail competition has had an impact on us over the last couple of years. It started in 2003 in Michigan. We had had almost a decade of steady growth at DTE Energy. Then in 2003 and 2004 we saw our earnings slip in both of those years, some of it driven by health care costs and pension costs, but largely by electric customer choice. We lost over 20 percent of our customer load. A lot of it was driven by the fact that the legislation had designed into it some subsidies to encourage the start of the marketplace.
Second, the design of rates in Michigan traditionally had what's called skewing in it-that certain rate classes really subsidized other rate classes. It was commercial, and industrial was subsidizing residential. The Public Service Commission last year took some of the initial subsidies out. As the market got started, it got overheated. It was one of the hottest choice markets in the United States. They concluded that you don't need all of these subsidies. And so when they were taken out, you started to see the choice market stabilize.
The second piece they said was, "We've got to get these inherent subsidies out of the rates and everybody ought to pay for their fair share of the transmission system and the cost of running the utility in the state." That so-called de-skewing case again will help us to where there will be a level playing field once we get through that case. So, while we were hurt in 2003 and 2004 by customer choice, [and] it still is having a negative impact on us, I think we are going to start to see those negative impacts reduced as we get through this case.
Fortnightly You have managed to cut $100 million in costs. How much more can you cut, and how do you propose to do it?
Earley This year we are looking at cutting probably $125 million out of the system. You have to remember that on the other side of the ledger, health care costs continue to go up very significantly. On the operating side of the business, we have adopted the DTE Energy operating system, but it is really modeled on the Toyota operating system: driving a culture of continuous improvement down to the shop floor. This is a technique that Toyota perfected in the 1980s that the auto industry struggled to catch up with. Many auto companies and suppliers and many industrial companies now have found the only way they can continue to cut costs is not to cut things out but to do things more efficiently. And the way to do that is through engaging your workforce in issues that reduce costs.
For example, I was recently over at our electrical shop where we overhaul transformers. It used to take 30 or 40 days to go through the process of overhauling the transformer. We turned our shop loose and let the people on the shop floor redesign how we did it. We used to have to move the transformer around the shop half a dozen times. We would have to move it to where it was disassembled, then to where it was reassembled, and where it was tested and painted and the like. They totally redesigned the process. Now we can overhaul a transformer in five or six days rather than 30 or 40 days, and all due to really getting people involved in redesigning their work and taking ownership of it. It was that type of thing we're driving across our company and it is yielding huge benefits.
Fortnightly DTE has various investments in energy technologies. How have these technologies progressed?
Earley You have to separate them into a couple of pieces. Our Plug Power fuel cell company investment continues to be attractive for us. We sold off a position in some of our stock in that business to generate some cash. That was a very profitable transaction. We generated about $25 million in cash out of that and sold that at a profit. Our DTE Energy technology company continues to lose money. We're hoping to get it into a breakeven position in the next year or two. We had actually expected it to be break-even in 2003 or 2004. What has hurt us there is natural gas prices. A lot of these technologies rely on natural gas as their source of fuel. They are very competitive at $2 and $3 gas, [but] they have a real problem competing at $6 or $7 gas. So, while we still believe energy technology has a future, some of it has been hurt by the run up in gas prices.
James E. Rogers
Chairman, President and CEO, Cinergy
"Given that we and other utilities are involved in planning to meet other pollution regulations, as well as soon adding new generation to meet growing demand, we need greater certainty regarding what these CO2 regs will require."Public Utilities Fortnightly What has caused Cinergy to get involved in the global warming and sustainability issue?
James E. Rogers We accept the science of climate change as expressed by the National Academy of Science report made to President Bush in 2001-the earth is warming, it will likely continue to do so, and human action is contributing to this. We think it is a problem that will require some action. We'd celebrate if new evidence strong enough to prove this wasn't happening should appear, but the skeptics have been working on this since the early 1990s and have yet to defeat the theory. Unable to defeat it via the peer review process, the "no club" has taken to claiming the entire process has been corrupted by group think and the scramble for funds. In science, great status comes from disproving a generally accepted theory. We think this ethic is still strong enough that if climate change could be disproved, it would be.
Fortnightly Why is Cinergy, a company that uses significant amounts of coal to power its electric plants, engaging in a discussing on greenhouse-gas emissions regulation?
Rogers We think Congress will eventually pass laws to regulate CO2. If you read the signposts, action is imminent. There have been state actions that require reporting and capping of greenhouse-gas emissions. There has been an increase in support in the U.S. Senate for global-warming concerns. Add to that the approval of the Kyoto Protocol by 38 industrial nations, and a growing number of shareholders are expressing interest in companies quantifying the risks associated with greenhouse-gas emissions. Not to mention, we have seen the development of CO2 and greenhouse-gas emissions trading markets in Europe and the United States and the increased media attention on the issue of global warming.
Given that we and other utilities are involved in planning to meet other pollution regulations, as well as soon adding new generation to meet growing demand, we need greater certainty regarding what these CO2 regs will require. Sooner would be better than later because of the massive amounts of investment capital soon to be deployed in new coal plants. When we make such large investments (about $1 billion for a coal plant), utilities and state regulators have to look at prices going out more than 20 years for fuel, allowances for NOx, maybe mercury, and electricity prices when we decide whether or not to invest. If and when CO2 hits, that will be another input to companies' financial models. We are including some CO2 in our analysis as sensitivity runs, but it is very fuzzy now. The vital question is when, and how much. This is what we think needs to be resolved. There are a lot of conventional coal-fueled power plants on the drawing board now. Greater price certainty for CO2 would greatly increase the odds these would be clean-coal plants.
Fortnightly What do you see as the solution to climate change in the electricity sector- IGCC, DSM, renewables, LNG, nuclear?
Rogers Coal will be part of the solution. It is the most available and least expensive energy source available to us now. We're confident it will remain so, even after you factor in the future cost of CO2. This will require new technology to efficiently convert coal to electricity and then capture the resulting CO2 and put it into geologic formations similar to those that have held natural gas for millions of years. We think the best approach now is IGCC (integrated gasification combined-cycle), where coal is converted to a synthesis gas of hydrogen and carbon monoxide, then burned in a turbine to create electricity. Other technologies like ultra-supercritical (very high temperature and pressures) may also work, but they are not as far along the development timeline.
We're told IGCC and carbon capture and storage is a very plausible approach, but obviously it hasn't been commercially deployed because it isn't without cost. Proving this technology represents a massive public good, for consumers, coal people, and environmentalists. Therefore its development should be supported with public money. Cinergy would like to be a partner in moving this forward, and already has a site picked out in Indiana on top of what is supposedly a terrific geologic formation. We're working with GE and Bechtel to make this happen. This technology may be the best source for hydrogen too for power vehicles. This is terrific opportunity for coal.
Fortnightly What is your view on renewables and conservation? What role do you think it will play?
Rogers Renewables and conservation will play an important role in a low-carbon future, but they should be brought on board as it makes economic sense, not forced ahead of time by mandates. As an example, we purchase five hybrid vehicles from Ford and Toyota for our fleet to give our folks exposure to this technology. These are terrific vehicles, but when we determine the costs of the CO2 reductions they make it's on the order of $150/ton. The CO2 price needed to make an IGCC plant a good investment is between $25 and $40/ton. From a carbon point of view, IGCC is the better investment. Technology mandates, whether for renewables or hybrids, risks spending a lot of money on one technology before the less expensive alternatives have been exhausted.
Fortnightly What approach to global warming would you recommend to regulators and policymakers?
Rogers We would prefer that legislators keep the following in mind when dealing with this problem. The economy is highly dependent on low-cost, high-CO2 energy. Therefore, we have to develop policies that have the least economic impact. We don't want to be required to install a particular technology. We prefer a market-based solution like that used to address acid rain, based on a cap-and-trade of CO2. This is the least cost, most economically efficient way to deal with emissions. The last thing we want is a mandate to apply a particular fix. With a market-based approach, the emission just becomes part of the financial calculation and pollution goes down.
The path for CO2 has to be to slow, stop, and then reverse growth of emissions - you don't want to just slam your car in reverse while cruising down the highway at 65 miles per hour. Therefore, we like an approach that has received a lot of attention by some prominent economists at Resources for the Future and the Kennedy School of Government and the bipartisan National Energy Commission-mainly a cap-and-trade, with an escalating price cap during the early years of the program. This would make the emissions cap "soft," meaning it could be exceeded in the early years of the program. This is much more cost-effective, lowers the risk of economic shocks and political rollback, and in the long run achieves 90 percent of the reductions of a pure cap.
Fortnightly What is your view on administration efforts to deal with the global warming issue?
Rogers The administration is actually doing quite a lot. Voluntary programs like President Bush supports are a terrific start. We've pledged to reduce our emissions to 5 percent below our year-2000 level by 2010. These programs get companies to begin thinking about the problem without forcing premature action. Forward-looking firms have begun to act. A voluntary program though will only get reductions that probably should have been made anyway-small items with some profit potential because of energy savings. No one will make the big money investments needed to build an entirely new energy system that the climate change problem will ultimately require unless they have a CO2 price signal that makes this a profitable move.
The administration is also working to provide funding for new technology development, sort of priming the pump to give us a head start. These technologies will be further developed and then ready to be widely deployed once we are required to make significant reductions, which will happen eventually. It is unlikely though that these new technologies will be widely adopted outside of a CO2 control regime because they often can't compete with current generation technologies that are well understood and fairly reliable. The administration is also providing a good deal of funding for ongoing climate research, and they should be applauded for this too. People may not like some of what is happening, but they should be willing to provide credit where credit is due.
Fortnightly One of the chief complaints by those that oppose U.S. action on global warming is that China and India, two of the biggest contributors to climate change, are not talking of participating. What is your view of this criticism, and how could they participate?
Rogers China and India have to be brought on board. We must be able to source carbon offsets (or create reductions) from these countries where they will likely be less expensive because of efficiency differences in some sectors. We don't see them as barriers but as future markets to buy low-cost reductions and to sell the technology solutions that will be developed here in the United States. Harvard's Stavins suggests the key may be in a trigger mechanism where developing countries agree to binding commitments once GDP reached an agreed level. Alternatively, growth targets could be used whereby CO2 limits tighten if economic growth exceeds a target level and eased if it fails to meet target (acting as a sort of economic throttle while controlling emissions). Major developing countries must be participants, but they will not necessarily have the same targets until they achieve a certain level of wealth.
Fortnightly Some have been advocating a carbon tax proposal that would incorporate all fuels that impact climate change. Do you support such an initiative?
Rogers There is a hole in the federal budget big enough to drive a super-tanker through. Much of federal spending is for non-discretionary items like defense, Medicare, Social Security, and so on. The president wants to reform Social Security, including private accounts. This will create even more debt. There is also a real interest in simplifying the tax code. Some note that a consumption tax is less of an economic drag than an income tax. It's more efficient. If forced to choose between raising income tax rates or implementing a small consumption tax, which would be preferred, the consumption tax would cause less of an economic drag. So, there is a big need to raise revenues combined with a desire to reform taxes. A cap-and-trade on GHG would raise revenue. It would be the economic equivalent of a consumption tax on fossil fuels. This would slow imports of oil and force a more efficient use of coal and natural gas, migrating us to cleaner technologies. It would also likely cause less of a drag on the economy than if marginal income tax rates were raised. This may be an elaborate "political-science fiction" but wouldn't it be surprising if it weren't the environmentalists who resolved climate change, but fiscal conservatives?
Fortnightly Is broadband-over-power-lines a viable business? Do you really believe in the technology? How might it change the valuation of the company if it takes off?
Rogers We believe in the technology, but we're taking a go-slow and a low-profile approach to learn all we can from our initial deployment in some Cincinnati neighborhoods. Given the changing dynamics of the broadband industry and the number of competitors, we want to under-promise and eventually over-deliver.
C. John Wilder
Chief Executive Officer, TXU Corp.
"This is a real industrial company with a real consumer business. It's not a kind of governmental confected business like many of these quasi-restructured market companies compete in."Public Utilities Fortnightly How would you say your company distinguishes itself from its peers? What businesses provide the most promise?
John Wilder For TXU, we are clearly a unique animal, a unique company, in the sense that we are the largest competitive company by, frankly, an order of magnitude in the utility space. We are a $20-billion market-cap company with-it depends on how you calculate it-with at least three quarters of that value coming from unregulated operations. We are the largest competitive retailer in the United States by a factor of 30, 40, 50 percent, [again] depending on how you calculate it. We have about 2 million truly competitive retail customers. These are customers that have real choice, not like many of these others confected markets that have been designed over the last dozen or so years that really don't drive real competition at the retail level. We have had customer switching rates in our market that are about 10- or 15-fold what these other markets have experienced. This is a real industrial company with a real consumer business. It's not a kind of governmental confected business like many of these quasi-restructured market companies compete in. This is a real market economy in Texas. That is what distinguishes us. We're moving down the path and have made, frankly, very good progress in running TXU, particularly TXU's manufacturing business, as an industrial company by trying to achieve operational excellence and cost leadership. We get the benefit of that to the extent that we can run our manufacturing complex at high performance levels. And if we don't run them at high performance levels, we get punished for that economically. Almost all the other companies that your readers read about don't have that same economic incentive or disincentive. And, as I mention, on the consumer business, we have customers that have real choice. There are 80 competitors in our market that are fighting for the same valued customers we are fighting for. So, that just introduces an entirely new dynamic and one that we believe distinguishes our company.
Fortnightly Your company has placed much emphasis on succeeding in the Texas competitive market. But with more than 2.5 million customers, what kind of growth do you hope to achieve from this business?
Wilder The great benefit that we have is the economy in which we compete. There was a recent report that came out from the Texas state demographer indicating that Texas is projected to be the fourth largest growing state in terms of population in percentage terms, and the largest in absolute terms. The market in which we compete, the Dallas-Ft. Worth area, is expected to double in size in the next 20 some years.
If you look at North American Electric Reliability Council (NERC) regions … the ERCOT market in which we compete has the highest growth rate of any NERC region in the country. We can grow our business like Florida can grow their business, which has slightly higher growth rates, just by virtue of new customer growth. This year alone we'll probably hook up 50,000 new houses. These are different kind of homes that have been built in the past. They're not all mansions. Home sizes are getting larger. Home cooling needs are getting larger. And electrical needs are getting larger because of swimming pools and various amenities people are building in. We can grow our business organically by virtue of the market that we can compete.
We also believe we grow our business around some of these core businesses that we have. We are a top quartile operator from an operating performance and cost performance in coal-plant operations. We have plants in place to drive that operation to a top operator. We believe we can grow our business nationally around coal plant operations, and maybe even gas plant operations. We have made a very small entry step outside our core territory or market [into the Southern Texas or Houston-Corpus Christi area]. We stumbled a bit when we entered into that realm. The year before last we lost about $100 million dollars in those markets. Last year we lost $50 [million] and this year we think we'll make about $20 million or so. We believe we can grow that business over the next three to five years in to a $100 million business.
Fortnightly Is the growth rate in Texas higher than the average growth rate in other states?
Wilder If you look at the average growth rate … [most] companies have from a half-percent to one percent growth rate per year. We have this really great incumbent position in a high-growth market, which is very valuable. The growth rate in Texas is about two-and-one-half to three-and-one-half percent.
Fortnightly Will TXU ever compete in other competitive markets?
Wilder We hope to. None of the markets today are constructed in a way that make them competitive. That's why there has been no switching. Most of these markets you look across there have been no more than a 1 to 2 percent switch rate. In Texas there has been a 75 percent switch rate for industrial customers, 50 percent switch rate for commercial customers, and about a 20 percent switch rate for residential customers. So, there is just no market that compares in terms of the real competitiveness of the market. So, if you look out near the end of the decade and you get some of these big markets like Pennsylvania, New York, Illinois, Ohio, they might unfold in a way that would enable a strong retailer of the consumer electricity product, and that's what we believe we are today. … It might enable a market opportunity in those markets. But right now we don't have any plans because the economic incentives just aren't attractive. The contribution margin that you can earn in those businesses because of the way the rate mechanisms are established just don't invite competition.
Fortnightly Natural gas prices have been extremely high throughout the country, particularly in Texas. Is there a market or legislative answer? What has been the impact of high gas prices to your business?
Wilder Natural-gas prices since the market opened have increased a couple hundred percent. Natural gas prices are the predominant price-setting commodity for electricity in Texas. It's difficult to market a product to a consumer when the underlying product pricing has been under some substantial inflationary pressure. The customer is not supposed to understand why we can't find more hydrocarbons in the ground and in North America. Or why there are drilling constraints in Alaska. Or why the geological structures 10,000 years ago didn't put more natural gas under the ground of the United States, but put five-fold of that under Brunei. Those are the kinds of issues that the consumer never can understand. But the reality is not that they are not smart enough, it is just that there is no reason that they should invest in an understanding of that. The consequence is that they have to pay more for their natural-gas product and their electricity product as a result. So, to be retailing that product to them in that escalating cost environment does offer up some challenges in the legislative framework because politicians like to look for easy answers. And there is not an easy answer to the long-term energy needs of the Unites States of America. … We have gone decades with under-investing in energy infrastructure across the entire business system. From refineries to oil and gas fields, to gathering systems to gas processing plants. You kind of name it, and there have not been adequate market signals and adequate reinvestment opportunities for industry participants to invest. It's going to take us at least a decade if there are adequate price signals, which today there seems to be in almost all of the key commodity lines to get the infrastructure back in productive shape…
Fortnightly TXU undertook in the last year one of the biggest business process outsourcing (BPO) deals in the industry with consultants Capgemini. Has the relationship and the projected savings performed to plan?
Wilder It is going really positive and good. What we didn't have at TXU, if you look at the basic performance level, our back office performed very poorly by any performance standard that we were able to apply to it. To take it a step further, [the back office] was performing poorly-high cost, poor service-and it was hurting us in the marketplace. Our phone answer time was 300 seconds when I got here. It's now sub-15 [seconds] on almost any given day. Many days we drive it down to a two- to three-second answer time. Those are clearly best in the industry and are best when you go across other industries like telephone.
What happens when [customers] get poor service and they call a utility and get the interactive voice response and it is hard to get through, or the customer service agent isn't friendly, or it takes 45 seconds to 60 seconds to answer the phone? Where does a customer go? Nowhere. It's a monopoly. We don't enjoy that here. We have to fight for every customer that we have. So, we had to transform our back office to be a competitive weapon for our consumer retail business. The way you transform a back office is through technology. We aren't good, we weren't good, and are not still that good at how to really employ technologies to provide better service to your customer. So, we needed a technology partner. We actually examined doing it on our own. What if we get a big technology implementation plan? We go through and try to refresh all of our technologies in a way that they are more customer services orientated to make us more productive. We thought the execution risk of that was just too high. It was much better to shift that execution risk over to a professional business processing outsourcer and a technology implementer. Let them absorb that risk. We would get the benefit of that risk transfer through lower contract. It lowered our operating expenses by about $200 million per year. So, it almost took 40 percent of our operating costs out of the back office and this is the real bonus, and dramatically improved the service to our customers. So, this is no way to look at that business transformation as anything other than a stunning success.
Fortnightly How do you benchmark Capgemini's performance to manage the effectiveness of your relationship?
Wilder Before we started that venture, we had a half-a-dozen measures across all of our back office. Today we have about 350 measures of which about 125 measures Capgemini actually gets paid on. Our measures range from customer service satisfaction to error rate on bills, to our collection periods on our accounts receivable, to our internal transaction inter-speed for our employees calling to find out the balance of the 401K account … just a wide variety of performance metrics that we monitor and work with Capgemini Energy and monitor on a monthly, weekly, and daily basis, and they actually get their compensation based on both the employees as well as the compensation for Cap Gemini Energy [the entity managing TXU's BPO]. … The contract is set for 10 years.
Fortnightly In the last year, TXU had been considering the novel step of outsourcing its energy trading and risk-management function to investment bank Credit Suisse First Boston. What made TXU change its mind? What did you hope to save, and what were the risks?
Wilder We still like the idea. It is kind of a good idea. … It was really a kind of competition for commodity trading talent. We were going into the [deal] to try to upgrade our management capability in that area. We thought a venture with a financial services partner would give us the right cache in the marketplace to attract and retain high-quality talent, because fundamentally commodity trading is a talent gain. We interviewed people for management of the [new trading] company, for CEO of the company, and interviewed some of the potential key participants. And it just kind of died of its own weight. The cost structure was going to be four or five times what we thought it was going to be. We were hoping to set the enterprise up in Dallas, but the demands among the talent were, no, "Let's set it up in the New York area."
That wouldn't be a big deal to us, but it kind of bothered us a little bit. We thought wait a minute we're not trying to set up a hedge fund up. The reality is that that is what most of these managers wanted. They wanted our capital and access to our information flows on how commodities trade, and they just wanted to trade the commodities like a hedge fund. To be frank, that's where they can get the most economic gain personally. A good commodity trader can make a lot of money working for a hedge fund. It was one of those ideas that is a neat idea. I still think it is a good idea, but the market opportunity probably wasn't right. We had a lot of other things going on in the company that we needed to execute. It looked like it wasn't going to get there. It was one of these exercises where the view isn't worth the climb. And we backed off.
Fortnightly Given your company's involvement in competitive markets, what direction do you think policy is headed and what have you learned from your experience in Texas? What could have been done better in overall competitive markets and in Texas?
Wilder I think overall policy development, particularly competitive markets, will be slow. It takes a long time for people to get the memories of Enron and rolling blackouts in California out of their mind. We are mindful in Texas that we are the model in the United States, meaning that if Texas works it could lead to a much more broad scale and much more rapid restructuring of the market in the United States. That is just the reality. We are a very large reality, the largest power consuming state in the country, equivalent to a Great Britain in size. So, this is a big power market. Globally, we rank in the top 15 or so. It is quite high. If we were a country on our own we'd be the fifteenth largest electricity consuming country in the world. If we get this thing right and it works-I think it's not a boastful statement to make, it's factual-that if this works and it drives innovation and new investment and new efficiency, I think other states will catch on…The arch enemy of utilities is always the industrial customer. The industrial customer generally finds it offensive that the utility doesn't have to be efficient, that they can pass on all their costs regardless of the bozo decisions that they make, etc. I