A decade of restructuring has not affected the financial integrity of the average regulated utility.
Ideological bias, economic principles, success of previous deregulation, inordinate greed, and political expediency fueled the movement for electricity deregulation. The authorities, however, never deregulated. They chose to restructure. Congress passed the Energy Policy Act of 1992, which ushered in wholesale power markets, opened the transmission market to competitive power producers, and freed electric utilities from restrictions on investment activities outside the regulated sector.
By 1996, several states had decided to open their markets to competition. By 1998, power producers and traders had achieved stock market valuations formerly reserved for glamorous technology leaders. By the end of 2002, though, the world's greatest energy trader had collapsed, the generating sector teetered on the edge of the abyss, the public had demonstrated its apathy toward competitive retail supplies, and restructuring had stopped at the state level. By mid-2003, the generators on the edge of the abyss had fallen in, federal regulators had backed off from their standard market design, and utility managers had trekked from coast to coast extolling the virtues of their plain-vanilla, regulated utility businesses.
Rather than rehash a list of errors made, delve into the unsubstantiated assertions that substitute for public policy analysis, or debate whether deregulation will rise from its coffin like Dracula, let us instead look at the numbers to assess the benefits of restructuring and, perhaps, look into the future.
Did restructuring damage the regulated utility? We know that competitive energy companies lost billions of dollars, bond ratings declined, and creditors had to restructure loans. Presumably, if investors and creditors choose to make bad business decisions involving risky ventures, electric consumers should not care. If, however, the regulated utility participates in such ventures, they should care to the extent that those investments destabilize the utility, raise cost of capital or reduce its ability to provide service. The bond rating agencies, which failed to foresee the collapse of the generating and trading sector, worry that corporations might "allocate assets,"1 that is, move funds from the sturdy utility to a shaky affiliate, thereby weakening the utility.
Table 1 looks at two key financial ratios: coverage of interest charges, and the common equity ratio. Pretax interest coverage shows how many times over the corporation earns its interest expense. Common stockholders equity as a percent of capitalization shows the size of the equity contribution that protects the value of senior securities. In both cases, the higher the value, the more secure the company is financially. The table presents two indicators for the regulated utilities alone, and for the consolidated entities that own the utilities and the unregulated ventures. If the consolidated entities had chosen to milk the utilities for funds in a dangerous manner, the numbers would show declines in both interest coverage and the equity ratio. Instead, the table shows steady ratios over time for the regulated utilities. The consolidated enterprises, however, show more erratic interest coverage and a declining common equity ratio.
Whether utilities decided to separate the utility and unregulated sectors or regulators decided to enforce such separation (known as "ring-fencing") does not matter.2 A decade of restructuring has not affected the financial integrity of the average regulated utility, even though it has allowed business decisions that have damaged the parent holding companies.
The decision requires that the utility have the opportunity to earn a return that will attract capital.3 Admittedly, utilities have not raised large amounts of capital in recent years, and regulators have enjoyed a reprieve from the disagreeable task of raising prices. Nevertheless, spending numbers could soon turn upward.4 The generators and traders appear to have taken big risks and reaped unsatisfactory returns. The consolidated power companies have compiled an erratic and unimpressive record that should affect their ability to raise capital.
What about the regulated utilities? Table 2 focuses on return on equity as the measure of profitability. The table shows that the regulated utilities maintained a relatively steady return, although one below the returns set by regulators in rate cases. Regulators, furthermore, kept the allowed returns close to 11 percent for the entire period, despite a trending downward in interest rates.
Consolidated entities, however, usually earned a lower return than the regulated utility. Despite the hype about extraordinary business opportunities opened up by deregulation, the evidence indicates that the unregulated activities, after deducting incremental costs, did not contribute to corporate coffers. (Most companies showed unregulated operations as earners, after allocating expenses and corporate overhead and separating extraordinary expenses. The calculations in Table 2 subtract utility net income from total consolidated net income to determine the non-utility contribution, and they do not distinguish between ordinary and extraordinary income.)
One might ask how the consolidated entities managed to make so many unproductive investments without damaging their core holdings, the regulated utilities. Simple: They borrowed heavily for unregulated investment. In the period 1993 to 2002, the companies may have borrowed more than $150 billion while investing roughly $20 billion of equity money. That equity investment represented less than 15 percent of consolidated equity, a sum easily raised through retained earnings and occasional stock offerings.
Recent studies show that equity investors should expect to earn a risk premium of 2 to 4 percent above the bond yield on the market value of the investment.5 With long-term government bonds yielding roughly 4 percent, the investor should expect to earn 6 to 8 percent on market value of investment, which at a price of 150 percent of book value (not uncommon for a high quality utility) translates into roughly 9 to 12 percent on book value. Data from Regulatory Research Associates show returns on equity granted in rate cases stayed close to 11 percent for the entire period, and current returns granted (not shown) are close to 10 percent. (Rate orders, however, have had only a minor impact on prices during the period shown.)
As much as they might want to, shareholders cannot buy stock in the utility as opposed to the holding company. In the decade since restructuring began, electric utility shareholders have suffered, despite a decline in interest rates that should have boosted utility share prices.
Table 3 presents total returns (dividends plus capital gains) for the 10-year period between 1993 and 2002. Electric utilities under-performed the stock market, gas stocks, and even bonds. The dividend accounted for almost the entire return, meaning that shareholders, in the end, received no value for all the money retained for unregulated ventures. (The utility tended to pay out most of its earnings to the parent.)
Mind the Gap
In the past, utility stocks have tended to follow the movement of interest rates.6 During the 10-year period under study, interest rates dropped more than 20 percent, while utility returns earned and dividends paid remained level. Those circumstances should have produced a total return of roughly 7 percent per year (5 percent dividend plus 2 percent capital gains) based on past experience. To put it another way, the unsuccessful deviance from the utility model probably cost utility investors 1.5 percent per year, or roughly $35 billion over the decade, based on the valuation of utility shares at the beginning of the period.
To reiterate, though, the poor total returns probably derive from the outcomes of investment decisions made outside the utility sector. Restructuring did not force utility management to make those investments. Rather, it enabled them to do so.
Consumers should benefit from the introduction of competition to a market. The market participants will have to work harder to provide services efficiently, and the threat of losing the customer to a competitor will force them to lower prices in a way that reflects the savings from the efficiencies.
Not all markets function as the textbook would predict. In some, a small number of competitors may collude to maintain prices at a high level despite efficiencies that have lowered costs, for instance. In markets structured by government agencies, the rules may provide market players with opportunities to jack up prices above competitive levels. The fact that customers have little opportunity to respond to price signals may contribute to the opportunity to charge high prices.
Table 4 shows the average price of electricity to all consumers, and to residential customers, as well as the fossil fuel cost per kilowatt-hour of generation.
In the decade covered, the real price of electricity fell 1.3 percent per year. Pass-through of fuel cost savings, however, could have accounted for 0.2 percent per year of the total, and normal productivity gains could have accounted for much of the balance without even considering the impact of restructuring on electric bills. Restructuring began for consumers after 1996, however. In the years 1997 to 2002, the real price of electricity fell 0.8 percent per year, none of which should be attributable to fuel cost savings. These calculations produce savings estimates so marginal that one has to question whether the country as a whole has seen any benefits from restructuring.7
Assuming that restructuring accounts for the cumulative drop in price (excluding fuel savings) from the time that restructuring began in earnest, consumers gained approximately $35 billion from the process, or roughly 2.5 percent of the electric bills paid in the period.
Some of the price reductions, however, derive from cost deferrals and securitization schemes that will require price increases in the future. Furthermore, depressed wholesale power prices now reflect a glut in supply that most observers expect to diminish over time. Thus, one can have little confidence about both the permanence of the savings and the magnitude. The calculations, furthermore, do not net out higher transaction costs or losses suffered because of lower reliability, if any, incurred by consumers on top of the electric bill.
Admittedly, the calculations suffer a bias. They examine numbers for the nation, rather than for the half of the nation that has attempted to restructure. Presumably, however, consumers in regulated states also could reap the benefits of a more competitive wholesale market and a more open transmission network. However, even if one assumes that only consumers in the restructured states received any benefits, those benefits still appear marginal relative to the accompanying turmoil.
So far, it looks as if the restructuring process has produced minimal benefits to consumers, and the financial losses incurred by investors in power production and marketing probably exceed the benefits to consumers. Electric utilities, on average, appear to have gone through the decade almost unscathed, despite a few bankruptcies or near misses. Utility investors cannot say the same, largely because utility affiliates made big bets in the unregulated sector-and lost.
Calculating capitalists and proponents of markets should not care if some people made bad investments. The power plants those people built won't go away, and consumers can benefit when producers create supply gluts. The problem, however, is that policy-makers put their bets on the unregulated entities to expand the supply sector. The unregulated companies do not have the resources and might encounter difficulty raising the capital needed. The regulated companies have the resources and the ability to attract capital. That combination of factors does not add up to a viable, competitive market.
Perhaps the time has come to call for a recess in restructuring, given the paucity of discernable benefits to date, in order to formulate the path forward. Perhaps the Northeast blackout of 2003, which could have happened in the most Stalinist of controlled environments, will provide the excuse for the recess.
- James Penrose, "Consolidated Ratings Methodology," Standard & Poor's, Oct. 19, 1999.
- Leonard S. Hyman, Howard S. Gorman, Richard J. Rudden, "Ring-fencing the Regulated Utility," R.J. Rudden Associates Inc., August 2003.
- 320 US 591.
- Leonard S. Hyman, "The Return of Plain Vanilla," , January/February 2003, pp. 32-40.
- Leonard S. Hyman, "Investing in the 'Plain Vanilla' Utility," , vol. 24, No. 1, 2003, pp. 1-32.
- EEI, price of electricity and fuel.
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