LDC Robustus? Which Would You Rather Be?

Post-Order 636 evolution depends on aggressive regulatory and legislative reform.

"Get out of the gas business. Drop the merchant function. We can't make any money selling gas and we are constantly at risk to having gas costs disallowed. It's a no-win situation. Our only hope of moving the ball forward is to set up a nonregulated gas marketing affiliate in the end zone."

I believe such opinions may overlook future opportunities. The nay-sayers assume an intransigent regulatory environment; their advice may prompt actions that jeopardize earnings for stockholders. Unfortunately, however, many local distribution companies (LDCs) have already set this course. Higher earnings, increased customer satisfaction, and lower rates are achievable, but only by reversing direction. Above all, it will take a courageous effort at state regulatory reform.

Three major obstacles stand in the way of a truly competitive natural gas industry, as envisioned by the Federal Energy Regulatory Commission (FERC). All three involve state law and regulation:

s Inconsistencies in state and local taxes assessed on LDC and third-party sales1

s Price distortions between customer classes, stemming from rules on gas-cost allocation

s Rules barring LDCs from realizing corporate profits on gas commodity sales in competitive markets.

No two LDCs are fully comparable. They vary in size and structure. Consequently, one cannot fully appreciate the comments, or the silence, of LDC executives without understanding the economic, competitive, and regulatory environment in which each company operates. To bring order to this seemingly chaotic picture, I recently conducted a survey of regulatory practices at the public utility commissions (PUCs) in all 50 states, including the District of Columbia. Some key elements of this survey are provided in the accompanying table.

Rate Methods: A PUC Survey

A truly competitive market requires clear pricing signals and a minimum of subsidies between customer classes. The extent to which regulators embrace that proposition can be seen in their required approach to allocating gas costs in LDC rates. The full cost of gas required to serve low-load customers can rise significantly above that required for high-load customers. For tariff-based rates, a uniform method allocates the same cost of gas to all firm rate classes, regardless of usage characteristics; a cost-based method recognizes the differences in the cost of gas between customer classes. [Editor's Note: Throughout this section, italicized words refer to the table of survey results opposite.]

Some jurisdictions permit both methods. Obviously, if an LDC's service territory encompasses a relatively homogenous customer group, the method makes little competitive difference. But many LDCs serve large and distinctly differing customer groups. Uniform gas-cost allocation puts these LDCs at a competitive disadvantage, both with competing alternative energy sources and with third-party marketers serving high load-factor markets. About two-thirds of PUCs currently require a uniform method of gas-cost allocation.

A more telling indication of the regulator's focus on competitive issues lies with market-based sales rates. Market-based rates permit an LDC to respond in real time to fluctuating market forces, such as alternative fuel prices. Some jurisdictions don't allow market-based rates because of a real or perceived lack of need; most restrict the cost of gas allocated to competitive markets according to the utility's weighted average cost of gas (WACOG). Such restrictions often render the utility unable to compete.

A growing number of jurisdictions, however, are permitting LDCs to respond to market forces in assigning gas costs. In fact, a number of states (AL, AZ, MN, MS, NJ, OK, UT, WI, and WY) now permit LDCs to arrange for or allocate a particular gas cost or supply to a particular customer under various specified conditions. South Carolina's situation is mixed: Some of its LDCs operate under WACOG-related rules; others operate under rules that are more market-responsive. The most restrictive gas-cost allocation regulations, however, require LDCs to assign incremental gas costs to market-based rates (em often the highest-cost gas within the utility's supply portfolio.

Equally diverse are the treatments required for the margins or earnings associated with market-based sales rates. Fifteen jurisdictions require LDCs to treat such margins like simple core-customer tariff rates, by placing all of the benefit, or risk, of attaining rate case pro forma margins on stockholders. An equal number of jurisdictions permit mechanisms that share the benefits and/or risks of such competitive sales markets between stockholders and firm ratepayers. In most cases, however, these sharing mechanisms are asymmetric. Finally, a few jurisdictions give LDCs only minimal ability to enhance earnings through sales efforts in competitive markets. Minnesota is quite progressive in that it allows the LDC to profit on the commodity cost of gas through its internal merchant service, an agency program, as would any other gas marketer.

In general, LDCs have responded to variable and restrictive state regulation by retreating from competitive markets and setting up separate, nonregulated gas-marketing affiliates. Thirty-four states report active LDC marketing affiliates. Regulators, for their part, have responded by attempting to restrict the activities of "nonregulated" entities via regulation. Thirteen states have various restrictive policies in effect; seven others currently have such policies under review.

Rate Alternatives: A Bigger Pie

If the purpose of utility regulation is to impart normative characteristics of free competition where monopoly power precludes effective competition, the demise of regulation over the commodity aspects of natural gas in commercial and industrial (C/I) markets is long overdue. The chart below displays the impact of third-party access on the C/I market since FERC Order 436. Utility gas sales to C/I customers now account for less than one-half of C/I customer gas usage.

Indisputably, effective competition now exists in the commodity sale of natural gas to C/I end users. So by what rationale do the PUCs regulate gas cost and price in competitive C/I markets? Keep in mind that the transmission and distribution of natural gas continues to be a natural monopoly and, thus, an appropriate subject of regulation.

Furthermore, in certain jurisdictions, the current morass of market-distorting or outdated regulations may stem not so much from intransigent regulators, but from timidity, apathy, or "monopolist mindset" on the part of utilities. My efforts to find the "why" behind various outmoded regulations frequently encountered this response: "Nobody ever asked us to change it."

The revenue pie available to support fixed utility costs can be enlarged. The annual net commodity margin associated with current nonutility sales (approximately 6 quads) to LDC C/I markets in the United States, while not immense, brings in an estimated half-billion dollars annually. Regulators and legislators take note: Not a penny of this margin supports local utility infrastructure. Further, it generally represents a cash outflow for the consuming state. Utility investors in the United States should also consider that little of this margin flows to individual LDC or parent corporate earnings.

I believe that the activities of many LDCs (and the response of many regulators) run contrary to the long-term well-being of both. They will play directly into the hands of the major gas-marketing firms. One 1995 survey found that approximately 265 major gas-marketing firms operate in the United States (em a number that continues to shrink rapidly.2 About 10 percent of these firms account for 90 percent of the throughput. These "Majors" are the big production companies and pipeline affiliates, some owned completely or partially by foreign firms. The current frenzy among LDCs to get out of the merchant function is exactly what the Majors want.

Strategy:

Evolve, Devolve, or Degenerate

A simple biological analogy illustrates the choices facing the gas distribution industry (see diagram on page 21).

Devolution. The simplest course is "business as usual," which requires no real effort by the LDC or, perhaps, just a bit of reactionary entrenchment. The result of this dull path: LDC Insipidus. Over time, much if not most of the LDC's C/I sales market will have eroded, to be served by independent marketers. Portions of its core market may also be served by third-party gas. But the LDC can rest assured that it will retain those segments of its markets most prone to uncollectible accounts.

Transportation and associated services will become increasingly varied and complex. All utility functions will become unbundled. Rebundling in competitive markets in an effort to capture economies of scope will be thwarted by Majors crying "competitive disadvantage." Administrative costs will grow. The LDC supply portfolio will shrink, but the obligation to serve and provide backup will not.

Although many utilities complain about the obligation to serve, the political reality is that regulated utilities are the only players that state and local officials can effectively hold accountable. Consequently, the LDC's WACOG will rise, further eroding its sales market share and provoking heightened scrutiny of its supply portfolio. Regulation will naturally become more complex and intrusive.

Risk of gas-cost disallowance will grow as the LDC sees its supply options shrink along with its declining sales base. Sales rates to remaining core customers will increase; cost-cutting measures will become the order of the day. LDC marketing departments will be the first to shrink and eventually disappear. (This shrinkage is occurring at many utilities now.) Main extensions and system expansions will slow down.

Depreciation will exert an increasingly detrimental effect on rate base. Payout ratios will rise and/or dividends will stagnate. The simple reality is that, barring a significant change in utility regulation, the business of LDCs is planting rate base. If utility management permits an erosion of the ability or motivation to grow the system, it risks reaping a diminished harvest.

Many might argue that independent marketers will provide cheap gas and actually grow the C/I market share. I suggest, however, that marketers will squeeze out every penny of margin the market will bear. They will plant no pipe. Industrial groups and gas marketers will pressure LDCs to reduce transportation rates, leading to a further reduction of an LDC's ability to grow the system; or, in the alternative, forcing it to take on higher levels of capital risk.

Further, independent marketers will not be willing or able to take on the overhead of local, front-line marketing of new gas technology, or the hands-on, long-term relationships with builders and developers. Nonutility gas marketing is a lucrative business because it is intensely focused on communications/computer technology and a minimalist labor force; it eschews field labor and nonportable capital investment.

Luckily, the "do nothing" path of devolution is slow. Utility managements should have the time to evaluate their business environment and opt for alternatives. Abysmal as this picture may appear, it is far brighter than the path of "degeneration" many LDCs are now embarking on.

Degeneration: "The Great Myth." In biological terms, "degeneration" marks the deterioration or loss of a function or structure in the course of evolution (em for example, the vestigial eyes of some cave animals. Many LDCs have begun separating noncore sales markets from the LDC and establishing a separate, "nonregulated" affiliate. Some have even discussed dropping the merchant function completely and "outsourcing" the gas-supply function. This behavior will produce LDC Minimus, a creature with all the predicted problems of LDC Insipidus, but more, and at a much accelerated pace.

Herein lies the "Great Myth" that the resulting "nonregulated LDC marketing affiliate" will totally escape state regulation. As noted above, 13 states already place significant restrictions on LDC affiliate relations, while seven others are considering it. Further evidence can be found in Standards of Conduct for LDCs and their Marketing Affiliates, recently released by the New Jersey Board of Public Utilities. Standards is touted as one of the first of its kind; doubtless, brethren in other states will soon emerge.

A corollary myth says that regulators will see no need to adjust the allowed rate of return of the diminished LDC. My discussions with regulators have indicated that this issue will remain open for debate.

Traditional management at LDCs may have presumed that their detailed knowledge of local customers and real-time knowledge of supply portfolios will promote synergies with nonregulated marketing affiliates, maximizing economic efficiency and competitive advantage for both sides. However, the New Jersey Standards permit no communication between LDCs and marketing affiliates, and no development of synergies. In fact, LDCs must provide to all marketers any useful information they provide to their affiliates, at the same time. Of course, anyone who has ever tried to extract customer information from a marketer or a pipeline is well aware that this is a strictly one-way street.

The Standards go on to establish additional reporting responsibilities for the LDC and an ever-expanding area subject to audit and review. LDC Minimus has not only given up a significant portion of its market, but now has surrounded itself with additional regulatory fences and risk. I suggest that regulatory risk is the single most deleterious factor in establishing the market value of an LDC's common stock. Some investors may be inclined to reevaluate their holdings in LDCs that needlessly build any new regulatory fences.

The resulting LDC marketing affiliate is literally impotent. Even the Majors know that only a few giants will survive, as evidenced by the recent proposed merger of Natural Gas Clearing House and Chevron. Which traditional LDC thinks that, without any local competitive advantage of any kind, it can effectively compete with the likes of Enron, Amoco, or any of the other Majors? Even if it makes a little money, who's to say that the LDC won't see its profit offset by a reduction in allowed return on equity for the regulated side? As LDCs embark on this course, the Majors are cheering them on. They can foresee that the "nonregulated LDC marketing affiliate" will likely remain a mirage, and that LDC Minimus will prove ripe for "cherry picking."

Evolution. Traditional LDCs all embrace the same ultimate goal: "Build the business" through marketing skill and regulatory insight so as to emerge healthy, vigorous, and subject to minimal regulatory constraint (em in other words, LDC Robustus. Unlike Insipidus or Minimus, this LDC is larger in scope and vision. LDC Robustus strives to become a "full service" utility, both unbundled and rebundled, by focusing on economies of scale and scope to generate synergies for the benefit of stockholders and customers as well as the community in which it exists. Through

its demonstrated sense of

"community," in fact, this LDC will evoke the "trust" that will lighten the heavy hand of regulation, thus ensuring its own evolution.

LDC Robustus currently exists throughout much of the world, except North America. Discussions with foreign clients, both LDCs and regulators, uncover a unanimous and undisguised distaste for the U.S. form of heavy-handed utility regulation. Some U.S. LDCs have embarked upon the path of "degeneration" as a means to "bypass" or "short-circuit" burdensome regulation and directly bring sales margins to the bottom line. This path is often falsely perceived as easier than confronting the inconsistencies between current regulation and the new, competitive marketing environment. I believe the ultimately more effective evolutionary path is to establish a partnership with state regulators and legislators to trim specific regulations and statutes, as is happening in Georgia (see sidebar).

Gas distributors must evolve or become extinct. True evolution must combine concrete regulatory reform with a vision for a brighter and more robust future. t

Vincent Esposito is an executive consultant with Stone & Webster Management Consultants. He leads the firm's natural gas utility consulting practice in Washington, DC. Mr. Esposito specializes in rate, regulatory, and competitive issues for local distribution companies.

Georgia Fights Extinction

Rather than witness the breakup of LDCs into multiple, feeble entities, Georgia seeks to empower them to compete in the post-Order 636 world to the benefit of all stakeholders. Georgia's regulators and legislators are considering:

. Deregulating gas cost and pricing in proven competitive markets

. Allowing LDCs to profit on the commodity cost of gas

. Sharing risks and rewards between ratepayers and stockholders.

1 See, "Death by Taxes: Gas Utilities Face a Cripling Disadvantage in Energy Marketing," V. Esposito, Public Utilities Fortnightly, Aug. 1, 1995, p. 23.

2 See, "The Top 25 Marketers", B. Shook, Gas Daily's NG, June/July 1995.

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