Converging Markets:

The First REAL Electric/Gas MergerEnron's bid

to acquire Portland General heralds a new phase

in utility competition.

Why the Holding Company Act doesn't matter.

By Charles M. Studness

The merger agreement between Enron and Portland General Corp. has reshuffled the electric restructuring deck. It makes electric utilities takeover targets for outside suitors after 60 years of peaceful immunity. It drives home the fact that electric utilities will be thrust squarely into the zero-sum game of head-to-head competition. It demonstrates that market forces will limit the ability of regulators to control restructuring. It brings the convergence of gas and electric markets to center stage.

Enron's proposed acquisition of Portland General appears surprising only in its timing. Since 1935, the Public Utility Holding Company Act (PUHCA) has effectively given electric utilities immunity to takeovers by outsiders. Its requirements have proven sufficiently onerous that no private corporation outside the utility industry has been willing to acquire a utility and fall subject to jurisdiction under the Act.

Enron apparently expects that PUHCA will have been repealed by the time it completes its acquisition of Portland General, since it is probably no more willing to be saddled with PUHCA than anyone else.

Without the protection afforded by the Holding Company Act, an electric utility should prove as likely a target for a takeover as any other company. In this case, Enron has simply anticipated repeal instead of waiting for it to occur. Now that Enron has made its preemptive strike, others can be expected to follow.

Competition Turned Aggressive

The proposed merger makes it clear that head-to-head competition will form a key component of the restructured electric industry. Given Enron's aggressive bulk-power marketing activity and Portland General's strategic location between the low-cost hydropower region of the Pacific Northwest and the huge California market, Enron obviously intends to compete vigorously for customers and sales.

No company that expects to participate in the California market can continue to view competition as a controlled process. Instead, competition means aggressive companies invading markets wherever prices are too high or service invites improvement. Success for invaders and incumbents alike will involve price, service, and marketing (em not just cutting costs to meet competition kept under control by regulators.

While the impetus for reform lies grounded in technological change, the transition thus far has proceeded under the comfortable control and guidance of regulators. Enron's prospective entry into the electric business underscores the fact that market forces have a life of their own. Regulators will undoubtedly exert less and less control over the transition as time progresses. As Enron and others press their case, regulators and legislators will find it increasingly difficult to deny customers access to competitive prices.

A Nationwide Market

The proposed combination of Enron and Portland General also appears likely to accelerate the convergence of the electric and gas markets into a broader energy market. The proposed merger furthers Enron's goal of becoming a national energy company in the production and marketing of gas and electricity. The merger will give Enron the physical electric generation capability it needs to anchor its portfolio of electric and gas contracts. To become a national energy company, however, Enron requires physical generation east of the Mississippi, which suggests that Enron will acquire another electric utility.

Enron is unlikely to remain the only national energy company for long. Large gas companies and some electric utilities will also adopt Enron's strategy. Some large, integrated gas companies will acquire electric utilities; some electric utilities will acquire local gas distribution companies (LDCs). Indeed, it is surprising that we have not yet seen a rash of LDC takeovers by electric utilities, since the electrics are flush with cash and eager to expand.

Even without mergers, electric and gas markets are likely to converge. Gas and electric companies largely hold the same customer base. End uses overlap for their energy products and services. Success in a nationwide market will hinge on the willingness of management to embrace competition. In this regard, gas companies enjoy distinct advantages.

Similarities and Distinctions

Gas LDCs essentially provide retail customers with two services: 1) transportation (from pipeline to customer) and 2) supply (the purchase and resale to the customer of the transported gas). The LDC provides gas transportation for all of its customers and gas supply for those that do not choose to purchase gas from a third party. It earns a regulated return for gas transportation, but nothing for gas supply, which remains essentially a customer accommodation with no markup. The gas LDC earns the same transportation fee no matter who supplies the gas. It thus sees no inherent incentive in opposing competition in gas supply.

Indeed, competition offers indirect financial benefits to a local gas distributor. If a third-party supplier can undersell the LDC, customers that switch will enjoy a reduced price for gas. Assuming some price elasticity, the reduced price would lead these customers to buy more gas. The LDC would see its earnings rise, since it would earn a transport fee on the increased throughput.

A gas LDC can also benefit from competition, at least for the present, by forming a subsidiary that will act as an independent third-party gas supplier in competition with its basic gas-supply service. If the gas LDC's subsidiary can buy gas cheap enough that it can add a markup and still sell the gas to the customer at a lower price than it does as an LDC, customers would have incentive to switch to the subsidiary's low-price service. The subsidiary would earn a profit equal to the markup on the gas it supplied. And if the reduced price should lead customers to increase their gas purchases, the LDC would also benefit from increased throughput.

An electric utility's role in producing the power it sells carries risks that do not apply to a gas LDC. The gas LDC has no financial stake in the wholesale price since it buys the gas it supplies. The electric utility, on the other hand, has an enormous stake in the wholesale price of power.

The current regulatory system immunizes the electric utility against price risks in the wholesale market. As an integrated vertical monopoly, the utility functions as sole power supplier to its franchise customers (em in effect procuring the power it supplies customers from itself. In a sense, the vertically integrated utility internalizes the wholesale market as power passes invisibly from the utility as power producer to the utility as power

supplier. Rate regulation enables the utility to set the phantom wholesale power price at a level that generally provides it with a reasonable return, even if achieving a reasonable return requires it to charge a price far above the free-market wholesale price.

Where the gas-supply function takes place on the open market, the electric supply function lies buried in the fabric of the electric utility's vertical integration. There is no explicit wholesale transaction between the utility as producer and the utility as supplier, which enables the utility to control the pseudo-wholesale transaction and its phantom price.

The risk for the electric utility lies in the

disparity between its phantom wholesale price and the free-market wholesale price that would exist if customers were free to choose their power supplier. To the extent that the phantom price lies above the market price, competition poses a risk for electric utilities that never touches a gas distributor. This distinction provides an incentive for electric utilities to delay competition to keep their phantom wholesale price high as long as possible.

Advantage, Gas

Gas LDCs enjoy several advantages over electric utilities in positioning themselves for competition in energy services. First, gas LDCs are farther along the path in implementing competition. Large customers are now free to choose their gas supplier, and gas LDCs are in the process of extending this freedom to the smallest customers. By contrast, electric utilities are just beginning their first experiments with freedom of customer choice. Moreover, freedom of choice will probably not reach any appreciable number of electric customers on a permanent basis before 1998. Accordingly, gas LDCs will have more experience in dealing with the freedom of customer choice for a number of years to come.

Second, gas LDCs have incentive to implement competition; most electric utilities have incentive to resist it. This is particularly important organizationally. The incentive that gas companies have to foster competition will permeate their strategies and accelerate the cultural change required to compete effectively. Conversely, the incentive that electric companies have to frustrate competition will slow the development of strategies and organizational change.

As customer choice becomes the driver in gas and electric markets, gas and electric companies or their successors will find themselves competing head-to-head in an energy services market that involves both gas and electric services. With more experience and greater incentive to engage in competition, gas companies will find themselves in a better initial position than electric companies. t

Charles M. Studness is a contributing editor of PUBLIC UTILITIES FORTNIGHTLY. Dr. Studness has a PhD in economics from Columbia University, and specializes in economics and financial research on electric utilities.

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