In the race toward competition, will outside investments break their poor track record?
The current rash of utility investments outside of the core franchise businesses appears to follow a pattern: a new spree of diversification every decade. Diversification was the rage in the early 1970s before the energy crisis, and revived during the mid-1980s when huge construction programs wound down. It has now reemerged as the threat of competition curtails traditional investment opportunities. Much of the industry's future growth depends on the returns from this current round of investments, but a look at the success of past diversifications offers little encouragement.
Conventional utility financial reporting does not segregate earnings by regulated and nonregulated activities, nor segregate the utility's capital structure or its financing charges. This failure makes it impossible to analyze the financial results of diversification programs directly. However, most utilities with substantial diversification efforts have formed holding companies and report financial
information for both the holding company and the utility. The difference between the holding company's financial results and those of the utility yields a close approximation of the financial results of the diversification efforts. Measuring the results of diversification in this way appears reasonable, since the utility subsidiary was the original entity, and continues as a self-contained entity.
Financial data can be constructed for the nonutility operations of 18 utilities that mounted significant diversification efforts during the 1970s and 1980s. The success of a utility's diversification effort is measured by 1) the return on equity (ROE) earned by the nonutility operations, and 2) the earnings contribution of the diversified operations as a percent of holding company earnings.
The Table (opposite), which presents data for these two measures for the 10 years from 1986 through 1995, reveals few bright spots. Only two utilities have been successful with their diversified operations, Montana Power and TECO. These two companies, along with PacifiCorp, represent the only three significant diversification efforts of the 1970s that survive. Both Montana Power and TECO have earned a higher ROE from their diversified operations than from their utility operations, and their nonutility earnings have typically accounted for 30
to 50 percent of corporate earning. PacifiCorp's diversification also enjoyed considerable success for many years, but was sharply downsized after 1992 when the company recorded a $640-million loss related to its mining and metals businesses.
None of the 15 diversification programs begun during the 1980s and included in the Table have been very successful. A number of them have been disastrous. For 1986-95, the ROE for these programs averaged a nominal 0.8 percent, and accounted for an inconsequential 1 percent of holding-company earnings. Only in 1995 did the aggregate ROE for these programs rise above 7 percent, and then only because Houston Industries sold its cable business. Otherwise, ROE would have been 4 percent, and diversified earnings would have contributed only 2 percent to holding-company earnings.
The experience of the individual utilities is no more encouraging than the aggregate. The ROE for the diversified operations was less than the holding-company return for 14 of these 15 utilities. Even Houston Industries' ROE was negative until it sold its cable business. Eleven of the 15 had a 10-year average ROE below 7 percent, and five of these posted negative returns.
The dismal record of past utility diversification efforts does not augur well for the success of current outside investments. Significantly, the outside investments of the 1970s, 1980s, and 1990s have been driven by a common denominator: strong cash flow, and management's desire to expand. They also share the same limiting factor: management inexperience in doing business outside of the regulatory framework. This inexperience prevented the diversification efforts of the 1970s and 1980s from succeeding, and it casts a shadow over the current round of expansion.
Current outside investments do differ from those of the 1970s and 1980s, however. First, whereas utilities used to invest in businesses unrelated to their core business in the 1970s and 1980s, they now generally confine themselves to investments close to the electric power business. Thus, utilities are bringing more expertise to their current outside ventures than they did in the past.
Second, since competition is invading the electric power industry, utilities can no longer retreat to the safety of their core business as they could in the 1970s and 1980s. Moreover, more and more of a utility's core business will be subject to the same competitive pressures that apply to their diversified operations. 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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