The question I am asked most frequently is "Who will emerge as the 'winners' and 'losers' among today's electric utility companies?" The short answer is painfully simple. The winners will offer the best prices (a.k.a., the low-cost producers). The losers will be unable to cut prices to meet the market (a.k.a., the high-cost producers).

Unfortunately, real-world answers rarely come in black and white. The electric utility industry enjoys less pricing flexibility than one might imagine. An analysis of industry cost options reveals that "production costs" do not vary significantly enough to create major differences in credit ratings between companies. Today, capital investment, as reflected in both the "Assets" and "Liabilities & Capital" sides of the balance sheet, is the single most critical variable driving costs. This fact raises serious questions about the ability of many companies to hold asset values at currently stated levels. For some, at least, assets have indeed become liabilities.

The Cost vs. Rate Debate

In the United States, we have seen electric rates set historically on a cost-plus basis, yielding a high correlation between "costs" and customer rates. Where rates are high, costs typically are also high. If this were not so, some utilities would be earning attractive returns (em but that's clearly not the case. In 1994, for instance, it appears that the average return on common equity (ROE) for the industry will come in at just under 10 percent. The single-digit nature of the aggregate ROE suggests that prices and costs track each other closely. But further examination of electric utilities and their flexible and inflexible production costs yields some interesting observations.

When fuel costs are compared exclusively, the long-held precept that nuclear is cheaper than most other fuels (primarily coal, oil, and gas) holds true. But this fuel-specific cost advantage quickly vanishes when other production costs and load factors are taken into account (please hold capital in abeyance for the moment). When all is said and done, the production-cost analysis usually reveals a startling find: The operating cost of producing electricity as a commodity does not vary significantly from company to company. In fact, whenever large variances in production costs do appear, they are often explained by items that are characteristically regional (em

specifically, local taxes. That's the hidden story behind electric generating "costs." The differentiating factor is not at the "production cost" level but the "capital cost" level (em a finding that gains even more credence when depreciation (an asset-related cost) is factored out of the production equation.

The Capital Dilemma

I can still remember my first day of accounting class back in college. The professor, who had practiced as a CPA, told us. "You will have no problems understanding accounting if you never forget this one thing: "Assets always equal liabilities plus capital." I never forgot that rule of thumb. (Fortunately, I passed my accounting courses.)

Let's apply that rule to electric utilities. Who's high cost and who's low cost? Production costs do not vary much when you add in nonfuel factors. So the key must lie on the balance sheet. Since rates are set on a cost-plus basis, that reliable college equation

(assets = liabilities + capital) must hold the answer.

Indeed it does.

The most critical aspect of the electric utility "cost" structure is the portion devoted to capital. Those utilities having low net investment per kilowatt of installed capacity will generally offer the lowest rates and, therefore, carry the lowest costs. This finding is not surprising when you consider that higher net-investment statistics (that is, asset values) will typically carry high capital charges (interest on liabilities and dividends preferred and common on equity). Moreover, when the net-investment figure is high, depreciation also tends to be high, exerting additional upward pressure on costs and rates. Thus, the search for winners and losers should end with the level of assets (and, correspondingly, capital) carried on the balance sheet, not the ability to "produce" the commodity we call electricity. This asset problem will often reflect three variables: 1) the presence and magnitude of regulatory assets, 2) fuel sources, and 3) the age of generating assets.

In December 1994, Moody's Investors Service published a report, Regulatory Assets Pose Risks to U.S. Electric Utilities as the Industry Faces Heightened Competition," that chronicles the extent of regulatory assets carried on the books by investor-owned utilities. (The term "regulatory assets" refers generally to paper accounts that reflect assumptions about future cost-recovery that will be approved by regulators.) Many of the synthetic assets listed are remnants of phase-in plans adopted in the mid-1980s or assets that failed to go into service for one reason or another. Moody's worried that recovery of these assets might no longer prove feasible in light of the competitive challenges facing the industry. The report went on to rank companies by the percent of "regulatory assets" to common equity and total assets. The larger the percentage, the greater the perceived risk. But why stop at synthetic assets? If deregulation is likely to force a reevaluation of assets, why only regulatory assets? Are not tangible assets equally as vulnerable to revaluation?

Another significant variable that drives competitive positioning involves the age of capacity. In newer-vintage plants (post-1979) the capital-cost burden generally outweighs the production-cost edge. Older plants (nuclear or not) will almost always carry lower asset values and capital cost than newer plants (again, plants placed in service after 1980). This age differential is the legacy of the hyper-inflation and high interest rates of the early 1980s.

Don't "Write Off" the Industry

I suspect that the problem of asset valuation may not be limited just to soft assets. All assets (notably, generating) may have to be "marked to market" to correct a company's true price/cost relationship. But before we write off the industry (no pun intended), we need to determine with some precision that prices will become completely unregulated. (One dare not say "market-based" for fear of incurring the wrath of auditors.)

At this juncture most states seem to be moving in a fairly deliberate manner toward deregulation (em even California, which had hoped to begin its comprehensive regulatory reform on January 1, 1996, has slowed its pace. Only the Federal Energy Regulatory Commission seems determined to forge ahead. Other individual states might find market-based pricing attractive in the near-term, but that idea only raises longer-term issues. In the short term,

market-based pricing offers customers lower rates but immediately creates the issue of stranded investment. In other words, a flash cut to deregulation entails a tradeoff. Might it not be preferable to let current power supplies diminish, leaving deregulation to take hold when the next increment of capacity is needed? Despite some regional generating capacity surpluses, there is evidence that new capacity may be needed sometime between 2003 to 2005 (em not that far away, even under the most optimistic estimate for full-scale competition in the United States.

Over the long run, market-based pricing may not be what states really want. The raw materials for making electricity (em namely fuel and money (em are inexpensive right now, resulting in a comparatively low cost of entry to the business of generating electricity. But will this ratio always hold true? Historical data for the past 20 years indicates that these two variables are unstable over time. Deregulation transfers this risk to consumers, yet one cannot help but wonder: Is this condition socially or politically acceptable?

Where's the Equity?

Having identified "assets" as the major source of the industry's pricing problem, what then is the solution? A revaluation of assets (em both hard and soft (em would certainly help alleviate much of the current pressure on rates that comes from the capital component. A revaluation would enable utilities to bring prices in closer alignment with the absolute prices offered by "greenfield projects" or "self-generation" alternatives. But this job is easier said than done. Writing down utility assets to values that can be supported by today's market prices is a painful process that entails disruptive capital market consequences (em for debt and equity holders alike.

Concerns over "competition" have already adversely affected the capital markets, frustrating offerings of new common equity by several utilities. Today, the debt and equity markets are more closely linked than ever. Utilities have promised the rating agencies that debt ratios will fall as competition advances. Many ratings have been held by this promise. Yet empirical evidence reveals that the industry's composite debt ratio has changed little over the past five years, and even less since October 1993, when Standard and Poor's (S&P) changed its rating criteria.

In 1990, the industry's total debt-to-capital ratio was 52.6 percent. By 1994 the ratio was virtually unchanged at 52.3 percent of capital. Curiously enough, the total debt ratio was 52.9 percent back in 1980 (em evidencing little progress over the past 15 years. If the industry is to fulfill its mandate and promise to reduce debt, access to equity will be critical. That access is today stymied by uncertainty in regulatory actions, poor earnings prospects, and concerns about dividend safety. With the composite industry's common dividend payout at nearly 94 percent, there is ample basis for worry. This high payout ratio, coupled with an inability to float new common shares, only amplifies the threat that dividends may have to be slashed to grow the equity account and increase financial flexibility. Here's an interesting fact: If the entire electric utility industry stopped paying a common dividend (an annual cash savings of nearly $14.9 billion), it would take 1.4 years before the industry could reach the 47-percent common equity target specified by S&P for a Single-A rating (Average Business Position company). Thus, the specter of any write-offs against an already inadequate common equity account is chilling at best.

The Capital Market Response

The fastest way to achieve lower electric prices for customers is to write assets down to levels that can be supported by current market prices. There can be no denying that some, if not many, utility assets are carried on the balance sheet at inflated values. But the write-off scenario carries with it many deleterious consequences (em such as the loss of cash flow from depreciation and from "promised" earnings on those portions of the assets written down.

Unfortunately, write-offs impact the balance sheet not only on the left side (assets), but on the right side (liabilities & capital) as well. This right-side effect occurs because suppliers of capital are unlikely to offer future funding as attractively or freely as they have in the past if asset values are to be driven exclusively by "market prices." With market-based pricing, the "cost of money" to utilities will reflect a higher risk profile (em costing more. Further, the applicable credit rating standards are likely to become substantially more restrictive. Debt leverage in the 52-percent vicinity will prove too high in a completely deregulated environment. An industrial model with respect to acceptable debt levels may have to be applied to utilities (em and such models call for debt ratios closer to 20 percent of capital. Common equity expectations will also be compromised (em dividend payouts in excess of 90 percent are rare in the industrial arena; the norm is nearer 40 percent.

In short, it would be wise to remember that every dollar of assets, tangible or intangible, carries with it a dollar of capital (em capital that has a real monetary cost. To tamper with or influence the asset values (specifically, the seemingly subtle shift from "cost-plus" ratemaking to "market-driven" prices) is to effectively tamper with the industry's capital-raising ability.

Changing the rules of the revenue game changes the rules in the capital markets as well (em and doing so is sure to affect the success of electric utility companies. t

Dan Scotto, senior managing director at Bear Stearns & Co., has been following electric utility companies since 1977. He is the former head of regulated industry coverage for Standard & Poor's and a frequent contributor to PUBLIC UTILITIES FORTNIGHTLY.

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