TODAY THE ELECTRIC UTILITY INDUSTRY HURTLES TOWARD massive restructuring. This fervor is not surprising as it appears society has become convinced that market forces can work better than a centrally planned, regulated environment. This conviction draws strength from deregulation in other industries, such as the airlines, natural gas production and telecommunications.
In the electric utility industry, however, this desire for markets is encouraged by a simple but powerful reality: For several years, the marginal cost of electric production has remained far below the average embedded total cost of production. The ground has been made more fertile by a substantial surplus in electric production capacity, especially in those regions where the greatest desire for restructuring has appeared. Because of this surplus, the risk to electric system reliability inherent in restructuring is perceived as low.
We see the rush toward restructuring most powerfully in California, New England and New York (em the regions where electricity tends to have the highest delivered price. In places where delivered prices are far lower, such as in the South and much of the Midwest, one hears talk of restructuring, but the discussion seems driven more by a need to be politically correct than by any real desire to move as fast as California or the Northeast. Any serious reflection leads quickly to a simple realization: The desire for restructuring directly correlates in intensity with the price of the delivered product.
A deeper investigation of the political, regulatory and social forces that drive restructuring initiatives can reveal some important conclusions about the consumer prices and investment returns that we will likely see in these 'leading edge' regions.
On a macroeconomic plane, investors should consider this question: Will they find any substantial opportunity for reasonably attractive returns on investment?
The Political Backdrop:
Dangers for Long-term Capital
From my experience, the underlying environment (em the events that have led California and the Northeast to acquire the point-position in restructuring (em will almost certainly ensure that investment opportunities will remain poor in the short and intermediate term.
California and the Northeast have been intimately involved in utility planning for the past 20 years. Generally, these states have demanded 20-year forecasts and supply plans to meet those forecasts (em leading to a heavy, state-approved commitment to nuclear power. Why? Supply availability or local environmental regulations virtually precluded base-load generation of any other technology (e.g., coal or natural gas). Electric rates ballooned in these very states when officials mandated huge cogeneration buy-back requirements at above-market rates and enforced other regulatory directives, such as massive expenditures for conservation and load management programs (em even during periods when load growth was flat or negative. The same forces that led to the high costs seen in California and the Northeast are now determined to lower electricity costs through restructuring, even if the costs for past regulatory mandates may not be recovered.
Any investor in a restructured industry would be well advised to consider this political backdrop in weighing the possible large-scale, long-term capital commitments for electric generation. The last 20 years is replete with examples of regulatory reversals of "policy" (em always with resulting damage to investors. One need only look at the unwillingness of New York state to permit Niagara Mohawk to recover the stranded cost associated with cogeneration buy-back requirements. The "negotiated" solution to this state-mandated, high-cost power has forced NiMo to hand over a large fraction of its equity to cogenerators. In New Hampshire, we have the spectacle of a state that first helped bring its home utility out of bankruptcy. The acquiring company relied upon a firm, written contract guaranteeing recovery of certain costs, but now appears unwilling to honor that contract. The result? The acquiring utility has had to go into federal court simply to get New Hampshire to honor its word.
This backdrop appears unsettling not only in its anecdotal caveats, but also because of what it implies for the transition to competition. It is unlikely that we will see anything like a rapid move to markets in the electric energy business. Almost certainly the transition will occur over an extended period with heavy oversight, both regulatory and political.
Consider the airline or telecommunications industries. Deregulation of the U.S. airline industry was signaled by dismantlement of the Civil Aeronautics Board in 1979. In 1984, we saw the start of deregulation of the telecom industry (em a restructuring which 14 years later has not generally been undertaken at the state level. These two industries are often singled out when discussing the pending restructuring of the electric industry. However, they provide poor models for projecting electric restructuring or the opportunities and risks for investment in a restructured generation market.
If state governments remain involved in electric restructuring, their work certainly will not parallel what occurred in the airline industry, with its quick dismantlement of CAB. Instead, the record to date at the state level implies a transition that will likely prove to be far slower and more intrusive, for example, than the more rapid attempts at telecommunications restructuring undertaken so far at the Federal Communications Commission. (In fact, a number of state regulatory commissions already are suggesting a need for more staff to oversee electric industry restructuring.) It is this ongoing state involvement that will inevitably exert a substantial negative force on the ability to earn satisfactory returns in the electric generating business in many parts of the U.S.
A number of behaviors at state level could raise serious concerns, such as:
• Chronic failure by state policymakers to follow established policies (em even their own.
• Unprecedented involvement by an entrenched state "consumer advocacy" infrastructure.
• Regulatory constraints on electric demand growth.
• Ongoing state control of electric distribution companies.
The well-documented cases of the failure of states to live by commitments made either under the "regulatory compact" principle or even underwritten contract obligations are not meant to suggest a lack of honesty or trustworthiness of individual regulators. Rather, these cases underscore the high risk of systemic inability to live up to past commitments, even if the commitments represent state mandates and particularly if they are long term in nature.
The regulatory process is truly a reflection of state politics (em a process that is driven by a two-year legislative election cycle. In some states, such as New Hampshire, even the gubernatorial cycle is a two-year cycle. Today's surplus generating picture, with marginal cost of production below average cost of production, has made deregulation and restructuring attractive because of short-term rate reduction possibilities. History suggests that making long-term bets when the economic picture can be drastically affected by short-term political considerations is extremely risky, particularly in states at the forefront of electric industry restructuring.
A Bureaucracy Like No Other
The political and regulatory picture is made more risky by an entrenched consumer advocacy infrastructure that does not exist in other business environments. In the case of airlines and telecommunications, the primary regulatory battles were fought at the federal level with various states involved as parties, but not as decision makers. The regulator, such as the FCC or CAB, conducted a series of complex regulatory proceedings. However, the proceedings were fairly judicial with rules generally understood and followed.
By contrast, the tone in many states in the electric utility marketplace is different. An extensive infrastructure of consumer advocacy in many states makes a consistent, reliable application of regulatory principles difficult to achieve. All the states at the leading edge of restructuring have full-time consumer advocate departments within state government (em departments that are active litigants in electric rate proceedings. Some states have two such departments. Connecticut has three! These groups typically cast all issues in a highly charged, short-term framework that has enormous political appeal to those seeking immediate electric rate reductions or other "consumer benefits." The focus of these consumer advocacy departments is invariably oriented toward residential customers, usually at the expense of business customers, and always at the expense of the owner of the asset, which cannot easily be moved. There is no indication that these groups will be dismantled or diminished on a going-forward basis, and we can be highly confident that these groups will be involved in attempts to force electric production bus bar costs down when the current surplus picture reverses or when marginal production costs again rise above embedded costs.
No Easy Platform for Growth
One of the underlying initiatives in any effort to restructure an industry is to grow consumption as a means of delivering value to customers and investors. No one would suggest that the transition from a highly regulated environment to an open, market-driven environment has been easy for the airline or telecommunications industries. Indeed, in many cases investors have yet to see assurance that commitments made in these industries will return value over the long term. At the same time, however, whatever value has been returned to shareholders and customers is clearly rooted in the growth that these industries have seen.
Without doubt, the transition from regulated to market-driven for the airline and telecommunications industries would almost certainly have been disastrous were it not for the explosive growth these industries have experienced in the past decade. The electric utility industry has no such platform for growth. Certainly, there are technologies which could enhance the attractiveness of electric energy utilization, thereby generating potential future growth. However, the very states leading restructuring have a deeply rooted "no-growth" energy philosophy. It should not be forgotten that these states mandated large, expensive conservation programs even when electric energy growth was zero or negative. These states are still deeply committed to a "no-growth" philosophy as witnessed by conservation requirements present in essentially all state restructuring plans.
Still "Wired" to Regulation
The states leading restructuring today have encouraged or even mandated the breakup of their vertically integrated electric utilities, so that the only surviving regulated entity is a distribution-only wires company. The ongoing state control and regulation of this wires business presents a strategic issue for potential investors in the generation business.
Investors should not think that this divestiture has removed the regulated wires entity from the energy supply business. The states have left the so-called "obligation to serve" with the distribution company. Furthermore, these states have generally mandated distribution companies to continue demand reduction programs, which must be paid for by all consumers, even those who wish to be totally on their own as far as energy supply issues are concerned.
The ongoing, tight regulation of distribution companies leaves a situation that may well affect the value of unregulated generation. The impact is unlikely until a time of rising or volatile prices (em something probably not likely to occur during the current surplus generation environment. However, when such volatility does occur, there is nothing to prevent the regulators from directing the distribution company to reenter the energy supply business either by building new generating plants with an average cost less than the current marginal cost or by mandating the distribution company to get back into the gross power contracting business. Such directives could severely distort a market-driven economy with the resultant erosion of the value of assets already in place and not readily movable.
Some examples in the recent past would suggest such a course of action is not only possible, it is highly probable. It might also be a fact of human nature that the management of the wires business might be attracted to the opportunity to expand, recognizing that resisting the regulatory pressure could be very difficult for the still-regulated company.
Risk and Reward: Doubly Strained
What do these considerations mean as to the attractiveness of investments in the electric energy supply industry? They do not mean that the electric energy supply future will be an unmitigated disaster for investors. There may well be highly successful investment strategies. They do, however, suggest there is a lower probability of satisfactory returns in many regions because of the market's history of intense consumer advocacy and political intrusion. No clear signal can be found that such intrusion will be mitigated in any meaningful way. Future investors will have to be more prepared for risk and disappointment.
A savvy investor in a capital-intensive, commodity industry should be aware of the risks associated with volatile pricing typical of such an environment. However, the risks in the electric market likely will be exacerbated by the high expectation that a powerful political and regulatory infrastructure will ensure deep involvement, which bodes poorly for investors. The investor will have to develop strategies for dealing with a business that carries the difficulties of a commodity market, but where the risk-reward ratio is doubly strained (em because of the very real potential of selective involvement by a challenging political and regulatory framework.
Bernard M. Fox retired this year as chairman and chief executive officer of Northeast Utilities System.
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