Electricity rates may be heading skyward sooner than we think.
Fortnightly Magazine - April 2004


Electricity rates may be heading skyward sooner than we think.

Are state regulators in danger of bringing about the thing they most fear-higher electricity rates? Critics charge that some regulators seem to be opening up the cookie jar, letting utilities have as they please with no supervision.

How else, they ask, to characterize rate-basing merchant generation with no competitive solicitation? And that's not to mention the recent trend of allowing utilities to recover in rates the full cost of upgrading power plants to meet environmental requirements.

Just those two categories could pump billions into rate base. Add in transmission upgrades and new coal plants, and the costs start to add up. Many of these expenses may well be necessary. But will they lead to regulatory rate creep? That's the question.

As we reported in our March issue, in 2003, just over 1.4 GW of unregulated generating capacity was converted into rate-based assets, while pending deals promise another 5.6 GW of unregulated capacity brought into rate base. The sum of pending and completed deals cost ratepayers in excess of $1 billion just last year.

Most of these plants are fired by natural gas. And, as many are aware, most of them were planned without a competitive solicitation. Ratepayers may never know to what extent they subsidized merchant losses, or even if they got a good deal.

But ratepayers may soon find out. On page 48, two authors suggest that reserve margins may not be as large as we think, as many gas plants cannot economically be called into service, or have been mothballed and won't be contributing to reserves. The so-called supply glut, the article warns, may be over sooner rather than later.

Furthermore, some utilities are "voluntarily" spending billions on emission reduction equipment to meet, in some cases, environmental targets that are not required for several years into the future. That's great for the environment. But with some utilities, ratepayers are taking on what amounts to $5 billion in capital investment over 10 years for emissions reduction equipment. Is that a prudent allowance? I imagine that question will be answered in the context of future rate increase requests. And there will be more requests.

Moreover, in some cases, the true rate impact may not be felt for many years to come from utility expenditures.

Legislatures have been getting into the act and extending rate caps to utilities in advance of the development of competitive markets. Some critics say such arrangements carry the risk that bad news will be postponed for years to come.

For example, the Virginia House of Delegates passed a bill March 10 that extends a freeze on electricity rates through 2010, delaying a move to a fully open competitive retail electric market amid concerns over slow market development.

A recent report from Morgan Stanley's equity research division found that the bill allows Dominion to sell power back to the utility at roughly $48/MWh for three years longer, and "[lock] in this attractive semi-regulated cash flow." Furthermore, the bill will allow AEP to get annual rate relief on environmental expenditures.

While all this may sound rather innocuous, experts say utilities should be concerned as many of the arguments I have outlined are beginning to be used in rate case proceedings. Certainly, shareholders and institutional investors are already concerned about the financial impact to utilities from possible disallowances.

The Return of Rate Cases: Investors May Not Be Impressed

Even as concerns rise over rate creep, so too do the worries of investors and Wall Street financiers, as they eye the growing number of utility rate cases.

An equity research team from Lehman Brothers, headed by Daniel F. Ford, recently released a follow-up to last year's report on rate cases, . This year's report is aptly titled,

Ford reviews 36 rate cases on the calendar for electric utilities over the next 24 months, and rates the regulatory commissions. He believes that these rate cases mark the beginning of a new cycle the likes of which has not been seen in 10 to 20 years. Further, they may well drive stock market performance for the utilities in question.

"Our review of 351 rate cases since 1986 shows that electric utility stocks underperform the group heading into cases." But Ford finds that in an environment like we have today, with long-term interest rates below 5.25 percent (for the 10-year Treasury), that such stocks tend to outperform after the rate case gets going, and recommendations start coming in from the commission staffers and intervenors.

According to Lehman Brothers Economist Ethan Harris, the current low-rate environment could continue through 2005.

"Overall," says, Ford, "we believe rate cases will serve as an overhang for the group in 2004, as 26 rate cases are in sight as we enter the year.

"Specifically, we found that when 10-year Treasuries are below 5.25 percent, electric utilities underperform the group by -8.1 percent prior to filing and in the early stages of discovery. This underperformance is reflected from the period seven weeks prior to a rate case filing to the time when staff and intervenors file positions. In this environment, electric utility stocks reach peak relative outperformance of 8.2 percent about nine months after the staff/intervenor filing. These proposals usually mark the most negative milestone of a rate case because they are made by competing and more consumer-orientated parties."

Furthermore, many companies have not had a full-blown rate case in eight to 10 years. Meanwhile, the industry has invested billions of dollars into infrastructure. Many costs such as post-retirement benefits, pensions, and environmental requirements have changed considerably as well, according to the report.

"While allowed ROEs are attractive in the industry relative to today's interest rate environment, some companies are likely to need to seek recovery of their investment through rate increases or to offset rate reductions," Ford finds.

Lehman does believe that certain utility stocks will trade at a price/book premium in constructive regulatory regions. "Overall, it seems as if the business-orientated Midwest and Southeast trade at the highest valuations, on average, and the more consumer and natural-resource-orientated New England and Southwest regions trade at discounts

"Specifically, the Midwest traded at a 10.6 percent premium to the average price/book value followed by the Southeast, which was a 9.7 percent premium. On the down side, the Southwest is a 17.6 percent discount and New England-based utilities are a 13.5 percent discount."

Lehman's ranking of utility commissions is based on six criteria: 1) elected versus appointed commissions; 2) PBR mechanism or not; 3) allowed ROEs; 4) settle vs. litigate; 5) rate levels; and 6) a subjective evaluation of investor "friendliness."

The bank ranked Ohio as the top-rated public utilities commission. Alabama, Colorado, Indiana, Kentucky, and Wyoming also fell into the top tier. The bottom tier consisted of Arizona, Nevada, New Hampshire, New Mexico, Vermont and West Virginia.

What to make of the fact that the majority of those voted the best and worst PUCs still hang on to traditional rate-base regulation? Even in regulated states, balancing shareholder interest against ratepayer interest is still more art than science. A fact that utilities will always dread, as long as there are rate cases.


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