Avoiding a Train Wreck


Fundamental issues set companies and regulators on a collision course.

Fortnightly Magazine - September 2010

Industry leaders see a disaster coming, as the need for infrastructure investments collides with the economic interests of utility shareholders and customers. In a shaky economy and a politically charged campaign season, proposals for new capital expenditures are certain to cause trouble. Avoiding the train wreck will require real leadership in finding compromise solutions.

As I write this, I’m seated outside, in a camping chair with my laptop at a resort. It’s a lovely day; the sun is shimmering off the sky-blue waters of a lake somewhere in northern Wisconsin. Tall maples are whispering in a gentle August breeze. The kids are bicycling, playing and fishing with their cousins.

And me? I’m thinking about a train wreck.

Not an actual train wreck, of course, but the metaphoric train wreck that many utility industry leaders are saying they see coming.

They foresee a collision of needs and interests—namely, the need for infrastructure investments, colliding with the financial interests of utility shareholders and customers. They see troubling uncertainties—about politics, regulation and fuel price trends. And most of all they see a shaky economy, still reeling from unemployment and the housing crisis, and straining under the weight of a record-breaking national debt.

It’s a depressing topic for such a lovely day here in the north woods, where the birds are singing and the children are laughing. Actually it’s a depressing topic anytime, anywhere. But fortunately enough, the industry’s best minds are working to avoid the disaster, or at least minimize its effects.

Collision Course

In part, train-wreck avoidance provides the implicit story line for several articles in this issue of Fortnightly. For instance, “Deja Vu or New Horizons” describes how public utility commissions across the country are dealing with the challenging rate cases that are coming before them today. “Hybrid Finance” proposes an innovative approach to paying for power capacity additions. And of course the Fortnightly 40 report spotlights companies that are managing to deliver outstanding shareholder performance even as they balance infrastructure-investment needs with customers’ financial interests.

But as admirable and worthwhile as the industry’s efforts might be, tensions are rising between companies and regulators, with outright conflict already happening in some jurisdictions. Florida and Maryland leap to mind, but trouble is brewing in many states.

When people in the industry talk about an impending train wreck, they’re usually referring to a collision between economics and regulation. Specifically, regulators are loath to approve cap-ex driven rate cases that raise rates substantially during a time of economic hardship. At the same time, lawmakers—especially at the federal level—are waffling. Clear direction on policy has gone begging. Examples include carbon regulation, renewable incentives and the much-touted nuclear renaissance. It all adds up to a fierce battle over who bears the risks and costs.

Beyond the current uncertainties, however, a few fundamental issues have set the industry’s companies and regulators on a collision course.

First, everybody knows there’s no such thing as a free lunch, but customers generally don’t appreciate how cheaply they’ve been served. Underinvestment has kept prices artificially low for too long. In many parts of the country, we’re still running utility infrastructure that outlived its intended life sometime last century. Utilities and regulators understand the real need for replacements and upgrades, but customers don’t understand why costs should rocket upwards for services that have remained substantially unchanged.

Second, the industry’s herd mentality guarantees that virtually every trend becomes a bubble that eventually bursts, often painfully for investors, customers or both. Previous bubbles included nuclear plant construction, and later the gas-fired turbine craze. Now it’s wind and the smart grid. Next, it might be natural gas again, as the industry stampedes toward what seems like the cheapest and easiest solution for adding clean generating capacity. But if shale gas fails to materialize in the volumes expected—or if gas demand rises precipitously, as it must with the power industry’s dash to gas—then that solution won’t look nearly as cheap as it does today.

“I don’t think the market has fully accounted for all the new gas-fired generation that’s being developed,” said Jean Reaves Rollins, managing partner with the C Three Group in Atlanta, which developed the Fortnightly 40 model and provides financial analysis for the report each year. “Well over 10,000 MW of new capacity has been announced or placed into the licensing process in the past 12 months, and we expect more announcements. The more gas-fired plants we install, the more integrated electricity and gas markets become, and the more important it becomes that we understand commodity price trends.”

Third, utility investors have become accustomed to a set of financial metrics whose days might be numbered. Those metrics were developed in a different world, when technology was more static, and the words “utility” and “risk” were strangers. And yet any utility CEO who today might dare pose a contrary strategy—one that might threaten those beloved metrics—will bring on swift punishment from Wall Street, via stock selloffs or credit downgrades.

This isn’t just the fault of utilities; it’s also the fault of a regulatory paradigm that exposes utilities to the risk of having their returns decimated every time they bring a rate case before the state commission. With such a disincentive, it’s no wonder utilities have avoided rate cases for so long. But now, with cap-ex spending likely to rise, utilities logically should be issuing new equity and tightening their dividends, to spread the costs and risks among shareholders and customers. Most companies avoid doing that because they need to maintain status-quo financial metrics, even though those metrics are based on a deferred cap-ex model. It’s a vicious cycle with no clear end in sight.

Compromise Solutions

As anyone on Wall Street knows, uncertainty is the enemy of investment, so the growing conflict poses major challenges for industry leaders. The term “train wreck,” however, implies a bigger catastrophe than we can let happen.

Just as industry precedent portends trouble ahead, it also suggests that, one way or another, we can work it out. All it will take is a few industry leaders to step up and find a rational equilibrium between economic realities and policy signals. Customers will react negatively to rising prices, and utility shareholders and bond investors might punish utilities for increasing risks and costs. But the birds can keep singing, and the kids can keep on playing, because the industry’s leaders will find compromise solutions that allow us to build needed assets and continue serving customers.