Another Domino Falls as US Electric Power Deregulation Roll Back Continues
Companies / US Utilities Sep 05, 2007 - 12:43 AMBy: Roger_Conrad
When California passed its long awaited electricity deregulation law in 1996, it was supposed to signal the start of a revolution.
Proponents had argued for years that breaking up utility monopolies would trigger an explosion in generating capacity.
That, in turn, would create cheap power, spurring economic growth and prosperity. Utilities and their investors were to be the big losers, and a new generation of feisty upstarts was to take their place.
The deregulation of the 1990s did trigger an explosion of power plant construction. In fact, nearly 100 gigawatts (GW) worth of plants were built in the late '90s, virtually to be run on natural gas. The impact on customer rates, however, hardly went according to plan. First came the unraveling of California, followed by the ENRON bankruptcy several months later. And since then, electric deregulation has been rapidly unraveling across the country.
At deregulation's peak in 2000, two dozen states and the District of Columbia had either moved to competitive generation--transmission and distribution (T&D) remained regulated monopolies--or else had plans in place to do so. This week, Ohio became the eighth state to roll back its restructuring, as Gov. Ted Strickland proposed restoring regulated power company monopolies. And it's not likely to be the last domino to fall as the last decade's experiments are reversed.
Strickland acted because the state's 10-year rate freeze/transition to deregulation is coming to an end. If no action is taken, starting in 2008 power prices will move to market-set levels, likely setting off a massive increase in customer rates.
That's what happened this year in Illinois. The transition to deregulation involved a 10-year rate freeze, beginning with the law's passage in 1997. This year, the state held a power auction, which set a baseline market price for electricity. That was then passed through in rate hikes to consumers, which were on the magnitude of 25 to 30 percent and higher, by the monopoly regulated distribution utilities.
The increases, however, set off a massive public outcry and an immediate reaction by the state's politicians. Led by Illinois Attorney General Lisa Madigan and a sizable contingent in the legislature, the state began moving to extend the rate freeze. If successful, they would have forced the distribution utilities to absorb the entire boost in market rates, with billions of dollars in potential losses. The distributors' owners AMEREN and EXELON threatened to put them into Chapter 11 in response.
Legislation for extending the freeze passed the Illinois house, but the utilities' allies prevented it from reaching the state senate.
Finally, a compromise was reached this summer. The upshot was that the competitive market was preserved. But the generating companies committed to a series of rebates over the next few years to basically phase in rate increases.
As in Illinois, major Ohio utilities AMERICAN ELECTRIC POWER, DPL, DUKE ENERGY and FIRST ENERGY own both distribution and generation.
Unlike in Illinois, however, none of these companies appear opposed to a return to regulated monopolies. Little competition has emerged in the state to date, so they'd likely be able to pass on whatever rate increases they wanted. But all four utilities are heavy into coal power, which will require substantial capital expenditures in coming years to meet clean air standards and--almost certainly--carbon regulation. That investment might better be recovered under a regulated regime.
Whatever the reason, generally pro-utility Gov. Strickland has now asked the legislature to abrogate the deregulation law and to officially revert to regulated monopolies so as to stabilize customer rates. The other goal of his plan is to require that utilities generate a minimum of 25 percent of electricity sold in the state from so-called advanced energy technologies.
Here, too, there's a treat for utilities. To date, most states--as well as the US House of Representatives in recent legislation--have restricted the definition of “advanced energy technology” to renewables such as wind, solar and biomass, as well as technologies that conserve energy. Strickland's definition is somewhat revolutionary in that he also includes clean coal and new nuclear power technologies. The deadline date of 2025 for the plan is also far more flexible than, for example, the US House's 2020 timeline, which has also been adopted by many states.
It's too soon to say whether Strickland's plan will be adopted in Ohio. Strickland, however, is a Democrat who has historically worked well with the Republican-controlled Ohio legislature. And Republicans have traditionally been supportive of utilities. As a result, the plan has decent odds of going through, particularly since it would prevent Ohio from experiencing an Illinois-style rate shock.
If it does pass muster, Strickland's plan could well become a template for other states now wrestling with higher-than-expected energy costs that will be felt full-on by customers in a real deregulated market place. And defining clean coal and nuclear power as advanced energy technologies gives states in the Southeast and Midwest--which use a lot of both fuels--the cover they need to stand up to federal legislation that could restrict regional utilities' options and threatens huge rate increases for consumers there.
DOUBLE-EDGED SWORD
From an investor point of view, the rollback of deregulation across the country is something of a double-edged sword. On the one hand, there's an emerging shortage of economic electricity, which is a plus for unregulated producers. And if deregulation is overturned in the remaining states with competitive markets, that profit opportunity will vanish.
On the other hand, ending deregulation and reinstating regulated monopolies means more stability for the industry. That means less financial and operating risk and a greater ability to withstand the impact of any crisis, provided companies enjoy regulatory support.
When California first began debating deregulation in 1993, the initial proposals called for simply ending utility monopolies by fiat. This was fiercely opposed by utilities, which saw it as a simple taking of property, namely their century-old franchises to provide power universally to their communities and regions.
Rather than see any action tied up in court for years, the state instead worked out a compromise, which wound up being copied across the country. Like the initial proposals, the final deal called for utilities to immediately relinquish their total control over generation of electricity. In fact, to ensure against self dealing, companies were required to sell their power plants.
The distribution and transmission of electricity remained monopoly businesses under the control of the utilities. Customers continued to pay a fee for the upkeep of these systems. But they purchased electricity from a new breed of unregulated power marketers, which competed with each other to provide the lowest cost energy. In some states, such as Pennsylvania, utilities were required to remain the provider of last resort (POLR) for customers not electing to use an alternative provider. These POLR customers received their electricity under a uniform rate set by regulators.
In return, utilities were allowed to recover their stranded costs, or investments made under regulation that would supposedly be uneconomic under deregulation. When deregulation was first proposed in 1993, there was no provision made for stranded costs. Using prevailing natural gas prices--then in the range of $1 to $2 per million British thermal units (MMBtu)--credit rater Moody's forecast utilities would have to write off billions of dollars of stranded costs, as a new breed of natural gas-fired power plants displaced the old nuclear and coal baseload capacity.
Before stranded cost recovery was adopted in the states, the threat of deregulation had triggered huge losses for utilities. By the end of 1994, the Dow Jones Utility Average had plunged by more than a third from its 1993 high, as investors abandoned the sector.
Widespread bankruptcies were forecast, with the California utilities the worst hit.
When the stranded cost compromise was first proposed, it was an instant salve for the industry. In fact, by late 2000 the sector had pushed out to new all-time highs, more than doubling the old lows.
California utilities were among the highest flyers.
Deregulation laws had a major problem, however. They were all based on the assumption that natural gas prices would remain indefinitely in the $1 to $2 per MMBtu. That was the price level on which the 100 GW of natural gas power plants built in the '90s were constructed.
Ten years later, it's hard to conceive of natural gas prices going that low again. Even with record high inventories, prolonged mild weather, a big drop in demand from industry and a lack of hurricanes in the Gulf of Mexico, prices are still well above $5 per MMBtu.
Moreover, production is collapsing in many parts of North America and we're importing a record 3 percent of gas supplies from overseas as liquefied natural gas (LNG).
The rise of natural gas prices has simply made uneconomic most of the gas-fired power plant capacity constructed in recent years. At any rate, it's unsuitable as baseload capacity and is now being used as peak load. Ownership of the plants--once the preserve of upstarts like CALPINE CORP--is now once again mostly in the hands of major power companies and even regulated utilities.
The gas plant collapse is proof positive once again that the best power mix is one that's diversified, where the price of no single fuel source can trigger big price increases. The spike in gas prices more than anything else is responsible for the higher power prices in the deregulated states of recent years.
Uneconomic gas generation, however, is now only a part of the picture. A decade of exploding electricity use--mainly for connectivity but also entertainment--has continued to lift power demand nationally. That's despite the fact that we've become continually more efficient in our use of it, and will be in coming years.
FROM GLUT TO SHORTAGE
Earlier this decade, industry observers, including Platt's, forecast a glut of power supplies to 2010 and possibly beyond. Instead, however, the glut that prevailed earlier in the decade has now been soaked up, and economic power supplies are increasingly in shortage around the country.
The second quarter, for example, marked a period of big profits for generating companies in the Northeast. That more than offset temporary weakness in Texas for giants like NRG ENERGY. DOMINION RESOURCES--which controls about a fourth of unregulated New England markets' power--also had a good quarter.
To date, the New York/New England market has been the most successful deregulated region in the US. Giant distribution utilities like CONSOLIDATED EDISON and NORTHEAST UTILITIES sold all of their capacity in the last decade, and are now in the pure wires and pipes business. Both have scored solid earnings gains in recent quarters by winning rate increases to pay for upgrades to their systems.
Con Ed currently is trying to win Empire State regulators' approval of its ambitious $5 billion program to expand T&D infrastructure in New York City. If it succeeds, the New York power system will include some of the world's most advanced technology, including superconductors and fuel cells. And the investment will also bring a major boost to company earnings. Northeast has several major power line projects in the works for its Connecticut-Massachusetts-New Hampshire territory.
Such investment expansion is very low-risk. It's also sorely needed in the region, which in many areas has power infrastructure that's at least 75 years old.
Getting a return on this investment, however, is no sure thing. It's a lot easier to get the T&D returns when the price of power is lower--and the overall customer bills are more reasonable--than it is when the price of power is high and rising.
A return to regulation in these states doesn't appear in the cards at this point. For the first time in a decade, Connecticut has decided to allow utilities to own power plants. The idea is to expand supplies and head off possible future price increases as supplies tighten. The companies, however, haven't exactly jumped at the prospect. And in any case, it will be a long time before enough new supply is created to boost supplies sufficiently.
Not surprisingly, the regions of the country where power prices are most stable are those that never deregulated their markets. That particularly applies to the Southeast, where SOUTHERN COMPANY and others headed up the “just say no” crowd for many years and, with the support of state legislatures, effectively blocked any action.
Those are also the regions of the country where there's the least regulatory risk and risk of shortages.
The biggest mistake investors have always made with utility stocks is to paint them all with the same broad brush. That attitude has been reinforced for years by lazy brokers and advisors, with the result that shareholders routinely minimize both risks and potential profits.
There are some factors that affect all utilities. Rising interest rates push up borrowing costs and reduce the value of dividends because other alternatives become more attractive. Federal legislation and actions by the Federal Energy Regulatory Commission affect all companies on those rare occasions when industry-wide policies are enacted.
For the most part, however, utilities' profitability--and ultimately their dividends and share prices--is determined by conditions affecting their business alone. That includes state regulatory mandates but also the skill of management in navigating sometimes challenging business conditions and positioning their companies for long-term success.
The worst mistake managements have made historically is trying to take their company where another utility has gone. That, for example, led to the attempt to copy Enron, which proved so disastrous in 2001-02. It also led to the wave of overseas investment by utilities, which they're now in the process of withdrawing from, some with a profit and others at a big loss.
As the battle over deregulation continues to unfold, how companies succeed or fail will depend on how well they navigate their own course. In some states, that will mean maximizing the advantages afforded by deregulation while positioning for a potential return to regulated monopolies. In others that are already regulated, it will mean being able to win rate increases needed to maintain profitability and financial health.
The best utilities to own are those in the surest region: the Southeast. The Southeast remains the economically steadiest and healthiest section of the nation. It's also the most conservative politically, and the least likely place to see vote-hungry public officials trying to make utilities their whipping boys.
There are exceptions to the rule. Arkansas, for example, recently denied a rate increase for a unit of giant ENTERGY, instead imposing a small rate decrease. That's a throwback to the state's days under then-Gov. Bill Clinton, who often used conflict with the utility as a way to drum up support.
Arkansas, however, is firmly in the regulated camp. Entergy and other utilities there may not get all they want in rate increases.
But neither are they likely to be shocked by grandiose schemes to reorganize their sector, as continue to rock other regions. Companies can't look forward to big profits in such a state. But they can expect stability, and that's an excellent underpinning for any business, particularly when the economy looks at least somewhat at risk.
As for Entergy itself, it remains uniquely positioned. At its core are regulated monopolies in Arkansas, Mississippi and Louisiana, including New Orleans. These are all in good shape, even the latter now that federal aid and rate increases are on the way. The company also owns the nation's second-largest fleet of unregulated nuclear power plants (after Exelon), and has a large and profitable stake in the unregulated Texas power market.
Regulated stability plus unregulated growth: That's a formula for substantial profits and dividend growth for years to come. And Entergy's strong second quarter earnings and 39 percent dividend boost this summer are pretty good proof it's a keeper.
The same goes for all three major Ohio utilities. Of the trio, Duke Energy is the most attractive, for its low share price, strong power plant portfolio and regional diversification. American Electric Power is also in good shape, though a bit expensive. First Energy is the fastest-growing but riskiest, given the spotty operating record of its nuclear power plant fleet.
MORE ON SUBPRIME
This week, the markets continued to be roiled by economic news.
Investors seem to be feverishly looking for evidence that will definitively show whether or not the ongoing mortgage market turmoil is spreading to the US economy and beyond.
Thus far, there's no hard evidence this is the case. Meanwhile, the Federal Reserve and the world's other major central banks continue to pump in liquidity, whenever the markets show signs of losing faith.
It's notable that we haven't seen anything close to the bloodbath in the stock market that we did in 1998. Alan Greenspan reacted with a massive capital infusion only after a 20 percent-plus collapse in the S&P 500. Instead, despite the daily gyrations, the actual market averages remain very close to all-time highs.
Tuesday was fairly wild and wooly, as selling in the US spread around the world. But it was followed by a big upmove Wednesday and a relatively flat Thursday, as markets calmed.
As for actual economic news, it pointed to some slowing, as initial jobless claims rose to their highest level since April. But the Commerce Dept reported that second quarter gross domestic product
(GDP) rose at a powerful 4 percent annual rate. That hardly smacks of a recession, though it was below what some were expecting; others worried the primary source of strength was business and not the consumer.
Again, evidence of some slowing of economic growth shouldn't surprise anyone. And despite BANK OF AMERICA'S move last week to take a stake in COUNTRYWIDE FINANCIAL, everyone should expect more fallout in the mortgage market as well, particularly from financial institutions that bought a few too many collateralized mortgage obligations over the past year or two.
The key here, however, isn't the remaining blow-ups we'll see or even if the stock market has a few more very bad days. It's that the Fed and the world's central banks are moving to shore up the system--and will continue to do so whenever it's needed.
It's possible growth will slow, or that we'll see some more corporate defaults, though those remain near historic lows. But with the Fed certain to respond quickly, the most likely outcome of that will be lower interest rates, which will eventually bring recovery.
Meanwhile, the benchmark 10-year Treasury note yield has now fallen to the 4.5 percent range. That's the lowest level since late 2006.
That hasn't benefited our utility and income stocks much to date.
The broad-based utility averages are down about 10 percent from the highs they reached earlier this year. Real estate investment trusts are down twice as much. And other income generators like bank shares, preferred stocks and closed-end bond funds are down even more.
Sooner or later, however, the market is going to lose its fear that subprime is going to escalate out of control. And at that point, income stocks across the board are going to make up their lost ground and more. The further the 10-year yield falls, the bigger the gains.
In the past 40 years, utilities have had a strongly positive fourth quarter 90 percent of the time. With the 10-year yield dropping and subprime fears receding, the stage is set for a repeat performance, and other income investments are virtually certain to follow suit.
You've still got to be a stickler for quality. It's also important to keep your eye on what's likely to be the next act for the markets. That's the Fed going too far to pump up growth, with the result of higher inflation and higher interest rates.
There's almost surely more turbulence ahead, and there's no guarantee weaklings won't take further hits. For now, this is the time to stick with good income investments, and even to add to positions in what you're most sure of.
By Roger Conrad
KCI Communications
Copyright © 2007 Roger Conrad
Roger Conrad is regularly featured on television, radio and at investment seminars. He has been the editor of Utiliy Forecaster for 15 years and is also the editor of Canadian Edge and Utility & Income . In addition, he's associate editor of Personal Finance , where his regular beat is the Income Report. Uniquely qualified to provide advice on income-producing equity securities, he founded the newsletter, Utility Forecaster in 1989. Since then, it's become the nation's leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks.
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