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The No 1 Gold Stock for 2019

US Electricity Generation Crisis Building

Commodities / Energy Resources Oct 21, 2007 - 11:00 AM GMT

By: Roger_Conrad

Commodities

Best Financial Markets Analysis ArticleOil prices are rapidly approaching $100 a barrel. Coal is vilified as the cause of global warming, and a big tax imposition is only a matter of time. Natural gas is several times its levels earlier in the decade, despite a sector depression that seems to continue to worsen.

New nuclear plants are a decade away at best. Wind and solar plants run at low capacity rates even under the best of circumstances. And geothermal is only available in a few regions.


Then there are the construction and operating cost issues. An explosion in infrastructure growth around the world has dramatically increased the prices of raw materials like copper, as well as essential products for building power plants like concrete reinforcing bars and fabricated pipe and fittings. And this trend continues to accelerate, with nations such as China constructing entire cities.

Energy-related engineering and power plant construction were hot fields back in the 1960s and '70s, as America urbanized and electrified. Then came the slower growth of the '80s and '90s, and the industry went into a virtual depression. As a result, fewer and fewer graduating students chose to pursue utility- and energy-related engineering careers.

Today, the generation that came on board during the boom is beginning to retire en masse. And although there are people ready to take their places, they're relatively scarce. That means higher salaries and higher costs for utilities.

Access to capital has increasingly been a bright spot for utilities in the past few years, as the sector has put the troubles of the ENRON era behind it. Getting back to basics and shedding unprofitable unregulated operations, however, can only go so far to strengthen balance sheets when capital needs are expanding.

According to the World Energy Investment Outlook 2006, worldwide power sector investment will total about $11 trillion between now and 2030. Much of that will go toward meeting environmental needs, such as reducing carbon dioxide (CO2) emissions from power plants.

Legislation to mandate a carbon tax or cap and trade system—where rights to pollute would be sold on the open market—is rapidly moving through Congress. There are still many bones of contention, including a controversial attempt by many utilities to set a price cap on traded credits to avoid severe economic dislocations. And there's the prospect of an almost certain presidential veto as well.

Even the president, however, has conceded the need to control CO2 emissions. And once he leaves office in 2009, pressure from the rest of the world—including nations such as China that are moving to control their emissions—will certainly elicit new legislation. That's the reality the industry has accepted, and the cost will be very high.

Moreover, environmental concerns are only a small part of the story. Between now and 2030, electricity demand in America alone is expected to grow by nearly 40 percent. And that's imputing a very conservative rate of annual growth that's far below the expected GDP rate.

That adds up to 258 gigawatts of new capacity demand in the US by 2030. And that's likely well underestimating plants that will likely have to be retired by that time.

Finally, the nation's long neglected transmission infrastructure is going to require a huge investment over the next two decades. That's partly to accommodate rising demand. Some 12,900 miles of high voltage wire is projected to be needed by 2015.

An even more pressing need, however, is to upgrade the reliability factor to a digital age, where even split-second outages can trigger millions of dollars of damages and lost productivity. That's an increasingly difficult task in the older industrial regions of the country, where the wires were put in place early in the last century. And it won't be cheap to fix the problem.

THE NEGAWATT SOLUTION

There are no easy answers to these challenges. Solutions will be found. They have to be for America to keep growing. But it's going to take a lot of hard work and money to make them happen.

For utilities, this capital challenge spells both an unparalleled opportunity and a very high level of risk. If they can recover and earn a return on their investment, the $11 trillion spent by 2030 will flow to their bottom lines. That means higher earnings, dividends and share prices for years to come.

On the other hand, if they fail to recover their investment, the capital challenge spells trouble. The lesson of the Enron debacle shows that even the weakest utilities always survive a fall. So does the lesson of the late '70s and '80s, when regulators with 20-20 hindsight forced utilities to write off billions of power plant costs in so-called prudency reviews.

But the recovery didn't happen without a great deal of pain. And there were wipeouts along the way for shareholders.

In the late '80s and early '90s, it was EL PASO ELECTRIC and PUBLIC SERVICE OF NEW HAMPSHIRE. In this decade, it was NORTHWESTERN CORP. Senior bondholders were ultimately paid off in full, but only after waiting several years for bankruptcy issues to be resolved.

Consequently, our challenge as investors in utilities during the next decade or two is to anticipate what companies will be able to recover their investment—and realize the fruits of rapid growth—and which will not. And as I pointed out last week, that really boils down to looking at things state by state and relationship by relationship. It will be a constant challenge for utility management and shareholders alike.

There's one way, however, that utilities will be able to control their costs and earn a strong return on what they invest to do it: conservation.

Despite dramatic advances in energy efficiency in the past 100 years, there's still a tremendous amount of wasted energy. Some of the losses come from simply transmitting electricity over high-voltage wires from power plants to the plug. Much of it involves how consumers use electricity, from the computer that gets left on overnight to power wasted by old appliances.

There are definitely limits to how much conservation can achieve, particularly with the economy continuing to electrify. But to the extent utilities harness it, they can cut their future operating and construction costs dramatically.

Better, state after state is virtually guaranteeing a generous return on whatever utilities spend on conservation. In my view, it's very unlikely California will achieve the goal mandated this week by state regulators: to basically force homebuilders to create programs to make every new home generate as much electricity as it consumes.

The fact that they're trying to force this kind of change, though, is a very good sign for California utilities that invest in conservation. For example, EDISON INTERNATIONAL this week unveiled the “circuit of the future” and has begun using it to deliver power to 1,420 residential and business customers in southern California.

The circuit is based on digital technology and is designed to minimize outages by identifying problems more quickly than human operators. That spells efficiency gains for both consumers and the utility itself because it will be better able to control power flows.

And the state isn't the only backer. The US Dept of Energy has already committed $1 million in research funds.

As my friend and seasoned industry attorney Jonathan Gottlieb points out, harvesting the promising returns of “negawatts” depends on implementing a suitable rate structure that actually rewards the utility for selling less power.

The concept of such “decoupling” isn't new. In fact, it's employed in many states for natural gas utilities.

Companies such as ATMOS ENERGY—which has pioneered this regulatory strategy across America's southern tier—now earn a steady return, which factors out the impact of weather. Whether temperatures are mild or frigid in the winter, earnings are steady.

Conservation spending is slightly more complicated. As I pointed out above, the incentive for utilities to conserve energy is definitely there. But it's very hard to match up particular expenditures with results--in other words, with how much energy is actually being saved.

Regulators want to reward utilities for spending money on reducing energy use. But if they automatically grant a return on all spending, rates will rise with no benefit to either the consumer or the utility. Sooner or later, the shareholder will pay for the imprudent spending, as the company is forced to spend in other areas with an already high cost structure and very likely extremely skeptical regulators.

Coming up with measurable standards for conservation spending, then, is absolutely essential for it to work long term. In the meantime, utilities can profit from regulators' enthusiasm in the near term, even if standards are never achieved. And there are some things that make economic sense, even if regulators are tardy in granting a return.

The clearest beneficiaries are transmission and distribution (T&D) companies in regions of the country that remain at least partly deregulated. These utilities were forced to sell off their power generation assets in the last decade and today purely operate the wires—and sometimes gas pipes—in their service territories.

These companies are winning two ways. First, as owners of the T&D infrastructure, they're the monopolies that will realize returns on new spending.

Second, they can earn returns on what they spend on conservation. And because they don't generate electricity on their own, there's no loss of sales on that score.

We've already seen some appreciation in this group, and yields are now stuck in the 3 to 4 percent area for most high-quality companies. An exception is UNITIL CORP, a small T&D company straddling New Hampshire and Massachusetts that pays close to 5 percent.

Another attraction of New England-based T&D outfits in particular is takeovers. Britain's NATIONAL GRID completed its sixth acquisition of a US T&D utility last month when it took over KEYSPAN ENERGY and is rumored to be eying more targets, particularly with the US dollar so cheap relative to its home currency the British pound.

And it's not alone. Spain's IBERDROLA is in the process of buying ENERGYEAST in a deal expected to close early next year.

T&D businesses make good takeover candidates because power grid assets can be easily joined and absorbed by other systems. UNITIL's assets would make a nice addition to a larger company's base.

So would neighboring NSTAR, which serves Boston and environs. Even much larger NORTHEAST UTILITIES, a pure T&D outfit that once owned the Seabrook nuclear plant, would be a solid addition.

As for the California utilities, all three—Edison, PG&E CORP and SEMPRA ENERGY—will be in fine shape as long as Arnold Schwarzenegger is in the governor's mansion. The gubernator has routinely granted solid returns on utilities investment and has worked with them to resolve problems, rather than publicly vilifying them.

All three companies are at the cutting edge of new technology, conservation as well as renewables. And the trio is healthier financially than it's been in many years.

History has shown us, however, that Golden State politics can turn on a dime. And it was a supposedly “pro business” Gov. Pete Wilson who set the state's utilities up for the Enron disaster. In any case, this is one situation I intend to watch very closely in coming years.

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.

KCI has assembled a team of top investment analysts to create the finest financial news service possible. With well-developed research skills and years of expertise in their particular fields, our analysts provide quality information that few others can match.

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