Electricity: The Power Shift Ahead

Deregulation will force the restructuring of a mammoth industry used to 90 years of monopoly

Nancy Flemming lives rustically, without electricity, on an island in Northern California's Humboldt Bay. But that doesn't stop her from complaining about the high prices charged by Pacific Gas & Electric Co. As mayor of Eureka, Calif., she recently wrote a protest letter to regulators. What galls her is that Eurekans pay far more for electricity than many of their neighbors. According to Bright Line Energy Inc., a consulting firm in Menlo Park, Calif., PG&E's average sales price is a little more than 10 cents per kilowatt-hour. Across the border in Oregon, Portland General Corp. charges barely half that--about 5 1/2 cents per kilowatt-hour. Says Flemming: "They try to give us explanations for that, and it's very difficult to understand."

Join the crowd. Ninety years of monopoly regulation of electrical power in the U.S. have produced a system that is reliable but inefficient--and byzantine in its complexity. Local prices for electricity depend on a multitude of factors, from cost overruns on local generating plants to the attitudes of state regulators. Eureka isn't even among the worst off. In the eastern suburbs of New York City, Long Island Lighting Co. customers pay about 16 cents per kilowatt-hour, partly to help pay for a mothballed nuclear plant.

Now, though, the thicket of regulation is being pared back. Utilities are preparing for a new era in which the generation of power will be unregulated and customers--including homeowners and small businesses--will be able to choose among a variety of power sources. The electric-utility industry--a $210 billion business that is larger than either autos or telecommunications--is undergoing its biggest upheaval in a history that dates back to Thomas Edison stringing the first electric wires in downtown Manhattan in the 1880s.

Utility restructuring will create both winners and losers, as it has already in Argentina, Britain, Chile, New Zealand, and Norway. Industry experts expect prices to fall by perhaps 20% over the next five years. That will benefit the economy as a whole and heavy users of electricity in particular. Local disparities in electricity prices will begin to narrow as cheap energy invades high-cost markets.

Among the losers will be utility employees, whose rolls will be trimmed, and investors in utility companies that fare badly. Taxpayers could lose as well if they get billed for utility company bailouts. And customers who aren't well-connected could be denied their share of rate reductions. Says Martin R. Cohen, executive director of Illinois' Citizens Utility Board: "One hopes this is not decided on the basis of who has the most lawyers and most lobbyists, because consumers will lose."

Power companies will look far different in the coming century. Today, each major utility has a strictly marked service area, generates most of its own electricity, and sells it over its own transmission and distribution network. But technology, politics, and deregulation are tearing down the walls of those peaceable kingdoms.

The business of transmitting electricity is likely to remain regulated for years to come. Wires are a de facto monopoly. Electricity generation, though, is becoming unfettered because there's no natural monopoly on the production of electricity--whether it's from coal, natural gas, oil, nuclear power, hydro power, the sun, or the wind.

POOR SHELF LIFE. Vertical integration--owning both the generation and the wires--will be far less common. Regulators will remove the incentives for having both under one roof. To make sure that wire owners don't discriminate in favor of their own generating plants, regulators will put the wires in each region under the control of an "independent system operator" to ensure reliability and equal treatment for all generators.

Indeed, restructuring could imperil reliability without independent system operators to keep supply and demand constantly in balance. Electricity, unlike other commodities, is impossible to store in large volumes. It must be consumed when it's produced. If too many producers try to send power over the same line at once, blackouts could ripple across wide regions.

Federal and state laws have stood in the way of utility mergers since the 1930s. But with those laws being reinterpreted or repealed, efficiency will dictate fewer, bigger players. "There are 16 investor-owned utilities in Massachusetts alone," says Stephen W. Bergstrom, senior vice-president at NGC Corp., a Houston-based natural-gas and electricity marketer. "I guarantee there isn't room for more than two."

Generating companies will need to consolidate so they can spread the costs of their operations and engineering staff across a larger number of customers. Several companies are already trying to carve out a niche as highly efficient electricity generators, including Duke Power, PacifiCorp, and UtiliCorp United. Electricity generators will combine with natural-gas companies--a good fit, since natural gas is the fuel for more and more electricity. The wires companies will merge, too, probably consolidating until there are just one or two per region.

FREEBOOTERS. A whole new class of players will come to the fore in the next five years: power marketers, who won't own wires and might or might not own generating plants. They will steal customers by promising lower rates and then obtain power either from their own plants or on the open market.

To win customers' loyalty, they could offer customized pricing plans, such as discounts for using electricity at night or for agreeing to accept a service interruption at times of peak demand. Even companies entirely outside the energy business could gain a foothold by packaging electricity with other products--say, a computer online account or the telephone bill.

Power marketers will deliver the electricity using competitors' wires--just as the old Bell System was required to let MCI Communications Corp. use its phone lines to deliver calls. A case in point is Enron Corp., a Houston-based natural-gas pipeline company that is on track to become one of the biggest providers of electricity in the U.S. by the end of 1996.

As this massive reshuffling takes place, it will become clear that the U.S. has far more generating capacity than it needs. For decades, regulations gave utilities a perverse incentive to overbuild. Companies were allowed a certain percentage of profit on their assets, so the more assets they could accumulate, the better. McKinsey & Co. values the unnecessary plants at about $150 billion.

These white elephants aren't a problem as long as utilities can charge whatever it takes to earn a reasonable return on the investments. Once customers are free to choose their electricity providers, however, the ability to recoup high costs through high rates will evaporate. So who will keep up the payments on the unneeded plants?

One camp, including an aggressive group of power marketers, argues that utilities' shareholders and bondholders should pay most of the costs of investments that went sour. "A bond is not a risk-free investment," says Frederick H. Abrew, CEO of Pittsburgh-based Equitable Resources Inc., a natural-gas distributor that's invading electricity markets. Abrew says he wouldn't flinch if some utilities went bust. "There have been probably a half-dozen utility bankruptcies in the last 10 to 15 years," he says. "I don't know of any customer that failed to get energy."

Actually, the chance that electric utilities will take the fall for their poor investments is small. Utility executives argue that in most cases, the assets on their books are there because some regulator ruled them prudent. Never mind that some regulators might have been asleep at the light switch when the filings came through.

CALIFORNIA SHUFFLE. So far, the utilities seem to be winning. California, a bellwether for regulation, decided this year to let utilities be paid by consumers for all of their "stranded costs"--that is, plants and power-purchase contracts that are uneconomical at lower electricity prices. To sweeten the pot for consumers, the state has worked out a deal with the utilities to provide a 10% rate cut up front, and 10% more in 2001. Other states that are in the forefront of deregulation, including Massachusetts, Rhode Island, and New Hampshire, are moving in a similar direction.

As deregulation spreads, rates are unlikely to fall as quickly as some optimists are hoping. That hope is based on the idea that a huge chunk of assets will be wiped off the books and out of the rate base. But regulators seem to feel that's too harsh a penalty for the utilities. So it's more likely that rates will fall more gradually as the utilities' efficiency increases, says Paul L. Joskow, an economist at the Massachusetts Institute of Technology.

Joskow advised California on its deregulation plan. He told regulators there that he favors making quick decisions on utilities' costs and then moving on, since there's no perfect solution anyway. "Only God knows what the right way of allocating sunk costs is," he says. But with billions of dollars at stake, the customers and utilities may not be so quick to settle. "The battle in California hasn't happened yet," says S. Mark Young, energy director for Praxair Inc., which uses electricity to produce industrial gases from air.

The big players aren't waiting for the final details to be decided. They're acting now to position themselves for competition. Large industrial customers, such as steel mills, paper mills, and auto plants, are bargaining electricity rates down by threatening to relocate--or to buy power from some neighboring utility once that's permitted. Seven states already have pilot programs allowing "retail wheeling," in which homes and businesses can choose electricity suppliers. The customer's home utility is required to transfer the competitor's power across its network--or "wheel" it, in utility jargon.

Industrial customers aren't shy about pressing their advantage. Five years ago, one big utility sold roughly 80% of industrial electricity at rates set by state regulators. Now, with those regulators granting exceptions right and left, it sells only about 25% that way, says Philip Giudice, a vice-president with Mercer Management Consulting Inc. in Lexington, Mass. Smaller customers are likely to form buying consortiums so that they, too, can drive hard bargains.

Where does that leave utilities? Jerry Taylor, director of natural-resources studies at the libertarian Cato Institute, fears that utilities will be forced to carry electricity for other generators at unfairly low prices. "The former slave masters become the enslaved," Taylor says.

That's a bit strong. True, the Standard & Poor's index of utility stocks has underperformed the S&P 500 in total return over the past five years--coming in at 45% vs. 114%. But S&P's median rating for senior secured debt of utilities is a healthy A-, lower than a few years ago but still higher than the corporate median. S&P forecasts that the utility median will drift down to around the corporate median--namely, BB or BB+. "We do not foresee the kind of credit collapse that other industries have gone through when they went through restructuring," says Richard W. Cortright Jr., a Standard & Poor's director.

Indeed, electric utilities seem to be making out quite well, considering that they own $150 billion or so of worthless assets and have no experience with competition. Regulators, both state and federal, are determined to ease them into the new world of competition gently. In return, the regulators hope they can avoid the kinds of court challenges that have delayed progress in deregulation of the phone companies.

The gentle treatment given to utilities irritates the likes of Equitable Resources' Abrew, who says consumers won't get the full benefits of competition. That's power politics at work. The break with the past may not be as clean as crusaders for deregulation would like. But for that very reason it has a better chance of taking hold.

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