Regulation Rules - The Risks of falling out of favour with the Industry Regulators
Companies / US Utilities Mar 31, 2007 - 02:31 PM GMTBy: Roger_Conrad
When it comes to utilities' long-term profitability and performance, nothing is as important as regulation. In fact, nothing even comes close.
A good relationship with regulators can restore even the weakest player to health. And history is littered with examples of hostile relations ultimately wrecking even the most vibrant company's prospects.
Up until the late 1970s, US utilities operated under what came to be known as the regulatory compact. In recognition of the long-term, capital-intensive nature of building and maintaining essential service infrastructure, federal and state governments granted utilities monopolies. Companies were allowed to recover all prudently incurred expenses in customer rates, along with a solid return on invested capital.
This arrangement started to break down amid the inflation of the '70s, which sent borrowing and construction costs skyward. Meanwhile, intensifying global competition launched a campaign by heavy industry lobbying groups to bring down rates.
In the power industry, some two dozen companies were nearly driven into bankruptcy in the late '80s and early '90s. The reason: Customers convinced regulators to disallow billions of dollars spent to build the current generation of nuclear power plants.
Then in late 1993, the other shoe dropped. Large industrial users convinced California politicians to propose stripping the state's utilities of their monopolies. The result was a deregulation scare that--combined with a spike in interest rates--sent utility stocks crashing amid speculation of mass bankruptcies.
That dire fate, of course, never occurred. Instead, utility lobbyists got to work, ultimately forging deals in a score of states
to open markets in exchange for being able to recover their stranded costs--i.e., the value of assets on their books that would supposedly become obsolete when markets were opened to competition. Most deals also called for utilities to freeze their retail rates for several years on the supposition that plunging wholesale power prices would enable them to further strengthen balance sheets.
Consequently, deregulation triggered no immediate bankruptcies of regulated utilities during the '90s. Instead in the deregulated states companies sold off their power plants to unregulated companies and focused on their wires and pipes businesses. Some used the cash to cut debt, others to invest in growth businesses, including producing power.
What no one reckoned with was natural gas prices. When deregulation's pitchmen--financed heavily by the former Enron--were making their case in state capitals, the rate cuts they promised were based on natural gas prices remaining in their then-current range of $1 to $2 per million British Thermal Units.
Based on that level of prices, a new generation of gas-fired power plants would have been far cheaper to build and run than the old baseload coal and nuclear plants run by utilities. Few even conceived that building a huge number of gas-fired plants would push up demand and prices.
As a result, when some 90 gigawatts of new gas plants created an all-new peak demand season in summer, the fallout was as unlooked for as it was swift and severe. Gas and power prices soared, then crashed. And by late 2002, some two dozen utilities were in danger of filing for Chapter 11.
A NEW ERA
Thus began the post-deregulation era of utility/regulator relations in the US. The good news is it has far more in common with the pre-1970s relationship than the recently passed era of industry deregulation.
Gone is regulators' prior obsession with getting the lowest possible rates for consumers and business immediately. Instead, state and federal officials are taking utilities' financial health into consideration. In fact, with environmental concerns increasingly on the agenda, regulators are working with companies to stimulate investment in needed areas to meet social goals.
Deregulation still has its supporters. This week at a meeting of western industry executives, California Public Utility Commission President Michael Peevey stated he was “committed to the fundamental principles that grew the restructuring movement in the first place which was competition and customer choice” and that he “had no intention of turning the clock back to the old model of the vertically integrated monopoly operating under cost of service alone.”
Peevey couched his comments by promising a draft rule in 30 days on whether to reopen long-term contracts between utilities and the California Department of Water Resources. These were inked earlier in the decade when the utes were in dire financial straits and desperately needed supplies. Nixing them would presumably open up more supply to competitive bidding.
California's massive economy and power market mean it has extensive influence on what its neighbors do. No one, however, should expect Peevey or anyone else in the state to turn the clock back to the '90s. Rather, any changes will almost surely be incremental. And the state's utilities today control relatively little power capacity, so they have little to lose no matter what's proposed.
Moreover, no one should expect other states to follow California's lead even part way on a road to more deregulation. In fact in most states the trend's accelerating in the opposite direction.
This week, Virginia Governor Tim Kaine gave his seal of approval to legislation effectively ending the state's deregulation experiment and restoring the old vertical monopoly system. The Democratic governor recommended only marginal changes to the bill passed by the Republican-controlled legislature, basically increasing incentives for conservation and renewable energy.
The legislation was, of course, heavily supported by Virginia's dominant utility DOMINION RESOURCES (NYSE: D). There was some opposition from consumer and environmental groups, both of which claimed there wasn't enough in the bill to protect the interests they represent.
But no one really questioned the underlying premise of the bill: that power utility deregulation is a failed experiment whose time has passed. Also, the bill passed the legislature with a huge bipartisan majority, a sure indication of just how unpopular deregulation has become in most of the country.
The defection of Virginia to the regulated monopoly camp leaves 19 states and the District of Columbia in the deregulation camp. And that number shows signs of dwindling further in coming months.
Michigan may be the next state to roll back restructuring, and the action may be a lot faster than anyone expects. This week, state House Speaker Andy Dillon (D-District 17) announced a plan is on the table to eliminate power competition in exchange for a new tax on utilities. The impetus for the plan is an estimated $940 million budget deficit in a state that continues to suffer from the decline of major job sources like automaker Ford.
The opposition to re-regulation in Michigan may be stronger than it was in Virginia, particularly given that heavy industry is still an important part of the economy. But with state regulators asserting competition has tailed off over the past two years and politicians anxious to head off a budget crisis--the state constitution requires balanced books--the momentum toward a rollback may be irresistible.
Supporters of the measure claim the new energy tax will rise from $500 million to $1 billion, more than enough to set the budget straight. We'll know more about this situation in the coming weeks, as more data on the legislature's budget proposals is due out. If deregulation is rolled back, it will be a major plus for the state's utilities, particularly CMS ENERGY (NYSE: CMS) and DTE ENERGY (NYSE: DTE). CMS has been in recovery mode since nearly collapsing in 2002 under heavy debt and accounting scandals. Last month, the company announced the last of its sales of an unregulated
asset portfolio built up in the '90s, completing its strategic refocus on running its regulated business.
Re-regulation will further reduce its operating risk and increase financial strength. The company restored its dividend earlier this year after a more than four-year hiatus, and it looks like there's a lot more to come. DTE never sank to the depths CMS did, but it has lost more customers and so should ultimately benefit even more from a rollback of deregulation.
New England and the Northeast remain the most solid backers of power deregulation. And with the region enjoying the benefits of lower natural gas prices on power costs, there's little impetus for radical change.
In Connecticut, however, NORTHEAST UTILITIES (NYSE: NU) is again pushing for the right to own and operate regulated power plants, in exchange for more regulatory oversight. And with a change in party control in several states--including Massachusetts and New York--it's possible there will be similar moves elsewhere back towards vertical monopolies.
HOW FRIENDLY
As regulated monopolies, utilities only had to worry about getting officials' approval for their spending plans, and then keeping the costs under budget. Under deregulation, the worries multiplied to include the impact of waxing and waning electricity demand, as well as the threat of sudden changes in the rules of competition.
The national move back to a more regulated environment eliminates complication and is thus much a positive for utility credit quality and operating risk. But as I pointed out in my regulation review in the December Utility Forecaster, good and bad climates exist in both deregulated and regulated states.
What's important is how a utility gets along in the environment where it operates. More than anything else, that should determine how much you're willing to pay for a particular utility stock, or even whether you want to own it or not.
As I've said, one of the major underpinnings of the utility recovery since late 2002 has been a rapid and sustained improvement of regulatory relations. This was in part born of the necessity of restoring the system to financial health, following the overbuilding boom and accounting/trading scandals that came out of often chaotic late '90s deregulation. But it's since continued--and in fact has intensified--as environmental concerns have grown.
Every major election, of course, brings with it the possibility of a change in regulatory relations for the worse. Despite the Democrats' landslide in November 2006, the climate has remained positive. In fact, even several states where relations appeared to be turning hostile have shifted back to a positive vibe, including New York and Maryland.
Even Illinois may be on the brink of a spring thaw, with a possible resolution of the war over a proposed rate freeze. Under the deregulation law passed in the mid-'90s, the major utilities agreed to a decade-long rate freeze and sold their power plants in return for recovery of stranded costs.
With the rate freeze set to expire this year, the state held its first auction for new supplies in 2006. Unfortunately, in large part due to rising coal and gas costs, the price of free market power proved to be far higher than the politicians envisioned when they opted for competition.
The rate freeze push is the response to that. The state's major utilities EXELON (NYSE: EXC) and AMEREN (NYSE: AEE) have threatened to put their regulated units in the state into Chapter 11 if the legislature extends the freeze to 2010 as the currently advancing bill proposes. This would hardly scratch Exelon but would be a major blow to Ameren, which is much more dependent on regulated revenue in the state.
The good news on this front is a rumored deal between the utilities and key legislators that would nix the rate freeze in return for concessions. That would supposedly include credits provided to more vulnerable customers. Such a deal would eliminate the possibility of bankruptcy for both utilities and alleviate the crisis.
Like anything else involving regulation and politicians, investors should take a skeptical view until something concrete is passed. But the ongoing discussions are a promising sign not only for resolving this situation, but for the future of utility/regulator relations in what has been the most challenging state in the country.
Ironically, free market bastion Texas is the only state where regulatory relations appear to be worsening. Even there, however, the risk appears to be confined to a single company, TXU CORP (NYSE:TXU).
The attempted $45 billion buyout of the company by a Kohlberg Kravis Roberts-led private capital consortium appears to have opened the floodgates to its critics. The normally servile state legislature is already moving rapidly on a bill that would compel state regulators
To reject the KKR deal were it found not to be in the public interest. And despite forging an agreement to kill plans for eight coal plants, the company's environmental credentials are coming under increasing attack as well.
This week, the staff of the Texas Public Utility Commission delivered a particularly harsh ruling, recommending that TXU pay a $210 million fine for allegedly manipulating the state's electricity market two years ago. A company spokesman declared the allegations flatly wrong. But in any case, it faces a tough battle to avoid the fine that will only complicate the proposed KKR deal.
As I wrote in a previous edition of Utility & Income, I'm extremely leery of this kind of private capital investment in the utility industry. The KKR deal is precisely the kind of thing that precipitated the industry's crisis during the Great Depression of the '30s, when dozens of operating companies were threatened with failure due to the financial weakness of the holding companies that controlled them. That led to the passage of the Public Utility Holding Company Act of 1935, which issued a death sentence for the holding companies and restricted utility ownership to utilities.
TXU shareholders, however, now have a more pressing concern: If KKR walks away, the shares are certain to lose the premium they gained following the deal's announcement. That would likely take the stock back to the low 50s.
The company would still be extremely profitable. But maintaining the immense cash flows it's been raking in depends on regulators allowing them to keep electricity prices at levels that are based on sharply higher natural gas prices.
TXU is allowed to do this under the state's extremely favorable deregulation law. But now roused by aversion to the KKR deal, many are starting to openly question a system that allows the company to keep power prices high even though gas prices are half their levels of a year ago.
In my view, these lofty rates--which are among the highest in the country--are going to catch up with the company and rates and profit margins are going to decline swiftly. With the shares yielding less than 3 percent, the dividend isn't going to offer much support.
TXU is a classic Wall Street favorite utility. Even the most cautious utility mutual fund managers have had no choice but to own it in quantity as it's moved higher in recent years, lest they vastly underperform the benchmarks that set their salaries. And I'll wager almost any report your broker sends you will be bullish on the company.
This one has been very good to those who've owned it over the past few years. Most will likely be loath to part with it. It's also entirely possible they'll resolve their growing difficulties to complete the KKR buyout. That would yield a hefty profit even from current levels.
Call me overly conservative, but I can't help think of it this way: By selling now and putting the money even into a money market fund, TXU owners will realize a higher income yield, book a huge profit and avoid the rising risks. That sounds a lot more appealing than risking it all to try to eke out a few more points of return. But maybe that's just me.
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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