Back in the good old days before restructuring, I used a simple formula to
pick electric utility stocks for the elderly, blue-haired clientele that loved
those fat dividends paid every three months. I chose utilities that had low
costs, strong finances and intelligent management. I did not expect the utilities
to maintain their monopolies forever, so I thought those traits would serve
them well when their markets became competitive. What is more, those superior
traits barely added to the price of the stocks — didn’t all the utilities
do the same things and earn the same profits whether they were well-run or not?
So why not chose the best when it didn’t cost extra? I would have made the same
choice for my own grandmother.

Complications Abound

Once restructuring began with the passage of the Energy Policy Act of 1992,
utility managements took advantage of their newly found freedom — some
more than others. By 1996, they had begun to make fundamental choices that changed
the character of their companies. By 2000, reacting to pressure from a new,
aggressive breed of shareholder, they began to do the unthinkable: divest some
lines of business in order to concentrate on others. Shareholders did not like
energy conglomerates that mixed regulated and unregulated activities, that had
different risk characteristics, and that required different managerial skills.

Investors could no longer opt for the best of a homogeneous group. They had
to choose between electricity suppliers with different risk profiles, strategies
and growth rates. The market not only differentiated in its valuation of those
groups, but valuations swung up and down in relation to each other (Table 1
presents data for 1996-2000.)

Table 1 – Sources: Salomon Smith Barney estimates based on four to five
company samples of large companies within each grouping. Notes: (a) Based on
year-end price and subsequent year estimated earnings (b) Latest 12 months (c)
Consensus forecasts

Portfolio managers could no longer buy just any electric stock as a defensive
investment or as a play on interest rates. For that matter, company executives
could no longer invest money in projects with confidence that the investment
would produce a predictable return as long as it did not run afoul of regulators.
As Table 2 shows using data for 2001 from an even more differentiated sample,
investors now face a plethora of choices — all valued differently. To make
matters more difficult for investors in 2001, they faced market valuations disconnected
from actual returns earned, meaning that investors had to make bets on the future
of a restructuring industry rather than depending on the patterns of a consistent
past.

Table 2 – Source: Salomon Smith Barney. April 23, 2001 prices, based on
the median for each group

Admittedly, after passage of the Energy Policy Act, most utilities used their
freedom to do the same things: power generation, power trading and investment
in foreign utilities. What is more, they ran their finances as if nothing had
changed (Table 3). They continued to raise money with long- and short-term debt
as if the new businesses entailed no higher risk than the old businesses. And,
through 2000 anyway, they have not raised overall returns to levels associated
with the unregulated sector.

Table 3 – Source: Edison Electric Institute data

The Energy Policy Act opened the door for utilities to enter new business
ventures. It also required the utilities to open their transmission system to
use by competitors, but it did not require that utilities provide competitors
with access to the utilities’ retail customers. Utilities regarded that omission,
I suspect, as a great victory, because it seemed to confine competition to the
wholesale level — an arena in which the utilities held a strong position
through both affiliated generating companies and their own dealings. The Energy
Policy Act did not, however, prohibit retail competition. It left the decision
on retail competition to each state.

Then the Californians stirred the pot. In February 1993, the California Public
Utilities commission issued the so-called “Yellow Book,” which examined the
electric industry’s structure and the high prices penalizing Californians and
suggested competition as a remedy for the state’s energy problems. In August
1993, a stock brokerage house issued the first report quantifying the electric
industry’s vulnerability to competition. In October of that year, speakers at
a conference sponsored by the Edison Electric Institute told a packed audience
that competition would arrive sooner than they expected. By the end of 1996,
37 regulatory jurisdictions had retail competition studies underway, legislation
pending, or had enacted plans for competition.

The electric utilities, however, did not stand by idly — let the deregulators
have their way. The industry rallied together, raising a cry of injustice. Competition
would destroy the value of investments and business arrangements made under
the assumption that the old regulatory compact would last forever. The industry
convinced policymakers to phase in the introduction of competition in order
to allow utilities to recover the supposedly “stranded costs” from consumers
before the onset of full-fledged competition. Some utilities, collecting the
proceeds of securitization bond sales, managed to recover those stranded costs
in one lump sum, seemingly making them better off financially than if regulation
had continued as before. No other industry undergoing deregulation had managed
such a feat.

Of course politicians had to show that they had accomplished something for their
constituents, so they required up-front price reductions (plus a subsequent
rate freeze) for their constituents. These were usually financed by issuing
a “rate reduction” (or securitization) bond, which consumers would have to pay
off with interest by means of a payment taken out of the monthly electric bill.
In order for the utility to recover its stranded costs quickly while still providing
an immediate rate reduction to consumers, the politicians had to fashion a peculiar
type of competitive market in which the government set prices and consumers
could not seek service outside the designated framework for years, because if
they escaped, who would pay for those stranded costs? Retailers could, of course,
offer to procure energy for consumers, but they had to compete against prices
set by the state, not by the market. And, given all the other charges piled
onto the consumers, a miniscule saving on the energy portion of the bill might
not be sufficient to cause customers to switch to the new suppliers.

Regulated Deregulation

So far, most observers would agree that restructuring (certainly not “deregulation”)
has produced little discernable benefit to consumers. In some markets, retailers
have managed to capture a small percentage of the market, and both service levels
and prices have remained stable. In others, prices rocketed, service levels
declined and dysfunctional behavior prevailed. I always wondered why American
market designers — all those consultants, legislators, regulators, lawyers
and utility executives — showed such little interest in what happened when
restructuring took place abroad. Even more astonishing, though, was the way
they disregarded the simple lessons of Finance 100 and Economics 101:

• They set up markets in which the utility acted as a fixed-price provider
of last resort. As a result, consumers chose service from the competitive provider
when its price fell below that of the utility but then returned to the utility
when the competitive market price rose above the utility’s price. That arrangement
made it difficult for the utility to earn a profit as a provider and for the
new retailer to establish a lasting relationship with the consumer, and allowed
the consumer to avoid facing the discipline of the market.
• They established wholesale central power markets using bidding systems
susceptible to gaming when only a limited number of generators bid into the
market. Furthermore, when the authorities encouraged the sale of power plants
by the utilities, they did little to ensure that the utilities sold the plants
to a sufficient number of operators to ensure competitive markets.
• They left customers out of the picture. Customers in other markets react
to price signals. Few utilities have installed the systems that would allow
them to track consumption by time of use, render bills that accurately track
costs, or allow customers to trim or increase usage depending on price signals.
Consumer reaction to price, which plays a vital role in dampening the gyrations
of price, is absent from today’s one-sided (seller only) markets.
• They launched regional markets without strengthening the transmission
links that could bring power to regions whose markets did not function competitively
or which suffered from shortages. In addition, regulators handed operation of
the networks to organizations that had neither the incentive nor the capital-raising
ability to fix the networks.
• They created markets that defined reliability in a way that downplayed
the value of fuel diversity as an insurance policy, and encouraged power plant
builders and operators to rush to natural gas, because it was the cheapest and
most accessible fuel.
• Some utilities themselves assumed a risky nonprofit role as the provider
of last resort, which obligated them to provide electricity at a fixed price
without having secured an equal supply at a fixed price.

Subsequently, power producers benefited from sales into poorly planned markets
and utilities collected billions for stranded costs. But, retailers dropped
out of the picture, wholesale prices gyrated and skyrocketed, natural gas prices
shot up, and providers of last resort piled up debts as the price of power rose
above what they charged their customers. One of the nation’s largest utilities
made the journey from a AA/A bond rating to bankruptcy in six months, and power
reliability fell to third-world levels in the high-technology capital of the
world.

California Leads the Way

California became the poster child for botched industry restructuring —
the reason, in the eyes of many, to not deregulate. But, in truth, California
had not deregulated. It had opted for rigid, state-mandated structures. It prohibited
market activities outside those structures. It fixed prices for end-use customers.
It required a utility to purchase all of its energy in a flawed wholesale market.
It discouraged power plant construction and interfered with power plant operation
— a policy that backfired when a drought reduced the availability of out-of-state
power. Consumers, who paid fixed prices, demanded more power. Prices in the
pool (paid by the purchasing utilities but not by their customers) shot up,
shortages loomed, the state put a cap on wholesale prices and the federal government
imposed its own price cap. Then, when power generators were unwilling to sell
to utilities that had no visible means of paying for the electricity, the state
stepped in to buy the electricity needed by Californians. Finally, the state
decided to do away with its version of a marketplace by entering directly into
long-term purchase contracts for electricity on behalf of the citizens of California.

Conceivably, California’s consumers could end up overpaying three times for
their electricity: once for the supposed stranded costs, again for overpriced
electricity purchased when the market functioned badly, and again if the state
locks them into long-term purchase contracts at the top of the market.

In the Wake of California

Aside from causing inconvenience and economic damage in the Golden State, though,
the California fiasco has had worldwide repercussions, causing foreign governments
to re-examine privatization and deregulation plans and American states to delay
market reforms. It has prompted electricity retailers to take still another
look at their already shaky business models. And, it has forced some power plant
operators and policymakers to rethink the universal reliance on natural gas
as the fuel of the future.

However, the shortage of generating capacity, so evident in California, may
have made its greatest impact on state governments. It has encouraged state
governments to play a bigger role in the procurement and generation of electricity.
And it has pushed government agencies to lift their objections to power plant
construction.

The breakdown of the market in California, as well as problems elsewhere, has
created a dilemma for regulators, especially those at the Federal Energy Regulatory
Commission (FERC). That agency still has the obligation to ensure that wholesale
customers pay no more than “just and reasonable” prices. The FERC, however,
had gone out on a limb, taking the view that prices set by a competitive market
would qualify as “just and reasonable.” The FERC had assumed that competition
between generators would lead to the lowest possible prices. Early in 2001,
one of the FERC’s commissioners argued that the markets operated dysfunctionally,
rather than competitively. The FERC, therefore, had a duty to protect consumers,
who faced noncompetitive (and therefore not just and reasonable) prices. The
commissioner proposed that the FERC place caps on power prices (in one eastern
state, regulators and utility executives took a similar tack, asking for price
caps until the competitive market matured). Nobody, of course, talked about
“price controls” but rather about “price caps,” “soft price caps,” or “market
mitigation,” because price controls had not worked during the various energy
crises of the Nixon and Carter years. Unfortunately, those regulators may have
sailed into the infamous waters between Scylla and Charybdis. They had to acknowledge
that they had put in place the malfunctioning market mechanisms themselves,
and they also had to acknowledge that parts of the country require more power
stations. Investors who have reason to fear what they think of as retroactive
institution of price controls (whether that characterization is just or not)
may invest their money elsewhere. They do have a choice nowadays.

Will regulators remove barriers to competitive entry, trust that customers will
react intelligently to price signals and enforce competitive market structures?
Or will they impose price controls, arrange subsidies to selected energy providers
or energy conservers, and draw the government further into the energy business?
The events of the summer of 2001 may determine the answers to those questions.

Choices

Investors have put hundreds of billions of dollars into the traditional electricity
supply business. Aggressive generating companies have bet on the new market
and will have to bet even more in order to satisfy growing demand for electricity.
Consumers demand electricity and will get it from investor-owned firms, from
government agencies or from on-site self-generation. And, in this new age of
computers and communications, consumers require a quality of electric service
that meets their own needs rather than the convenience of the utility. Nobody
can wait around forever, trying to extract certainty from the mix of free-market
rhetoric and centralized micromanagement that fills the air. Participants in
the electricity markets have to make decisions now in order to keep the lights
on, protect investments and take market-leading positions while their competitors
dither.

If large-scale generators pull back, that will open up the market for small-scale
generators (now a real option) or the government will fill the gap with public
power. If the utility cannot provide the required power quality, private firms
can. High natural gas prices create markets for renewable resources and clean
coal technologies. Unstable prices and confusion in the marketplace may drive
out small retailers, but could open the way for a few large, well-financed firms
adept at both customer billing and risk management. A rigid, monopoly-minded
transmission entity will not long enjoy the fruits of its customer-unfriendly
activities, because it will face competition from fuel transporters and distributed
resources. In a competitive market, customers have choices. With technology
that now exists, customers served by dysfunctional monopolists and harried by
micromanaging regulators might find ways to opt out of the service provided
by the traditional electric industry. Few people in the business or in the regulatory
agencies seem to take that possibility seriously.

As Robert Burns famously described:

“The best laid schemes o’ mice and men
Gang aft a-gley.”

Perhaps he was writing about electric utility restructuring.