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Leonard Hyman & William Tilles

Leonard Hyman & William Tilles

Leonard S. Hyman is an economist and financial analyst specializing in the energy sector. He headed utility equity research at a major brokerage house and…

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Utilities Cling To Regulated Model As Markets Turn Against Them

Utilities Cling To Regulated Model As Markets Turn Against Them

In the early days of electric deregulation, policy wonks compared power plants to oil refineries. The refinery purchased oil at market and transformed it into refined products that it sold at market. Refinery managers paid careful attention to demand, hedging, commodity spreads and capital structure. They had to manage the risk, and oil producers often owned refineries as a risk management mechanism because refinery margins rose when oil prices fell and fell when oil prices rose.

Old style utility managers built for ever increasing demand and did not have to hedge because they could pass on costs to consumers. They operated low-risk firms and financed them accordingly, with a lot of debt, and they stuck to their old, debt-laden capital structures. When they went into unregulated generation. Business risks rose, debt ratios remained high, and the generators had no market mechanisms to hedge their output on a long term basis, which turned into a toxic combination when prices and volumes fell short of expectations. Look at the ten year stock price charts for Exelon, Entergy, FirstEnergy or NRG to see the results of bets that unregulated generation would make big money for investors.
The Problem Now

Managing an industry in decline is difficult, especially when owners of the four key sectors of the business generation, transmission, distribution and retail all want growth in earnings in a market with static sales volume whose formerly captive customers can now choose outside providers.

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The electric company manager has to deal with five challenges simultaneously: first, the rapid decline in the price of solar photovoltaics toward grid parity; second, easy access to financing for residential and commercial solar applications; third, declining cost of battery storage which, coupled with solar photovoltaics, increases potential for grid defections; fourth, extension of generous federal tax credits for renewable installations; fifth, smart software that, at a minimum, enhances efficiency and reduces demand especially during peak periods.

Each of these developments, alone, raises risks for the utility business model. Together they could add up to a gamechanger: software links between distributed generation resources and storage batteries could provide the consumer with the ability to resell excess power back to the utility at peak periods at peak prices. That development would cut into the peak period sales by existing generators, to their economic distress. The Federal Energy Regulatory Commission v Electric Power Supply Association (FERC v EPSA) case before the Supreme Court (in which the members of EPSA, the generators, try to maintain their hold on the peak power market) deals with a subset of a larger issue driven by advances in technology.

Residential customers with rooftop solar plus storage might stay with the local utility to get backup power and retail billing. Large commercial and industrial customers might prove more of a problem. If a non utility renewable provider offers them a long term power contract at a relatively low price, they could leave the utility for good. And if they don’t, they will demand a competitive price to stay. Talk about a Hobson’s choice: lose the customer or lower the price.

Natural monopoly and unnatural relationships

In the old days, governments gave integrated utilities a legal monopoly but controlled the prices they charged, an arrangement justified by the “natural monopoly” nature of the utility business. The relationship between utility and consumer was paternalistic — the utility knew what the “meters” wanted or should want— and it assumed a static market environment that would assure the sustainability of the natural monopoly and the financial policies based on it.

Deregulators divided the integrated utilities into four parts, generation (unregulated), transmission (regulated), distribution (regulated) and retail (unregulated). The regulated sectors still operate under the regulatory compact — if they build it the customer must pay (within reason). Whether this policy leads to stranded assets in the future, if microgrids and distributed generation and storage get traction, is another matter. Right now the regulated utilities are happy campers, earning returns that exceed cost of capital on an increasing rate base.

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The generators, on the other hand, have faced relentless downward pressure, exacerbated by a pro fusion of pro-renewable policies. They thought that they would gain the most from deregulation. Now they want guaranteed returns before they commit capacity to the market. Witness the recent Ohio deal to provide returns on investment in legacy power plants. The last thing generators want is a government agency (FERC) introducing more competition into the market. Customer welfare seem to have become a tertiary goal, behind keeping the regulated sector well fed and throwing lifejackets to struggling unregulated entities.

EPSA spells dysfunction

The EPSA lawsuit is more than a squabble over dwindling revenues. It lays bare the dysfunctional structure created by yesteryear’s deregulators. Basically, nobody is in charge of fashioning a product for the customer or responsible for its sales, cost and competitiveness.

Ordinary businesses, like Toyota or Apple, don’t manufacture every component of their product but they do choose suppliers, decide what to pay them, fashion the product, set its price and take responsibility for its quality. They resist supplier price hikes that would reduce their profits or force a product price increase that would affect sales. All suppliers understand that they are in this together, and any change in the sales picture for the final product will affect their own sales and profitability.

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In the deregulated electric supply chain each link works to maximize its own profit and somehow, the invisible hand of the market combines their efforts into an efficient product for the consumer. If any component of the chain ups its price, the chances are that the price to ultimate customers will rise. Sounds just like the old regulatory arrangement? Yes, and it works only as long as the ultimate customer must buy the product and is insensitive to price. Once the customer can find alternatives, the model unravels.

Alternatives to grid based electricity are on the horizon. Electricity sales have gone nowhere for a decade despite economic growth, so consumers may already have found alternatives, including using less electricity. Price increases to ultimate customers caused when one supplier in the supply chain raises its price and the others do not compensate by reducing theirs raises the likelihood that customers will take less grid electricity.

When nobody is in charge, everybody is in charge. That is what the EPSA case is about. The dysfunctional structure of the electricity industry prevents purveyors of grid electricity from controlling the looks and price of the product they sell in the way normal businesses do, and they will have to compete against normal businesses.

To make matters worse, the electricity industry — now divided into regional satrapies, holding companies with scattered holdings, non-profit grid managers, municipal and federal agencies and shaky generators — will have to fight for markets against national or international firms with big ambitions and bigger pocketbooks. To succeed, the electric industry has to get its act together, which is what 25 years of restructuring was designed to prevent. Humpty Dumpty had the same problem.

By William Tilles and Leonard Hyman for Oilprice.com

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