Melissa Davis

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Duke Deal on State Oversight Could Boost Wholesale Profits

Melissa Davis

Duke DUK just boosted its earnings power.

Under a deal reached this week, the company's regulated utility, Duke Power, is now free to rake in all the wholesale power profit it can without fear of exceeding the rate of return that regulators consider fair in its major North Carolina market. In return, Duke Power will split those profits with its customers, a compromise that effectively reduces power bills without subjecting the company to the upheaval of a full-blown rate review.

Previously, Duke Power counted wholesale profits, which are generated by selling excess electricity to other utilities and power users, in its regulated earnings -- earnings that were already considered by some critics to be fishy. Many of Duke's industrial customers believe this week's agreement simply confers the state's blessing on an accounting change that lets the company keep earning more than it should.

For its part, Duke celebrated the deal as a way to provide relief now rather than later for its struggling industrial customers. And John Olson, an analyst at Sanders Morris Harris, called the arrangement a "happy settlement" that is fair for all parties involved. Still, Duke's critics are complaining.

Under terms of the deal, Duke industrial customers are poised to receive an estimated rate cut of 2% by sharing wholesale power profits with the utility. But the Carolina Utility Customers Association, or CUCA -- which labels Duke's rates "grossly excessive" -- believes its members are entitled to a rate cut of up to 20%. The group failed to convince state regulators to even hold a public hearing on the matter, however.

"The commission finds no basis to grant the relief requested by CUCA because CUCA has not raised compelling issues in support of its protest and request for an evidentiary hearing," the North Carolina Utilities Commission stated in a formal order on Wednesday. "The commission believes that Duke Power's application is in the public interest and should be approved as filed."

The commission staff does not agree with Duke's reporting change, however. It just convinced Duke to start including wholesale power profits in its regulated earnings last year. And other utilities, including Dominion D and Progress Energy PGN, continue to do so.

But the commission approved Duke's proposal because it offers a guaranteed rate cut -- during a rate freeze that extends through 2007 -- that can start benefiting hard-hit industrial customers immediately. A rate review, on the other hand, could require significant time and still result in no reduction at the end.

"Any attempt to involuntarily reduce Duke's rates ... is likely to be seriously contested and involves all of the uncertainties associated with protracted litigation," the commission stated. "Thus, approval of Duke's proposal strikes us as the most expeditious way of lowering rates for Duke's North Carolina retail industrial customers and obtaining other customer benefits."

CUCA preferred to fight.

"Just because a battle may be long or challenging does not negate the necessity of it," CUCA Executive Director Sharon Miller told TheStreet.com on Thursday. "And it is the commission's job to regulate utilities -- no matter what the time frame is."

Two years ago, CUCA requested a formal review of Duke's rates. But the commission denied the request because it had already agreed to freeze Duke's rates through 2007 while the company invested in expensive pollution controls. CUCA has since lost an appeal of that decision and is now asking the North Carolina Supreme Court to review the case.

In the meantime, the association continues to feel shortchanged. Miller says that CUCA agrees that "industrial customers are in dire need of rate relief" right now. But she criticizes the new arrangement as inadequate.

"We don't think the potential short-term gains are worth the long-term costs," she said. "A token 2% rate cut pales in comparison to the potential for double-digit rate reductions" through a formal review.

Miller questions whether industrial consumers will even receive the modest cut they have been promised. She says that Duke is in the process of requesting an increase to cover rising fuel costs that, if granted, could totally offset the new reduction.

She says that CUCA will continue to monitor Duke Power's profits -- including those from bulk power sales -- for signs of over-earning. Duke has agreed to disclose its wholesale profits to the utility commission even though it will separate them from regulated earnings. But the commission has promised to leave the new arrangement in place, regardless of how much Duke earns through bulk power sales, for at least a year.

The agreement expires along with the rate freeze at the end of 2007. Some people believe that Duke will then stop sharing -- or even disclosing -- its bulk power profits. Others, however, feel that the commission might finally intervene and review Duke's rates if that happens.

In the meantime, Duke is hoping to strike a profit-sharing deal in its secondary market of South Carolina as well. Duke Power spokesman Tom Williams told TheStreet.com on Thursday that the company plans to submit a proposal to South Carolina regulators in a matter of weeks. At least one Duke insider -- known for blowing the whistle on the company's accounting practices -- doubts that South Carolina regulators will be quite as receptive, however.

Barron Stone, a Duke accountant who provided regulators with evidence that the company had been downplaying utility profits in the past, says that South Carolina isn't restrained by a rate freeze like its neighbor to the north. Instead, he says, the state has managed to get rate relief for customers simply because the company exceeded its allowed return.

"I think Duke is going to march down to Columbia, [S.C.], and try to do the same thing they did in North Carolina," Stone said. "But I can't imagine that South Carolina will go for it. ... The culture is a little less agreeable down there."

Stone believes that Duke is scrambling to find "creative" ways to squeeze more profits out of its existing assets. The company is relying heavily on its regulated units to support it through a drastic downturn in the merchant energy business. It is weathering huge merchant losses that some believe will exceed the $300 million management has forecasted so far.

Olson, for example, predicts that losses in Duke's merchant division will total $360 million to $390 million this year. He also believes that a turnaround in the business could still be years away.

Even so, Duke has managed to win over many investors by hiring proven turnaround CEO Paul Anderson and maintaining a rich dividend as the company works to recover. Olson, who has owned Duke stock for more than a decade, calls Anderson a "good man" who has made a name for himself by steamlining troubled businesses.

Duke chose Anderson as its CEO last year after originally passing him over for the top job in 1997 and offering it to Richard Priory instead. But Stone, for one, doubts that even Anderson can restore Duke to its former power anytime soon.

"I think Paul Anderson is quite a visionary," Stone conceded. "But the mistake was made in 1997 when we chose Priory instead. Now, we're expecting this man to come in and straighten things out in one, two -- even three -- years. And without drastic changes in the market, I just don't see how that is going to happen."

Duke's stock, which had fetched more than $45 at its peak before the merchant energy meltdown, slipped a penny to $19.41 on Thursday.