As Old Order Crumbles, Electric Utilities Engage in Power Struggle -- Part 1 of 3

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Electric utilities once were so predictable.

Today there's a power struggle for market share and the growing threat of competition. Regulators want to eliminate guaranteed returns. Essentially, the electric utility industry is evolving from one of regulated monopolies to a highly competitive marketplace.

This story opens a series that will analyze the rapidly changing industry, attempting to give investors an edge. Today a quick overview, next week a competitive analysis of utilities and finally a closer look at innovative utilities.

First, the U.S. has one of the world's most reliable and efficient systems for generating and delivering electric power. It is a rare 110-degree day in Manhattan when there is even the hint of a "brown-out." While natural disasters may bring the system to its knees, advanced technology and parallel infrastructure quickly restore power to damaged areas.

The primary reason: the decision to deliver universal service. For decades, electric utilities have been regulated by state public utility commissions (PUCs) and the

Federal Energy Regulatory Commission

(FERC) through a "regulatory compact." Under the compact, utilities are granted exclusive service territories. They are then obligated to serve all consumers in the territory on demand.

Historically, utilities have been vertically integrated -- both generating and delivering electricity. As long as service territories remain protected, the natural monopoly perpetuates and regulation is required to maintain an orderly marketplace. But that formula has changed.

A major shift came with the

Public Utility Regulatory Policies Act of 1978

(PURPA), which required utilities to buy power from nonutility generating companies that used renewable energy sources or co-generation. While the primary goal of the legislation was to reduce dependence on foreign oil, PURPA served as a catalyst to stimulate competition in the power generation business.

Experience with PURPA provides evidence that independent power generators can build generators on time and on budget and can be reliably integrated into the transmission systems subject to utility controls. The 1978 legislation showed utilities and regulators alike that competition could drive energy prices lower.

The

Energy Policy Act of 1992

expanded the ability of independent power generators to compete in the power market, selling power to utilities at unregulated rates. As a result many utilities refrained from building and expanding generation plants and, in some states, PUCs required utilities to look elsewhere to purchase power prior to creating new generation infrastructure.

The latest move toward a competitive landscape came in April of last year when FERC ordered electric utilities nationwide to allow other electricity providers to transmit electricity through utility transmission systems. Utilities and other companies in areas where electricity is less costly to produce will be able to sell cheaper electricity to areas where it is more expensive to produce power.

This evolution has expanded wholesale competition among generating firms as they market power to traditional utilities. Pressure is growing to permit retail competition as well, allowing both generation companies and utilities to sell directly to a final customer in the franchise territory of a different utility. Some go as far as to suggest that you and I could sit in front of our personal computer (on the Internet of course) and pick our daily power supplier, much like we buy and sell securities. In a purely competitive scenario, your local utility would be compelled to deliver that power to you across existing transmission lines, for which you would pay an agreed-upon delivery fee. Such fees would remain regulated by the local PUC, as duplicative transmission systems make no economic sense.

While stakeholders in the utility industry have varying views on the subject, a universal theme is clear -- the era of competition for electric power is here. Forty-nine states are considering some form of competition. The only exception, Tennessee, has a majority of its power supplied by a federally sponsored agency, the

Tennessee Valley Authority

. Go figure.

While many of the states are simply studying the concept and developing guidelines for future competition, others are surging ahead with plans for competition before the dawn of the new millennium. Regions with the most aggressive retail wheeling policies (the term commonly used for competition in the industry) are those with the highest electric rates -- namely California and the Northeast. So far, 15 states have adopted principles and timetables to implement a retail wheeling program. (A great source for information on action in each state is the home page of the

National Rural Electric Cooperative Association

at

www.nreca.org

.)

Why the move to competition? You know the argument: Consumers are smart, they can make choices when given the opportunity, and everyone's costs should decline in a competitive environment.

However, like in the telecommunications and even airlines industries, not everyone is in favor of unrestricted competition. More importantly, the history and structure of the industry dictate an incremental shift toward a competitive environment. Should the move toward competition occur without a plan, the unintended consequences could be devastating.

Because of uncertainty surrounding competition, utility stocks have not participated in the recent market rally. The main worry centers around utilities' stranded costs. In short, who pays for all the plants and equipment that are still being financed under the old system as the new, competitive system gets rolling?

Estimates of potential stranded costs range from $50 billion to as high as $300 billion (think big nuclear plants and the like). Many argue that the establishment of a mechanism to recover these stranded costs that is fair and workable is critical to assuring the development of a competitive system that benefits all consumers.

Credit and stock analysts both want to see a stranded cost solution before getting too excited about competition. Caren Byrd, a principal at

Morgan Stanley

, says: "Once

stranded investments were reflected in rates, investors had every right to expect the regulatory compact would remain intact."

There are some, however, who argue that free market forces should be allowed to take their toll on flabby former monopolies. Electric utilities that have overbuilt and been unrealistic in their expansion plans should be punished -- perhaps fail. Utilities that have planned prudently for competition will surge ahead.

As states and FERC address the stranded cost issue and we learn more about utilities and their cost structures, the investment community will begin to change its perception of the utility industry. No longer a monolith, this industry is ripe for picking winners and losers. Next week we will get to that list.

Christopher Edmonds is vice president and chief market strategist for the

Guardian Trust Co.

, a Topeka, Kan.-based private trust and asset management concern.

This story was orginally published August 14, 1997