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Duke Takes a Hit in South Carolina

A state panel orders a rate cut that could shave earnings even closer at the big utility.

The brightest spot on

Duke's

(DUK) - Get Duke Energy Corporation Report

earnings report is about to get dimmer.

Beginning next month, Duke must cut electricity rates for customers in its second-largest market. In a unanimous decision on Tuesday, the Public Service Commission of South Carolina effectively shaved $30 million from Duke's bottom line in the 12 months going forward. The ruling comes less than two months after South Carolina regulators discovered that Duke had significantly exceeded its so-called allowed rate of return earlier this year.

"I'd characterize this as a prospective rate reduction, because that's what it is," said Gary Walsh, executive director of the commission. "Beginning Oct. 1, there will be a new, lower rate for all of South Carolina."

Duke had hoped to dodge a rate cut by securing an accounting order that would allow the company to book $50 million worth of long-term financing costs in a single quarter and, thus, lower its regulated profits to acceptable levels. But the commission declined even to meet the company halfway. Instead, the regulators permitted Duke to accelerate only $16 million of debt costs and return nearly twice that amount to customers through a rate cut going forward. Walsh said the commission will continue to monitor Duke's profits to make sure they do not exceed maximum levels again.

Duke shares slipped 20 cents to $17.40 before news of the ruling on Tuesday.

Hitting the Ceiling

Duke Power -- which ranks as the company's most profitable division -- relies on South Carolina for roughly 25%, or $400 million, of its annual earnings before interest and taxes. So the rate cut should reduce South Carolina profits by around 10% in the coming year.

"We expect it to

cost $46 million before taxes," said Duke spokesman Terry Francisco. "But even with this, we still expect to hit the low end of our

full-year $1.35 to $1.60 range."

On a per-share basis, the earnings hit should be a modest 3 cents annually. But the company was already struggling to meet earnings targets even before the rate cut. And excess utility profits -- like those that pleased Wall Street in the first quarter -- may not be allowed to help out.

"This sends a clear message to Duke that there's a ceiling on regulated earnings," said F. Barron Stone, an internal accountant who blew the whistle on the company for understating its regulated profits in the past. "They cannot completely pay the mortgage on their bad investments in unregulated businesses on the backs of North and South Carolina ratepayers. ... If they earn too much, they're going to have to give it back."

Stone fully expects Duke to keep bumping up against -- and even through -- its regulated profit ceiling going forward. He says the company significantly exceeded its allowed return at a time when the Carolina economy was suffering and some of its regulated power plants were under maintenance. So he sees Duke's regulated profits going up, not down, in the future.

Late Charges

In the meantime, he points to one big reason -- beyond those offered by Duke -- for the sudden jump in regulated profits. Thus far, Duke has credited a cold snap and heightened demand for its cheap electricity for the surge in power earnings. But Stone says the company is benefiting even more from the absence of a charge that's forever gone away.

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In the final quarter of 1999, Duke took an $800 million hit to earnings when it established a reserve for potential asbestos claims. But instead of reporting the same one-time hit to regulators, the company secured permission to amortize the charge over a three-year period that was scheduled to end around the time the Carolinas would deregulate their electric utility industries. As a result of that accounting order, Stone says, Duke was able to consistently report regulated profits that fell beneath the cap established in South Carolina.

Duke's asbestos payments ultimately ended last year without the deregulated power industry -- and the uncapped utility profits -- many had expected.

On Tuesday, Duke described the asbestos arrangement as beneficial to both the company and the regulators because it provided the stable earnings reports that both parties prefer. But Duke has come back and asked the same regulators for permission to take a one-time hit, accelerating rather than delaying payments, so that it can eliminate excess profits.

In both cases, Stone says, the company sought accounting changes that could shield it from a rate cut. Moreover, he adds, Duke sought permission to amortize the asbestos payments only after it saw that secret accounting changes -- like those criticized in an independent audit by Grant Thornton -- would not be enough to keep regulated profits under allowable limits going forward.

Even today, Duke continues to take deliberate steps to protect its power rates. For example, the company recently indicated that it will make little effort to cut expenses in its regulated businesses despite pledges to slash costs by more than $100 million companywide.

"One of the challenges that we do have is where we are in the Carolinas with the earnings we have approaching their allowed return on equity," Duke President Fred Fowler told analysts this month. "That does limit us somewhat on cost-cutting in the power company. ... But

cutting will be across all the other businesses."

Stone, for one, questions Duke's priorities.

"This is the fundamental problem with having a company with large regulated and unregulated assets," he said. "There is absolutely no incentive for the management of this company to look for savings and efficiencies in the regulated electric company. ... From the company's perspective, shareholders are going to always come first."

Carolina Critics

And customers in both Carolinas are complaining. In Tuesday's meeting, South Carolina's consumer advocate group recommended against the $50 million accounting change and instead requested a full-blown rate review.

"Duke's rates and rate structures have not been thoroughly examined since its last rate case 12 years ago," said group representative Elliott Elam. "Therefore, the Consumer Advocate requests that the commission issue a notice of investigation of Duke's electric rates in South Carolina, which would allow interested parties to intervene. ... This investigation should not be limited to a staff examination closed to public view and participation."

Duke customers have been unhappy since an independent audit, initiated by Grant Thornton after Stone blew the whistle, turned up evidence that the company had been intentionally understating its regulated profits to authorities for years. The company paid a modest sum to settle with the two states, but federal authorities have since taken over with a criminal probe that could turn up indictments. Meanwhile, customers in Duke's largest market of North Carolina -- where Duke Power generates the bulk of its profits -- are still calling for justice.

Sharon Miller, executive director of the Carolina Utility Customers Association, refers to Duke's $25 million settlement with state authorities as "minuscule." Like the South Carolina watchdog organization, Miller's group is calling for the first full-blown review of Duke's rates in more than a decade. And Miller is hoping that South Carolina's latest move might finally push North Carolina regulators to act.

"We believe that the Grant Thornton report, on its own, should have given the commission enough concern to initiate a rate case," Miller said. "Perhaps this second event in South Carolina will give the commission enough cause."

Duke says its North Carolina rates are protected by a seven-year rate freeze implemented last year. But Miller disagrees.

"There is language in that bill that gives the commission leeway to initiate a rate case if circumstances dictate it," she said. "It doesn't prohibit the commission from carrying out its mandate to protect ratepayers."

For now, Miller is applauding the developments in her neighboring state.

"I certainly commend the South Carolina commission," she said. "I would hope that the North Carolina commission would do the same thing."