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<title>The RIMCO Strategy: Wolf in Sheep's Clothing</title>
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<td width="82%" valign="top"><p ALIGN="left"><strong><font face="Arial" size="6"><b>THE
RIMCO STRATEGY: WOLF IN SHEEP'S CLOTHING?<br>
</b></font><font face="Arial" size="4">BY GERRY RUNTE<br>
</font><font face="Arial" size="3">M-C POWER CORPORATION<br>
</font></strong><font face="Arial" size="2">(<em>originally published by PMA OnLine
Magazine: 99/03</em>)</font><font SIZE="2"> </font></p>
<font SIZE="4"><p ALIGN="CENTER"></font><b><i><font FACE="Arial" SIZE="4"> </p>
</font></i></b><p><font face="Arial">A number of electric utilities are beginning to
implement a strategy that seeks to position the corporation as a regulated infrastructure
company, or RIMCO, in the post deregulated world. To paraphrase an old <u>Saturday Night
Live</u> skit showing an interview with a baseball player, the RIMCO strategy seems to be
saying "Regulation’s been very, very good to me." On its face, the strategy
presumably is an attempt to maintain the lowest risk profile possible in the new
competitive environment. The reality, however, could be that the RIMCO strategy is a very
high risk strategy masquerading as a low risk measure, inasmuch as it seems to contemplate
little change in the future rate regulatory environment for companies remaining under
regulation. </font></p>
<b><p><font face="Arial">Our hypothetical electric utility</font></b></p>
<p><font face="Arial">Let’s first understand what is meant by the RIMCO strategy by
creating a hypothetical company. Consider ABC, Inc., a large electric utility holding
company. It has the traditional forms of business: generation; transmission and
distribution, and has all of the appropriate financial ratings, but with essentially flat
earnings growth over the past several years. In addition, the company has made a number of
disparate independent power investments, primarily abroad, which were largely
"targets of opportunity," rather than elements of an overall portfolio strategy.
A new CEO is appointed by the board and inherits this collection of business units. Our
new CEO, who "grew up" in the operations of the distribution company, is
extremely concerned about the risks associated with the impending deregulation of his
marketplace. </font></p>
<p><font face="Arial">He summarizes his circumstances as follows: </font></p>
<blockquote>
<ul>
<li><font face="Arial">Regardless of restructuring scenario chosen, maintenance of the
status quo will result in declining earnings as commodity margins decline, even assuming
full efficiencies of current operations are achieved.<br>
</font></li>
<li><font face="Arial">In an environment of considerable industry consolidations,
maintaining current size will result in a decline of relative size and an increase in the
probability of being acquired.<br>
</font></li>
<li><font face="Arial">In many U.S. and international energy markets the provider of a
single energy commodity will become increasingly non-competitive over the long term.<br>
</font></li>
<li><font face="Arial">Regardless of the direction of industry restructuring, the
"wires business" will remain regulated.<br>
</font></li>
<li><font face="Arial">Virtually all of ABC’s current earnings, expertise and
competence are derived from regulated lines of business or contractually secured
unregulated businesses: future actions to grow earnings should primarily focus on
businesses with these characteristics. </font></li>
</ul>
</blockquote>
<p><font face="Arial">He views the core competencies of his company as: 1) managing the
rate regulatory process; 2) community relations; and 3) engineering infrastructure
expansion within a regulated investment context. His experience tells him that reliance on
generation, particularly nuclear generation, has been a mistake for his company in the
past. He knows he does not understand (or have the in-house expertise to manage) a
competitive environment on any front. His generation personnel are not staffed to compete
in a merchant plant environment, and there is no expertise whatsoever in providing energy
related services or commodity sales. While recognizing that there may be foregone
opportunities, he chooses to eschew the competitive world and accept the lower, but far
more assured returns available to him in the regulated rate base. New investments in
infrastructure, then, provide the foundation for earnings growth: acquisitions of more
infrastructure provide the vehicle for earnings growth.</font></p>
<b><p><font face="Arial">The RIMCO Strategy</font></b></p>
<p><font face="Arial">Within a few months of his assumption of command, Mr. CEO announces
the following strategy:</font><ul>
<li><u></u><font face="Arial">Build upon our core competency of regulated infrastructure
management</font><u></u></li>
</ul>
<blockquote>
<ul>
<li><font face="Arial">The existing transmission and distribution business of ABC is the
core investment resource of the firm. It is to be managed as a mature, slow growth
business with very limited opportunities to improve on the growth rate. <br>
</font></li>
<li><font face="Arial">Opportunities to "grow" the business through domestic
merger or acquisition should be viewed as being very valuable. Acquire other regulated
commodity transport and distribution systems, including natural gas, water and
telecommunications<br>
</font></li>
<li><font face="Arial">Optimize all to become "best in class"</font></li>
</ul>
</blockquote>
<ul>
<li><u></u><font face="Arial">Dispose of currently regulated nuclear and fossil generation
assets</font><u></u></li>
</ul>
<blockquote>
<ul>
<li><font face="Arial">Disposition of regulated fossil assets removes questions of market
power that might cloud our transmission/distribution operational strategy<br>
</font></li>
<li><p ALIGN="JUSTIFY"><font face="Arial">Sale of assets accelerates write down of stranded
assets, debt reduction and improves competitive position </font></p>
</li>
</ul>
</blockquote>
<ul>
<li><u><p ALIGN="JUSTIFY"></u><font face="Arial">Dispose of domestic IPP and unregulated
off-shore investments and operations.</font></p>
</li>
<li><p ALIGN="JUSTIFY"><font face="Arial">ABC will not to attempt to compete in all
potential markets.</font><u></p>
</u></li>
</ul>
<blockquote>
<ul>
<li><p ALIGN="JUSTIFY"><font face="Arial">With respect to wholesale or bulk trading
activities, we will leave that to other more risk-oriented firms.</font></p>
</li>
<li><p ALIGN="JUSTIFY"><font face="Arial">ABC will not participate in the new energy
services markets, and will execute an exit strategy for its small, unregulated subsidiary.</font></p>
</li>
</ul>
</blockquote>
<p><font face="Arial">The underlying assumption in this strategy is that regulation
continues, more or less unchanged, into the foreseeable future. Therein lies the
strategy’s potential fatal flaw: ABC may very well find itself operating under
regulatory constraints that are governed by standards established by unregulated entities.
Why? Performance Based Rates (PBR). If ABC fails to prepare for this new regulatory
environment – by taking the many of the same steps that would have been necessary to
prepare its businesses for unregulated competition – disaster is likely. </font></p>
<p><font face="Arial">PBR (sometimes called "Incentive Based Rates") is a
concept that has been around for over 15 years, albeit in relatively few jurisdictions and
usually to resolve specific local issues. Initially, PBR was established as an alternative
to the growing, costly and time consuming prudence reviews relating to nuclear and other
costs. Rather than conduct lengthy hearings on the appropriateness of investments and
expenditures, simply let the regulated company live within a range of predetermined costs:
if costs are exceeded, penalties ensue; if costs are reduced, the entity keeps its
"windfall." </font></p>
<b><p><font face="Arial">Performance Based Ratemaking</font></b></p>
<p><font face="Arial">PBR is very likely to become mainstream regulation for the remaining
regulated entities, post deregulation, precisely for the same underlying reasons that
caused its implementation in the first place. Until the late 70’s and early
80’s, most electric utilities secured growth in earnings by growing the
"ratebase" – that sum total of invested capital in the system. Big
increments to the ratebase, with relatively assured recovery over time formed the
foundation for their equivalent of a growth strategy. The environment of the old
"regulatory compact" incentived utilities to fully embrace nuclear power. What
could be more attractive than a multi-billion dollar addition to ratebase, extended over a
10 year construction period and a 30 year operating period, than a nuclear unit?
Particularly when the regulators not only authorized the total investment in rates, but
also the interest on the capital necessary for construction. When construction costs way
exceeded budget, or when operations became far more costly than expected, regulators
turned to their only available tool – prudence reviews.</font></p>
<p><font face="Arial">If we look to the mid-2000’s, how do our new RIMCO’s
intend to grow their earnings? Through infrastructure capital additions to the ratebase.
The experience of RIMCO management tells them that, of all the investments they made in
the past, even after the era of prudence reviews, T&D infrastructure capital was a
shoe-in for rate recognition. The ingredients will therefore be present to repeat history.
Regulators know this, or will come to know this, once their all-consuming efforts to
define restructuring and deregulation are completed. Regulators will also find it
necessary to figure out what their role in the new world will be as well. Regulators may
find salvation in PBR.</font></p>
<b><p><font face="Arial">Potential features of PBR</font></b></p>
<p><font face="Arial">So what might PBR mean for the RIMCO? One insight into how
regulators are beginning to think about RIMCO regulation can be found in a report entitled
"Performance-Based Regulation in a Restructured Electric Industry," published by
the National Association of Regulatory Utility Commissioners (NARUC). A web address for
the report is given at the end of this article.</font></p>
<b><p><font face="Arial">Service Quality</font></b></p>
<p><font face="Arial">Service quality is a key ingredient to PBRs. These standards allow
the regulator to ensure that adequate incentives exist to ensure a quality and level of
service is maintained for all customers. The NARUC report recommends that service quality
be evaluated utilizing the following six criteria:</font></p>
<blockquote>
<blockquote>
<ul>
<li><font face="Arial">Customer complaints to the utility</font></li>
<li><font face="Arial">Outage frequency</font></li>
<li><font face="Arial">Outage duration</font></li>
<li><font face="Arial">Major outage recovery</font></li>
<li><font face="Arial">Momentary outage frequency</font></li>
<li><font face="Arial">Employee safety</font></li>
</ul>
</blockquote>
</blockquote>
<p><font face="Arial">It further recommends that the PBR structure develop penalties (and
no rewards) based on:</font></p>
<blockquote>
<blockquote>
<ul>
<li><font face="Arial">3 year historical averages of peer performance according to
established indices (see discussion below)<br>
</font></li>
<li><font face="Arial">Penalties that allow for a full reduction of 100 basis points of
return on equity spread equally over the six criteria<br>
</font></li>
<li><font face="Arial">Separate penalties to prevent gaming: i.e., evaluating specific
circuits, and not the service territory as a whole</font></li>
</ul>
</blockquote>
</blockquote>
<p><font face="Arial">The final bullet above is not so far fetched. In the new competitive
environment, an information technology system that can identify hourly uses of electricity
and accommodate frequent changes in retail suppliers will be necessary. This IT system
will therefore enable a micro examination of circuit reliability with some ease.</font></p>
<p><font face="Arial">What’s very important to the ABC in this monitoring of service
quality, is how "peer performance" is defined. In the post deregulated world,
many of these services will be provided by other than regulated service companies. To the
extent that regulated companies outsource elements of their delivery business (customer
services, metering, billing, distributed generation, maintenance of infrastructure, etc),
the peer group, either directly or indirectly, will include entrepreneurial firms that
are, indeed, competing in the unregulated environment. These service companies will be
aggressive, competitive companies with strong customer service objectives combined with
least cost operations. ABC believes that it need adopt a competitive culture (which will
entail hiring significant help from the outside and a wholesale reevaluation of how
current regulated operations are conducted) because it believes there is shelter to be
found in regulation. If ABC is very likely to be evaluated, at least in part, by
comparisons with unregulated service companies, can it take the risk of not adopting
unregulated company cultures and expertise? </font></p>
<b><p><font face="Arial">The RIMCO and generation.</font></b></p>
<p><font face="Arial">The NARUC report recommends that the RIMCO make use of distributed
generation within its territory, both to encourage cost effective operations and to ensure
a proper balance of market power between the distribution company and unregulated
generation companies. As a consequence, the report suggests that PBRs should allow for:</font></p>
<blockquote>
<blockquote>
<ul>
<li><font face="Arial">RIMCO ownership of distributed generation<br>
</font></li>
<li><font face="Arial">RIMCO use of distributed generation to:</font></li>
</ul>
</blockquote>
<blockquote>
<blockquote>
<blockquote>
<blockquote>
<ul>
<li><font face="Arial">Mitigate line losses</font></li>
<li><font face="Arial">Sell energy, capacity and credits to end use customers, ISOs, spot
market or marketers</font></li>
</ul>
</blockquote>
</blockquote>
</blockquote>
</blockquote>
</blockquote>
<blockquote>
<blockquote>
<ul>
<li><font face="Arial">Provide an option for the RIMCO to solicit bids to supply distributed
generation<br>
</font></li>
<li><font face="Arial">Provide an option for the RIMCO to solicit bids for load relief and
pay generators for avoided T&D costs (allowing the generation company to sell the
capacity and energy value)<br>
</font></li>
<li><font face="Arial">RIMCO sales of distributed generation to customers netting out line
losses and T&D benefits (with an energy buy back provision)<br>
</font></li>
<li><font face="Arial">RIMCOs initially installing and operating distributed generation,
with an agreement to the regulator stipulating that it be sold later in blocks back to the
market.</font></li>
</ul>
</blockquote>
</blockquote>
<p><font face="Arial">ABC currently has no expertise in distributed generation because it
viewed the technology as part of the competitive environment it seeks to avoid. It’s
RIMCO strategy has caused ABC to largely ignore distributed generation. Those companies
that have experimented with distributed resource technology have learned that it is not a
spectator sport, requiring significant, hands-on experience for cost effective
utilization. Failing to embrace this technology early, and well before PBR, might very
well cause ABC to face penalties for several years until it has made up lost time.</font></p>
<b><p><font face="Arial">RIMCO Integrated Resource Planning</font></b></p>
<p><font face="Arial">NARUC recommends that distribution integrated resource planning
(DIRP) be required of the RIMCO in a post deregulation regulatory environment. DIRP should
encourage:</font></p>
<blockquote>
<blockquote>
<ul>
<li><font face="Arial">Cost effective substitution of targeted energy efficiency and modular
generation (fuel cells, PV) and energy storage for T&D upgrades<br>
</font></li>
<li><font face="Arial">More efficient design and operation of the T&D system, including
how infrastructure is added for customer growth<br>
</font></li>
<li><font face="Arial">Inclusion of the cost of line losses in evaluating T&D delivered
performance<br>
</font></li>
<li><font face="Arial">Least cost planning, including the incorporation of the cost of
environmental effects of energy production in the RIMCO’s evaluation.</font></li>
</ul>
</blockquote>
</blockquote>
<p><font face="Arial">ABC thinks that its new regulated business will consist largely of
planning and installing additions to the wires system in the old integrated utility
context: line upgrades; extensions; new customer hookups; and construction of substations.
Further, it anticipates that regulatory treatment of this capital is assured. Because ABC
considers energy efficiency measures (aka, DSM ) as the purview of the unregulated,
competitive companies, it has long since let go those few individuals within the company
that understood this business. When combined with the absence of expertise in distributed
generation, ABC is very likely to fail to consider alternatives to the traditional means
of expanding the infrastructure to meet load growth. </font></p>
<b><p><font face="Arial">Regulation provides no shelter</font></b></p>
<p><font face="Arial">ABC regards its RIMCO strategy as a convenient way to continue to
collect a relatively secure return on investment by avoiding the unregulated, competitive
market. If PBR does come to pass in any significant way, a company’s performance in
service quality and their implementation of DIRP will, in some fashion, impact those
"relatively secure returns," perhaps significantly. Whether competing directly
in the marketplace, or competing indirectly by virtue of PBR standards, the ABC <u>will</u>
compete. And as such, ABC will have to accept the cultures and risks of a competitive
enterprise.</font></p>
<b><p><font face="Arial">Survival</font></b></p>
<p><font face="Arial">PBR and its ramifications are still just a concept in virtually all
jurisdictions. As PBR evolves, ABC and other companies that regard themselves as RIMCOs
will have time to evolve, as well, and there is every reason to believe that some will
make the changes necessary to survive. Our CEO at ABC may even be right about his
company’s competence in managing regulators, thereby indefinitely delaying or
avoiding altogether PBR. </font></p>
<p><font face="Arial">Prudent management in non-hypothetical energy companies must examine
the long term view. Pursuit of the RIMCO strategy might be appropriate for some companies,
provided that they recognize that it is very unlikely they can avoid the adoption of
competitive cultures, acquisition of talent outside the industry, and deployment of
distributed and other emerging technologies. Without this recognition, the RIMCO strategy
represents high risk. For ABC and others, RIMCO could easily be the proverbial wolf in
sheep’s clothing.</font></p>
<p><font face="Arial">The NARUC report can be viewed at: <a href="http://http://www.naruc.org/Publications/PBR%2520Report.htm">http://www.naruc.org/Publications/PBR%20Report.htm</a>.</font></p>
<hr>
<p><small><font face="Arial">Gerry Runte is Director of Strategic Planning and M-C Power
Corporation’s Eastern Regional Office in Bernardsville, New Jersey. Before joining
the company in 1997, he spent 21 years in nuclear fuel procurement, regulatory and
legislative affairs, new product development and strategic planning for a major utility,
where he had primary responsibility for fuel cells beginning in 1991. Gerry also serves as
a board member of the U.S. Fuel Cell Council and the Fuel Cell Power Association. </font></small></p>
<p><font face="Arial"><small>Gerry Runte</small><br>
<small>M-C Power Corporation</small><br>
<small>125 Mount Airy Road</small><br>
<small>Bernardsville, NJ 07924</small><br>
<small>(908) 630-0900 voice</small><br>
<small>(908) 630-0922 fax</small><br>
<a href="mailto:[email protected]"><small>[email protected]</small></a></font></td>
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