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<title>Ten Hurdles to Full-Scale Competition in the U.S. Electric Power Industry</title>
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<td width="75%" valign="top"><p ALIGN="left"><font face="Arial"><b><big><big><big><strong>TEN
HURDLES TO FULL-SCALE COMPETITION IN THE U.S. ELECTRIC POWER INDUSTRY</strong></big></big></big></b></font></p>
<font SIZE="2"><p></font><font size="4"><strong><font face="Arial">BY Richard J. Rudden</font><font size="4" face="Arial"><br>
</font><font face="Arial">President and CEO, R. J. Rudden Associates, Inc.</font></strong><br>
<small>(<em>originally published by PMA OnLine Magazine: 10/98</em>)</small></p>
</font><i><b><p></b></i> </p>
<p ALIGN="center"><em><big><big>The more things change, the more they stay the same.</big></big></em></p>
<p ALIGN="JUSTIFY"> </p>
<p ALIGN="JUSTIFY"><font face="Arial">There are some in the energy business who would
adhere to this old adage, while others would junk it along with Fridgaires, Edsels and
Hulahoops. I�m one. The business of generating, transmitting and distributing electricity
is changing in such fundamental ways that it will not likely resemble its old self ever
again.</font></p>
<p ALIGN="JUSTIFY"><font face="Arial">Policy makers, legislators and regulators all make
deregulation and restructuring out to be about economic efficiency, lower energy prices
and more customer choice. The business community, on the other hand, sees it as one
incredibly large jig-saw puzzle, now scrambled into many pieces, awaiting it to take on at
least the suggestion of the ultimate picture. And, of course, industry change is about
businesses and investors finding the sources of future value and profit growth. Thrown
into this change is a fair dose of panic and chaos, as well as some very neurotic, if not
schizoid, leadership personalities. Thankfully, there are also occasional reality checks,
like the extraordinary price spikes which occurred this past summer in the unregulated
wholesale power markets.</font></p>
<p ALIGN="JUSTIFY"><font face="Arial">Just think about it. An industry which generates in
excess of $200 billion a year in revenue, and with a market capitalization for investor
electric utilities of $335 billion, is going through one of the most massive
restructurings this nation has ever experienced, without the benefit of a roadmap, or some
other unifying plan. Some of the most raw elements of a free market economy are at work,
with only the �invisible hand� guiding its participants. Tens of billions of dollars in
generating assets are being divested; independent power projects are being placed in cold
standby, going bankrupt, being shut down, refinanced and restarted; utilities are being
merged at an unprecedented rate into huge, diversified energy companies offering every
sort of energy and non-energy service; and regulators are proposing to throw open energy
metering and billing services to non-utility competition. Technology providers, financial
institutions and a host of other service companies are scrambling to understand the new
energy value chain and find the new market niches. And, most perplexing of all, the pace
and form of deregulation is being driven by more than 50 autonomous state and other
regulatory bodies, each with its own regulatory and political agenda. Unifying Federal
legislation appears to be a ways off.</font></p>
<p ALIGN="JUSTIFY"><font face="Arial">The number of recent utility financial transactions,
including asset divestitures and corporate mergers and acquisitions, has been
awe-inspiring. In the past two years, according to the Edison Electric Institute, 64.5
gigawatts of the investor-owned fossil and hydro generating capacity in the US has been
sold or made available for sale; that's 11.1% of the total installed generating capacity
of the industry. The value of completed or scheduled generating asset divestitures totals
$8.2 billion, with AES Corporation, U. S. Generating Co. and Houston Industries emerging
as the three leading acquirors so far. These companies have agreed to acquire a little
over 50% of the generation capacity offered, in transactions valued at $3.6 billion, or
about 44% of the total dollars. </font></p>
<p ALIGN="JUSTIFY"><font face="Arial">Regarding mergers and acquisitions, about seven
years ago there were approximately 119 investor-owned electric utilities traded in the
public markets. Since then, 27 of those companies, or 23% of the total number, have been
merged, and there were 11 mergers still pending as of September 30. So, if all pending
mergers are approved, almost one-third of the industry will have consolidated in just
seven years. In addition, the number of active electric power marketers has proliferated
from a handful just three years ago, to about 110 today, and the volume of electricity
traded has increased nearly eightfold from the year 1996 to the twelve months ended June
30, 1998. Many power marketers sell electricity and natural gas, as well as a variety of
other fuels. It has been estimated that the monetary value of electricity trades (i.e.,
including physical and financial trades) will be in the order of $2.5 trillion by 2003.</font></p>
<p ALIGN="JUSTIFY"><font face="Arial">It is informative to look at the natural gas
marketing industry. Natural gas has been in the process of deregulating over a longer
period of time�approximately 10-15 years. The number of natural gas marketers has
actually declined from its peak as larger companies acquired smaller ones to realize the
benefits of volume purchasing, market power and economies of size in operations and in
managing risk. However recent trends indicate a rise in the number of smaller gas
marketers to fill the niches that the larger firms have been unable to address. This is
what may be expected from a more mature electricity market: large players meeting many
needs with smaller players providing service, reliability and product diversity. </font></p>
<p ALIGN="JUSTIFY"><font face="Arial">As the power industry becomes more commoditized, and
trading margins drop further, we can expect a consolidation of power marketers similar to
the consolidation we have already experienced in the natural gas industry. Further, if
measured only by commodity price volatility, the risk associated with trading electricity
today is also significant. According to one source, the average annual variability in the
commodity price of electricity ranges between 60% and 160% of the average. During a
limited number of hours last June, the variability index went off the charts: in the
Midwest, electricity traded at multiples in the order of hundreds of times the normal
prices.</font></p>
<p ALIGN="JUSTIFY"><font face="Arial">Then why should the nation engage in all of this
restructuring with its attendant dislocations and uncertainty? The answer is to reduce
electricity prices and enhance customer choice. Unfortunately, these precepts are
presently more articles of faith than they can be shown to be empirical facts. But the
Department of Energy believes that prices will fall. In DOE's Annual Energy Outlook 1998,
it provides data which suggests that between the years 1996 and 2010, national average
electricity prices will decline by just over14% in real terms. The decline in regions
where prices are presently the highest will be greater than the average. For example, the
decline in New England will approach 21% and, in the mid Atlantic states about 18%. In the
low cost states, the percentage declines will be lower than the national average. The
Mountain states, for example, are expected to see declines of only about 8% over that
approximate 15 year period.</font></p>
<p ALIGN="JUSTIFY"><font face="Arial">But here is the rub. From many a policy maker�s
perspective, particularly that of one charged with safeguarding a regional or political
constituency, it is not sufficient that electricity prices simply decline. Rather, it is
necessary that there be equity in the distribution of the resultant benefits. Policy which
permits the real or perceived redistribution of wealth as between, for example, low cost
mountain states and high cost coastal states, is often simply not good policy�and
practically speaking, not policy at all�at least from a parochial point of view.</font></p>
<p ALIGN="JUSTIFY"><font face="Arial">It should be evident that the regional
redistribution of benefits suggested by the statistics I listed earlier would be enough to
slow the progress of deregulation in a geographically-defined middle America. It is also
no surprise that deregulation is on a much faster track in the higher cost, more populous
coastal states, such as Massachusetts, Pennsylvania, New York, New Jersey, Rhode Island,
and California. However, when you throw the anticipated effects of deregulation on
residential customers into the equation, the sources of policy resistance become even more
evident. The same DOE study shows that while electricity rates overall will decline by
about 14% by the year 2010, residential rates are expected to decline by only 13%, while
industrial rates will decline by about 16%. Our own experience at R.J. Rudden Associates
suggests industrials will reap�and, in some cases, have already reaped�greater benefits
sooner than the DOE is prepared to recognize. At the extremes of the averages, residential
rates in the mountain states are expected to decline by only 5%, while industrial rates in
the New England should decline by over 24% and in the Mid Atlantic states by over 20%.</font></p>
<p ALIGN="JUSTIFY"><font face="Arial">Clearly, to the extent there is no overriding
Federal policy or legislation, the process of deregulation will be a daunting challenge.
It will, no doubt, stutter and stammer for a number of years to come. Unlike the telephone
and even natural gas industries which had substantial components of their business subject
to Federal regulations and interstate commerce law, the electric industry remains
predominantly regulated by the states. While the Energy Policy Act of 1992 opened the door
to wholesale competition more than just a bit under the authority of the Federal Energy
Regulatory Commission, the retail end of the business was affected only indirectly. Until
individual state policies converge on an acceptable form of deregulation nationwide, the
process of deregulation at the retail level of business will be long and painful. Right
now, the identity crisis from which the industry suffers is causing many regulators to sit
on the side-lines and wait things out, while others actively or passively resist change.</font></p>
<p ALIGN="JUSTIFY"><font face="Arial">When all is said and done, there are a number of
issues that need to be addressed before the industry can really accomplish its promised
metamorphosis. These are what I refer to as the �ten hurdles� to full-scale competition
in the electric utility industry.</font></p>
<i><p ALIGN="JUSTIFY"><font face="Arial"><strong>First</strong></i>, policy makers must
craft ways to deal with the residential rate implications of deregulation. Presently, it
is simply more expensive per kilowatt hour delivered to serve residential customers. If
free market forces are allowed to reign, residential rates will not enjoy as much of a
benefit as other customer groups that are less expensive to serve and, by the way, have
more competitive options such as on-site generation and multiple fuels. Generally
speaking, the prescription to date has been to mandate rate freezes or uniform reductions
in rates during some transitional period, while hoping that the true economics of
competitive power and new technologies will soften the shock to residential customers when
the transition period ends. Further, it has been argued that a pro-industrial policy
supporting rate reductions to large customers will promote economic development and
employment, with benefits redounding to the residential sector.</font></p>
<i><p ALIGN="JUSTIFY"><font face="Arial"><strong>Second</strong></i>, utilities and
consumers need to know how regulators will dispose of the issue of �stranded costs��the
investments that utilities made with the tacit or implicit approval of their regulatory
commissions, which the utilities might be unable to recover in a completely competitive
market. It is estimated that between $100 and $300 billion in investment capital may be at
risk�a number high enough to put the fear of God in the hearts and minds of investors,
and big enough to represent a significant source of savings for electricity consumers, to
be worth their pursuing very aggressively on all political fronts. Although most
regulatory commissions and state legislation support recovery of prudent and measurable
stranded costs, that tenet is being challenged on a number of fronts�California�s
Proposition 9 being the primary example.</font></p>
<i><p ALIGN="JUSTIFY"><font face="Arial"><strong>Third</strong></i>, the early
disappointments and failures of companies that entered the competitive fray perhaps a
little too aggressively or too early should be recognized as the natural and inevitable
costs of competition and structural change, not an invalidation of it. The retreat of
Enron from the California residential market, Power Company of America�s bankruptcy due
to the June price spikes, LG&E�s exit from trading altogether and its associated $225
million write-off, UtiliCorp�s and PECO Energy�s abandonment of their EnergyOne branding
initiative, and Montana Power Company�s departure from wholesale trading have all been
the source of great satisfaction for restructuring nay sayers. In fact, however, these
events are affirmative of free market forces: they attest to the speed with which the new
utility industry can now react to change, and to the ways the market will exact its price
for poor business practices. </font></p>
<i><p ALIGN="JUSTIFY"><font face="Arial"><strong>Fourth</strong></i>, according to many
industry experts, the Public Utilities Holding Company Act (PUHCA) needs to be repealed.
It requires that electric generators make a Hobson�s choice�they can restrict their
activities to one state or contiguous states, or they can register under PUHCA.
Registration under PUHCA, which is so onerous that only 16 companies have chosen to do so,
means that the SEC must approve the issuance of securities, the purchase and sale of
assets and corporate acquisitions. It also means that the registered company may undertake
only limited diversification. Until PUHCA is repealed or substantially amended, it is
difficult to see how the users of electricity can reap the benefits of vigorous price
competition and economies of scale, such as we have seen in telecommunications. </font></p>
<i><p ALIGN="JUSTIFY"><font face="Arial"><strong>Fifth</strong></i>, environmentalists are
concerned that the deregulation of generation assets, coupled with intense competition,
will encourage the use of more and dirtier, but cheaper, coal-fired generation. They are
also concerned that the focus on competitiveness will discourage investments in clean and
renewable fuels, such as bio-mass, solar and hydro and in demand-side management.<b> </b>In
response to this concern, as an example, New York State utilities will have a special
charge for societal benefits applied to their customers� delivery service rates, and
these funds will be transferred to, and used by, the New York State Research and
Development Authority, to fund R & D for energy efficiency, conservation and
demand-side management programs, and environmental protection. A similar delivery service
charge is collected in California, with the funds used for Public Purpose Programs. These
Programs also include environmental initiatives, a lifeline program and R&D for
alternative energy sources. New Jersey is expected to have a similar charge, although the
application of the funds is less well-defined at this date.</font></p>
<i><p ALIGN="JUSTIFY"><font face="Arial"><strong>Sixth</strong></i>, various interest
groups remain concerned that certain other <em>public benefits</em> provided by regulated
utilities, such as economic development programs and discounts for the poor and elderly,
will be discontinued. Until protocols are in place to assure continuation of at least a
down-sized version of these programs, various industry stakeholders will remain opposed to
deregulation or will seek to abate any adverse impacts of deregulation on specific groups.
For example, New York State has taken steps to protect economic development and low-income
consumers. One step is that, at least during the transition period to market-based rates,
electric generation from low-cost resources such as nuclear and hydro will be �streamed�
to electricity users in economic development programs. This means that those users will be
charged the lower costs of generation from the least-cost resources in the system. A
second step is to make a greater number of user groups eligible for the least-cost tariff
classes. The costs of these efforts will be funded by a Competitive Transition Charge to
be paid by all electric users. In an interesting new twist on energy, convergence,,
qualifying low-income consumers in Washington DC can participate in, Joint Utility
Discount Day, and receive discounts to help pay gas, electric and telephone bills. </font></p>
<i><p ALIGN="JUSTIFY"><font face="Arial"><strong>Seventh</strong></i>, the conflict
between publicly-owned and investor-owned utilities needs to be resolved as a precedent
for establishing a level playing field for universal electricity competition. It is argued
that governmentally-owned utilities are subsidized by the general body of taxpayers
through the preferences of tax exempt bonds, exemption from Federal income taxes, and
priority access to low-cost, government-owned hydro power. Consequently, municipal and
cooperative utilities have lower cost structures which place investor-owned utilities at a
clear competitive disadvantage. Pressure to privatize municipal and cooperative utilities,
as well as Federal Power Marketing Agencies, such as TVA and Bonneville, has been great.</font></p>
<i><p ALIGN="JUSTIFY"><font face="Arial"><strong>Eighth</strong></i>, transmission
constraints in many parts of the country need to be relieved if electrons are to flow
freely from low generating cost areas into high cost regions in response to market
demands. However, the siting and reinforcement of transmission lines has become
environmentally problematic, and the responsibility for planning and paying for
incremental capacity has not yet been fully defined without new transmission capacity, the
nation will remain a patchwork of broad regional markets and more narrow �load pockets�
where transmission constraints will sustain the market power of some generators, restrict
power flows and place upward pressures on intra-regional electricity prices.</font></p>
<i><p ALIGN="JUSTIFY"><font face="Arial"><strong>Ninth</strong></i>, the organizational
and technology infrastructures of utilities and non-regulated energy marketers need to
evolve more rapidly if open access and competition are to achieve their full potential.
Sophisticated and lower-cost metering, load monitoring, billing, and customer information
and communications systems will all be required to accommodate the complexities of
competitive energy commerce.</font></p>
<i><p ALIGN="JUSTIFY"><font face="Arial"><strong>Tenth</strong></i>, and last, the energy
commodities markets, particularly for electricity, need to mature in order to provide the
pricing transparency, counter-party creditworthiness and liquidity required by the
participants in this market. Until this market matures, we can expect to see more headline
grabbing stories such as Power Company of America�s bankruptcy, which can only serve to
nourish the nay-sayers. Ideally, the markets will have a sufficient variety of contracts,
with standardized terms, creditworthy participants and/or margin requirements as we have
come to expect in other markets, and low bid-ask spreads. Once the markets mature, energy
users will be able to lock in costs and generators will be able to lock in revenues. And
the unbundling of generation, transmission and distribution can take place more
efficiently as the energy component of electricity service evolves into a true commodity. </font></p>
<p ALIGN="JUSTIFY"><font face="Arial">In summary, past is not prologue within the energy
industry, and the more things change, the<b> <i>less</i></b> they remain the same. The
industry is moving inexorably towards a new competitive paradigm (I had to use that word
somewhere), albeit slowly and somewhat clumsily. In the end, however, once the ten hurdles
are vaulted, the change will result in more robust competition, a better rationalization
of what should remain regulated and what should be competitive, more choice (for those who
want it), and lower prices overall for consumers.</font></p>
<hr>
<font SIZE="3"><p></font><font size="2">Founded in 1981, Rudden provides a wide range of
management and economic consulting services to the energy industry regarding strategic,
managerial, operational, economic and regulatory issues. The firm advises organizations in
the natural gas, electric and private power industries throughout the world, and has been
extensively involved in electric and natural gas industry restructuring activities within
the U.S., Canada and Australia. Rudden is headquartered in Hauppauge, New York (Long
Island). Additional information about the firm is available on Rudden's web site at <a href="http://www.rjrudden.com">www.rjrudden.com</a>.</font></td>
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