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<td width="75%" valign="top"><b><font face="Arial" size="6">ELECTRIC POWER
INDUSTRY CHANGES</font></b>
<p><font face="Arial"><strong><big>by Leonard S. Hyman, CFA<br>
</big></strong></font><b><span style="font-size:11.0pt;mso-bidi-font-size:10.0pt;font-family:Palatino;
mso-fareast-font-family:"Times New Roman";mso-bidi-font-family:"Times New Roman";
mso-ansi-language:EN-US;mso-fareast-language:EN-US;mso-bidi-language:AR-SA"><font face="Arial">Senior
Industry Advisor<br>
Salomon Smith Barney</font></span></b></p>
<p><font face="Arial">(<em>originally published in the <b>Cogeneration and
Competitive Power Journal</b>. For subscription information, call (770)
925-9388</em>)</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">People
who pick themes for articles or conferences have to choose words
carefully.<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><span style="font-size: 10.0pt"><font face="Arial" size="3">They
cannot say, for instance, that electricity suppliers would just as soon
sell dirty power in an oligopolistic market at high prices, so they
subtitle the article "Generating clean reliable electric power in a
competitive market." Consumers, at least, would applaud that goal.</font></span><font face="Arial" size="3"><o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">Then
there�s another subtitle: �The clash between environmental policy and
competition in electricity supply.�<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">What
does that mean? For one thing, environmentalists and suppliers of
environmental energy, in the past, sold to only one customer: the
government. Convince the government, and it imposes its will on the
utilities, who impose their will on captive customers. Now, environmental
activists have to sell their wares to the consumers. Is that a problem?
Not if you have a good product. In fact, they will do better with the
public than they did acting through regulators who made hostile utilities
the implementors of the policy.<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">Another
topic: �Price and/or reliability of electricity supply.� That�s a
dichotomy cooked up by lawyers, regulators and utility engineers. In the
future, price and reliability will go together, as they should in a
commercial market. Participants will pay more when they want higher
reliability, and less when they choose to take their chances. That�s
good, not bad. It makes for efficiency. It moves from one-shoe-fits-all to
custom fitting.<span style="mso-spacerun: yes"> </span>What�s
wrong with that?<o:p>
</o:p>
<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">But,
at the same time, those issues count in other ways. This article covers
these and subsidiary issues that will affect the value of present and
future power generating investments. <o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3"><b>COMPETITION
AND MARKET POWER</b><o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">Only
the most efficient make super-normal profits, over time, in a competitive
market. Many power plant buyers must consider themselves super-efficient
(which means that they would cancel each other out as happened in
Argentina) or they don�t think that they are buying into a competitive
market. So we might conclude from some of the bidding. <o:p>
</o:p>
<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">With
a small number of market participants, and the right transmission
configuration, market participants can bid collusively to rig prices, as
shown by work at Cornell <span style="mso-spacerun: yes"> </span>University.
A generator with the right portfolio of power plants can bid in a way to
clog up the transmission system. Academics at the University of Wisconsin
and M.I.T. have <o:p>
</o:p>
found ways to run plants in a manner that affects the operations of
competitors, and to glean information about competitors from
characteristics of the network. A generator with a place on the grid has
greater value because the transmission grid, under current management and
regulation, seems incapable of expansion.</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial">History,
though, tells us that every cartel has within it the seeds of its own
destruction. Too high a price encourages the development of alternative
products or the reduction in demand, or both. Natural gas pipelines
already bypass the transmission bottleneck. Inside the fence generation
could take load off the network. Small generators will come<o:p>
</o:p>off
the assembly line just as anticompetitive transition charges end in some
states, which will give impetus to those who want to escape before the
next round of stranded costs (from stranded distribution).</font><font face="Arial" size="3"> <o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">New
cables, undergrounding techniques and transmission equipment all increase
the probability that local generation oligopolists could face lower than
expected prices some time in the future. What do oligopolists do when they
realize that somebody could get to their customers? They trim their prices
to levels that discourage competitors<o:p>
from
entering the market, which, of course, trims their profits, as well.<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">In
other words, power prices will gravitate to competitive levels, as long as
conditions allow the entry of competitors, even if the competitors do not
enter the market. In the United States and Canada, where natural gas
pipelines, railroads, rivers and existing rights of way cries-cross the
land, I doubt that generators can avoid severe competition in most
markets, despite the severely congested nature of the transmission grid,<o:p>
unless
the government exercises its authority to prevent competition. <o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">In
less developed parts of the world, where competitive infrastructure does
not exist, and consumers do not have the capital to install distributed
resources, generators have a better opportunity to maintain higher prices,
although the ability of the consumers to pay for the product may,
ultimately, affect the profitability of the venture.<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">In
short, producers of a commodity should not expect to earn profits normally
associated with owners of brand names. <o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">In
addition, ask yourself about the direction of generation technology. Will
costs, in the future, go up or down? Think about what happened to natural
gas prices as exploration and production techniques improved.<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">Finally,
consider the peculiar and unnatural nature of the electricity bidding
process, in which generators bid into a market, thereby setting prices of
supply, with demand represented by a bidder who does not consult the
ultimate users about what they would take given the price set in the
market. In other words, this is not a real time market, not<o:p>
</o:p>a
market in which buyer and seller interact.<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">Once
real time metering is put in place, customers will react to price, they
will put in distributed resources in order to avoid paying peak prices,
and expensive generators that hoped to make out like bandits at peak times
might find that customer choice has shaved the peak off their profits.
Eventually, generators will face powerful buying<o:p>
</o:p>groups
that will combine distributed resources, alternate fuels and control of
consumption, all of which will operate with one aim: to reduce to a
minimum the take of the generators. You could see a repeat of what HMOs
did to doctors, hospitals and drugstores.<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3"><b>ENVIRONMENT<o:p>
</b>
</o:p></font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">Environmentalism
plays out on several fronts. First, there is the fear that cheap, dirty
coal beats out other fuels, and the cheapest electricity, derived from
dirty coal, wins in the market, because coal-burners do not pay the costs
that they dump on people downwind of them (presumably to the northeast, if
you follow the trail of lawsuits).<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">But
that brings us to the wild card of the generation game, CO<sub>2</sub> . Nobody believes that this Congress will ratify the Kyoto
Treaty. A lot of people believe that the Kyoto Treaty would make CO<sub>2</sub> abatement
needlessly expensive. A few people don�t believe in global warming, and
a smaller number do believe but don�t care or even like the idea.<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">Sooner
or later, though, I expect governments including that of the United
States, to take steps to decarbonize the power industry. I do not expect
them to forbid the combustion of certain fuels, but rather to force fuel
users to bid against each other to buy the rights to burn those fuels.<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial">Obviously,
power generators that produce the least amount of CO<sub>2</sub> per unit of output, or who have found the most cost effective
means of sequestering CO<sub>2</sub>, will
gain an edge in the marketplace. What are the business and financial
implications of: <o:p> </font><font face="Arial" size="3"> </o:p>
</font>
</p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">�
Higher prices for electricity, which will reduce demand.<o:p>
<br>
�
Need to repower or replace the many, old, coal burners in the fleet.<o:p>
</o:p>
<br>
�
Revaluation upward of nuclear power stations.<o:p>
</o:p>
<br>
�
Revaluation downward of fossil-fuel stations.<o:p>
</o:p>
<br>
�
Renewed interest in renewable resources.<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">The
last point brings up the matter of renewables. One might dismiss
renewables as overly expensive sops to the conscience of people who take
their empty bottles to the recycling station in four-wheel drive vehicles.
Renewable energy producers, in the past, did not worry about cost or
competitiveness. They convinced regulators that their products were good
for the world. The utilities bought or subsidized the products,<o:p>
which
meant that all consumers (and tax payers) subsidized the product
development and use. Despite all the help, renewables never really took
off.<o:p>
</o:p></font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">True
believers will argue that cheap fossil fuels undercut the demand for
renewables, and that renewables cannot compete in a free market that
continues to exhibit low prices. For the good of the environment, then,
they say, we must continue to force consumers to take some minimal level
of renewable energy.<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">I
don�t want to argue with those premises, but rather to take a different
view. I believe that failure of renewables, to some extent, is due to the
fact that the manufacturers and purveyors did not have to contend with the
discipline of normal market constraints, such as price, product
reliability, consumer satisfaction, strong management and standard
commercial contracts and financing terms. Instead, they had to excel in
lobbying and writing contracts. <o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">The
next generation of renewable energy firms, real businesses, will think in
terms of selling differentiated products at reasonable prices to
consumers. Once we get beyond the transition charges, which discourage
retail competition, I would expect that a combination of menu offerings, a
trend to distributed resources, and CO<span style="font-size:8.0pt;font-family:Palatino-Roman">2
</span><span style="font-size: 8.0pt; font-family: Palatino-Roman">, </span>mitigation
measures will turn renewables into a real business. Furthermore, think of
renewables as
the closest thing power producers have to a differentiated, brand name
commodity.<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3"><b>RELIABILITY<o:p>
</b>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">We
could tackle reliability in several ways. Unless regulators see the light,
reliability could decline and congestion increase in the electricity grid,
because transmission owners seem reluctant to invest under the current
regulatory regime. That, of course, would create greater opportunities for
favorably located generators, but it also hinders the development of new
facilities that do not have the right grid connections.<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">I
do not expect this situation to persist, because of the introduction of
new technology and new business organizations, once regulators realize
that current rules discourage the expansion of the grid. But, during a
transition period, reliability issues will affect profitability, valuation
and ability to locate many power stations. <o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">This
period of confusion, however, could encourage another answer, one that
would profoundly affect the dependence on the grid: the development of
distributed resources, to provide reliability to the network and to
provide power directly to consumers. Now, step back to think about the
players in the business. <o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">The
operators of the central stations, grid connected facilities, are the old
line industry players wearing new hats: utility company affiliates and
independent power developers, doing the same old thing, except more
efficiently or aggressively.<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">The
people pushing distributed resources, however, are subversives, out to
undermine the foundation of the old utility structure, as well as the new
structure that the utility successors hope to impose. The significant
players range from venture capitalists to automobile manufacturers to
makers of aircraft parts to retail energy purveyors. They make money by
offering decentralized solutions. In some parts of the world, they may
offer more economical energy than central station power. <o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3"><b>CONCLUSION<o:p>
</b>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">Investors
want to earn returns commensurate with risk. Firms should invest when
expected return equals or (preferably) exceeds cost of capital.<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">In
the United States, utilities are collecting huge sums from stranded cost
recovery mechanisms. Where do they invest that money? The power business
is growing slowly. In Europe and Japan, the market for electricity grows
even more slowly. Where do the firms in it put their cash?<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">Well,
American firms are more comfortable investing here, and foreign firms
believe that they must have a presence here. Does that produce too much
cash chasing too few projects? If it does, then some of those buyers so
eager to get into the market may have made optimistic assumptions about
ability to control prices or about availability of<o:p>
</o:p>transmission.
And they won�t earn cost of capital.<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">But,
as the market shakes out, I expect that highly efficient operators will
take over from many of the first entrants. And specialty operators will
move into sectors too large to be called niches, such as nuclear power,
highly efficient operating procedures to upgrade old facilities,
distributed resources, and renewables. In fact, we could see the<o:p>
</o:p>emergence
of a growth industry within a static overall demand, as new entrants
replace the conventional players who keep doing the same old thing. I
would expect this trend on a worldwide basis.<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="3">In
sum, as an investor, I�m not thrilled about putting my money into a
generic generating industry, that multitude of firms doing all sorts of
things, all over the place, in a slow growing, unbranded market. At the
same time, the enormous market for electricity offers major opportunities
for skilled players who see the trends, act on them, and avoid the
lemming-like tendencies that characterize the business. I�d bet on<o:p>
them
any day.<o:p>
</o:p>
</font></p>
<hr width="98%" color="#FFFF00" size="1">
<p><span style="font-size:10.0pt;font-family:Arial;mso-bidi-font-family:"Times New Roman""><font face="Arial" size="3"><b>ABOUT
THE AUTHOR<br>
</b></font></span><i><span style="font-size:10.0pt;font-family:Palatino-Italic">
</o:p></span></i><font face="Arial" size="3"><br>
</font><font face="Arial" size="2">
Leonard
S. Hyman, CFA, is
a senior industry advisor to Salomon Smith Barney. Previously he was
managing director of Fulcrum International Ltd., as well as an independent
consultant specializing in the economics and finances of energy and
telecommunications utilities.<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="2">From
1978 to 1994, as head of the Utility Research Group and first vice
president at Merrill Lynch, he supervised and maintained equity research
on foreign and domestic energy and telecommunication utilities. He was a
member of privatization teams for offerings of British, Spanish, Mexican,
Argentine and Brazilian utilities and consultant for other restructuring
studies. Prior to joining Merrill Lynch, he was a partner at a New York
Stock Exchange member firm and an officer at Chase Manhattan Bank.<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="2">Author
of America�s
Electric Utilities. Past, Present and Future, author of The New Telecommunications Industry: Evolution and
Organization and
editor of The
Privatization of Public Utilities, he has contributed to other books and to
professional journals.<o:p>
</o:p>
</font></p>
<p class="MsoNormal" style="punctuation-wrap:hanging;mso-vertical-align-alt:auto"><font face="Arial" size="2">For
more than a decade, Mr. Hyman was cited by <span style="font-size:10.0pt;font-family:Palatino-Italic">Institutional
Investor </span>as
one of the leading research analysts in his field. He is a Chartered
Financial Analyst (CFA). He holds a BA from New York University, where he
was elected to Phi Beta Kappa, and an MA in economics from Cornell
University, where he majored in industrial organization<o:p>
</o:p>and
minored in Latin American studies.<o:p>
</o:p>
</font></p>
<span style="font-size:10.0pt;font-family:Palatino-Italic;mso-fareast-font-family:
"Times New Roman";mso-bidi-font-family:"Times New Roman";mso-ansi-language:
EN-US;mso-fareast-language:EN-US;mso-bidi-language:AR-SA"><font face="Arial" size="2">Salomon
Smith Barney, Inc., 388 Greenwich St., New York, NY 10013; 212-816-8508.</font></span>
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