The U.S. Energy Utility Regulatory Model May Fail

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The US energy (gas and electric) utility regulatory model is now 75 years old. It was designed for the circumstances, technologies, isolated economies and unconnected asset classes of the 1930s. The utility model was designed for small, local utilities with generally local ownership and management (once the utility trusts were broken), a substantial degree of footprint insularity from other franchised footprints and mostly local or regional supply chains.

No regulatory model can survive for so long a period. The model has diverged sharply from market and technological realities while the interests of Wall Street, Utility executives and politicians have converged just as sharply, compromising accountability and oversight. There is nothing special about this divergence/convergence. It happens in most heavily regulated industries.

Market Realities

Market realities have now asserted themselves in the energy utilities industry and reveal that :

  1. Management by quantitative models does not succeed for long and is no substitute for management experience, insight and tested judgment.
  2. There is now, through financial engineering on a global scale, true, deep and potent connectivity in all asset classes and commodities in most parts of the world’s economy: no asset is an island, no business is an island and no economy is an island.
  3. Frequent mark to market accounting of long lived physical assets in inherently cyclical markets such as real estate, fossil energy reserves, mineral deposits, nuclear power plants, LNG facilities, steel mills is wrong policy and destructive.
  4. Formal risk management models and risk management theories as practiced today in the energy business do not capture reality and cannot be relied upon for critical decisions.
  5. Complex, multi-party transactions or agreements or contracts that are unequally understood by all parties involved lead to tremendous risk shifting on the ignorant party or parties and can collapse when the disadvantaged party or parties fail to act or contribute as expected by the more sophisticated or advantaged party.
  6. Even a medium sized utility (a million customers) faces supply chains that are international and global: e.g. for raw energy, equipment, capital, software, outsourced services, which means that, increasingly, management is subject to critical business factors well outside its control while its ambit of decision making is inherently local and experience often parochial. Utility managements are mostly composed of men and women who have been with the company for a long time, place a premium on personal chemistry and whose professional experiences are of the single industry-limited geography nature. Once, these were great strengths. Utility cultures and traditions that emphasize “localness”, deliberate decision making, slow and long budgeting cycles , mistake avoidance and legacy continuity do not resonate with mutable, apparently capricious and sometimes inscrutable international and global supply chains.

The forces of the market cannot be resisted for decades. The more the market is resisted via bad/irrelevant management or bad/obsolete regulation or bad legislation or a combination, the more explosive the force with which the market asserts itself and the more destructive the consequences. Markets have scant regard for theories, models, regulations or laws that pretend the unreal is real and the uneconomic is economic.

Utility Industry Issues

There are three issues that, in concert, may lead to such significant strain on the current utility regulatory model (in economically and demographically stagnant footprints) that it may buckle and then crash. Of course the model will not fail in all franchises or at the same time. Generally utilities and the utility in the South, Mountain states, Southwest are fairly secure because of favorable demographics and public policy . Nonetheless, failure anywhere will reverberate everywhere.

The first issue is credit contraction, which is likely to endure for several quarters. The second is the stacking of special charges and fees on top of commodity rate increases (utility bills reflect the prices of fuel that prevailed 4 to 8 months ago, not current prices, because of procurement necessities, storage management practices and regulatory strictures so the consumer price of natural gas and electricity can rise sharply even as spot prices are plummeting, which baffles and infuriates consumers; moreover a utility bill is beyond the ability of 99% of consumers to decipher) because of proliferating regulatory mandates. The third is increasing customer frustration.

Utilities, worldwide, have capital projects on their books that require massive external financing. In addition, they have growing working capital needs that must be met by issuing and rolling over commercial paper and short term notes. Credit contraction will raise the cost of debt while limiting access to capital markets. At the same time the credit quality of several utilities will deteriorate as the quality of their revenue base is eroded. Distressed accounts have increased very sharply in the past 90 days because of slow payments, part-payments and non-payments by customers. In some franchises distressed accounts are nearing 30% of all accounts.

By law, utilities can compel good customers to pay for the revenue losses from bad customers, which raises the bill for good customers, pushing some into the distressed category. The extra burden of financing must either be borne by customers or by shareholders in the form of dividend cuts, which will cause at least some shareholders to abandon utility stocks in favor of other assets. Regulators and most utility managements have no experience coping with such disturbed capital markets. Efforts to move the financing challenge into the years ahead will only compound the bad consequences. New financing strategies are needed but the current regulatory model precludes such innovation.

Fee stacking is the result of adding on layers of special charges to finance system enhancements, comply with regulatory mandates (often enthusiastically supported by utilities) for expensive renewable energy and efficiency projects and facilitate social engineering. These charges are added to other rate increases. The result is that utility customers are faced with sharply rising bills without any increase in perceived benefits. This unrestrained fee stacking may well shred the compact amongst consumers, regulators and utilities if customers believe coercive fees have become intolerable and appear to benefit only special interests, utility managements and their political allies.

Mounting customer frustration is a potent source of risk for the current regulatory model, for regulators and utility executives in an environment when there is a lack of trust in almost all major institutions. Both residential and business/institutional consumers are caught in a squeeze between rising costs of living (e.g. Healthcare, property taxes, education, insurance) or doing business (especially utility bills) and declining wealth, income and access to affordable credit. Customer frustration will initially be expressed in ways we have already seen: as part payments of utility bills, slow payments or no payments. Then as shut offs and customer distress escalates and good customers are increasingly forced to pay the bills of bad customers, there may well be growing calls for reducing the ROE, directly or through regulatory subterfuge, of utilities and unpleasant scrutiny of management compensation and corporate privileges (which are rising while customer incomes are often falling). Regulators, caught between the legal rights of utilities and the political anger of consumers, may feel threatened and ineffective, inviting legislative intervention. Hasty and poorly crafted intervention is likely to deter capital providers and suppliers, perhaps toppling the entire regulatory model into failure.

It is very difficult and perhaps impossible for an insider (regulator, executive, board member) to see that a model, regulatory or business, is being distorted to the point of severe damage and even collapse. It takes decades of pressure on the model before stresses reach the tipping point. Then, failure is sudden, dramatic and catastrophic. To the insider, the model appears adequate and even robust until the day before the failure. Moreover, there are no institutional mechanisms for warning signals( a trend line of declining real, risk adjusted, ROE is a leading indicator but almost never taken seriously) to reach key decision makers and no safe forum within which such signals can even be discussed. Therefore, they are ignored.