Retail gas and electric utilities are increasingly finding themselves in a pincer between state regulators and energy consumers. In general, most utilities (except the very largest), are the messengers of wholesale commodity market signals and public policy decisions. The message, in the main, is one of increasing burden on retail energy consumers. Regulators, who know better, have chosen to portray the utilities as instigators rather than as intermediaries. A hostile press and anxious consumers have turned to the regulators for explanations and action. The regulatory response has, largely, consisted of pandering.
Regulatory pandering is creating and will continue to create regulatory risks that are and will keep translating into earnings and credit risks for retail gas and electric utilities, especially those whose residential, commercial and institutional customer base accounts for a substantial majority of revenues and cash flows.
The pandering takes 7 forms:
- Management audits without any specific reason other than to find some fault, somewhere, in the target utility. Of course, if one looks hard enough fault will be found since this is what the auditors (consultants hired by the state regulators) are paid to do and how they build their reputation.
- Disallowances of expenses deemed to be imprudent. This is surprisingly easy even if not based on any reasonable interpretation of the law, because of the often very vague criteria and subjective judgments of hostile regulatory staff or consultants.
- Fines for (supposed) non-compliance with a performance standard or clause in some regulatory agreement. The regulators can allege non-compliance readily enough with no cost for being wrong but the utility must prove compliance.
- Regulatory lag in approving legally valid spending by utilities caused by multiple factors beyond the utility’s control. For large utilities the sums involved can be in the scores or even hundreds of millions of dollars.
- Attacks on incentive rates of return even as new mandates are imposed on utilities that result in diversion of management time and financial resources.
- Pressure (overt or disguised via revenue under-recovery) to reduce the allowable rate of return on equity even when the utility is already earning below the allowable rate of return. An increasingly popular covert method is to eliminate several essential cost recovery mechanisms in the course of designing revenue decoupling schemes. These schemes, embodied in proposals or orders, deliberately confuse average commodity use per customer with unit costs per customer, which can rise and indeed are rising independent of use, and pretending that baseline average use is flat when calculating revenue neutrality. Instead of providing more earnings stability, revenue decoupling, under such circumstances, can increase earnings volatility or actually compress long term earnings and dividends. The negative effect is amplified if the capital structure is altered to reflect less business risk because of revenue decoupling. Moreover, with per capita gas use expected to decline over the next 10 years while per capita electricity use is expected to increase substantially, a revenue decoupling method that works for natural gas does not work for electricity. The divergent trends require different mechanisms tailored to each utility.
- Preventing the utility from pursuing customer facing innovations that create new benefits for consumers and new earnings for the utility. The regulatory model dictates the business model.
Regulators determine corporate strategy. The more ossified the regulatory model, the more fossilized, the business model.
No one source of regulatory risk is of great consequence. It is the cumulative effect that, if not mitigated, alters in important and unfavorable ways the risk/return profile of a utility or multi utility holding company. Utility CEOs and Boards are, for the most part, not willing to fight back. They are either intimidated or view themselves as “ tax collection and policy implementation arms of the state” or do not want to attract attention to rich and still rising executive compensation or want to “ strategically manage” the political/regulatory environment and preserve privileged access to state governors, big city mayors and other politically powerful people.
Revenue quality continues to decline for almost all retail utilities as customer distress increases. Millions of utility customers are slow paying, part paying or defaulting entirely. In addition, the number of customers scheduled for service shut off has also risen (water utilities are seeing the same thing) but regulators are preventing utilities from exercising well defined shut off rights, creating more cash flow problems.
There is both anecdotal and indirect evidence that the utility roll rate (a measure of defaulting customers used in most retail industries) is increasing. Customers stop making payments on credit cards before they stop paying utility bills and they stop paying utility bills before they stop paying wireless service bills. The utility roll rate is sandwiched between credit card and cellular service roll rates: both continue to rise. No utility reports its roll rate and hardly any (even the few that have the resources to do) engage in footprint specific tracking of credit card and wireless service roll rates.
New York provides persuasive anecdotal evidence. Late payments for nine utilities regulated by the PSC are up significantly compared with a year ago. LIPA (owned by the state of New York and serving Long Island with retail electricity and gas) notes that distressed customers have pushed its 90 day arrears to over $50 million. Total late payments for LIPA are reported to be up by over 10% from a year ago. Similar anecdotal evidence comes from Maryland and Virginia. In Maryland, BG&E (PINK:BGLEP) has over 80,000 customers who have completely defaulted and the figure for Pepco is over 100,000. Delmarva Power and Light says 40,000 customers are “in collections”. In Virginia, Columbia Gas and Richmond’s Department of Public Utilities report substantial increases in delinquencies.
In New York , NYSEG and RG&E (both now owned by Iberdrola, the Spanish utility holding company: one of the largest in the world) cite worsening defaults by customers (and falling use) as an important reason for seeking unscheduled rate increases of $278million.
The financial pressure on utilities grows by the month. Most vulnerable are retail utilities in the Northeast, Upper Midwest, and California while, in general, utilities in the South are the least vulnerable.
Under overt pressure from the Governor of NY and its senior Senator, the New York PSC voted (in early April) to dismiss the special rate increase request by NYSEG and RG&E. The regulators suggested the utilities get money from parent Iberdrola instead. Both utilities already have a credit rating lower than other NY utilities and are concerned that their rating will be further degraded. Of course, if the cost of capital for these utilities does go up, they have a clear legal right for recovery via a rate increase. Good customers will pay for bad customers yet again.
In Maryland, the regulators responded to pleas from utilities for relief by doing the opposite: temporarily banning legally permissible shut offs (now that the heating season has officially ended) and announcing that they will “study utility price spikes”. Good customers, here, too are at risk from bad customers even though the regulatory system is supposed to protect paying customers. The utilities have now proposed no interest payment plans for delinquent customers, provided the customers can be current before the next heating season.
The regulators have responded by (a) asking for 12 month payment plans, knowing full well that the failure rate for such plans is 80% and (b) recommending late fees instead of interest on outstanding balances. Customers who don’t pay most of their bill won't pay late fees at the end of 12 months either, while the interest would have been collected monthly as a priority payment. The regulators also want people disconnected for non payment to be reconnected by paying only 75% of the outstanding amount. The 25% haircut, of course, will have to be made good, eventually, by the good customers.
The utilities are now in the shoulder months when demand is low and so too are revenues, cash flows and earnings. The cooling season will start in a few weeks. As the economy continues to deteriorate, past due amounts will start mounting again, especially for electric bills. If the utilities enter the next heating season with no improvement in the quality of their revenue stream, then the probability of widespread dividend cuts in the utility sector serving the Northeast, Midwest and California, in particular, rises sharply.
Some cuts have already been announced, the most notable from mid sized Ameren (footprint is Missouri and Illinois). Ameren announced that reduced cash flow from a deteriorating revenue base and higher financing costs compelled it to embark on a major cash conservation effort. The company has curtailed its dividend by 39%, is reducing capital expenditures (hence compressing its future rate base), putting some generating assets up for sale and cutting executive compensation. Investors were not amused.
The regulatory model for retail gas and electric utilities is under increasing stress. In several footprints it seems to be headed for failure. Utility managements and boards have not, so far, shown the will to change the model (too politically and personally risky, very difficult to execute, too busy with operational matters, why be first. ...are the reasons advanced). Regulators have no interest or conceptual capacity to propose a new model. Therefore, the current model will stay intact until the day it fails. Then it will be the usual spectacle.
Customers, investors, vendors, retirees and at least some employees will get hurt. Regulators, politicians and boards will blame “unprecedented economic challenges and extraordinary global credit market conditions”. Bailouts, rescues and even more destructive government interference, calls for municipalization of investor owned utilities and the need for more state and city owned generation and transmission assets and yet another bold and visionary “energy infrastructure stimulus” plan will resound in press conferences and staged media events. And yes, there will be the predictable articles claiming that if only we had the courage in early 2009 to invest hundreds of billions of dollars of taxpayer money in The Smart Grid and nationalize the 10 biggest utility holding companies in the US, the regulatory model would not have failed.
Disclosure: The author has no investment positions in the companies mentioned in this article