Power Industry's "Prolonged and Muddled Transition" Producing New Uncertainties, Balkanization and Possible Re-regulation

The "prolonged and muddled transition" from regulation to market of the North American electric power industry, including recent highly publicized brownouts and extremely volatile prices, raises public concerns about the industry's ability to deliver reliable service at affordable costs, according to a new report on power industry trends.

Potential consequences of the transition difficulties include the likelihood of renewed political intervention and re-regulation that could worsen the current transmission gridlock and increase the industry's valuation gap, Cambridge Energy Research Associates (CERA) and Arthur Andersen say in "Electric Power Trends 2001." The result would be creation of additional impediments to reliable delivery of electric power.

The report is a mid-course examination of the results of electric power deregulation in the two years since California led the nation in deregulating its electric industry. It uncovers a "Baker's Dozen" of surprises in the new power market and provides a useful overview as politicians, consumers and the industry struggle with understanding what went wrong with the California deregulation that was supposed to be a model for the nation.

"The electric power industry faces broad challenges in a market that is only partially de-regulated and where already-complicated market dynamics are further compromised by incongruent, but extremely powerful, expectations from disparate sources," said Larry Makovich, CERA's senior director, electric power. "The most important case in point is California where recent system failures are not a surprise because the trends indicated a reliability crisis would happen, the only question was when. It exposes the consequences of flawed power market design: transmission gridlock and political backlash," he added.

"The key to success of an organization in this industry is their ability to judge, anticipate the impact and timing of and ultimately mange risks," said Jon Wierda, the partner-in-charge of Arthur Andersen's North American utility practice. "What is happening in the electric utility business is virtually a complete change from top to bottom. It is a very rough road to go down fororganizations that, perhaps in the past, were focused mainly on 'a dollar of cost equals a dollar of revenue' mentality," he added.

Specific findings of the study include:

Price Volatility-- Pricing dynamics changed drastically with industry restructuring. Previously, pricing was largely governed by long-term sales contracts supplemented by seasonal exchanges and short-term exchanges. However, a number of new dynamics, including centralized power exchanges, electronic trading floors, new futures instruments and FERC-certified power marketers, respond to demand and supply conditions. Variation in regional supply and demand will continue to contribute to price volatility.

Natural Gas Prices-- The doubling of natural gas prices in the last year took many by surprise. However, the report notes a "surprising disconnect" between trends in natural gas-fired power generation and trends in natural gas exploration and development, which has been flat or declining in recent years.

Electric Supply Tsunami -- Linked to the concern over natural gas exploration and production is what the authors called a projection "electric supply Tsunami," a wave of new supply both proposed and currently under construction. Proposed power projects in North America go from less than 10,000 MW in early 1997 to about 250,000 MW in 2000. Ninety-five percent of proposed North American power plant development is natural gas-fired. The report suggests that if natural gas price levels continue at these peaks, then changes in fuel and technology selection is likely to occur.

Electric Supply Tsunami II-- The report sees a serious misalignment between the location of the 50,000 MW of proposed power projects currently under construction and the needs for new supplies in regional markets. The overbuilds in several regional power markets while shortages crop up in other markets will be particularly acute in the absence of a true national market.

Electric Stock Valuation Gap-- Capital needed to improve transmission, generating and distribution capacity is not likely to materialize unless current investor sentiment is changed. In general, power company stocks are trading at 12 times forward earnings compared with 25 times earnings for typical S&P 500 companies. Other indices are even clearer: during the five years ending December 31, 1999, the S&P Utility Index (SPU) and the Dow Jones Utility Index grew about 50% while broader market indices grew by 195% (Dow Jones Industrial Average), 215% (S&P 500), and 455% (Nasdaq Composite Index);

Transmission Gridlock-- Although policymakers envisioned national physical and financial transmission markets, neither has emerged. Current transmission lines were built decades ago but no one in the transmission sector has the means or incentives to optimize transmission network investment. In addition, regional organizations, the independent system operators that manage the transmission network, have widely varying responsibilities, services, governance and pricing. Gridlock and regional Balkanization mean that trends toward greater network congestion, occasional sagging voltage and reliability are likely to persist.

Myths and Misdirection-- The report also explodes other generally held perceptions about trends in the electric power industry. Although natural gas is currently the popular fuel of choice for many reasons, including environmental considerations, prices may dictate utilization of other technologies. Coal and nuclear power, commonly thought to be on the decline in terms of utilization, are surprisingly viable. And despite the common perception that the new economy depends on massive amounts of electricity, the reverse may be true.