Business & Money
Electric Reliability: The Merger Solution
Can economies of scale make the industry more stable?
Month 2004
By George W. Bilicic And Ian C. Connor
The recent Northeast Blackout framed for regulators and public policy-makers one of the central issues confronting the utility industry: infrastructure reliability and the significant capital investment requirements necessary for improvement. While estimates vary widely, some industry experts currently project that the investment necessary to revitalize and secure the transmission infrastructure in the United States may run in excess of $100 billion. The challenge for policy-makers in addressing these significant investment needs will be to create a sustainable economic and regulatory regime that is supportive of infrastructure investment while not unduly burdening either utilities or ratepayers.
The challenge is made more complex when one takes into account the already existing pressures on rates, especially from natural gas prices. Moreover, many utilities have not
realized rate increases for some time, with current rate levels also frequently funded by cost savings strategies that are not sustainable over the long term.
The good news is that a solution is readily available that would properly balance these structural and economic imperatives: create a comprehensive regulatory environment supportive of utility consolidation that directs a significant portion of the derived merger synergies toward infrastructure investment.
The North American utility industry remains highly fragmented, in part as a consequence of a regulatory environment that is adverse to consolidation. For example, current state regulatory practices typically result in 50 percent or more of merger-related cost savings being passed on to ratepayers in the form of rate cuts. This inability to capture the economic benefits of mergers, coupled with onerous and extraordinarily time-consuming regulatory approval processes, has significantly impeded merger activity in the industry. As a result, the consolidation that occurred in most industries over the past two decades, and that resulted in significant respective economies of scale, largely bypassed the utility industry.
Utility mergers create exceptional efficiencies, yielding average cost savings of approximately 5 to 10 percent of the combined company's non-fuel operating expenses. These substantial untapped cost efficiencies could be harvested through more merger-friendly state regulatory policies that would enable utilities to retain these merger cost savings so long as a significant portion was channeled toward infrastructure investment. Provided that utilities would be allowed to earn timely, economic returns on such investments, this would provide a powerful inducement for consolidation and generate enormous investment capital. For example, if 50 percent of merger synergies were directed to investment in the U.S. electricity system and the top 100 utilities merged to create only 50, it could result in as much as $50 billion in derived cost efficiencies being allocated toward electricity system investment.
As a result of the earnings-growth challenges facing the industry (see Figure 1) at a time of historically high trading multiples (see Figure 2) and significant exposure to interest rate increases (see Figure 3), the utility industry could be quite inclined to pursue consolidation, assuming reasonable regulatory support exists. Consolidation remains a viable means to generate earnings growth and value, as compared with other methods that have been pursued in the past (e.g., international, non-utility businesses, large merchant plays) and would be severely scrutinized in today's marketplace.
Comprehensive regulatory policies supportive of consolidation in the utility industry would benefit all constituencies. Regulators would be able to achieve significant reliability investment while avoiding, or at least significantly mitigating, the politically unpalatable proposition of increasing rates. The utility industry (and its shareholders) would materially benefit by eliminating currently embedded cost inefficiencies, realizing economies of scale and generally becoming financially stronger. And ratepayers would avoid shouldering the entire burden of infrastructure investment in addition to other rate pressures described above.
Currently, however, and notwithstanding the compelling economic proposition outlined above, it is uncertain whether the overall regulatory will exists to properly align the industry's economic policies with the need for significant industry investment. While there are features of the proposed federal energy legislation that would ease the administrative burdens of seeking consolidation approvals, much more still must be done on the regulatory front. What is certain is that, in the absence of the necessary economic incentives, utilities will continue to find new investment in transmission and other system infrastructure challenging, thereby impoverishing the U.S. power system and ultimately degrading reliability over time. While the causes of the Northeast Blackout will be considered for some time, the debate about the causes of the blackout reminds us that the price for the continued neglect of the U.S.'s electricity infrastructure needs is very steep and very real.
Investment in infrastructure, however, requires that a fair return be available that someone-i.e., ratepayers-must fund. In an economic and general rate environment with many pressures that will otherwise require rate increases, additional rate increases to fund investment may be politically challenging albeit necessary. Having access to the embedded economies of scale from industry consolidation could ease these burdens and create benefits through further system reliability and investment.
George Bilicic heads the Global Power & Utilities Group of Lazard in New York where he is a managing director. Ian Connor is a director in this group. Contact Bilicic at george.bilicic@lazard.com and Connor at ian.connor@lazard.com.
Business Bytes
Progress Energy Earns $3.30 Per Share for 2003
Progress Energy reported full-year consolidated net income of $782 million, or $3.30 per share, compared with earnings of $528 million, or $2.43 per share, for 2002. For the fourth quarter 2003, net income was $102 million, or 42 cents per share, compared with $123 million, or 55 cents per share, for the fourth quarter of 2002. The Thomson First Call mean estimates for the fourth quarter and full year 2003 were 76 cents and $3.53, respectively. The company's management uses ongoing earnings per share to evaluate operations; the company reported ongoing earnings for the full year 2003 of $844 million, or $3.56 per share, compared with full-year 2002 ongoing earnings of $827 million, or $3.81 per share. Fourth-quarter ongoing earnings for 2003 were 82 cents per share.
Progress provided 2004 earnings guidance of $845 million to $880 million, or $3.50 to $3.65 per share. "Our success in selling non-core assets has positioned us to be able to pay down $500 million of holding company debt in March. Compared to 2002, we reduced our capital expenditures, and our leverage is below 59 percent, down over 200 basis points. Importantly, we raised our dividend for the 16th consecutive year," said Chairman and CEO William Cavanaugh.
Banc of America Securities Downgrades Xcel Energy
Banc of America Securities analyst Shelby Tucker lowered his investment opinion of Xcel Energy to "neutral" from "buy." The analyst wrote in a research report, " Now that most of our expected catalysts have taken place, we see little that will drive valuation beyond a traditional utility. The only remaining catalyst is a potential dividend increase in June 2004. We forecast that the dividend will increase to 80 cents from 75 cents."
Entergy Loses 17 Cents Per Share in Fourth Quarter
Entergy reported full-year 2003 as-reported earnings of $926.9 million, or $4.01 per share, compared with $599.4 million, or $2.64 per share, in 2002. For the fourth quarter, reported losses were $39.5 million, or 17 cents per share, compared with earnings of $75.8 million, or 33 cents per share, for the fourth quarter of 2002. The Thomson First Call mean estimates for the full year and fourth quarter were $4.22 and 37 cents, respectively. In the fourth quarter, higher-than-expected participation in a voluntary severance program resulted in special one-time charges. CEO J. Wayne Leonard said 1,100 employees participated.
Avista Files Rate Increase in Idaho
Avista Corp said it filed to increase electric rates in Idaho by 11 percent and natural gas rates by 9.2 percent. The rate increase would raise annual power revenues by $18.9 million and gas revenues by $4.8 million. The Idaho Public Utilities Commission usually has seven months to review rate case filings. Avista said its current rates are based on 1997 operating costs on the electric side and 1987 costs on the gas side. Under the company's proposal, average monthly power bills would increase about $8.22 per month, and gas bills would increase by about $5.58 per month.
Enron Bankruptcy Judge Approves Sale Of Portland General
Enron Corp.'s bankruptcy judge will allow the company to sell Portland General Electric to an investment group headed by the former governor of Oregon, according to an Associated Press report. The utility will be sold for $1.25 billion in cash and the assumption of $1.1 billion in debt. The deal is subject to approval by state and federal regulators. The investment group is headed by former Gov. Neil Goldschmidt. Texas Pacific Group will finance the purchase; the group's investors include banks and pension funds. A spokesman for the investment group told the wire service that the firm hopes to close the PGE deal before the end of the year, pending regulatory approval. The city of Portland, along with consumers, had considered turning the utility into a municipal utility, but voters rejected a ballot initiative.
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