Letters to the Editor
August 2004
To the Editor:
An earnings gap? Is that like the "missile gap"-a false alarm but a sure attention getter? Gary L. Hunt and Jon Ecker assert, in their article ("Back to Basics: A Starvation Diet for Utility Earnings Growth," June 2004) that investors expect 10 percent growth but a back-to-basics strategy will deliver only 3 percent. I agree with the latter observation but not the former. The earnings gap sounds, to me, like a leftover from the 1990s. I doubt that utility investors, in general, expect 10 percent, at least not the investors that I know.
Just about every utility that comes to town to tell its story preaches the line that the back-to-basics strategy will produce growth rates of at least 3 percent, and investors do not walk out in disgust and promptly dump the stocks. At a recent Edison Electric Institute conference in New York City, a panel of institutional investors berated utility managements for having engaged in strategies that destroyed value, not for going back to basics. I suspect that energy utilities, as a whole, have produced no earnings or dividend growth over the past decade just because they strayed from basics into fields in which they had no experience or advantage. Three percent is a lot better than nothing.
Finally, let's get real about investor expectations, now that investors have begun to get real. Articles on the topic fill the financial journals. They feature variants on this theme: Over time the average equity investment produces an annual total return (dividends plus stock price appreciation) of 6.5 percent per year in real terms, the bulk of which comes from the dividend component. Add inflation expectations to that number, and you get an 8.5 to 9.5 percent return in nominal terms. The average back-to-basics utility yields about 5 to 6 percent and might grow 3 to 4 percent per year, which adds up to produce a total return expectation of 8 to 10 percent per year, not far from the return that the journals posit for the market. Where's the gap?
With past experience as a guide, as an investor I'd worry more about utilities in my portfolio that are shooting for 10 percent growth than about the ones that manage to grow at 3 percent.
Sincerely,
Leonard S. Hyman, Senior Consultant Associate
R. J. Rudden Associates
To the Editor:
I would like to commend Michael Burr for his coverage of electric cooperative consolidations and acquisitions ("Consolidating Co-ops," June 2004). However, I'd also like to offer a point that was omitted: the potential acquisitive interest of financial buyers.
The first purchase of an electric utility by a financial buyer occurred in 2000 when Laurel Hill Capital Partners, led by former Long Island Lighting CEO William J. Catacosinos, acquired Texas-New Mexico Power Co. A couple of years later, Warren Buffet's Berkshire-Hathaway purchased Mid-American Energy. Now, KKR and Texas-Pacific Group are acquiring UniSource Energy and Portland General, respectively.
Given the dull but predictable returns of the "wires business," co-op acquisitions are a good fit for this kind of buyer, who frequently is attracted to above-market growth prospects and opportunities to achieve greater efficiencies.
Regards,
Kevin T. Williams, Attorney at Law
kevintwilliams@att.net
To the Editor:
I would like to comment on views included in your June 2004 edition by [AEP CEO] Michael Morris in the article "The New CEOs" and [Contributing Editor] Michael Burr in the article "Consolidating Co-Ops." Industry's common use of the approach to benchmarking in the first article does not result in an economic benefit to consolidation that the second article uses as a basic assumption.
In the first article Mr. Morris states, "We benchmark ourselves against other utilities on O&M per kilowatt delivered and O&M per worker in the field." Similar benchmarking metrics common in the industry are cost-per-customer and number of customers-per-employee. In all these types of benchmarking, which we classify as single dimensional, there is no built-in expectation of economy of scale. That is to say, as the number of kilowatts delivered, or numbers of customers are doubled, the metric stays the same (no economy of scale).
Our analysis affirms the basic assumption that there is no economy of scale for utilities in the United States. This is true for utilities ranging from small co-ops with as few as one customer per mile and 5,000 customers, to very large IOUs with over 50 customers per mile and millions of customers for both distribution-system and transmission-system costs. Thus, total costs double when the number of customers in a utility doubles or the number of pole miles of transmission doubles (all other factors kept the same). It is interesting to note that in the United Kingdom distribution system costs increase by less than 75 percent when the number of customers doubles, a significant economy of scale.
Mr. Burr's article discusses the concept that co-op costs are higher on average than IOU costs and that consolidation of co-ops would likely reduce this disparity. This is based on the normal economic principle of economy of scale. His article states that Tennessee attorney Kevin Williams and others argue that co-op rates would be lower if it weren't for the large number of small systems each with their own significant overhead. He goes on to say, "In terms of density, of course, co-ops are tiny, with less than 7 consumers per mile of line, compared to 34 for IOUs."
Our research finds that the higher co-op costs are predominantly caused, not by overheads, but by lower customer densities (higher O&M and capital) and by higher customer growth (higher capital). Our research using linear and non-linear multiple regression analysis on hundreds of U.S. IOUs, public, and co-op utilities finds that distribution system O&M is expected to be 25 percent and 50 percent greater at 7 and 4 customers per mile, respectively, compared to 34 customers per mile. A 1 percent increase in customer growth results in a 20 percent increase in distribution capital requirements. Thus, unfortunately, consolidation in itself would not provide the expected economic benefit of economy of scale considering the way utilities are managed in the U.S.
We believe part of the reason for this lack of economy of scale in the United States for T&D costs is the common use of these single-dimensional benchmarks by both utility management and regulators. These single-dimensional benchmarks do not assume any economy of scale. In the United Kingdom, multi-dimensional analysis is used by the regulator (Office of Gas and Electricity Marketing) to determine benchmarks for the distribution utilities. These benchmarks take into account the diversity of physical differences between their utilities and include an economy of scale expectation. If U.S. utilities had a modest economy of scale where costs increased by 90 percent when the number of customers or pole miles of transmission were doubled, there would be cost savings of billions of dollars each year that could fund the modernization/expansion of U.S. T&D systems.
Jim Lewis, President
J Lewis and Associates
jlewis@mdbenchmarking.com
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Utilities Fortnightly & Spark
