Public Utility Companies And Regulatory Risk

Editor: Please provide our readers with a brief summary of the work done by your practice group.

Miller: Our energy and utility attorneys advise investor-owned utilities, merchant generators of electricity, energy marketers, large consumers of energy, institutional investors and lenders, investment bankers and governmental entities on the development, siting, purchase, and sale of energy, telecommunications, water and wastewater projects. We represent energy, utility and telecommunications companies in new facilities construction, complex rate and regulatory proceedings, rule-making proceedings, condemnations and appeals from agency decisions. We advise and represent clients on air and water quality and land use issues involving utilities and energy companies and in environmental pollution cases. Finally, we work on energy and utilities M&A matters, project finance and corporate finance transactions, federal bankruptcy cases and energy restructuring matters and the tax issues associated with energy transactions.

Editor: Your firm sponsored a world class Public Utility Symposium: Public Utility Companies and Regulatory Risk of June 9, 2008. Please describe the industries participating.

Haye: Our participants included senior executives from utility companies, state public utility commissioners, and leading financial and economic investors, advisors, and analysts of the energy and utility industry.

Editor: What do you consider the primary challenges for the utility industry today?

Curran: In the Mid-Atlantic region, the critical challenge is ensuring the reliability of the electric system. Reports show there is a tightening of supply and demand in the region and as a result there is a pressing need for new infrastructure investment in both transmission as well as new "environmental-friendly" generation resources. The challenge is how we are going to pay for the billions of dollars of investment needed to maintain the electric grid. These reliability concerns are occurring at the same time there is high upward pressure on the rates for electric service. This is the real challenge for state leaders.

Haye: This need for increased investment and the resulting cost increases to customers can be mitigated by putting the proper regulatory incentives in place to encourage companies to make the most efficient choices. The water industry right now may be doing a bit of a better job than the electric and gas industries because the regulators have more tools to allow some of the costs to flow through to the customers more quickly and efficiently.

Editor: What was the consensus of the panelists regarding mergers between utilities? Are some types of utilities better suited than others?Miller: I think there is a consensus that there will be more limited and more targeted mergers in the future that will be done in order to rationalize assets. For example, there do seem to be more opportunities for mergers in the electric sector than the water sector. It was pointed out that around 20 years ago there were maybe 30 publicly traded water companies in the U.S. and now there are roughly only ten. That considerably reduces the merger opportunities in that industry.

Editor: Texas Utilities' acquisition by a private equity investment firm was problematic before the merger was finally approved. Do you think another big buyout of a utility is likely in the near future?

Miller : Given the investments that need to be made in infrastructure, it is clear that private equity is going to play an important role in the future - whether that means a takeover of a utility by a private equity firm or a significant investment that allows the firm to have a major say in management. So there will be a role for private equity in the future. One thing to be kept in mind is that in many states there is a limitation on the ability of any entity to buy more than a certain percentage of a utility's common shares before having to go to the public utility commission for approval to exceed that threshold.

Editor: What is the attitude of the commissions in approving takeovers of utilities?

Curran : Most state commissions evaluate these mergers and acquisitions based on a public interest standard. They normally look for a "net benefit" to rate payers as a result of the merger. State commissions have expressed a concern about the long-term commitment of private equity investors and whether they really want to be in the utility business and make needed investment in infrastructure. I understand that was an issue with the Arizona commission in 2004 when they denied the sale of the state's second-biggest utility to a partnership backed by Kohlberg Kravis Roberts & Co. (KKR). Private equity has to be able to satisfy the state regulator's concerns as to: (a) value added to rate payers from their ownership interest, and (b) the long-term investment in utilities.

Editor: What do you mean by the "decoupling mechanism"?

Miller: When we talk about decoupling generally, we are talking about decoupling rates from usage as a means of giving utility companies an incentive to promote conservation. Currently, the way rates are set, if customers of a utility use less, the utility's earnings will decline because its revenues will drop. So the idea is if you don't want to penalize the utility for promoting conservation, you decouple a utility's revenues from its earnings, thus giving the utility an incentive to promote conservation. One reason to decouple in general is that for those utilities that provide service either through wires and pipes, the infrastructure costs remain fixed. To give the utility an incentive both to promote conservation and to continue to invest in the infrastructure you need to decouple the revenues from the earnings to protect the utility from earnings losses. A number of different states have already decoupled revenues from earnings to promote successful conservation programs. In a utility rate case a commission sets a utility's earnings based on an assumed level of sales. Traditionally, if that level of sales isn't met, the utility will earn less. Under the decoupling scenario, the commission sets a formula that will allow the utility to recover the same return on investment whether sales are more or less. And, because customers pay less when they use less of the commodity, they are really saving money. If you look at natural gas prices at over 12 dollars per thousand cubic feet and rising, that is a tremendous savings.

Haye: The idea of decoupling rates from usage has attracted considerable attention and controversy, but much of it misplaced. It also has created allies of environmentalists and gas utility managements - a seemingly unexpected coalition to some.

Editor: What should be the role of utilities and public service commissions in promoting sustainability and conservation?

Curran: Now that rates are in some cases 85 percent higher than they were a decade ago, public service commissions are under increasing pressure to find ways to reduce customer consumption. This is also a hot topic now in light of significant need for new infrastructure and the fact that it takes years to actually get that new iron in the ground. One concern is that long-term rate caps have worked as a disincentive to conservation because rates were artificially low and failed to send the proper price signals to consumers. With the elimination of rate caps, legislatures and public service commissions are requiring the utilities to initiate conservation programs. For example, Maryland just passed an initiative to reduce peak consumption by 15 percent by 2015. To achieve this goal, the State PSC is evaluating a number of energy efficient programs - CFL programs - as well as looking at smart metering and Smart Grid infrastructure pilot programs that enhance the efficiency of the distribution system.

Editor: What is a Smart Grid?

Curran : The Smart Grid is a communications system on an electric distribution network that provides real-time information to the utility regarding its operations. Smart Grid manages or monitors equipment on the electric distribution network to optimize efficiency and to perform power outage avoidance. It also provides real-time pin-point outage and restoration detection. This is significant because electric distribution networks are aging and facing increasing strain. A Smart Grid provides a utility with real-time actionable intelligence about its network that can be used to prevent costly disruptions. Studies show that investment in Smart Grid infrastructure is outweighed by the long-term savings resulting from the utility's enhanced ability to monitor distribution systems and diagnose potential outages. At the conference, a number of state regulators stated that they plan to investigate the best way to implement Smart Grid technologies and explore the appropriate way to allow cost recovery for it.

Editor: Has this been tried anywhere? Who will pay the cost of installation?

Curran: Yes. There's a deployment in Dallas, Texas with Oncor.

If state regulators approve these programs and direct utilities to implement Smart Grid technology, the cost will be built into rates; however, the commissions will only direct the utilities to undertake these costs if they find that there is an ultimate savings to customers as a result of this technology.

Editor: What is the present verdict on how well retail choice programs are working?

Miller: One needs to look at retail choice in a number of different ways based on the size of the customer. It's clear that retail choice has been a great success in the area of large commercial and industrial customers who began retail choice back in the mid-'80s when they could source their own natural gas. Probably nearly 100 percent of large retail industrial customers take their supply from an entity other than a utility. With the small commercial and residential customers the answer is more difficult. In some states, it has been demonstrated that the only place where you get 100 percent participation in retail choice is where the utilities are taken out of the equation, such as the program in Georgia with Atlanta Gas Light. In other states where the utility commission provides support for retail choice for small customers the participation has ranged from say 10-25 percent, sometimes as much as 50 percent. In other states where choice is theoretically available but incentives are not provided to marketers, those programs have not been very successful.

Editor: Should the market regulate the way we conserve energy by allowing rates to climb or should we rely more on educating the public in ways to be greener and better able to sustain the planet?

Miller : In the programs where there has been decoupling, there has been state utility commission support for conservation programs by the utilities whereby the commissions have provided financial support for utilities by, for example, offering rebates for the most energy efficient appliances. Customers buying the most energy efficient appliance might see a refund of as much as $400 on the purchase of that appliance, paid by the utility but supported in rates. Utilities have also been supported by the commissions in conservation education that includes, among other things, instructions to customers about weather stripping, insulation, setting back thermostats, etc. Those programs have been successful. It's our belief that the market alone will not be successful without the programs that we are talking about.

Curran: I agree with that. Additionally, one of the problems that policymakers face is the lingering adverse effect that long-term rate caps had on conservation. Rates have climbed dramatically with the expiration of these rate caps; however, customers' usage patterns have become fixed as a result of years of low prices. Appropriate transitional mechanisms must be in place to move customers from rate caps to market rates in order to avoid rate shock. However, ultimately consumers will modify their behavior when they see the true costs of the service they are being provided.