Utility Regulation,
Then, Now, Tomorrow
What You Need to
Know to Understand
How What You Do
Fits Into the Utility
Client’s Business
Success
Allen W. Williams, Jr.
©2012 Foley & Lardner LLP • Attorney Advertising • Prior results do not guarantee a similar outcome • Models used are not clients but may be representative of clients • 321 N. Clark Street, Suite 2800, Chicago, IL 60654 • 312.832.4500
History of the Energy Industry


What are disruptive technologies? 19th
Century; 20 Century?
How does electricity fit into history of
Disruptive Technologies? From work bench to
world domination in 20 years.
– How was this many billion dollar infrastructure
build out accomplished?
– What does Wall Street require?

Local, to regional, to national grids – and back
again?
©2012 Foley & Lardner LLP
2
What Are the Disruptive Changes
Facing Utilities?





Renewables
CO2 Restrictions
Electric Storage
Others
And what could they mean?
– For the architecture of electric infrastructure
– For investor owned utilities
©2012 Foley & Lardner LLP
3
What Downside (or Upside) Do
Disruptive Changes Create?



Loss or gain of investment opportunities?
Change from centralized generation connected
to transmission and distribution wires? To
what?
How can utilities protect their interests – or
are they the land line telephone companies?
How did the dinosaurs become extinct?
©2012 Foley & Lardner LLP
4
The Utilities’ Challenge:




What makes regulated utility earnings grow?
What makes utility stocks more valuable?
Two questions – related answers.
Concepts:
– Stock value [yield and growth]
– DCF
– Real Returns
– Difference between debt and equity, valuation
©2012 Foley & Lardner LLP
5
The Utilities’ Challenge:
– Pay out ratio
– Market/book value ratio
– Accretive or dilutive sale of equity
– Expanding KWHs of sales and expanded rate base
– “Rate base” or book value, of novel importance to
utilities, book value/share and growth in book
value per share
©2012 Foley & Lardner LLP
6
The Utilities’ Challenge:
Debt and Equity
 The value bases for utility common equity and
debt - how do Investors attribute value to
(utility) common stock?
– Present value of future pay-outs


Dividends paid
Future sale price of stock
– Retained earnings
– Book value of stock
– Price – earnings ratio

Why is stock valued differently than debt?
©2012 Foley & Lardner LLP
7
The Utilities’ Challenge:
Growing Earnings
 How do utilities earn returns for equity
investors? How can utilities grow earnings
over time?
– Regulatory “compact”



Prudent investments
Used and useful
Recovery of reasonable return on and of capital
invested in prudent utility assets, and of capital for
assets no longer used and useful?
– Ratebase – What is it?
– How do EPS for a utility grow? Growth in book
value (rate base) per share, or increase in ROE
©2012 Foley & Lardner LLP
8
The Utilities’ Challenge:
– What happens to stock value without earnings
growth?
– Relationship of growing sales, capital investments,
and EPS growth – What if sales don’t grow? And
rate base/share doesn’t grow?
©2012 Foley & Lardner LLP
9
The Utilities’ Challenge:

Utility earnings (and projected earnings per
share) grow, which drive stock price because:
– The total invested capital dedicated to utility
service (“rate base”) grows in size; and
– The market value of the utility stock sold to
support the additional capital (rate base)
investment exceeds the stock’s book value; and
– The additional equity raised is awarded a return on
equity in the rates set equal to the return expected
on existing investments; and
©2012 Foley & Lardner LLP
10
The Utilities’ Challenge:

Utility stock price (and earnings per share)
grow because:
– The utility has a demonstrated track record of
actually earning at or near the allowed rate of
return; and
– The existing rates for utility service and service
area demographics support the likelihood of
actually realizing the return on equity to support
the growing investment; or
– Are rates so high there will be pressure on
obtaining adequate rate increases? Or pressure to
reduce ROE? Or pressure to corrupt the regulatory
compact?
©2012 Foley & Lardner LLP
11
The Utilities’ Challenge:
Without Increasing Rates
 Can utilities grow their earnings without
increasing their rates?
– If the product they are selling has flat or shrinking
units of sale?
– Trends in “real price” of electricity
– Rate pressure (and back pressure) then, now, and
in the future
©2012 Foley & Lardner LLP
12
The Utilities’ Challenge:
Infrastructure
 What infrastructure investments will support
utility growth going forward?
– Environmental
– Replacement
– Effect of replacement already depreciated with
new, more expensive (in rates)
– Demand-side investments?
©2012 Foley & Lardner LLP
13
The Utilities’ Challenge:




Electricity is a political necessity, and the political
environment in which utility regulation is carried
out requires electricity to be provided at
reasonable costs, and with reasonably adequate
reliability
Both are required, and the determination of
“reasonable” cost is a relative determination
based upon the public’s perception of what is
prevailing in other markets (other states) and as
well compared to their recent historic costs
Rapid price increases are unacceptable
Unreliable service (periodic brown outs or
shortages) is not acceptable on an absolute basis
©2012 Foley & Lardner LLP
14
The Utilities’ Challenge:


Unacceptable prices or unacceptable reliability
will lead directly to political intervention, and
that intervention will result in resistance to
rate increases necessary to protect the
shareholder’s interest in a reasonable return
and to support the additional costs associated
with earning an adequate return on additional
infrastructure investments
A disruptive technology could render utilities
which don’t evolve the next dinosaurs
©2012 Foley & Lardner LLP
15
The Utilities’ Challenge:


The price elasticity of demand for electricity, while
relatively low in the short term, has been shown
to be much greater over a period measured in
several years
This has been reflected in conservation effects
recognized after the Arab oil embargo of 1973,
and then the run up in electric prices tied largely
to high inflation rates and the very large nuclear
generating units planned in the late 1970’s to
meet projected high growth in electric demand (in
areas experiencing rapid demographic growth)
which experienced astronomic cost increases
after the Three Mile Island incident
16
©2012 Foley & Lardner LLP
The Utilities’ Challenge:



Electric demand did not increase as projected,
making very large and surprisingly expensive,
nuclear power electric plant additions surplus to
the requirements
The result was increases in electric costs to
consumers in the state jurisdictions experiencing
infrastructure “gluts” becoming unacceptable –
creating the exigencies which produced the major
political interventions of “re-regulation” in a
number of states
The political lesson regarding significant real price
increases in electricity
17
©2012 Foley & Lardner LLP
The Utilities’ Challenge:


The price increases were enough to cause a
surprising price elasticity of demand reduction
in demand
Electric generation is built with 3 to 7 year lead
times, and the process of constructing the new
fleet of generation could not respond to
unpredicted vicissitudes in electric demand
©2012 Foley & Lardner LLP
18
The Utilities’ Challenge:




The situation also set the stage for long term
periods of no rate relief during the time the glut in
supply was in the process of being eroded by
underlying growth
The political processes in a number of states
became used to static or even falling electric rates
as the electricity market grew into its infrastructure
The price cross elasticity of demand for electricity
became more latent during the static price periods
The real price for electricity fell on a secular basis,
essentially for the entire 20th Century
©2012 Foley & Lardner LLP
19
The Utilities’ Challenge:


The recent period of price freezes in a variety of
jurisdictions, as well as wholesale
experimentation in electric market re-regulation
created a great deal of uncertainty about who
had appropriate incentives and adequate
financial underpinnings to support the
construction of needed electric industry
infrastructure
In a period of rate stability and while safety
margins were being eroded but had not yet
disappeared, political intervention did not resolve
uncertainties and allowed such safety margins to
be prejudicially eroded
©2012 Foley & Lardner LLP
20
The Utilities’ Challenge:



Reactions to shortages or price spikes are typically
exaggerated and relatively severe, and political
interventions limit the ability of electric generation
owners to profit to the full extent of a market
shortage
The political process, over the long term, demands
that electric infrastructure equal or exceed demand
for it. Service interruptions and price spikes are not
tolerated
This almost assures infrastructure will exceed
demand over the long term – a circumstance which
almost requires regulation to avoid chaotic failures
and unreasonable costs of capital
©2012 Foley & Lardner LLP
21
The Utilities’ Challenge:


Due to recent periods of price stability, the
tolerance of electric customers for price
increases has been reduced
That tolerance has also been eroded by price
volatility in those jurisdictions with direct pass
through associated with the cost of fuel used
for electric generation
©2012 Foley & Lardner LLP
22
The Utilities’ Challenge:

Recent experience in the electric use market
involving price “fly-ups”, either because utility
cost increases have been bottled up by
jurisdictional price controls (the price freezes
exacted in the re-regulation bargains in a
number of states) or because of the rapid
increase in the cost of coal, have created a
perception of electric shortage/crisis, which
threatens both political intervention as well as
the reawakening of the latent price elasticity of
demand for electricity
23
©2012 Foley & Lardner LLP
The Utilities’ Challenge:


The political crisis environment creates more
resistance to rate increases, even if they are well
justified by needed electric infrastructure
improvements
The re-awakening of price elasticity of demand
portends the possibility of an (unexpectedly large)
dampening of the demand for electricity (note the
period from 1980 to 1995) which could
exaggerate the upward rate pressure from the
infrastructure investments supporting the robust
growth rates in earnings for utility common stock
needed for the “successful utility” common stock
market price/earnings multiple
24
©2012 Foley & Lardner LLP
The Utilities’ Challenge:

In fact in many parts of the U.S. total required
demand for electricity has fallen or been
stagnant since 2009, while at the same
existing coal and nuclear plants will apparently
require very expensive generation plant
replacements just to meet the existing or even
shrinking loads. Upward rate spikes, price
elasticity of demand dampening of sales,
political back pressure, technological
innovation in electric storage – here we come 25
©2012 Foley & Lardner LLP
The Utilities’ Challenge:

The value of a utility’s common stock is
dependent on the projected growth rate in its
earnings, or its current “yield,” and underlying
inflation and interest rates
– Today’s circumstance – yield and inflation


Utility’s earnings are ultimately dependent on the
level of utility capital investments, and the growth
of those earnings dependent on the projected
growth rate of those investments
Growth in utility investment requires
infrastructure investments in excess of the rate at
which the utility’s assets are being depreciated 26
©2012 Foley & Lardner LLP
The Utilities’ Challenge:

Coal plants are likely dinosaurs, of sorts, and
electric generation could move towards
distributed sources, with electric storage and
more interconnected grids
©2012 Foley & Lardner LLP
27
The Utilities’ Challenge:


Low costs and service reliability are not simply
“apple pie” politics, bones tossed to regulators,
politicians and interveners, but rather are
fundamental to the shareholders interests in
obtaining a growth in earnings which will sustain
a robust common equity price
The same goes for far sighted initiatives which
might line up with political interests in
alternatives to current electric generation
technologies or the promotion of conservation – if
they also line up with reliability and low cost
©2012 Foley & Lardner LLP
28
The Utilities’ Challenge:

Development of new technologies, particularly
in generation and storage could well line up
with a shareholder interest in having more and
new infrastructure investment opportunities
– In the assets
– Financing the assets
©2012 Foley & Lardner LLP
29
The Utilities’ Challenge:

Shareholders need to worry about the very
long run, and therefore need to concern
themselves with assuring a management
which has a strategy for continuing
infrastructure investments which present
themselves at a rate in excess of the
depreciation of the current assets faster than
would result from the mere stewardship of the
existing systems under current technologies as
today’s infrastructure catches up to current
needs
30
©2012 Foley & Lardner LLP
The Utilities’ Challenge:
Headroom
 Can the utilities get political headroom for the
rate increases needed for earnings growth?
©2012 Foley & Lardner LLP
31
The Utilities’ Challenge:
Rates and Investments
 Could infrastructure investments reduce usage
to accomplish “purpose of use” enough to
offset the per unit of use rate increases?
– Supply side investments?
– Smart grid?
– Demand side opportunities?
– Electric Storage?
©2012 Foley & Lardner LLP
32
The Utilities’ Challenge:

How do investor owned utilities stay in the
game if electric storage obviates need for new
central station power, and reduces the
importance of wires – are large electric
storage facilities the electric industry’s
wireless phone nightmare?
– Can we help utilities stay in that new game?
– How?
©2012 Foley & Lardner LLP
33