A Hidden Risk for Utilities

 | Aug 31, 2012 | 5:00 PM EDT
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If you are the chief executive officer of an investor-owned utility, you should be focused on three big issues. The first is delivering consistent earnings and dividends to shareholders. The second is maintaining credibility with state regulators. The third is earning the public's trust and confidence. The third issue is often overlooked, but it can be the critical success factor.

Shareholders of investor-owned utilities are unique investors. They do not like surprises, and they expect steady and growing dividends. CEOs of these companies must deliver solid financials, and they must deliver those dividends.

Blocking utility CEOs are state regulators. State utility commissions review utilities' expenses, decide if those expenses are prudent and approve revenue against those expenses. Regulated utilities are essentially cost-plus businesses, and the regulator, not the utility, decides margins.

If a utility straddles more than one state, as does Duke Energy (DUK), Pepco Holdings (POM), Exelon (EXC) and Northeast Utilities (NU), the challenge is multiplied. Multistate utilities have to manage multiple relationships. A single misstep can damage company's earnings.

Influencing state regulators are the utility's customers. Not only are they customers, they are also political constituents. If the state's customers are unhappy, regulators hear about it, and they have an obligation to act. Their primary tool is rate-setting, and if they become upset, regulators can disallow utility expenses and cut the company's margins.

If customers become really unhappy, they have a nuclear bomb at their disposal. It's called municipalization.

Municipalization is a process that converts investor-owned utility assets to community assets. A local municipal government, such as a county, city or town, can repeal the utility's privilege to operate as a monopoly and replace the utility's local distribution system with a government-owned system.

On paper, municipalization sounds like a simple process. In reality, it is a challenging endeavor. For a city or town to condemn a privately owned utility system and replace it with their own takes political will and access to low-cost financing. In the end, most municipalities lack the political will, and even more are unwilling to fund the takeover.

To start the process, the local government must put the question of municipalization to a referendum. Voters must agree to municipalize their utility, and they must agree to pay the costs.

The utility will run a political campaign to scare voters into believing that the new system will be more costly and less reliable. It will try to get the backing of local businesses, and it may even try to cut a deal with large power users.

If the referendum is successful, voters will face significant costs. The utility will claim that the municipalization will create stranded assets. It will also claim that additional stranded assets reach beyond the municipal government's territory.

The utility's claim of stranded assets has merit, and it will likely get recovery. In the end, the municipality must pay for the stranded costs and must pay for additional infrastructure. Adding the expenses together could make municipalization uneconomic.

Nevertheless, the threat to some investor-owned utilities is real. Just ask Xcel Energy (XEL).

The City of Boulder, Colo., initiated a municipalization process to consider condemning some of Xcel's utility assets. According to the city's website, its goal is "to provide cleaner, competitively priced and reliable electricity to Boulder residents and businesses with as much local decision-making and generation as possible." But as Xcel points out, the final costs have not been tallied, and the decision to proceed has not been reached.

While Boulder's project may not proceed, the situation in Washington, D.C., is different. Customer sentiments about Potomac Electric Power Company's performance are abysmal. Pepco is a regulated utility owned by Pepco Holdings, and it serves Washington, D.C., and Maryland suburbs.

It appears that Pepco Holdings lost control of all three critical issues. Its earnings are in trouble, and its payout ratio is upside down. The company has challenges with state regulators. And it has enraged customers.

It's not just state regulators. Pepco is now facing angry municipal governments. Maryland's Montgomery County and the city of Takoma Park are openly discussing municipalization.

Politicians and constituents are looking at Pepco Holdings' executive compensation, and they are comparing it to government compensation. They also are looking at the hundreds of millions that Pepco Holdings pays to shareholders each year. They wonder if some of that money could be better used by a nonprofit utility to increase reliability and lower costs.

Municipalization is a difficult process that can take years to complete. It frequently fails. But when a regulated utility loses the public's trust, it loses control of its destiny. Worse, they face years of contentious arguments with their most important asset: its customers.

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