This has been a tough week for Duke Energy (DUK) and James Rogers, the company's chairman, president and CEO. Their most important stakeholders, state utility commissions, want to know what happened to Duke's former president and CEO William Johnson. Specifically, North Carolina's utility commission asked Rogers to testify about corporate discussions and decisions that led to Johnson's hasty departure. Other states were listening in.
Utility commissions are important to regulated utilities like Duke. Because many of Duke's assets are regulated, the company's earnings are heavily dependent on utility commissions. Duke must negotiate with six individual states to extract fair revenues, margins and earnings. But it's up to the states to decide how much Duke may earn from regulated operations.
To cut it another way, Duke's fiduciary responsibilities are to their shareholders and, because of this, it must seek the highest possible revenue from each state commission. For state commissions, fiduciary responsibilities are to their ratepayers -- and, as such, they must prevent Duke from extracting excessive profits. To complicate it further, each state defines excessive profits differently, and they have a tendency to change their definition over time.
Utilities don't run themselves. The art of managing a profitable utility requires developing a trusting relationship with state regulators and legislators. Each state has veto power over the utility's operations. The regulator can accept or deny a utility's investments, revenue and returns. As a result, the state utility commission, backed by their legislature, can be loosely viewed as a co-CEO over the utility's regulated assets.
A utility's reputation is essential. If a commission loses trust in a utility, the commission becomes motivated to protect consumers by over-regulating and withholding rate relief (revenue).
This tendency just played out when Rogers testified in North Carolina. Individual commissioners voiced regret that the commission trusted Duke. Prior to the CEO switch, the commission accepted the utility's verbal assurances and didn't impose detailed restrictions on Duke's merger. Now they are reconsidering their trust in Duke and they will likely add new orders.
It's not just North Carolina. Duke has regulated assets in five other states. They were observers in North Carolina's proceedings and they may plan proceedings of their own. As a result, there's likely to be some contagion among other states and commissions.
Duke already experienced unpleasant challenges with state regulators. On April 30, just prior to the merger and under Rogers' leadership, Duke was unsuccessful with Indiana's utility commission. The company was on the carpet for mismanaging one of the most expensive projects in Indiana's recent history. A power project called Edwardsport experienced a $1.3 billion cost overrun, and Duke's attempt to push its costs onto consumers caused years of bitter fighting.
In the end, Duke lost big. According to The Indianapolis Star, Duke's Indiana customers will absorb a 14.5% rate increase and Duke's shareholders will take a $700 million loss. To add insult to injury, Indiana's commission also denied Duke two other rate requests.
South Carolina is another challenge. The state wants Duke to buy some of the state's ownership in the new V.C. Summer nuclear project. The Summer project is managed by Scana (SCG), and many believe this firm's cost estimates, which are billions below a duplicate project under way in nearby Georgia, are way too low. As a gesture to regulators, Duke may feel compelled to partner with Scana and in the process risk exposure to growing cost estimates.
Duke is expected to have challenges with Florida. Duke's Crystal River nuclear facility has incurred huge maintenance costs. In addition, their plans for new nuclear units in Florida have been deferred indefinitely. In all likelihood, the state will deny rate relief for Duke's maintenance costs and they will want to recover ratepayers' construction work in progress costs for the deferred units.
Finally, there's the issue of shareholders banking huge savings from the merger. Of course, duplication will be eliminated and costs will be reduced. But regulated utilities are different; they have a cap on profits and they're required to share savings with consumers. So any bonanza for shareholders is muted.
Nevertheless, Duke will muddle through. It'll win in some states and lose in others. But, with a damaged reputation, it'll likely see growing challenges as the company works its way through six state utility commissions.
As Duke saw in Indiana, success with state regulators is never assured. There is good reason to question Duke's forward earnings. The stock's lofty price-earnings ratio of 19.9x may not be sustainable. While dividends may be secure, preservation of capital is not.
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