In 2012, the energy sector experienced three unexpected events. Understanding these events can help investors join me in learning new lessons so we all can become wiser going forward.
Lesson 1: The Worst Case Scenario Is Possible
Hurricane Sandy was not only horrible for families and businesses; it was also the worst-case scenario for gas and electric utilities. Gas and electric distribution systems were destroyed. Repair and replacement costs are still unknown, but the final tally will reach historic levels.
Compared to transmission systems, distribution systems owned by local utilities including Consolidated Edison (ED), First Energy (FE), Public Service Enterprise Group (PEG), Pepco Holdings (POM) and Northeast Utilities (NU), are small, fragile and prone to outages. Natural events, such as Hurricane Sandy and June's derecho (a widespread , sustained wind storm), will destroy distribution systems, causing agony for millions of families and businesses.
Most electric distribution is overhead and gas systems are buried underground. In Sandy and the derecho, electric systems were damaged while most gas systems were left unaffected. This leads many to conclude that electric systems should be buried like natural gas systems are.
But burying electric systems could be a costly mistake. Flooding was the root cause of Sandy's power blackouts. Water and electricity do not mix. Burying distribution lines in areas prone to flooding makes matters worse, not better. Underground systems in flooded area could actually take longer and cost more to fix than above ground systems.
A lesson learned from the worst-case scenarios is not to simply bury infrastructure but to invest in smart grids and redundant delivery systems. Smart grids isolate problems, limit the affected area, dispatch crews and attempt to self-repair. The question remains if ratepayers are willing to pay the price. In suburban and rural areas, most are unwilling.
Lesson 2: It Takes a Village to Destroy a Great Company
Duke Energy's (DUK) management team sold investors and state regulators about the benefits of acquiring their neighbor, Progress Energy. They claimed the benefits would help consumers and shareholders by streamlining costs and avoiding unnecessary duplication. It would also make Duke the nation's largest utility and provided Duke's management team with unprecedented economic and political power.
The merger was also a poke in Washington's eye. The national trend was to deregulate and restructure local distribution companies. This included expanding Regional Transmission Organizations (RTOs) and moving more power plants into the free markets. This had the effect of reducing utilities' influence over regional economic and political decision-making.
Duke took the other path. They and their state regulators wanted nothing to do with federally regulated RTOs. They wanted power plants regulated and they were fine with utilities having influence in regional decision-making.
But Duke's management team and its old board of directors overreached. They saw Duke as their own private club, not the shareholders' company. They believed they were bigger than the states regulating them; they thought they could do as they pleased. They were wrong.
By the close of 2012, the states won and the old management team lost. Duke's CEO and his top executives either left or they will be forced to leave. Duke's old board of directors was told by the state how to govern. The state not only stepped in to protected consumers, they also protected the company's shareholders.
It took a team to mess up a great merger. It will take time before shareholders will see all the benefits of this merger and alternative energy policy.
Lesson 3: Free Markets Can Harm Generating Companies
On the opposite side of the spectrum is Exelon (EXC). This company also undertook a huge merger by acquiring Constellation Energy Group. The management team also sold their shareholders about the benefits of the merger. But they took a big gamble with shareholders' money and they lost.
Before the merger, Exelon owned the nation's largest merchant fleet of nuclear power plants. Post-merger, they owned even a larger fleet. But unlike Duke's case, most of Exelon's generating revenues are dependent on the power markets. In 2012, those markets fell.
The economy wasn't the only reason power markets to fall. Savvy consumers learned to use new conservation technologies. Other consumers installed distributed energy systems. Utilities saw a net drop in nationwide consumption. With lower consumption came lower prices.
The interesting aspect of power markets is they are technology agnostic. Power markets don't care how power is produced; all they care about supplies and demand.
Exelon is not alone. All merchant plants, including wind, solar, and coal-fired power plants, depend on the markets and they are experiencing lower margins.
With lower market prices, it is difficult to see why anyone will build new generation without government assistance. Small wind and solar are possible, but capital-intensive generators seem unlikely.
Looking Forward to 2013
Learn from these lessons. Fundamentals matter. Companies do not run themselves. Leadership counts. Invest wisely. Most importantly, have a healthily and prosperous New Year.