C&B Notes

Run That By Me Again?

Public utilities, by the nature of the regulations that stipulate their profit margins and/or returns on capital, are incented to spend more to make more.  The unsurprising outcome is that customers are the losers in this equation, as they are required to pay higher prices.

Families in New York are paying 40% more for electricity than they were a decade ago.  Meanwhile, the cost of the main fuel used to generate electricity in the state — natural gas — has plunged 39%. Why haven’t consumers felt the benefit of falling natural-gas prices, especially since fuel accounts for at least a quarter of a typical electric bill?  One big reason: utilities’ heavy capital spending.  New York power companies poured $17 billion into new equipment — from power plants to pollution-control devices — in the past decade, a spending surge that customers have paid for.  New York utilities’ spending plans could push electricity prices up an additional 63% in the next decade, said Richard Kauffman, the former chairman of Levi Strauss & Co. who became New York’s energy czar in 2013.  It’s “not a sustainable path for New York,” he said.  New York is no outlier.  Capital spending has climbed at utilities nationwide — and so have their customers’ bills.

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Experts say there are several reasons for soaring spending, including environmental mandates, and the need to harden the grid to protect it from storms, physical attacks and cyber hacking.  But utilities have another incentive for heavy spending: It actually boosts their bottom lines — the result of a regulatory system that turns corporate accounting on its head.  In most industries, companies generate revenue, deduct their costs, and are left with profits, which can be expressed as a percentage of revenues — the profit margin.  Regulated utilities work differently.  State regulators usually set an acceptable profit margin for utilities, and then set electric rates at levels that generate enough revenue to cover their expenses and allow them to make a profit.

At the moment, it is common for utilities’ allowable profit to be capped at 10% or so of the shareholders’ equity that they have tied up in transmission lines, power plants and other assets.  So the more they spend, the more profits they earn.  Critics say this can prompt utilities to spend on projects that may not be necessary, like electric-car charging stations, or to choose high-cost alternatives over lower-cost ones.  “Until we change things so utilities don’t get rewarded based on how much they spend, it’s hard to break that mentality,” says Jerry R. Bloom, an energy lawyer at Winston & Strawn in Los Angeles who often represents independent power companies.

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Overall, SoCal Edison intends to spend $15 billion to $17 billion on dozens of initiatives from 2014 through 2017.  Similarly, Charlotte, N.C.-based Duke Energy Corp. expects to make $17 billion worth of capital expenditures from 2014 and 2016.  A rule of thumb it recently shared with investors: for every billion dollars in assets it adds to its inventory, it boosts earnings by about 8 cents a share.  Utilities can’t bill customers for new capital expenditures without first getting the consent of state or federal regulators, notes Richard McMahon, a vice president at the Edison Electric Institute.  But Ken Rose, an energy consultant in Chicago, says that regulators don’t always do enough to make sure projects are the best deal for the customers footing the bills.  He says companies have a propensity to choose expensive solutions to problems — building a new power plant instead of promoting energy efficiency, for example — because it puts big chunks of capital to work that lift profits.