Power Hungry: Strategic Investing in Telecommunications, Utilities, and Other Essential Services / Edition 1

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Overview

The Best Strategies for Investing in the Power Industry

The face of the utilities industry has changed dramatically since the deregulation laws were passed. And, in many ways, this has affected no one more than investors in this industry. How can you, as a sophisticated individual investor, take advantage of the recent changes and avoid the pitfalls while navigating this new terrain?

Written by industry expert Roger Conrad, Power Hungry can help you profit from the enormous potential in this field. Power Hungry details for the investor:
* How energy deregulation works
* The role of new technology in the utilities industry
* The aftermath of utility deregulation
* The most effective criteria for picking the best utility stocks

As the only book focused on investing within the energy, communications, and water industries, Power Hungry offers a comprehensive look at the past, present, and future of the utility industry, allowing you to make the most profitable investing decisions.

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Product Details

  • ISBN-13: 9780471442950
  • Publisher: Wiley
  • Publication date: 1/18/2002
  • Edition number: 1
  • Pages: 336
  • Product dimensions: 6.10 (w) x 9.10 (h) x 1.30 (d)

Meet the Author

ROGER S. CONRAD edits Utility Forecaster, a twelve-year-old newsletter from KCI Communications which has a subscription list of more than 20,000. He is also the coauthor of two other books.

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Table of Contents

Acknowledgments.

Introduction.

CHAPTER 1: A Shock to the System.

A New Paradigm.

Deep Roots.

Electrics Take the Bait.

Wholesale Changes.

A Taste of Armageddon.

Industry Profile: Jonathan Gottlieb.

CHAPTER 2: The High Price of Power.

Help Wanted: Power Plant Builders.

It's Gas, Gas, Gas.

Crisis of Confidence.

Industry Profile: Richard Osborne.

CHAPTER 3: Toward the Next Ma Bell.

The Rise and Fall of AT&T.

Vail's Revenge.

Secrets of Success.

The Next Ma Bell.

Industry Profile: Jim Linnehan.

CHAPTER 4: The New Politics of Water.

The Muni Monopoly.

The Worm Turns.

The New Order.

Water's Winners.

Diluting the Competition.

Industry Profile: Anton Garnier.

CHAPTER 5: The Foreign Invasion.

Going Global.

Back to the Future.

Why Go Abroad?

Managing Risks.

Winners and Losers.

Industry Profile: Dennis Bakke.

CHAPTER 6: Technology's Revolutionary Evolution.

Revolution's Evolution.

The Wireless Evolution.

Paradigm vs. Prophecy.

The Next Re-Evolution.

Industry Profile: John Howe.

CHAPTER 7: Riding the Boom.

Scapegoat and Savior.

Energy Efficiencies.

Wires and Pipes.

Wired for Growth.

Water Works.

The Winners' Circle.

Industry Profile: Nick DeBenedictis.

CHAPTER 8: Morgan, Mergers, and Money.

Empire Builders.

Back to the Future.

Picking Targets.

High Percentage Bets.

Consolidation's Limits.

Industry Profile: Robert Fagan.

CHAPTER 9: Hidden Treasure.

The Story of Diversification.

Success Stories.

Finding Assets.

Hidden Minefields.

Industry Profile: Rick Green.

CHAPTER 10: Five Rules for Investing Success.

Rule #1: Buy for the Long Haul.

Rule #2: Be Your Own Analyst.

Rule #3: Diversify.

Rule #4: Never Sell on Bad News.

Rule #5: Reinvest Dividends.

Industry Profile: Lowell Miller.

CHAPTER 11: The Surest Return.

Safety First.

Preferred Option.

Uncommon Common Stocks.

The Ideal Income Portfolio.

Industry Profile: Göran Mörnhed.

CHAPTER 12: The Consumer's Guide to Utility Deregulation.

Buyer Power.

Villains and Victims.

Tip #1: Take Control of What You're Paying For and Whom You're Paying.

Tip #2: Organize Whenever Possible.

Tip #3: If You Believe in Renewable Energies, Buy Green.

Tip #4: Use the Internet for Information.

Industry Profile: Tyson Slocum.

AFTERWORD Making Change Your Friend.

APPENDIX 1 Utility Data Bank.

APPENDIX 2 Mergers.

APPENDIX 3 Glossary.

APPENDIX 4 Model Portfolios.

APPENDIX 5 For Your Information.

Index.

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First Chapter

CHAPTER 1

A Shock to the System

In the late 1970s, America was gripped by a paralyzing energy crisis. Gasoline was suddenly breaking the family budget. Gas lines and outright shortages were common. The public was nearing open revolt.

President Jimmy Carter declared the "moral equivalent of war" on the nation's growing dependence on imported oil, and the country turned down its thermostats in winter, up in summer, and bought smaller cars to meet the challenge.

A generation later, we're on the brink of an energy crisis even the Saudi Arabians are calling more serious. Oil prices have been on the move, breaking through 10-year highs. Even with the world's economies slumping in late 2001, humanity's appetite for black gold continues to increase, particularly in China. Despite oil-producing countries' willingness to pump to the last drop, and the slowdown in world growth in 2001, prices are more than twice those of the late 90s.

Oil supply isn't the only challenge, however. Today's looming energy crisis has another especially sharp edge: volatile electricity prices, punctuated by severe shortages of power in many regions of the country. For the first time since the Great Depression, the very ability of the nation's electric system to provide reliable power is at risk, even as it's needed more than ever to power the new economy.

In California, the summer of 2000 and the following winter brought the issue home to millions. Razor-thin reserve margins, the cushion utilities have traditionally maintained in production capacity to meetemergencies, shrank to near zero. Rotating blackouts, transmission and distribution congestion, and price spikes as much as ten times normal levels were the result.

Only mild temperatures prevented similar breaches elsewhere in the country. Nonetheless, electricity prices spiked along the East Coast and throughout the Midwest as soaring demand overwhelmed supply. With demand rising at twice the rate of just a few years ago, these markets are also becoming extremely vulnerable to wild spikes, outages, and even full-scale shutdowns of overloaded systems.

A NEW PARADIGM

All this was part and parcel of the energy crisis of the 1970s. Just ask New Yorkers who survived the great blackout of 1974.

What's different this time around is deregulation and the effect it's having on power producers, investors, and especially consumers. With competition and market prices for power replacing regulated monopolies, consumers are no longer insulated from changes in electricity prices, and they're starting to feel the bite.

In San Diego, power prices tripled in summer 2000 from prior-year levels before the state imposed a freeze. Upstate, a shortage of power triggered rolling blackouts. Wholesale power prices have spiked to ten times the levels that prevailed in 1999. The Golden State's largest utility—PG&E - has filed Chapter 11 due to rolling up $9 billion in debt by purchasing power at sky-high prices and selling it at legally fixed rates to consumers.

With more power shortages looming in coming months, the crisis now threatens to literally black out the California economy, upsetting the nation's already weakened e-commerce industry and banking system. Politically pressured politicians and regulators have imposed price caps and mandatory rate cuts. Some are pushing for a complete overhaul of the state's deregulation plan. Whatever the government decides, chaos is sure to continue.

Farther up the coast, consumer discontent is raging in Washington and Oregon. Though neither state has yet opened its markets to competition, electric rates have soared over the past year. The reason: Regional power producers have been exporting as much energy as they can to meet demand in California. Coupled with poor hydropower conditions, that's put a strain on local supplies and forced local utilities and their customers to pay up to three times the price for electricity of just a few years earlier.

As yet, the East has avoided energy shortages. Still, utilities from New York City to Maine have passed huge rate increases on to their customers due to the spiking price of purchased power. In summer 2000, for example, Consolidated Edison pushed through a 43 percent rate hike to cover its energy costs, provoking the ire of regulators and consumers and launching a government investigation of the company's rates and power suppliers. All this occurred in the context of a relatively mild summer. Things could get really ugly when the weather takes a more extreme turn in either winter or summer, as it surely will.

Runaway price increases and shortages have led to an epidemic of finger-pointing. The U.S. Department of Justice is investigating alleged energy price fixing in New York, New England, California, and the Midwest, where gasoline prices burst through $2 a gallon in early summer 2000. State regulators have joined in, particularly in California and New York, where some are calling for the government to limit utility profits.

Consumers and regulators alike are starting to eye the record earnings reaped by power generators across the country. States that have not yet broken up utility monopolies are asking Congress to exclude them from any future federal deregulation legislation. And even reregulation—derided as dinosaur socialism just a few years ago—has moved to the realm of respectability in industry debates.

The bad news is there's no end in sight for either volatile electricity prices or shortages. In fact, given the severity of the crisis and the deep-seated factors behind it, the situation will get worse before it gets better. The more dramatically regulators act to stanch rising rates, the greater the potential for disaster.

DEEP ROOTS

The roots of the current crisis run very deep in two directions. One is the ongoing explosion in demand for electricity, due mostly to the growth of the Internet, as well as population and economic growth. The other is the series of extremely disruptive changes that have turned the U.S. electric and gas utility systems on their ear over the past 20 years, dramatically shrinking power supplies.

Explosive demand for electricity in the latter 1990s came as a complete shock to most energy analysts. As recently as 1996, the Energy Information Administration projected power demand would grow just 2 percent a year in the world's developed countries through 2010. Their estimate was well below the 2.6 percent rate that prevailed between 1970 and 1993. Instead, power demand is increasing nearly 4 percent a year in many parts of the United States and shows every sign of accelerating even more. Despite sluggish economic growth in 2001, power demand still rose more than 3 percent.

By some estimates, computers now consume 13 percent of power used in the United States, up from just 1 percent in 1993. If current trends hold, they'll suck down nearly half the nation's power by 2010.

A typical desktop computer consumes no more than a couple of lightbulbs of power. The key is volume. There are more than 100 million computers in the United States alone, with some 45.2 million sold in 1999. The more powerful these machines become, the more energy they use. The biggest energy users are web servers, the powerful computer banks that run the Internet, the average one using enough power to run 25,000 homes, or eight 40-story office buildings.

Even with the rest of the economy just holding its own, growing computer industry use adds up to a quantum leap in power demand. Annual demand growth nationwide will likely peak close to 5 percent over the next few years, as long as the economy avoids a severe recession. Even then, demand growth will be merely delayed. Based on that, the U.S. Department of Energy projects some 1,200 new power plants will have to be built by 2020 just to meet that new demand. That estimate could be even greater if the 10 percent demand growth recorded in California in 2000 returns.

DOE projections also don't include plants scheduled to be shut down over the next few years due to old age. Over 35 percent of the power plant capacity currently online in the United States is 35 years or older. In New England, 75 percent of the plants came online before 1972. Some estimate as much as 90 percent of current capacity will have to be replaced by 2015, and evidence suggests 40 percent of the nation's nuclear plants will be shut down before their licenses expire.

Put into perspective, we need almost half as many new power plants to be built in the next few years as are currently operating, just to meet conservative estimates of what new demand will be. The result has already been the biggest power plant building boom since the 1960s. Unfortunately, it won't come close to increasing supply enough to keep prices from rising.

During the last energy crisis, utilities were monopolies holding government-sanctioned franchises to provide electric and natural gas heating service to set territories. Coal was the fuel of choice for most power plants, but oil was used heavily. As oil prices soared, so did the desire of management, regulators, and consumers to shift to fuels with lower, more dependable costs. The result was an unprecedented building spree of nuclear power plants, with nearly 120 reactors licensed by the early 1990s.

Building these plants, however, proved costlier than in even the wildest imaginations of the industry's severest critics. Building cost overruns and expensive construction delays were common even before the 1979 near-catastrophe at the Three Mile Island nuclear plant near Harrisburg, Pennsylvania. After Three Mile Island, safety concerns triggered an explosion in costs upward from $1,135 per kilowatt of capacity for plants completed in 1980 to $4,590 by 1990, a more than fourfold increase. Power that proponents had dubbed "too cheap to meter" in the 1950s had become too expensive for consumers and regulators to swallow.

At the same time nuclear power costs were skyrocketing, the prices of oil and other fossil fuels were cratering. A decade of dramatically slower economic growth dampened oil demand worldwide, which combined with rising production levels in the North Sea to break the Organization of Petroleum Exporting Countries' (OPEC) stranglehold on oil prices. Oil took a final dive in 1986 from which it's only now recovering, as the Saudis abandoned their traditional role of propping up prices and triggered the collapse of OPEC.

Low fossil fuel prices and skyrocketing construction costs came to a head by the late 1980s and early 1990s. Under the monopoly franchise system, state and local regulators set electric rates. To recover their nuclear plant investments, utilities had to win regulators' approval for rate hikes.

Given that the public pays these officials' salaries—and elects them directly in many states—regulators' reaction was predictable: Nuke costs were met with skepticism that bordered on outright hostility. Starting with hefty write-offs imposed on Union Electric for the cost of its Missouri-based Calloway plant, state regulators from New York to California and everywhere in between disallowed billions of dollars in utilities' construction expenses.

The result was nothing less than a financial catastrophe for dozens of utilities. Orders for new nuclear plants abruptly dried up in 1978, and some 60 plants on order were canceled. Companies were forced to cut and even eliminate dividends to reflect their reduced earnings power. Two companies—Public Service of New Hampshire and El Paso Electric—slid into bankruptcy. Utility stock prices plummeted and credit agencies like Moody's and Standard&Poor's slashed bond ratings across the board.

Worse still, the nuclear plant rate increases that regulators did grant provoked an outcry from consumers, particularly large industrial users. Even regulators in states like Oklahoma, where utilities had built no nuclear plants, began to launch so-called prudence reviews, questioning management decisions for even routine expenditures. Those found wanting by the often-shifting criteria were punished severely with rate cuts and customer refunds. Even companies that hadn't asked for rate hikes in years were forced to keep a constant vigil for fear of having their rates reviewed.

By the early 1990s, even the hint that a company would have to build power plants was enough to set off jitters on Wall Street. Most utility boards of directors avoided new building, preferring instead to buy the power they needed. What plants were built were smaller, peaking facilities designed to run only during periods of extremely high demand. New baseload capacity—huge plants meant to run all the time—was practically nonexistent.

ELECTRICS TAKE THE BAIT

It was in this environment that deregulation came to the utility industry. The urge to lift regulations on industry had been gaining steam since the late 1970s, when President Jimmy Carter, President Ronald Reagan, and British Prime Minister Margaret Thatcher first popularized it. In the United States, airlines, financial services, telecommunications, utilities, and others had operated under tight government scrutiny since the 1930s to guard against a repeat of that era's turmoil.

One by one, these industries were opened to competition as government controls lifted. The effect on consumers has been a mixed bag. Airline deregulation has brought the speed of air travel to the average citizen, while savings and loan deregulation triggered one of the greatest financial fiascoes of all time. Each opening emboldened the deregulators and encouraged industry players to seek change on their terms.

Electric utilities' turn came in the early 1990s. At the time, natural gas prices were scraping multidecade lows and new technology was emerging that allowed far faster construction of gas-fired plants than ever before. As a result, new power plants running on gas could be built and operated far more cheaply than the nuclear and coal plants that dominated electricity generation.

Deregulation proponents claimed that if the monopoly electric markets were opened to competition, a new breed of independent, savvy, and nimble nonutility producers would build a massive fleet of the state-of-the-art, natural gas-fired plants. The low-cost power generated would force utilities to cut the cost of power generated from their own plants, driving down rates and benefiting consumers and industry alike. All that was necessary, according to proponents, was to slash the regulations that had been in place since the Great Depression and allow the market to work its magic.

Estimates of the actual savings under full competition varied widely, but most projected a drop of at least 30 percent in consumers' rates, with the savings spread across the board to both large and small users. Some cited the experience in Argentina, one of the first electricity markets in the world opened to competition, where rates fell 40 percent as regulatory barriers came down.

Typical of the consensus of the times was Peter Navarro, author of the 1989 book Creating and Destroying Comparative Advantage. Navarro claimed in a winter 1996 Harvard Business Review article that rates would fall by 30 percent if the United States simply adopted less-onerous Japanese-style regulatory rules.

The D-men (deregulation-men or proponents) found a willing audience among major U.S. industrial concerns. Companies like General Motors and USX, for example, were facing ever-tightening global competition and were anxious to cut costs in all areas. Large users had long complained that they were subsidizing low residential rates by paying too much under the monopoly system, and since they used tremendous amounts of electric power, they were extremely interested in anything that would leverage their buying power. Under the umbrella of benign-sounding lobbying groups like the Electricity Consumers Resource Council, they used their political clout to bring about change in their favor.

Big users finally got their chance for change in April 1994, as California regulators announced a radical plan to transition the electric industry to competition. The state Public Service Commission proposed a system that would create a central spot market power pool into which all generators would sell their power. All customers were to have a choice of suppliers by 1997, and utilities were to sell their power plants and become pure transmission and distribution, or wires-and-pipes, companies.

In the weeks that followed, several states followed suit with their own plans to radically shake up the utility industry, and dozens more announced they were studying a potential shakeup of their local monopolies. Any expectation of rapid change, however, was soon dashed as problems emerged. The original California proposal raised serious concerns about the state's interconnection with other states that were still operating under monopoly systems. That posed the danger of jurisdictional disputes with the Federal Energy Regulatory Commission (FERC), which directs federal energy policy.

The proposal had an even bigger problem: It completely undermined Wall Street's confidence in the utility industry nationwide. The key issue was stranded costs, capital expenses made by utilities under the monopoly era that, according to Wall Street, would not be economic under competition. Nuclear power plants were the most visible of these assets, but they also included contracts to purchase renewable energies that utilities had been forced by law to enter under the Public Utility Regulatory Power Act (PURPA), passed in 1978 as a way to get the country off imported oil.

By some estimates, stranded costs were equal to nearly half of utilities' total capital, and several times shareholder equity. Being forced to write off these costs outright would theoretically trigger dividend cuts, drastic restructuring, and even potential bankruptcies for the most heavily impacted, as formerly rock-solid companies suddenly would be in violation of financial covenants with lenders.

Stranded cost worries gave California utility stocks a quick 50 percent haircut in 1993 and 1994, but even companies in states not considering regulatory changes crashed and burned. The once safe and slow-moving Dow Utility Average fell from a high of 256 in autumn 1993 to a low of around 170 in late spring of 1994.

Bond ratings entered freefall as the credit agencies revised their rating systems to reflect what they thought was the emerging reality. Terrified, many of the safety-first investors who had traditionally purchased utility stocks and bonds panic-sold.

Even the utilities themselves had little confidence in their future under deregulation. In a 1995 survey of industry executives taken by the Washington International Energy Group, only 19 percent believed higher profits were likely in the changing environment, while 62 percent looked for falling earnings. Half of respondents forecasted an increase in utility bankruptcies and 73 percent predicted price wars, with companies forced to cut rates to the bone to keep customers.

After the California proposal, utilities across the country found it more difficult to raise capital. Meanwhile, the growing uncertainty about what changes would occur made utility boards even more reluctant to approve large capital expenditures for new power plants.

Even the nonutility producers, whom deregulation proponents expected to flood the market, saw their capital sources wane. Most of these actually owed their livelihood to PURPA, which required utilities to buy independents' output at a premium in order to encourage new power sources. They were worried that deregulation would end PURPA and the profitable subsidies that kept them in business.

The level of panic peaked in 1997, when the U.S. Department of Energy released a study forecasting a wave of utility bankruptcy filings. Utilities, the study said, would be forced to "absorb revenue reductions exceeding 30 percent in some cases." And while the DOE stated its belief that the utility industry would remain solvent, it nonetheless reinforced the idea that these stocks were far too risky for the conservative investors who had traditionally owned them.

The crisis of confidence in the industry had a direct and chilling effect on the construction of new power plants. For example, a summer 2000 California Public Utility Commission report showed only 672 megawatts of new generation had been added to the state's system since 1996, compared with a 5,500-megawatt increase in demand. The situation was similar in other regions of the country.

The utility industry's crisis of confidence has persisted even under the new order for the utility industry. The result: Despite clear runaway demand for power, utilities and other power producers have been slow to commit the resources to meet it. While some companies like Calpine have been on building sprees in recent years, overall industry spending to build plants continues to lag behind projected demand growth, despite the overwhelming evidence that volatile power prices are here to stay.

The California compromise of 1996 basically set the rules for the new order nationwide. Led by Southern California Edison CEO John Bryson and the lobbying group, the Edison Electric Institute, the utilities fought and eventually won the only battle they really cared about: the issue of stranded cost recovery. Utilities were allowed to recover these by issuing stranded cost bonds in the amount of their estimated stranded assets. The bonds themselves were guaranteed by a surcharge imposed on all California residents, regardless of whether they chose a competitor for service.

Other states where utilities had large stranded costs—such as Illinois, Michigan, New Jersey, New York, Ohio, Pennsylvania, Texas, and most of New England—also allowed companies to issue stranded cost bonds financed by a rate surcharge. The result is that the financial risk to utilities of stranded costs has essentially been eliminated. In fact, for many companies recovery has amounted to a multibillion-dollar cash windfall that they've used to pay off debt as well as to make profitable new investments.

While they gave ground on the stranded cost issue, the most radical D-men ruled the day. In California, as elsewhere, consumers were granted an immediate 10 percent rate cut and five-year rate freeze. Competition was phased in immediately, with the objective of total deregulation in 2002. Utilities sold their power plants to third parties and turned their transmission systems over to an independent system operator, or ISO, and regulators' power to set rates was dramatically curtailed to emergencies.

Over the past six-plus years, some 25 states have enacted deregulation based on similar parameters. As a result, competition on the retail level is creeping in for two-thirds of the U.S. population, though two out of every three Americans were unaware of electric deregulation as recently as late 1997.

WHOLESALE CHANGES

Deregulation of America's wholesale market has happened even more quickly. Using powers gained fromtfrom thegy Act of 1992, the FERC has been pushing the envelope for change, shaking up transmission policy to make it easier to ship power around the nation. The lack of federal legislation for retail electric deregulation—due largely to a combination of ambivalence, general party politics, and gridlock—has limited the scope of what FERC can do. Nonetheless, the competition in the wholesale market continues to grow rapidly and shape the overall industry.

Under the monopoly system, wholesale power sales, which are mostly bulk power transactions to utilities, municipalities, and large industrial concerns, were largely conducted as a gentleman's agreement. Power-short utilities could count on power-rich neighbors to provide sufficient output in times of need, and at a rock-bottom price. Wholesale transactions were very low-margin deals, mostly transacted under long-term contracts between companies.

In contrast, wholesale markets today are one of the bloodiest shark pools in the world. Customers are fought over not just for their power sales, but for myriad other services as well. Profits depend on how well power marketers anticipate market changes and weather, control their costs, hedge their exposure to unforeseen conditions, maintain their financial strength, and above all build reservoirs of talented traders who understand the market.

On the retail level, things continue to move slowly, even in deregulated states. Most consumers have been reluctant to switch power suppliers even after being informed of their choices.

On the wholesale level, even a few minutes can be a lifetime for those buying and selling power. In fact, a rapidly growing percentage of this business is being transacted on the Internet through such companies as EnronOnline, now the largest e-commerce site in the world and arguably the most profitable as well.

Over the next five years, the fast-moving wholesale market will transform the larger retail market. Some companies will remain vertically integrated—both producing and distributing power—particularly in states where deregulation has been delayed, but most will decide to specialize in one area or another. Utility profits will be set by market forces, rather than established by regulators based on their costs.

In most of the 25 states opening to competition, the wires-and-pipes side of the business—managing the network that connects plants to customers—will remain regulated. The reason is no one wants multiple power lines running down their street. Operators of networks will receive a fee, set by regulators as a return on investment, from customers to access their networks. In contrast, the business of generating power will be fully competitive, with profits determined by a company's efficiency and the market price of power.

As is the case in the wholesale market, power marketing is the linchpin of the new retail system. Marketing companies line up the generators and the consumers of power, competing with each other to provide the most reliable and inexpensive service. Some own and operate their own power plants, while others simply buy what they need on the wholesale market. How much they'll earn depends on how well they manage their costs and risks, as well as on how many customers they attract.

Pure wires-and-pipes companies are the lowest-risk segment of the new electricity industry, with extremely predictable revenue and profit streams. They're also the slowest-growing, since regulators still control their profitability. In fact, their only road to growth is signing on new customers.

Marketing and generation companies will reap huge rewards if they correctly perceive opportunities and capitalize on them. Companies like Duke Energy, Mirant, and UtiliCorp have already used their smarts to make a fortune in the wholesale market, particularly as electricity prices have gyrated wildly in recent years.

The downside of unregulated marketing is, of course, that returns are not set. Adverse market conditions, a poor decision, even a freak power plant outage can mortally wound a marketer if it's unprepared.

Competing effectively also means marketers must continually add to their expertise to meet changing market conditions. For example, natural gas and electricity have become virtually interchangeable as energy sources. Gas's clean-burning capabilities have made it the fuel of choice to both generate electricity and heat homes. Scores of industrial companies are swapping gas for electricity and, though still a niche market, fuel cells using gas could become a substitute for grid-generated electricity. To compete effectively selling electricity, marketers must now be adept at selling natural gas, and vice versa.

Utility managements have coped with these changes in different ways. Some withdrew early on from the more competitive generation and marketing sectors of the business, selling their power plants. Others made that decision after learning some painful lessons in competitive markets. The remaining few continue to build national and even global operations to produce and sell energy in deregulated markets.

Regardless of the path they've chosen, however, utility managements have come to the same simple conclusion about their mode of travel: Size spells success. Since 1986, there have been more than 100 utility mergers, and some dozen more were pending in late 2001. Since 1998, the number of energy utilities has shrunk by nearly half.

Distribution companies have merged to pool capital and spread costs over a wider area to become more efficient. Gaining heft will also potentially allow them to offer a range of new products such as telecommunications service, boosting growth.

The rationale behind generation company and marketing company mergers is even more compelling. Only large companies have the size and strength to ride out the inevitable setbacks in the industry. These include events within a company's control, like ill-placed bets on the weather and inadequate hedging, but as the summer power crunches of 1998 through 2001 attest, events beyond a player's control can be just as catastrophic.

A TASTE OF ARMAGEDDON

Before the summer of 1998, there were a record 400-plus power marketing companies in business. The typical player's portfolio was a diverse mix of purchase and sale contracts, mostly with other industry players. Everyone assumed everyone else was following the rules and had the financial power to make good on any errors.

How wrong they were. On June 26, 1998, America's power marketing companies got their first taste of the danger of unbridled electricity competition. A series of major power plant outages, combined with record high temperatures in the Northeast and Midwest, launched power prices into orbit.

Caught betting the wrong way on prices, a number of overly aggressive, underfunded power marketers defaulted on their contracts to provide power. The traders and utilities doing business with them were forced to look for alternative supplies at any cost. As a result, electricity that had been selling for $30 per megawatt hour a few days before traded as high as $10,000 per megawatt hour.

Both the nation's 13th-largest marketer—a unit of investment bank Barr-Devlin—and the city of Springfield, Illinois, were in default for millions in broken contracts to marketers. Both had bet heavily on falling or at least steady power prices. The price spike forced them to make good on low-priced contracts by buying power at sky-high prices, and their money soon ran out.

The marketers hurt by the crisis included several of the biggest and savviest players, like Southern Company, who suffered sizable losses despite betting the right way on power prices. As temperatures cooled, these players began to freeze out the weaker marketers. The result has been a dramatic shrinkage in the number of significant energy marketers, with larger players increasingly dominating the market.

That concentration is likely to increase further in coming years as loss-plagued firms like Washington state- based Avista, Delaware's Conectiv, and Kentucky-based LG&E exit the business or at least scale back their efforts. And even healthy, small players like NiSource have sold out as well, to focus on areas in which they're large enough to compete long-term.

Huge capital needs and concerns about the future of electricity prices have made consolidation in the generation business even more striking. The same small group of buyers has dominated the dozens of utility power plant auctions around the country in recent years. And they've dominated permits for new construction as well.

According to a study by global law firm Baker & McKenzie, the 10 largest generators have increased their share of America's power plant capacity from 36 to 51 percent since 1992. The 20 largest firms—several of which are currently merging with each other—own 73 percent, up from 56 percent.

Like large marketers, larger generators are able to spread their risks more effectively than smaller firms. Owning a mix of plants burning different fuels limits the risk of cost increases in the price of a single fuel—natural gas for example. Owning several plants in a single territory increases a company's economies of scale, while owning plants spread geographically reduces exposure to weather swings or regional economic downturns.

In contrast, having only a few plants leaves a company vulnerable to unexpected outages, fuel cost swings, the collapse of a major power sale contract, weather, and unexpectedly tough regulation. That's why, of the hundreds of nonutility power producers that sprang up following PURPA, the only survivors are AES, Calpine, Dynegy, and Enron—all of which found a way to get much bigger, fast.

The jury is still out on how well today's merged utilities will perform, but thus far the record has been very positive. That makes it a certainty more deals lie ahead as the partners cope with changes gripping their industry.

Size will ensure the survival of the best companies, and it should lower the cost of running America's electricity and natural gas systems. Unfortunately, as you'll see in the next chapter, it won't stop electricity rates from rising.

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