Utility sector's present, future punctuated by question marks

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Related Companies Duke Energy Corp (DUK) Entergy Corp. (ETR) Exelon Corp. (EXC) Northeast Utilities (NU) PG&E Corp. (PCG)

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Over the course of the last five decades, the U.S. utility industry has undergone periods of profit and stability, contraction and attenuation, rivalry and competition, big mergers, big divestitures, and big failures — periods that have been shaped both by forces larger than the industry and by the industry's own collective actions.

Entergy Corp. Chairman and CEO J. Wayne Leonard, in a presentation, "Gone With the Wind," at the Edison Electric Institute's 44th Financial Conference, described the transient trends the industry has passed through since the 1960s and questioned what lies ahead.

"Given the industry track record, given the issues facing the industry over the next few decades, the question is: Are the industry's ways of doing business, and Entergy's aspirations, equally gone with the wind?" Leonard asked.

The 1960s were the best time for the industry, with 7.5% growth, followed by a dismal decade in the 1970s, when "no matter how hard you tried, you couldn't get ahead of the game," he said. "The future looked pretty good when we went into the '80s," he said, and then competitors emerged, sending utilities on a massive spending spree.

"All we had to do was get bigger, and we could beat the Enrons of the world at their own game." The utility industry realized too late it had been chasing a ghost, Leonard said, and reacted in the early 2000s by divesting, but into a seller's market. "All that cash that had been invested in the '90s in all these businesses around the world again was gone with the wind, as far as investors were concerned," Leonard said.

The U.S. utility sector is nearing the end of another decade. It has been estimated to have to spend nearly $1 trillion over the next 10 years, and $2 trillion over the next 20 years, to meet the expected growth in electricity demand and to keep the industry reliable and safe, to use its mantra — objectives that entail building both new generation and transmission lines.

But the financial crisis and ensuing recession have thrown a wrench into the mix. For one, capital expenditures have been cut by 10% to 20%, according to preliminary estimates.

"The most interesting thing is that [these cuts have] happened on the front end of rather big capital requirements," said IHS Cambridge Energy Research Associates Vice President Larry Makovich, who helped open the EEI conference Nov. 2. Makovich said this kind of short-term solution to adverse market forces is viable if companies do not incur a long-term penalty.

Both Makovich and Leonard pointed out that knee-jerk reactions to economic forces, or what Makovich called business cycles, can have long-lasting consequences for the next evolution of the utility industry.

"The danger, of course, is the pullback will have a costly consequence" when there is a bump up in power demand and the industry's focus turns back to keeping up with load growth and environmental and other financial demands, Makovich said.

Indeed, many companies are turning their gaze inward, to investments that, in this down environment, ensure some kind of earnings accretion. In tandem, they are focusing on cutting costs in operations and maintenance expenses.

Exelon Corp., the largest U.S. investor-owned utility, has identified its $4.4 billion nuclear uprate project as providing among the highest returns on equity and, in an interview with SNL Energy, said the message it is trying to convey to shareholders is one of navigating uncertainty and positioning for growth. During its third-quarter earnings conference call, the company also said it has met its targets for cutting 2009 O&M costs by $150 million and is on track to cut an additional $100 million of one-time costs.

"There are certain things that are beyond our control," Executive Vice President William Von Hoene told SNL Energy on Nov. 2. "We're trying to do two things in response to that: to be as strong as possible to weather the economy and take advantage of its uptick" whenever that may occur. Von Hoene added that, of all its utility peers, Exelon is in the best position for a price recovery because of its nuclear fleet. For the near-term, however, the company has identified uranium expenses to be a significant headwind.

One benefit few industries can lay claim to that the utility industry can is access to capital markets, which may more easily facilitate meeting the demands on the industry. Bankers and power executives alike at the conference reiterated the relative ease with which the sector could raise both debt and equity, albeit at higher costs. Credit facilities, however, will be another matter. Billions of dollars worth of credit facilities will come due in the near term, but a popular saying among bankers now is "three times the cost — one-third the size."

PG&E Corp. Chairman, President and CEO Peter Darbee said he has been discouraged from the idea of increasing credit facility size and is relying instead on capital markets. "[M]oving up the size of revolving credit facilities and lines of credit … The signals were, 'Don't go there unless you absolutely have to,'" he said. "We still see the banking industry reticent about expanding credit facilities, and that's caused us to be more dependent on capital markets." Darbee mentioned the company is looking at doing a 30-year financing and rates are "extremely attractive."

Third-quarter earnings reports have reflected a mixture of economic data. Industrial sales, which serve as a barometer for the health of the industry and broader economy, continue to be off, though some companies are reporting stabilization in their still-depressed numbers and have seen improvement in residential sales. But with the exception of those who are more bullish on the economy's progress, such as Northeast Utilities' CFO David McHale, who has insisted that the recession is over, most are hesitant to call a rebound in the economy.

Lynn Good, Duke Energy Corp.'s CFO, said signs of stabilization were just that. After talking with the company's industrial customers, she said she expects fourth-quarter sales to be similar to the third quarter's, which saw sales rise 11% from second-quarter 2009 levels.

As Makovich pointed out, the economy and electricity business are "fellow travelers," mimicking each other's rates of growth and decline. As the economy emerges from recession, the utility industry will return to business as usual but will need to navigate an altered landscape.

"As we look out over next decade, we see we need to build power plants" and transmission, Makovich said. "We also see a need to transform the fundamentals of the power business, to reduce the footprint of greenhouse gas emissions. … As we look ahead, the big job is managing upward pressures on costs [and] prices."