In my last blog, I discussed the regulatory compact that exists between utilities and the communities they serve. The essence of this compact is that we provide the utility with a monopoly to provide service so they can earn predictable profits and we gain by getting build out of the required service infrastructure, the ability to negotiate reasonable rates as well as safe and reliable service.
We have all benefitted from this monopolistic business model that permitted the rapid electrification of the USA with electrical supply even spreading into rural areas. We have gained enormously from the reliability of our electrical supply – it is there all the time when we need it. (If you have reservations regarding the reliability of the US grid, I encourage you to spend some time in any of the less-developed countries to gain an appreciation for the dependability of US grid.) It makes possible our modern lives, it cooks our food, lights our homes and powers our communications and - increasingly - our transportation. Moreover, as knowing and unknowing investors in utility companies, we have benefitted from the regular profits and dividends produced by utilities that have funded part of our retirement and pension plans.
As noted previously there are three aspects to the electrical utility business as shown in the figure below. There is the generation of power, typically at a large power plant located in a central location. Then there is the transmission of electricity over long distances from the generation point to towns and cities and, finally, there is the distribution of electricity through the community via the sub-stations, wires and transformers to individual homes and businesses. Not all electrical utilities focus on all aspects of the business. Some for example, such as my local electrical company, just focus on the distribution part of the business. Others, such as the merchant wood-fired power plants or the wind farms in NH, just focus on generation, whereas other utilities, such as PSNH ,are fully integrated organizations involved in all three aspects of the business.
In NH we find several types of electrical utility companies:
- There are those that are owned by shareholders who are seeking a financial return on their investments. These are referred to as investor-owned utilities (IOUs) which are most commonly public-traded companies. In NH the big three are (1) PSNH, which is wholly owned by Northeast Utilities (NU), (2) Granite State Electrical Company, which is part of the Liberty Utilities group owned by the Canadian company, Algonquin Power and Utilities Corporation, and (3) the NH-based Unitil company. The key to these organizations is that you do not have to purchase electricity from these organizations to be an investor and the more shares you own, the greater say you have in the running of the company. Because these companies are investor owned, they are driven by the need to maintain profitability and regular dividend payouts.
- Electrical cooperatives are organizations that focus on supplying electrical services to their customers who are the members and owners of the cooperative. New Hampshire Electric Cooperative is a good example. Each member of the cooperative has an equal voice in the organization and profits are used for infrastructure investments, maintaining low electricity rates or are paid out as dividends to members. These types of utilities are very customer focused as they don't have to face the investor pressure that the IOUs are subject to. These organizations are largely in the distribution business as they purchase their power from a number of generators.
- There are also electrical utilities that are run by local government organizations, such as municipalities. These are called "munis" and they are only responsible for the distribution of electricity within their communities. In NH we have a few of these organizations: Ashland, Littleton and Wolfeboro, among others, have their own municipal electric companies that are responsible for the distribution of electricity within their town limits.
When Insull started his career in the electricity business, electrical companies were then limited local enterprises that generated and distributed electricity to customers within the vicinity of the generating facility. But Insull was a superb businessman and very astute, and he soon realized that to cover the enormous cost associated with generating plants, he needed to sell a large volume of electricity. To do so, he needed to increase his customer base to more than the customers in close proximity to the generating plant. To sell more electricity, he set up tiered electrical rates with lower rates available in lower demand periods, he invested in alternating current transmission technology which allowed him to transmit electricity over long distances and he invested in large coal-fired generating plants. He also bought up his competitors and, with his transmission capability and tiered rates, was able to diversify his customer base, sell more electricity over a wider area and increase the utilization of his equipment.
Insull also saw the benefits of a natural monopoly as it eliminated competition and would provide the returns necessary to raise money for the big infrastructure investments. He actively advocated for government regulation of utilities in order to ensure their status as a natural monopoly. As a natural monopoly he could be assured of a large customer base, steady revenue and profits and, with these, he could provide steady returns to investors and he would also be able to borrow money for large infrastructure projects at low interest rates. Insull's model was soon adopted by electrical companies throughout the country.
State regulation of utilities started in 1907 when New York and Wisconsin enacted regulations that required state oversight of utility financial performance and the establishment of electricity rates based on the revenues and costs of a utility. By the start of the World War I in 1914, most states had established regulatory bodies for electrical utilities. In NH, regulation of electrical utilities started in 1911 with the establishment of the Public Service Commission which was given oversight and rule-making authority over railroad and public utilities. In 1951, the Commission became the Public Utilities Commission and, in 1985, regulation of transportation activities and railroad were moved to the Department of Transportation.
Samuel Insull's influence even stretched into New Hampshire. In 1925 the Chicago-based, Insull controlled Middle West Utilities holding company purchased the NH-based Manchester Traction, Light and Power Company which supplied power to the City of Manchester and other companies on the Merrimack River. Middle West Utilities established the New England Public Service Company (NEPSCO) in 1925 to consolidate all of its New England acquisitions under one holding company. One year later, Public Services of New Hampshire was established as a formal company to operate all of the New Hampshire electrical companies that Insull's group had purchased (Source: History of PSNH). In the early years, PSNH operated steam, gas, electrical railway and bus services but, by the 1950s, many of these non-electricity businesses were closed or sold to allow PSNH to focus on supplying electricity. In those early years, a lot of PSNH electricity was generated by hydroelectric plants located on various rivers in NH but, as demand grew, PSNH built the large fossil fuel plants located in Bow and Portsmouth.
In 1972, PSNH started planning for the construction of the Seabrook Nuclear Power plant. The intent was to build two 1.2 GW reactors. Opposition to nuclear power, cost overruns and construction delays led to the commissioning of only one unit - 18 years later in 1990, at a cost of about $7 billion. The second unit was never completed and the huge debt taken on by PSNH lead to its formal bankruptcy in 1988 and its consequent acquisition by Northeast Utilities in that same year. It was the largest US bankruptcy at that time.
Northeast Utilities, the parent company of PSNH, is a publicly traded holding company that owns four electric companies, two natural gas companies and electric transmission business serving NH, MA and CT. Six of these are key companies here in New England: Connecticut Light and Power, NU Transmission, Western Massachusetts Electric Company, Yankee Gas Service Company, the recently acquired NStar Electric and Gas Company and, of course, Public Services of New Hampshire. The bulk of Northeast Utilities' revenue comes from the distribution and transmission of electricity rather than from its generation. Electricity generation only contributes 6% of NU's revenue, largely from the generating plants in NH.
Northeast Utilities is a profitable company with over $7 billion in revenues, a profit margin of about 11% and it pays out about 57% of its earnings as dividends. Return on net property, much of which is regulated, is about 8%. Based on its present stock price of $41/share, it earns its investors a dividend yield of about 3.6% - certainly much better than you and I earn by keeping our money in a savings account at a local bank. A great deal of NU's stock is held by institutional investors, mutual funds, retirement funds, insurance companies, etc., which means that a good number of us with 401K or retirement plans end up indirectly with an interest in NU.
If we take a closer look at the PSNH part of the NU business we learn the following:
In 2012 PSNH delivered 7821 GWh hours of electricity in NH and earned $946 million dollars doing so. This equates to revenue of 12.1 cents per kWh. Remarkably, only about 26% of this electricity came from PSNH's own generating fleet. The rest came from long-term power purchase agreements with other independent generators, such as the Iberdrola wind farm in Lempster, NH, and purchases on the short-term and spot electrical market administered by ISO-New England.
PSNH owns 13 transmission substations, over 100,000 distribution transformers of different sizes and more than 13,000 miles of transmission and distribution lines. PSNH also owns generating assets and, except for some small solar operations in Western Massachusetts, these are the only generating plants in the Northeast Utilities stable of assets.
The generation assets of PSNH include ~1200 MW of generating capability, of which the Merrimack and Newington plants are the largest. The table below provides some more detail on PSNH's generating assets in New Hampshire.
These generating assets are listed at $1.1 billion on the NU balance sheet and, based on the overall depreciated value of all PSNH assets (which include generation, transmission and distribution), the depreciated or remaining value of these generating assets are of the order of $700 million. The bulk of this value seems to be the $421 million spent on the scrubber at the Merrimack plant a few years ago. It is this scrubber, and its associated costs, that feature heavily in the ongoing deregulation and PSNH debate here in NH and which we will take a look at in future posts.
Operating an investor-owned regulated utility like PSNH used to be an easier task. They had a monopoly to serve customers, and every time they made an investment, they could pass on the costs to the rate payers and earn a reliable and quite generous return for their investors. The challenge was that they had to think long term - sometimes thirty years out or more and they had to make large investments in infrastructure and, to make those investments, they had to raise money that then needed to be returned over the long term. Electrical utilities had long depreciation timelines as it was assumed that their monopoly position would continue. All that would be fine if the world did not change - but it has. There is now a wind in the wires* as economic thinking has changed, consumers demand choice and competition, fuel prices have shifted and regulations allowing competition have been introduced.
With these winds of change blowing through the wires, many integrated utilities with generation assets find themselves in competitive, instead of monopoly, generation markets, and with a great deal of non-depreciated capital on their books, as well as the obligation to service the long-term debt they incurred when they originally funded the investments. This, in turn, leads to the issue of stranded cost recovery, in which the utilities, having made their long-term investments, seek compensation for those investments when they cannot realize their anticipated returns due to regulatory changes. This is a very critical part of the present debate about PSNH and its generation assets and we will take a closer look at these issues in future posts.
In my next post, we will take a look at the very different world that the integrated electrical utility companies now face. In the meantime, be sure to turn off the lights when you leave the room - but keep in mind that every time you do, there is an electrical utility investor who will be unhappy that you did.
Mike Mooiman
Franklin Pierce University
mooimanm@franklinpierce.edu
10/6/13
(*Wind in the Wires – A dark tune about electricity from Patrick Wolf, a young UK artist who draws a lot of chamber music influences into his arrangements. If you are a Smiths or a The Cure fan, this will appeal to you. Don't forget to apply the black mascara beforehand.)
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