DEREGULATIONOFUTILITY- dominated industries such as power, natural gas, and telecommunications was well under way in North America and Europe in 1998 and anticipated in other regions.
In the U.S., telecommunications services had been unbundled, and deregulation of the natural gas industry was largely complete except for local distribution. Electric power generation and transmission had been deregulated by federal action to the wholesale level, and states were taking various approaches to deregulation of retail activities.
"The gas and electric industries, with their legacies of monopolistic operations, are undergoing a period of great transition," said NationsBanc Montgomery Securities LLC, San Francisco, in a report titled The Changing Face of Energy. "However, the fundamental direction is becoming obvious: activities traditionally conducted by regulated utilities will be increasingly unbundled and subject to competition.
"The model to study as a transition `footprint` is the telecommunications industry."
Eighteen U.S. states were in the process of deregulating electricity in 1998; initiatives were in various stages of completion (Fig. 1). On the national level, the Clinton administration proposed deregulating the entire U.S. electricity market by 2003.
In the U.K., deregulation of the electricity market was more advanced than in the U.S.
Most other countries lagged behind the U.K. and U.S. In Canada, deregulation was slow. "To date, competitive initiatives have focused solely on the wholesale sector," Moody`s Investors Service said in 1998. Relatively low prices in Canada provided little reason for consumers to press for liberalization of electric power markets.
France was to begin deregulating electricity markets for large consumers in 1999, providing some competition for state firm Electricité de France.
U.S. deregulation efforts
Opening of the U.S. electric power industry to competition was sure to have far-reaching effects.
According to a report by the U.S. Energy Information Administration (EIA), "With the (U.S.) electric power industry accounting for more than $210 billion in annual sales, the implications of deregulated electricity generation markets for capacity choice, operating costs, and fuel choice are significant.
"Retail competition is being deliberated on a state-by-state basis," said EIA. "The utility regulatory commissions and the legislatures of nearly all 50 states and the District of Columbia are in different stages of the implementation process, from informally studying the idea to passing legislation that specifies the date and conditions of full retail competition."
In its bimonthly publication, Southwest Economy, the Federal Reserve Bank of Dallas said that, under some proposals, only large industrial customers would buy electricity from the electricity marketing firms, while residential customers would continue to buy from local distributors, as had been the case with natural gas deregulation.
In the U.S., electric power costs were relatively low, in general, but varied by region. Proponents of power deregulation argued that it would balance out the rate structure, making costs more uniform across the country.
"The high-rate states seem to be expecting such an outcome, as (they) have been more inclined to deregulate," said the Federal Reserve Bank. "Whether that outcome is realized depends greatly on what is done in the name of deregulation."
The areas of the U.S. where electricity was more expensive typically were supplied by generation facilities with high sunk costs, such as nuclear power plants. In some cases, utilities were required by federal or state regulations to buy electricity from other types of high-cost plants, such as cogeneration or wind power units.
An overall lowering of electricity prices by deregulation would spoil the operating economics of expensive generating facilities built during the era of regulation. Owners of those facilities thus faced possible need to write off the unrecovered portions of their investments. What to do about these so-called stranded costs was a major issue in the deregulation debate.
Estimates of the total assets potentially stranded by deregulation ranged from $10 billion to $500 billion, said the Federal Reserve Bank. The extent of stranding depended on the degree of competition, natural gas prices, and the timing of deregulation.
"Seventeen of the 18 states that have deregulated have made some provisions for recovery of stranded assets," said the Federal Reserve. "These states used a variety of measures to distribute the costs of previous electricity plant investment."
In most states, deregulation legislation mandated an initial pricing structure that compensated owners of stranded assets by enabling them to at least partly recover costs of those assets through charges to customers.
"Of course, customer payment of exit fees or transition charges as part of the electric bill would delay the hoped-for decline in effective electricity prices in those regions with the highest electric rates," said the Federal Reserve.
Enron Corp. cited such fees as one reason its attempt to sell electricity to households in California-the first U.S. state to deregulate electricity-was relatively unsuccessful.
The EIA stresses that electricity and natural gas are particularly sensitive to price volatility. As evidence of this, utilities in the Midwest U.S. found themselves paying electricity rates as high as $7,500/MW-hr in June 1998, as a result of power traders` inability to deliver on their contracts.
A Federal Energy Regulatory Commission investigation into the price spike concluded that it was the result of an unusual combination of events, including soaring temperatures, storm-damaged transmission lines and generating facilities, temporarily idled nuclear plants, and some wholesale marketer default.
The effects of continued deregulation on this volatility were uncertain in 1998. FERC investigators concluded that, as buyers and sellers gained experience in the increasingly competitive market, they would develop better risk-management skills.
Fueling generation
More than one third of the primary energy consumed in the U.S. is used for electricity generation.
Coal is the principal fuel used for electricity generation, followed by nuclear, natural gas, renewables, and petroleum. In 1996, said EIA, utility purchases accounted for 87% of coal sales in the U.S., 12% of natural gas sales, and 2% of petroleum sales.
"The deregulation of electricity markets will have far-reaching implications for the coal industry," EIA noted. Coal is usually cheaper than natural gas on a thermal-equivalent basis. But new combined-cycle power-generating capacity fired by gas is cheaper to operate overall than much old coal-fired capacity because of sharply lower capital costs.
The effects on the nuclear industry might be even greater.
"Competitive electricity prices may be so low that nuclear power plant operators will not see enough income to enable them to recover the costs of operating and maintaining the plants and the costs of capital improvements," said EIA. "In the immediate future, some nuclear power units will be at risk of early retirement as a result of restructuring."
Electricity deregulation was expected to have little effect on distillate and residual fuel oil in their nearly extinct market for power generation. Use of residual fuel oil would probably decline further, said EIA.
The role of renewable fuel in a newly competitive market was unpredictable in 1998. It depended almost totally on what regulatory and technical developments emerged in the future to enable renewables to compete.
Effect on gas
Electricity deregulation promised to reshape the most important growth market for natural gas. EIA noted the similarities of the industries.
"The electric power and natural gas industries are both network industries, in which energy sources are connected to energy users through transmission and distribution networks," it said.
Both sectors were in transition in the late 1990s and eventually would become much less regulated and much more competitive than before.
The only component of the gas and electricity industries to remain regulated would be transportation, observed NationsBanc Montgomery Securities. The natural monopoly aspects of pipelines and transmission wires require oversight to ensure fair treatment of customers.
Worldwide electricity use was expected to exceed 20 trillion kw-hr in 2015, double the 1996 demand. The question was what would fuel the additional generation.
"Firms investing in new electricity-generating capacity will have an incentive to use the lowest-cost sources," said the Federal Reserve Bank. "Such investment favors the direct use of carbon-based fuels over wind power, cogeneration, and nuclear energy.
"On a pure cost basis, one might predict that coal could become more heavily used, but EIA forecasts that most of the new electricity-generating capability added in the coming years will be either combined-cycle gas turbine or combustion turbine-diesel technology.
"Of course, such decisions will be greatly affected by changes in technology and environmental regulation," said EIA.
Gas demand
Natural gas was considered almost universally to be the economically favored fuel for new power-generation capacity. This trend was coupled with "a more favorable supply-demand outlook than has been exhibited in the past 20 years," said NationsBanc Montgomery Securities.
Growth in gas-fired power generation was expected to account for most of the expected increase in natural gas demand. The fuel`s increasing share of generation capacity would result, in part, from the retirement of less-competitive nuclear plants and, possibly, old coal-fired capacity.
EIA said that as much as 50% of all nuclear generating capacity in the U.S. could be replaced by 2020 as a result of deregulation of the electricity industry. In addition, EIA expected fossil-steam plants with operating costs of more than $0.04/kw-hr to be retired by 2008. These plants could add up to a 16% reduction in fossil-steam capacity.
Growth in global gas consumption could outpace that of oil by a factor of three, said EIA. Total demand could reach 145 tcf in 2015-an 85% increase over 1985 gas demand.
The increase was projected to come primarily from developing countries. Pacific Rim countries might increase gas use 8%/year, while Central and South America might increase gas consumption 5%/year. In this region, the growth would come primarily from electric generation and industrial energy demand, plus replacement of hydroelectric generation capacity, said NationsBanc Montgomery Securities.
In contrast, natural gas demand in developed countries was expected to increase at 2-3%/year-more than double the expected increase in oil demand. The exception to this trend was Western Europe, where expanding privatization of electricity generation would create 4%/year growth in gas demand.
The EIA expected U.S. energy consumption to increase more than 26% from 1996`s level by 2020. But it expected natural gas use to grow much more-46%.
In the U.S., gas use was expected to exceed 30 tcf in 2015 and account for about 28% of U.S. energy needs, said EIA (Table 1). Gas demand was 22 tcf in 1995.
EIA said electric power generation would utilize 7-9 tcf of gas in 2015 vs. 2.7 tcf in 1995 (Fig. 2).
"Technological innovation will be the primary catalyst that leads to natural gas consumption expansion," said NationsBanc Montgomery Securities, "as gas-fired power generation is projected to be utilized for one third of all generation in the U.S. by 2020."
The firm explained: "The cost savings associated with electricity production from new combined-cycle generating plants is significant. Moreover, natural gas turbine technology continues to be more affordable and efficient and also requires less lead time than other forms of power generation.
"Combined-cycle, gas-fired plants can now generate electricity for approximately $0.03-0.04/kw-hr, vs. new coal plants at $0.04-0.07. This, combined with environmental advantages and technologies that have enabled power to be transported over great distances, has eliminated the need for the traditional protected monopoly structure."
The costs of generating electricity with selected fuels are shown in Table 2.
NationsBanc Montgomery Securities also saw on-site, small-scale generation as key: "Distributed energy, which utilizes raw turbine technology and has been developed by companies such as Allied and General Electric, offers the potential for low-cost, on-site electric generation and gives the user the opportunity to bypass the traditional electric power providers. This should continue to be a reason behind strong natural gas demand."
NationsBanc Montgomery Securities expected natural gas prices to trade in the $2-3/Mcf range for several years after 1998.
"Our favorable outlook [for prices] is based on projected increases in demand from both electric generation and the industrial sector, combined with U.S. and Canadian production that will just about keep pace with demand."
Companies readjust
Deregulation of the electricity industry was expected to create opportunities for natural gas producers and distributors.
Companies were taking one of two distinct strategies, focusing on either the wholesale or retail market, said NationsBanc Montgomery Securities.
Companies taking the wholesale, or "upstream," route recognized that commodity-dependent businesses typically had low margins; therefore, scale was critical. Diversifying the commodities offered could increase a firm`s profit potential, said the analyst.
The large upstream market offered enormous potential for the toughest competitors. Its risks included high entry costs, slow market development, credit risks (resulting from entering untested markets), and possible trading losses.
The retail, or "downstream," strategy focused on the distribution end of the gas and electric business. There are fewer risks in this approach in comparison with the wholesale route.
A few companies were expected to take both routes and remain vertically integrated.
M&A activity
Many observers of gas and electricity deregulation expected the trend to accelerate merger and acquisition activity among participants.
"Large electric utilities are expected to be the major acquirers of natural gas companies," said NationsBanc Montgomery Securities. "Combinations that have already taken place are: Duke Power and PanEnergy Corp., Enova Corp. and Pacific Enterprises, PG&E Corp. and Valero Energy Corp., Texas Utilities and Enserch Corp., and Houston Industries and NorAm Energy."
In the U.S., the total value of combinations and buyouts during 1996-98 exceeded $24 billion. The takeover activity revealed three dominant themes, said the firm: acquiring assets, increasing customer base, and gaining experience.
"Because of the fragmented nature of the industry, we expect an accelerated level of M&A activity as utilities experience large cash inflows from the sale of generation assets. Beyond utility combinations, major oil companies, telecommunications, cable television, and even retail companies have expressed interest in the energy services industry, and vice versa," said NationsBanc Montgomery Securities.
Several strategies had emerged in M&A transactions, said the firm. These are:
- Retail focus via utility combinations aimed at gaining or preserving market share and achieving economies of scale (examples were Ohio Edison and Centerior Energy, Atlantic Energy and Delmarva Power, Western Resources and Kansas City Power & Light).
- Electric utilities acquiring or merging with natural gas distributors, for similar reasons (examples were Texas Utilities and Enserch Corp., Houston Industries and NorAm Energy, Enova Corp. and Pacific Enterprises).
- Electric utilities acquiring or merging with natural gas pipelines to enhance trading and marketing capabilities for multiple fuels (examples were Duke Energy and Sempra Energy, itself a result of the Enova-Pacific Enterprises combination).
- Electric utilities acquiring or merging with firms in other nonregulated industries, such as telecommunications or cable television, to gain customers and offer bundled services.
Other tactics included the outsourcing of services and the ignoring or delaying of restructuring as long as possible, said NationsBanc Montgomery.
"We believe there will continue to be acquisitions, joint ventures, and alliances during the (transition). Diversified energy companies should continue to decide whether to embark on wholesale or retail strategies.
"Scale will be critical, and companies without strong balance sheets will not survive as independents, in our opinion...Winners in electric deregulation will likely be the early movers with low-cost operations that possess the size, intellectual resources, and ability to achieve economies of scale.
"In our opinion, the companies that will prosper will need dual commodity strategies and will further embrace the concept of convergence of energy sources."
Industrial restructuring
Deregulation of electricity markets in the U.S. alone constituted an enormous industrial restructuring.
"Changes expected in the supply, delivery, and technology related to the U.S. energy industry represent the largest industrial restructuring in the history of the country, and possibly in the world," said the National Energy Marketers Association.
And efforts of similar scope were taking place in other industrialized nations.
EIA summed up the likely and far-reaching effects of this important trend: "Today, as the (U.S.) electric power industry is moving rapidly toward retail competition, the wholesale electricity market is already reaching full-scale, open competition. The deregulated wholesale market is proving to be highly dynamic; prices tend to be volatile and transaction terms short.
"The electric power industry is undergoing consolidation through mergers and acquisitions and, at the same time, has started unbundling its generation, transmission, and distribution functions from an integrated structure.
"Electricity deregulation may provide oil companies with opportunities to expand synergistically into a related business. A number of oil companies have gained experience in electricity production as a means of exploiting their natural gas holdings in other countries, and they could become important players in the U.S. market as capacity needs grow in the future.
"As the restructuring of electricity markets proceeds, the development of institutions, such as futures contract markets and electronic auction markets, could lead to greater integration of the electricity and natural gas industries and the emergence of competitive energy markets."
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