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Why California's electricity problem may leave you in the dark.
Tim Reason, CFO Magazine
July 1, 2001
Tim Condon isn't overly worried about the soaring electricity costs at his own office. After all, electricity is still a small portion of the operating costs for Household Automotive Finance, in San Diego. But the CFO is worried about the electric bills of Household's customers-- all subprime borrowers. "For someone with a modest disposable income, energy costs have a disproportionate impact," says Condon. "It is like a regressive tax."
Talk shows may debate the demise of the Internet bubble, but the real issue facing the economy this year is much more fundamental. Once a predictable cost for both consumers and businesses, energy prices have emerged as the factor that could determine whether the slowing economy slides into recession.
Condon notes that although unemployment is still relatively low, consumer debt is at record levels and high energy prices translate into increased prices for food and other goods. "You look at all of this together and say, boy, this is something to be very afraid of right now."
And then there are the outages. The well-documented electricity- supply problems already plaguing California will escalate throughout the summer. The North American Electric Reliability Council (NERC) estimates the state will see a minimum of 260 hours--15 hours a week-- of rolling outages this summer. And that number assumes demand for electricity will drop in response to an average rate increase of 46 percent. Without sufficient conservation, there could be as many as 700 hours of outages, says Tim Gallagher, who coordinates NERC's Reliability Assessment Subcommittee.
California companies like Rodney Strong Vineyards, in Sonoma County, understand all too well what that means. If the winery's crushers and refrigeration units aren't working when the grapes are ripe, says CFO James Bielenberg, a year's worth of product can be ruined. "Sugar levels in a grape on the vine can rise above desired levels in a matter of hours," he says, and picked grapes will begin to ferment naturally if not processed immediately. "If that happened to, say, our Alexander's Crown Vineyard cabernet, which has a retail price close to $30 a bottle, we would have a serious problem--a loss of about $4 million." Insurance would cover the financial loss, he says, "but then we've lost market share and have to build that line item up again in the marketplace. That is the real risk for us."
OUT OF JUICE
That's life in the Golden State these days. But what about the rest of the country? Clearly, companies everywhere are paying more for all types of energy. "We are in an energy crisis," says Tom May, CEO of Boston-based utility Nstar Electric & Gas Corp. Nationwide, electricity prices are expected to average 10 percent higher than last year, according to Heather Upton of research firm DRI-WEFA.
And that's not counting the cost of power interruptions. Power- hungry industrial operations may suffer the most serious financial hits when prices spike, but every business is hurt by outages. "Energy is a very small part of most company budgets, but there still isn't a proper way for CFOs to value the cost of not having it," says Jason Makansi, president of Pearl Street Inc., an energy-technology consulting firm. "You could have one or two outages, and the lost opportunity costs might run $10 million to $15 million. Somehow, that isn't reflected in the general ledger as an energy problem."
The good news for most companies is that the risk of rolling blackouts or voltage reductions is largely confined to three areas of the country. "One thing CFOs should understand is that our markets are regional in nature," says Nstar's May, who is quick to note that New England has plenty of generation capacity. "New England is in pretty good shape for the next five years. We don't have to worry about the lights going out or being interrupted. Most of the Northeast is like that."
An assessment of summer conditions released by NERC in May cautiously agrees. "We expect to see tight capacity in the Pacific Northwest, New England, and New York City," says NERC's Gallagher. "But in none of those areas do we expect to see rolling blackouts."
There's plenty of power in the region around New York City, but the Big Apple imports 20 percent of its demand, maxing out the transmission lines that feed the city. "If they are importing as much as they can," explains NERC spokesman Gene Gorzelnik, "then they need to start generating power [inside the city]." Despite resistance from businesses and residents, local utility Consolidated Edison was expected to complete installation of special generators within the city by June. "If any of those are delayed, there may be shortages in New York City," says Gallagher.
The Pacific Northwest, usually awash in cheap power from its many hydroelectric plants, has suffered a drought for almost a year that has left reservoirs at 53 percent of traditional levels. "We need rainfall of biblical proportions to bring us back to normal," says Jerry Rust, president of the Northwest Power Pool. "We will potentially see blackouts this winter."
Right now, that's primarily a problem for California, which can't rely on its neighbors for extra juice this summer. But California's problems pose a risk to the rest of the country. "It is the single largest economy within the U.S., and the sixth largest in the world, so there are definitely spillover effects," says DRI-WEFA's Shawn Intorcio. "We just have to wait to see how big the impact is going to be." In short, although energy markets are regional in nature, even companies located far from California should be worried about how well it manages its energy needs.
What also bears watching is how the first major state to deregulate its electricity market fixes the mess it made. So far, no other deregulated state has had such a spectacular failure, but there hasn't been much in the way of success, either.
Utility restructuring was supposed to encourage companies to shop for the lowest price among alternative electricity suppliers by making it easier for these suppliers to compete. For the most part, it hasn't worked that way. According to a recent survey by Booz-Allen Hamilton, only about 20 percent of business customers nationwide have switched electricity providers, and "a significant number of those either saved nothing or were exposed to higher prices."
Last year, Nstar delivered power from alternative suppliers to 5,100 of its customers, almost all of them companies that had found a better deal than Nstar's regulated rate, known as the "standard offer." Today, however, only about 1,400 Nstar customers actually buy their power elsewhere. "The prices we offer--by regulatory fiat--are below market," says Tom May, who would dearly like to get out of the business of reselling power at a loss and focus on delivering it.
Large companies certainly share his pain. Ironically, the large industrial firms that lobbied hardest for deregulation are the ones most exposed to the volatility of the semicompetitive market that exists today. Although certain regions of the country may offer access to more than one supplier, the choices are "minimal," says Marc Yacker, director of government and public affairs for the Electricity Consumers Research Council, in Washington, D.C.
With little or no choice of energy providers, companies with more moderate power needs have more in common with residential customers than with their larger industrial cousins: Their incumbent utility is the best supplier because regulated rates are currently lower and protect them from market volatility. For these companies, the only visible results of deregulation appear to be steadily rising bills and the disintegration of their once-reliable electricity supply.
BREAK OUT THE CARDIGAN
Although deregulation hasn't helped most companies lower their bills yet, many businesses are realizing that some simple measures can offer immediate savings. The first step is the most obvious: Read the bill carefully. "Quite frequently, we find utilities not billing appropriately, and in more cases than not, they are overbilling," says Jim Negus, leader of KPMG's Financial and Energy Risk Management Group. Even if the bill is technically correct, he says, most regulated utilities have about 30 unique rate schedules, and companies often fail to select the best rate for their consumption patterns. "On average, companies can save 3 to 5 percent of their total energy spend through rate-analysis techniques," claims Negus. "Either we find an inaccuracy in the utility bill, or we can find a better plan for that company."
Karen Joyner, vice president and controller of Dollar Tree Stores, in Chesapeake, Virginia, says her company just outsourced its bill payment to Spokane, Washington-based energy service firm Avista Energy, which will provide analysis and recommendations. "We are a dollar-price- point store," explains Joyner. "We're not doing this because of higher rates, but because our growth and inability to raise our prices means we need to continuously improve our operations and keep our expenses down."
Indeed, despite the fact that conservation has become something of a political football in the Bush Administration, improved energy management is the next step for most companies. At this point, it is still by far the best way to save on energy costs, and there's a thriving cottage industry of energy-management-technology providers, such as Sixth Dimension, Silicon Energy, Powerweb, Lodestar, and Power Measurement, offering to help. "If all the energy-management technologies now available were being widely used, we probably wouldn't be having these supply-shortage problems," says Kevin Cooney, vice president of research at energy consulting firm E Source.
"You can expect at least 5 to 10 percent savings through implementation of an enterprise energy management system," says Gord Lancaster, CFO of Power Measurement. Brian Walshe, of energy consultancy Barrington Energy Partners, says companies need at least 10 percent savings to make a comprehensive energy management program worth the effort. "But 10 percent is very doable, and with advances in technology, it could go as high as 15 percent." Although implementation costs vary, Lancaster says a typical rule of thumb is that a company must spend 10 percent of its electricity bill to implement an energy management system, with payback in 6 to 12 months.
Marshall Witt, CFO of San Josebased FedEx subsidiary Viking Freight, says even simple conservation measures produce tangible financial results. "Electricity is not one of our larger costs," he admits, "but in transportation, margins are slim." In March, he says, the company's headquarters reduced its consumption by 20 percent. That's enough power, says Witt, to run five of his truck terminals for a month.
Viking also participates in "peak shaving"--running generators in its trucking terminals to reduce its utility demand during peak periods. Of course, with five blackouts hitting various truck terminals in the first five months of this year, it is in Viking's self-interest to help out its struggling utilities. But thanks to time-of-use monitoring by PG&E, Viking also saves the peak price. Time-of-use, rather than average, pricing gives companies more incentive to reduce demand during peak periods. Although such specific pricing signals are still not available in many parts of the country, it is increasingly common for companies to seek market-rate compensation for conservation or on-site generation.
The most extreme example of this strategy was the highly publicized decision by several aluminum companies in the Pacific Northwest to actually shut down their smelters and resell contract power--in some cases for as much as 18 times the original price. Kaiser Aluminum, for example, booked $228 million in power sales in the first quarter of this year.
Likewise, Phoenix-based Phelps Dodge Corp. is considering selling power from the new cogeneration plant that it is building to help shield the mining company from the volatile electricity market in its region. "We do not intend to be in the spot [electricity] market-- except as a seller," CEO J. Steven Whisler told analysts. Although the economics of such a deal would have to include paying idle workers, he said, "we might even get lucky and get two to three days of sales."
But similar deals are also becoming part of standard market offerings. Select Energy Inc., a subsidiary of Northeast Utilities, allows companies to buy hourly blocks of power for a fixed price, notes information operations manager Jim Grace. If the companies use less power through conservation or on-site generation, they receive a refund that is calculated against a market index. Essentially, they are selling the power back at market price. Although many of Select's customers--General Electric and International Paper, for example--are still large consumers, that profile is changing, he says.
"Of course, evaluating energy costs, hedging, turning on standby power, and regulating lighting are all a real headache," notes Pearl Street's Makansi. "Most CFOs just want predictable costs in an area that is frankly very difficult to understand."
It's not surprising, therefore, that outsourcing energy management and procurement is another booming business. For example, Boeing, Eastman Chemical, and Bank of America all have outsourced elements of their energy management or procurement to DukeSolutions--an unregulated affiliate of Duke Energy. And energy giant Enron's Energy Service Group provides similar services for Quaker Oats Co., Eli Lilly, and Simon Property Group. Jack Jenkins-Stark, CFO of Silicon Energy, which helps companies procure and manage their energy, says his company's target market includes "enterprises that are spending $3 million or more on energy [gas and electricity]." E Source energy analyst Barry Friedman says there's a unique niche called "total energy outsourcing," in which such companies as Sempra Energy Solutions assume complete ownership of the equipment at a company's site, and simply sell back desired levels of lighting and temperature.
There are even companies happy to assume responsibility for the complex issues surrounding backup power. Rodney Strong Vineyards's Bielenberg began evaluating generators when PG&E moved the company off a "favorable grid" (a section of the transmission system protected because of sensitive users such as hospitals), guaranteeing that the winery will be exposed to rolling blackouts this summer. But generators cost about $300,000, and come with a blizzard of regulatory and environmental headaches. More attractive, he says, is a proposal from Power Innovators to install and operate a cogeneration plant on Rodney Strong's property, providing the winery with power and giving Power Innovators the right to sell the excess capacity back to utilities at market rates. "We are very interested in this option," says Bielenberg, though it looks like Power Innovators will not be able to get through the regulatory hoops in time for this year's harvest.
That means Bielenberg still must make the final decisions when it comes to energy risk. And he's not alone. Power outages and volatile energy prices are a risk-management issue--even outside of California. Nstar's May recalls a customer visit he made 10 years ago to the patrician Edward C. "Ned" Johnson III, chairman of Fidelity Investments. "It amazed me that he knew more about the power grid than I did," recalls May. "He knew where the transformers were that fed his business, and he understood what was under the sidewalks outside the buildings where his computers were housed--because it was critical to his business." That, says May, is the right attitude for any executive.
Tim Reason (email@example.com) is a staff writer at CFO.
Darkness on the Edge of Town
It has been an uncertain year for workers at the Chino and Tyrone copper mines in New Mexico. In January, executives at Phelps Dodge Corp., the Phoenix, Arizona-based owner of the mines, weren't sure the company could afford the mines' electric bills this summer, when market prices are sure to rise dramatically in response to chronic power shortages in the West. To comply with the Worker Adjustment and Retraining Notification Act (WARN), the executives told 2,400 workers that they might have no choice but to halt production and lay them off by March.
March brought the miners mixed news. The upside: The company had shielded itself from possible price spikes by signing a fixed-price contract with Tucson Electric Power Co. for most of the summer, planning rotating work stoppages throughout all of its mines in the Southwest during the peak month, and building its own 40 megawatt power plant at the Chino mine. "Beginning in early May, our exposure to the electricity market was virtually zero," says CFO Ramiro G. Peru.
Peru's effort saved all but 130 jobs. But the remaining workers weren't off the hook. The possibility of unexpected power disruptions still loomed, forcing the company to renew its WARN notice for another two months. On May 29, the company laid off another 80 workers and extended the notice for yet another two months.
"Obviously," explains Peru, "given the situation in California and throughout the West, firm power is only as good as the ability of the producers to deliver it to you." Last summer, that ability wasn't very good. "We had a number of disruptions in 8-to-16-hour increments," he says. "They can be quite costly." In 1999, Phelps Dodge spent 11 cents on energy (electricity, gas, and diesel) for each pound of copper it produced worldwide. By fourth-quarter 2000, that figure had shot up to 17 cents per pound--the result of soaring costs and unexpected outages at its U.S. mines. --T.R.
A selection of some of the largest companies offering outsourced energy management and, in some cases, electricity procurement.
|DukeSolutions||www.dukesolutions.com||Car America, Boeing, Kraft, Formica|
|Enron Energy Service||www.enron.com||Starwood Hotels, Chase Manhattan, Polaroid, Simon Property Group|
|Sempra Energy Solutions||www.sempraenergysolutions.co m||DreamWorks, Venetian Resort Hotel|
|Service Resources||www.serviceresources.com||Federated Department Stores, Home Depot, Toys R Us|
|Trigen-Pepc||www.pepco-services.com||Washington, D.C., Convention Center, National Institutes of Health|
|TXU Energy Services||www.txu.com/us/ourbus/en ergyserv/||John Deere, Catholic Healthcare West, Crescent Real Estate|
Source: E Source