Risk & Compliance

Power Struggle

Deregulation of the electric industry was intended to substantially lower energy costs. It hasn't.
Tim ReasonJune 1, 2000

When Jonathan Swann took a job in the corporate finance department at The Limited Inc., in 1995, he was happy to escape the turmoil at Dayton Power & Light, which was struggling with the pending deregulation of the electric industry. The Limited, a $9.7 billion (in revenues) clothing retailer based in Columbus, Ohio, was about as far from an electric utility as Swann could get.

But two years after Swann signed up at The Limited, the CFO there at the time read a newspaper article claiming that the deregulation of the electricity industry could reduce the cost of power by as much as 25 percent. The Limited’s 5,500 shops were then running up an annual electric bill of around $130 million. Eager to capitalize on the potential savings from deregulation, management set up a new energy services department. Not surprisingly, Swann, who worked his way up from accountant to manager of a service territory during his six years at Dayton Power & Light, was picked to head up that department.

Almost immediately, however, The Limited’s energy czar came to a rather painful realization: Deregulation of the electricity industry was not going to generate sizable cost savings for The Limited. “Probably 5 to 7 percent [savings] will come from competition,” Swann says. “We see much larger [savings] than that in some states and much less than that in other states.” While management still aims to reduce the clothing retailer’s annual electric bill by around 18 percent, Swann says much of the savings will come from better energy-management techniques. Those techniques, along with some savings from deregulation, have already shaved $6.5 million from The Limited’s electricity costs in just two years.

Shocking but True

Swann’s disillusionment with deregulation is not uncommon. The fact is, the merits of a deregulated power industry have been vastly oversold. Congress passed the first real harbinger of utility competition, the Electricity Policy Act, in 1992. Four years later, the Federal Energy Regulatory Commission opened up long-distance transmission grids to competing wholesale power providers. Since then, it’s been up to state legislators to bring meaningful competition to the local distribution level.

That, in turn, has led to a wildly fragmented power market. Industry observers note that deregulation is at a reasonably advanced stage in a handful of states — notably California, the first to completely open its market to all customer classes; and Pennsylvania, which has arguably done the best job of fostering competition. New York, Massachusetts, New Jersey, and Rhode Island have also done a passable job of opening up more options for customers. But most southern and midwestern states are moving at a lethargic pace. Says John A. Anderson, executive director of the Electricity Consumers Resource Council (Elcon), a corporate coalition that accounts for 6 percent of all the electricity consumed in the United States: “Nowhere in the States do we have anything approaching true competition.”

The numbers don’t lie. Retail electricity rates in the United States range from 2 cents to 15 cents per kilowatt hour. “No commodity has a price variability [like that] in a competitive market,” Anderson notes. “But nobody argues that this is a competitive market. It is Balkanized along state laws that end up protecting the monopoly utilities.”

What’s more, many corporate executives don’t see things getting any better, says Bill LeBlanc, vice president of retail consulting for E Source. The Boulder, Colorado-based energy information and consulting firm keeps tabs on about 50 energy managers at Fortune 500 companies. In an E Source survey in 1996 — with deregulation just under way — an overwhelming majority of corporate energy managers said they expected prices to drop; only 4 percent predicted they’d stay the same. This year, though, barely half say they think prices will go down. And, for the first time, many managers — almost 1 in 4 — actually expect prices to rise.

They might be right. Transition fees intended to help utilities recover earlier capital outlays on facilities (so-called stranded assets) have kept electricity charges high. In addition, teaser rates currently offered by new market entrants aren’t likely to last. “Most of the aggressive players have been pricing their electricity at unsustainable levels to capture market share,” says LeBlanc.

Moreover, many companies are already locked into agreements with their power providers. “Many large commercial and industrial customers have negotiated pretty sweet deals with their utilities,” explains LeBlanc. “So there isn’t much room to wiggle.”

Marvelous Hagglers

That hasn’t stopped some companies from seeking savings, however. Take Praxair Inc., a $4.6 billion supplier of industrial gases headquartered in Danbury, Connecticut. The electricity bill for the company’s huge compressors, turbines, and cooling equipment runs about $475 million a year worldwide and about $260 million in North America, says James B. Rouse, associate director of Praxair’s energy policy. “Electricity [accounts for] up to 70 percent of our operating costs,” Rouse says. “We consider it a raw material.”

Given that thinking, it’s not surprising that Praxair is already an accomplished haggler when it comes to buying power. The company has a 10-person staff devoted to buying and managing energy. With operations in all but a handful of states, Rouse expects deregulation to produce some savings in localities with costly power production. But, he adds, “we won’t save anything in the low-cost states.” Overall, Rouse predicts deregulation will reduce Praxair’s electric bill “only slightly.”

Ford Motor Co. is no stranger to the bargaining table, either. Ten years ago, Ford had difficulty negotiating a favorable rate with monopoly provider Cleveland Electric Illuminating Co. Frustrated, managers at the automaker struck a tentative deal with the city of Brook Park, Ohio, to create a rival municipal power company. Faced with that unsettling prospect, managers at Cleveland Electric Illuminating (now a part of FirstEnergy Corp.) finally caved in, offering Ford a 28 percent discount on its electric rates. “We shared that with the city so that all the residents and Ford each got a discount of about 23 percent,” recalls Pradeep Mehra, vice president of energy efficiency and supply at Ford subsidiary Ford Motor Land Services Co.

Deregulation should lessen the need for such strong-arm tactics. And in fact, Mehra says competition in New York and Illinois has led to rate reductions at Ford plants in Buffalo and Chicago. He also points out that electricity prices have held fairly steady while state regulators and utility representatives wrangle over deregulation. Further, the specter of deregulation has given corporations added bargaining power when negotiating with their local utilities. Such leverage can’t last forever, however. “It’s nice to have the threat of deregulation,” Mehra explains. “But what I’d like to have is deregulation itself. You can use the threat for only so long.”

Still, some corporate energy managers point out that deregulation has many CFOs thinking about electricity as a variable, not a fixed, cost. “Any dollar savings you can make on electricity goes right to the bottom line,” notes Elcon’s Anderson.

Of course, variable costs have a tendency to, well, vary. Indeed, the electric industry has experienced serious growing pains during the past two summers, including massive price spikes in the Midwest. How massive? Over a period of a few days in 1998, spot prices rose from $30 per megawatt hour to $7,000 per megawatt hour. Peak summer loads — at a time when an unusual number of plants were down for repair — caused the shortage. But the rate rise also underscored how woefully unprepared many power suppliers were to deal with electricity as a commodity.

Mehra knows all about such price jags. In 1999, Ford’s Louisville plant felt the heat of a summer spike. The plant was operating under a six-year interruptible contract with a buy-through option. Unlike a firm contract, which guarantees that power keeps flowing at all times, interruptible contracts provide deep rate discounts for customers that agree to shut down operations if the local utility’s supply of electricity runs low. If Ford chose not to shut down, the buy-through option allowed the utility to purchase power for Ford on the spot market. “When you’ve got a thousand people standing around building cars,” says Mehra, “it’s very difficult to say, ‘Go home.’ “

The Louisville plant kept operating during the summer of 1999 — but at a cost. “The premiums in that one week offset all the savings for the year,” Mehra says. All told, the special contract in Kentucky ended up costing Ford $1 million more in 1999 than the normal tariff rate.

A Lot of Sweaters

Hedging may offer some protection against those sorts of calamities. “Companies like ours will have to take advantage of financial futures to help protect ourselves during the summer peaks,” acknowledges Praxair’s Rouse. “As energy purchasers, we will have to become comfortable with [hedging and risk management], just like anybody who deals with a commodity product.”

The New York Mercantile Exchange (Nymex) has doggedly maintained an electricity futures exchange since 1996. But a lack of liquidity saw traders abandon the pit, forcing Nymex to move all trading in electricity to an electronic exchange last November. For his part, Ford’s Mehra still has doubts about electricity exchanges. “I don’t believe there is transparency in the marketplace today,” he says bluntly.

Many industry watchers agree, predicting it will be another two to three years before the fledgling electricity exchange puts on enough muscle to attract a large number of corporate users. But Rouse isn’t waiting. “I have been urging our financial people that we prepare to hedge our electricity pricing on [Nymex or some other exchange].”

Until then, the best bet for many companies may be to court upstart power providers in recently deregulated states. Typically, newcomers to a market are keen to attract high-profile customers — and are often willing to cut deals to get them. Los Angeles­based New Energy (formerly New Energy Ventures) signed a very favorable agreement with The Limited in 1999 to supply power to its stores in Pennsylvania, says Swann, but wouldn’t renew the deal this year. Swann doesn’t seem to mind one-off arrangements, though. “You have to take advantage of [those opportunities],” he explains. “You have to be a smarter purchaser of electricity.”

You also have to be a smarter consumer of electricity — or pay someone to worry about it for you. While many companies have formed in-house energy management departments, others are outsourcing the function. In February, for example, New York­based Chase Manhattan Corp. outsourced the energy management of 860 facilities nationwide to Enron Energy Services, of Houston, for a period of 10 years.

In either case, the results can be dramatic. The Limited recently installed special monitoring devices at 500 of its retail shops. Initially, says Swann, the idea was simply to shed some light on how the company used electricity. Now the device is used to evaluate each store’s power usage and create a load profile. Swann then uses the profile to negotiate better deals with local power providers.

That sort of intelligent energy management, coupled with tough negotiating, should pare $25 million from The Limited’s energy budget. Ironically, the regulation of consumption may be the real legacy of the deregulation of the electricity industry. “The traditional energy expense [was] not sexy,” Swann explains. “Now it is. Think of the number of sweaters we have to sell to make $25 million.”

Keeping the Lights On

While free-market competition is almost always a good thing, some observers wonder if a deregulated electricity industry is such a hot idea. Critics note that substantial cost savings from deregulation have yet to materialize — and, in fact, may never. What’s more, some industry watchers wonder if the pressures of competition may actually cause the lights to go out.

Indeed, experts are still debating whether a lack of cooperation between utilities contributed to the massive outage that shut down much of the West Coast in 1996. At the very least, the wild price spikes over the past two summers seem to illustrate the difficulty of moving power to areas where it is in short supply.

In theory, a competitive market allows buyers to purchase electricity from the cheapest power plant, and deliver — or wheel — the power over transmission lines that act as a common carrier. But the hard truth is, the transmission grid in the United States was simply not designed for interstate commerce of electricity. Monopoly utilities built power plants to serve their own distribution networks, not transmit electricity to other regions.

The problem of distributing power is particularly acute in areas where geography limits the number of available links to the grid — peninsulas like Michigan and Florida, for instance. Worse, moving power from areas where electricity is relatively inexpensive to areas where there is high demand can put a severe strain on the grid. In the past, monopoly providers worked together to prevent local or regional blackouts. But the onset of competition has put an end to the warm fuzzy days of cooperation.

All of this is particularly worrisome for managers at energy-dependent industries. Executives at semiconductor fabricators, for example, say one unexpected outage — or even a blip in power quality — can wipe out any savings from reduced electricity prices. “An unscheduled power outage is a serious issue for operations like ours,” confirms Mark Falconer, a government affairs manager at Hewlett-Packard Co.

According to E Source, a Boulder, Colorado-based energy consultancy, continuous process manufacturing companies and financial services firms suffer the highest losses when the power goes out. In a study of continuous process manufacturers with more than 100 employees, E Source determined that the average annual cost of outages was $79,000. For financial services firms with more than 250 employees, that number was about $60,000 per year. On average, a typical U.S. company suffers about 17 interruptions in electricity service each year.

Don’t expect deregulation to put an end to the outages. Corporate managers looking to ensure a 24/7 supply of power have two options. One, they can install back-up generation systems — an expensive, but fairly foolproof, option. Failing that, they can sign firm power contracts and negotiate stiff penalties if their supplier fails to provide uninterrupted service. But as John A. Anderson, executive director of the Electricity Consumers Resource Council, notes, such contracts do not come cheap. “Those who want high reliability,” Anderson says, “will vote for it with their dollars.”