©2012 Foley & Lardner LLP Attorney Advertising Prior results do not guarantee a similar outcome Models used are not clients but may be representative of

©2012 Foley & Lardner LLP • Attorney Advertising • Prior results do not guarantee a similar outcome • Models used are not clients but may be representative of clients • 321 N. Clark Street, Suite 2800, Chicago, IL 60654 • 312.832.4500

Utility Regulation, Then, Now, Tomorrow

What You Need to Know to Understand How What You Do Fits Into the Utility Client’s Business Success

Allen W. Williams, Jr.

2©2012 Foley & Lardner LLP

History of the Energy Industry

What are disruptive technologies? 19th Century; 20 Century?

How does electricity fit into history of Disruptive Technologies? From work bench to world domination in 20 years.– How was this many billion dollar

infrastructure build out accomplished?– What does Wall Street require?

Local, to regional, to national grids – and back again?


What Are the Disruptive Changes Facing Utilities?

Renewables CO2 Restrictions Electric Storage Others And what could they mean?

– For the architecture of electric infrastructure

– For investor owned utilities


What Downside (or Upside) Do Disruptive Changes Create?

Loss or gain of investment opportunities?

Change from centralized generation connected to transmission and distribution wires? To what?

How can utilities protect their interests – or are they the land line telephone companies? How did the dinosaurs become extinct?


The Utilities’ Challenge:

What makes regulated utility earnings grow?

What makes utility stocks more valuable? Two questions – related answers. Concepts:

– Stock value [yield and growth]– DCF– Real Returns– Difference between debt and equity, valuation



– Pay out ratio– Market/book value ratio– Accretive or dilutive sale of equity– Expanding KWHs of sales and expanded

rate base– “Rate base” or book value, of novel

importance to utilities, book value/share and growth in book value per share



Debt and Equity The value bases for utility common equity

and debt - how do Investors attribute value to (utility) common stock?– Present value of future pay-outs

Dividends paid Future sale price of stock

– Retained earnings– Book value of stock– Price – earnings ratio

Why is stock valued differently than debt?



Growing Earnings How do utilities earn returns for equity

investors? How can utilities grow earnings over time?– Regulatory “compact”

Prudent investments Used and useful Recovery of reasonable return on and of capital

invested in prudent utility assets, and of capital for assets no longer used and useful?

– Ratebase – What is it?– How do EPS for a utility grow? Growth in book

value (rate base) per share, or increase in ROE



– What happens to stock value without earnings growth?

– Relationship of growing sales, capital investments, and EPS growth – What if sales don’t grow? And rate base/share doesn’t grow?



Utility earnings (and projected earnings per share) grow, which drive stock price because:– The total invested capital dedicated to utility

service (“rate base”) grows in size; and– The market value of the utility stock sold to

support the additional capital (rate base) investment exceeds the stock’s book value; and

– The additional equity raised is awarded a return on equity in the rates set equal to the return expected on existing investments; and



Utility stock price (and earnings per share) grow because:– The utility has a demonstrated track record of

actually earning at or near the allowed rate of return; and

– The existing rates for utility service and service area demographics support the likelihood of actually realizing the return on equity to support the growing investment; or

– Are rates so high there will be pressure on obtaining adequate rate increases? Or pressure to reduce ROE? Or pressure to corrupt the regulatory compact?



Without Increasing Rates Can utilities grow their earnings

without increasing their rates?– If the product they are selling has flat or

shrinking units of sale?– Trends in “real price” of electricity– Rate pressure (and back pressure) then,

now, and in the future



Infrastructure What infrastructure investments will

support utility growth going forward?– Environmental– Replacement– Effect of replacement already depreciated

with new, more expensive (in rates)– Demand-side investments?



Electricity is a political necessity, and the political environment in which utility regulation is carried out requires electricity to be provided at reasonable costs, and with reasonably adequate reliability

Both are required, and the determination of “reasonable” cost is a relative determination based upon the public’s perception of what is prevailing in other markets (other states) and as well compared to their recent historic costs

Rapid price increases are unacceptable Unreliable service (periodic brown outs or

shortages) is not acceptable on an absolute basis



Unacceptable prices or unacceptable reliability will lead directly to political intervention, and that intervention will result in resistance to rate increases necessary to protect the shareholder’s interest in a reasonable return and to support the additional costs associated with earning an adequate return on additional infrastructure investments

A disruptive technology could render utilities which don’t evolve the next dinosaurs



The price elasticity of demand for electricity, while relatively low in the short term, has been shown to be much greater over a period measured in several years

This has been reflected in conservation effects recognized after the Arab oil embargo of 1973, and then the run up in electric prices tied largely to high inflation rates and the very large nuclear generating units planned in the late 1970’s to meet projected high growth in electric demand (in areas experiencing rapid demographic growth) which experienced astronomic cost increases after the Three Mile Island incident



Electric demand did not increase as projected, making very large and surprisingly expensive, nuclear power electric plant additions surplus to the requirements

The result was increases in electric costs to consumers in the state jurisdictions experiencing infrastructure “gluts” becoming unacceptable – creating the exigencies which produced the major political interventions of “re-regulation” in a number of states

The political lesson regarding significant real price increases in electricity



The price increases were enough to cause a surprising price elasticity of demand reduction in demand

Electric generation is built with 3 to 7 year lead times, and the process of constructing the new fleet of generation could not respond to unpredicted vicissitudes in electric demand



The situation also set the stage for long term periods of no rate relief during the time the glut in supply was in the process of being eroded by underlying growth

The political processes in a number of states became used to static or even falling electric rates as the electricity market grew into its infrastructure

The price cross elasticity of demand for electricity became more latent during the static price periods

The real price for electricity fell on a secular basis, essentially for the entire 20th Century



The recent period of price freezes in a variety of jurisdictions, as well as wholesale experimentation in electric market re-regulation created a great deal of uncertainty about who had appropriate incentives and adequate financial underpinnings to support the construction of needed electric industry infrastructure

In a period of rate stability and while safety margins were being eroded but had not yet disappeared, political intervention did not resolve uncertainties and allowed such safety margins to be prejudicially eroded



Reactions to shortages or price spikes are typically exaggerated and relatively severe, and political interventions limit the ability of electric generation owners to profit to the full extent of a market shortage

The political process, over the long term, demands that electric infrastructure equal or exceed demand for it. Service interruptions and price spikes are not tolerated

This almost assures infrastructure will exceed demand over the long term – a circumstance which almost requires regulation to avoid chaotic failures and unreasonable costs of capital



Due to recent periods of price stability, the tolerance of electric customers for price increases has been reduced

That tolerance has also been eroded by price volatility in those jurisdictions with direct pass through associated with the cost of fuel used for electric generation



Recent experience in the electric use market involving price “fly-ups”, either because utility cost increases have been bottled up by jurisdictional price controls (the price freezes exacted in the re-regulation bargains in a number of states) or because of the rapid increase in the cost of coal, have created a perception of electric shortage/crisis, which threatens both political intervention as well as the reawakening of the latent price elasticity of demand for electricity



The political crisis environment creates more resistance to rate increases, even if they are well justified by needed electric infrastructure improvements

The re-awakening of price elasticity of demand portends the possibility of an (unexpectedly large) dampening of the demand for electricity (note the period from 1980 to 1995) which could exaggerate the upward rate pressure from the infrastructure investments supporting the robust growth rates in earnings for utility common stock needed for the “successful utility” common stock market price/earnings multiple



In fact in many parts of the U.S. total required demand for electricity has fallen or been stagnant since 2009, while at the same existing coal and nuclear plants will apparently require very expensive generation plant replacements just to meet the existing or even shrinking loads. Upward rate spikes, price elasticity of demand dampening of sales, political back pressure, technological innovation in electric storage – here we come



The value of a utility’s common stock is dependent on the projected growth rate in its earnings, or its current “yield,” and underlying inflation and interest rates – Today’s circumstance – yield and inflation

Utility’s earnings are ultimately dependent on the level of utility capital investments, and the growth of those earnings dependent on the projected growth rate of those investments

Growth in utility investment requires infrastructure investments in excess of the rate at which the utility’s assets are being depreciated



Coal plants are likely dinosaurs, of sorts, and electric generation could move towards distributed sources, with electric storage and more interconnected grids



Low costs and service reliability are not simply “apple pie” politics, bones tossed to regulators, politicians and interveners, but rather are fundamental to the shareholders interests in obtaining a growth in earnings which will sustain a robust common equity price

The same goes for far sighted initiatives which might line up with political interests in alternatives to current electric generation technologies or the promotion of conservation – if they also line up with reliability and low cost



Development of new technologies, particularly in generation and storage could well line up with a shareholder interest in having more and new infrastructure investment opportunities– In the assets– Financing the assets



Shareholders need to worry about the very long run, and therefore need to concern themselves with assuring a management which has a strategy for continuing infrastructure investments which present themselves at a rate in excess of the depreciation of the current assets faster than would result from the mere stewardship of the existing systems under current technologies as today’s infrastructure catches up to current needs



Headroom Can the utilities get political headroom

for the rate increases needed for earnings growth?



Rates and Investments Could infrastructure investments

reduce usage to accomplish “purpose of use” enough to offset the per unit of use rate increases?– Supply side investments?– Smart grid?– Demand side opportunities?– Electric Storage?



How do investor owned utilities stay in the game if electric storage obviates need for new central station power, and reduces the importance of wires – are large electric storage facilities the electric industry’s wireless phone nightmare?– Can we help utilities stay in that new game?– How?

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©2012 Foley & Lardner LLP Attorney Advertising Prior results do not guarantee a similar outcome Models used are not clients but may be representative of