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RIMCO STRATEGY: WOLF IN SHEEP'S CLOTHING? A number of electric utilities are beginning to implement a strategy that seeks to position the corporation as a regulated infrastructure company, or RIMCO, in the post deregulated world. To paraphrase an old Saturday Night Live skit showing an interview with a baseball player, the RIMCO strategy seems to be saying "Regulation’s been very, very good to me." On its face, the strategy presumably is an attempt to maintain the lowest risk profile possible in the new competitive environment. The reality, however, could be that the RIMCO strategy is a very high risk strategy masquerading as a low risk measure, inasmuch as it seems to contemplate little change in the future rate regulatory environment for companies remaining under regulation. Our hypothetical electric utility Let’s first understand what is meant by the RIMCO strategy by creating a hypothetical company. Consider ABC, Inc., a large electric utility holding company. It has the traditional forms of business: generation; transmission and distribution, and has all of the appropriate financial ratings, but with essentially flat earnings growth over the past several years. In addition, the company has made a number of disparate independent power investments, primarily abroad, which were largely "targets of opportunity," rather than elements of an overall portfolio strategy. A new CEO is appointed by the board and inherits this collection of business units. Our new CEO, who "grew up" in the operations of the distribution company, is extremely concerned about the risks associated with the impending deregulation of his marketplace. He summarizes his circumstances as follows:
He views the core competencies of his company as: 1) managing the rate regulatory process; 2) community relations; and 3) engineering infrastructure expansion within a regulated investment context. His experience tells him that reliance on generation, particularly nuclear generation, has been a mistake for his company in the past. He knows he does not understand (or have the in-house expertise to manage) a competitive environment on any front. His generation personnel are not staffed to compete in a merchant plant environment, and there is no expertise whatsoever in providing energy related services or commodity sales. While recognizing that there may be foregone opportunities, he chooses to eschew the competitive world and accept the lower, but far more assured returns available to him in the regulated rate base. New investments in infrastructure, then, provide the foundation for earnings growth: acquisitions of more infrastructure provide the vehicle for earnings growth. The RIMCO Strategy Within a few months of his assumption of command, Mr. CEO announces the following strategy:
The underlying assumption in this strategy is that regulation continues, more or less unchanged, into the foreseeable future. Therein lies the strategy’s potential fatal flaw: ABC may very well find itself operating under regulatory constraints that are governed by standards established by unregulated entities. Why? Performance Based Rates (PBR). If ABC fails to prepare for this new regulatory environment – by taking the many of the same steps that would have been necessary to prepare its businesses for unregulated competition – disaster is likely. PBR (sometimes called "Incentive Based Rates") is a concept that has been around for over 15 years, albeit in relatively few jurisdictions and usually to resolve specific local issues. Initially, PBR was established as an alternative to the growing, costly and time consuming prudence reviews relating to nuclear and other costs. Rather than conduct lengthy hearings on the appropriateness of investments and expenditures, simply let the regulated company live within a range of predetermined costs: if costs are exceeded, penalties ensue; if costs are reduced, the entity keeps its "windfall." Performance Based Ratemaking PBR is very likely to become mainstream regulation for the remaining regulated entities, post deregulation, precisely for the same underlying reasons that caused its implementation in the first place. Until the late 70’s and early 80’s, most electric utilities secured growth in earnings by growing the "ratebase" – that sum total of invested capital in the system. Big increments to the ratebase, with relatively assured recovery over time formed the foundation for their equivalent of a growth strategy. The environment of the old "regulatory compact" incentived utilities to fully embrace nuclear power. What could be more attractive than a multi-billion dollar addition to ratebase, extended over a 10 year construction period and a 30 year operating period, than a nuclear unit? Particularly when the regulators not only authorized the total investment in rates, but also the interest on the capital necessary for construction. When construction costs way exceeded budget, or when operations became far more costly than expected, regulators turned to their only available tool – prudence reviews. If we look to the mid-2000’s, how do our new RIMCO’s intend to grow their earnings? Through infrastructure capital additions to the ratebase. The experience of RIMCO management tells them that, of all the investments they made in the past, even after the era of prudence reviews, T&D infrastructure capital was a shoe-in for rate recognition. The ingredients will therefore be present to repeat history. Regulators know this, or will come to know this, once their all-consuming efforts to define restructuring and deregulation are completed. Regulators will also find it necessary to figure out what their role in the new world will be as well. Regulators may find salvation in PBR. Potential features of PBR So what might PBR mean for the RIMCO? One insight into how regulators are beginning to think about RIMCO regulation can be found in a report entitled "Performance-Based Regulation in a Restructured Electric Industry," published by the National Association of Regulatory Utility Commissioners (NARUC). A web address for the report is given at the end of this article. Service Quality Service quality is a key ingredient to PBRs. These standards allow the regulator to ensure that adequate incentives exist to ensure a quality and level of service is maintained for all customers. The NARUC report recommends that service quality be evaluated utilizing the following six criteria:
It further recommends that the PBR structure develop penalties (and no rewards) based on:
The final bullet above is not so far fetched. In the new competitive environment, an information technology system that can identify hourly uses of electricity and accommodate frequent changes in retail suppliers will be necessary. This IT system will therefore enable a micro examination of circuit reliability with some ease. What’s very important to the ABC in this monitoring of service quality, is how "peer performance" is defined. In the post deregulated world, many of these services will be provided by other than regulated service companies. To the extent that regulated companies outsource elements of their delivery business (customer services, metering, billing, distributed generation, maintenance of infrastructure, etc), the peer group, either directly or indirectly, will include entrepreneurial firms that are, indeed, competing in the unregulated environment. These service companies will be aggressive, competitive companies with strong customer service objectives combined with least cost operations. ABC believes that it need adopt a competitive culture (which will entail hiring significant help from the outside and a wholesale reevaluation of how current regulated operations are conducted) because it believes there is shelter to be found in regulation. If ABC is very likely to be evaluated, at least in part, by comparisons with unregulated service companies, can it take the risk of not adopting unregulated company cultures and expertise? The RIMCO and generation. The NARUC report recommends that the RIMCO make use of distributed generation within its territory, both to encourage cost effective operations and to ensure a proper balance of market power between the distribution company and unregulated generation companies. As a consequence, the report suggests that PBRs should allow for:
ABC currently has no expertise in distributed generation because it viewed the technology as part of the competitive environment it seeks to avoid. It’s RIMCO strategy has caused ABC to largely ignore distributed generation. Those companies that have experimented with distributed resource technology have learned that it is not a spectator sport, requiring significant, hands-on experience for cost effective utilization. Failing to embrace this technology early, and well before PBR, might very well cause ABC to face penalties for several years until it has made up lost time. RIMCO Integrated Resource Planning NARUC recommends that distribution integrated resource planning (DIRP) be required of the RIMCO in a post deregulation regulatory environment. DIRP should encourage:
ABC thinks that its new regulated business will consist largely of planning and installing additions to the wires system in the old integrated utility context: line upgrades; extensions; new customer hookups; and construction of substations. Further, it anticipates that regulatory treatment of this capital is assured. Because ABC considers energy efficiency measures (aka, DSM ) as the purview of the unregulated, competitive companies, it has long since let go those few individuals within the company that understood this business. When combined with the absence of expertise in distributed generation, ABC is very likely to fail to consider alternatives to the traditional means of expanding the infrastructure to meet load growth. Regulation provides no shelter ABC regards its RIMCO strategy as a convenient way to continue to collect a relatively secure return on investment by avoiding the unregulated, competitive market. If PBR does come to pass in any significant way, a company’s performance in service quality and their implementation of DIRP will, in some fashion, impact those "relatively secure returns," perhaps significantly. Whether competing directly in the marketplace, or competing indirectly by virtue of PBR standards, the ABC will compete. And as such, ABC will have to accept the cultures and risks of a competitive enterprise. Survival PBR and its ramifications are still just a concept in virtually all jurisdictions. As PBR evolves, ABC and other companies that regard themselves as RIMCOs will have time to evolve, as well, and there is every reason to believe that some will make the changes necessary to survive. Our CEO at ABC may even be right about his company’s competence in managing regulators, thereby indefinitely delaying or avoiding altogether PBR. Prudent management in non-hypothetical energy companies must examine the long term view. Pursuit of the RIMCO strategy might be appropriate for some companies, provided that they recognize that it is very unlikely they can avoid the adoption of competitive cultures, acquisition of talent outside the industry, and deployment of distributed and other emerging technologies. Without this recognition, the RIMCO strategy represents high risk. For ABC and others, RIMCO could easily be the proverbial wolf in sheep’s clothing. The NARUC report can be viewed at: http://www.naruc.org/Publications/PBR%20Report.htm. Gerry Runte is Director of Strategic Planning and M-C Power Corporation’s Eastern Regional Office in Bernardsville, New Jersey. Before joining the company in 1997, he spent 21 years in nuclear fuel procurement, regulatory and legislative affairs, new product development and strategic planning for a major utility, where he had primary responsibility for fuel cells beginning in 1991. Gerry also serves as a board member of the U.S. Fuel Cell Council and the Fuel Cell Power Association. Gerry Runte |
