TRANSFORMING THE POWER BUSINESS THE BLOATED, 120-YEAR-OLD ELECTRIC POWER INDUSTRY ISN'T JUST BEING DEREGULATED--IT'S BEING REVOLUTIONIZED. THE IMPACT ON BUSINESS WILL BE HUGE.
By BRIAN O'REILLY

(FORTUNE Magazine) – It seems so incredibly obvious you want to slap your forehead for being so obtuse all these years. Electric power costs a bundle in places like New York and California but barely a third as much in out-of-the-way states like Idaho, West Virginia, and Kentucky. Why not take all that cheap power the West Virginians aren't using and ship it to Manhattan, Chicago, or San Francisco?

That, vastly oversimplified, is the idea behind the move to deregulate the electric power industry: If your power company is charging too much for electricity, why should you be forced to accept it? Why can't you shop around? Why can't a power company from Pocatello knock on your door and offer a bargain kilowatt or two?

It's coming. There will be far more competition in the electric power business. It is reasonable to expect that deregulation will cause the nation's $212 billion-a-year electric bill to drop by 20% to 30% or more in the next five to ten years. But not before a vast tangle of technical, economic, and political problems gets solved.

If it works, and it should, the consequences will be enormous. "Electric power is the biggest American industry ever to be deregulated," says Kenneth Lay, chief executive of Enron, a big, aggressive gas and electricity marketer that has led the drive for deregulation. "It's about twice the size of the long-distance telephone business and dwarfs the gas, airline, trucking, and railroad industries, which were all once regulated." The average homeowner, who uses about $850 worth of power a year, won't be financing trips to Bermuda with the impending savings. But the potential savings for business are huge: Electricity can account for more than 15% of operating costs for a big company such as Chevron, which spends about $250 million a year for power in the U.S. Lay notes that industrial and commercial companies consume about 60% of all power sold. "The billions they stand to save will boost corporate profits and make American companies more competitive internationally," he says. (The upheaval in this once-staid industry will hit investors too: Owning utility stocks isn't just a matter of waiting for dividend checks anymore. For a look at how electricity deregulation affects the market, see Personal Fortune.)

All this is small comfort for the big, often bloated electric utilities, which have lived a long, comfortable existence as regulated monopolies. Already the prospect of deregulation is prompting much moaning and groaning, and with good reason: Deregulation will force many utilities to become far smaller. They will have to sell off some or all of their brawniest assets--those massive generating plants--and make a living mostly by operating the wires that run to homes and factories.

BUT WHAT ABOUT GRANNY?

Naturally, utilities are piously declaring that they relish the bracing winds of competition. But with barely a pause, they urge caution, hinting darkly at the havoc any rapid move will bring to this complicated, delicate industry: grandmothers stuck in elevators, hucksters who won't deliver the juice you need on a hot night, novice power plant owners frying transmission lines as they greedily try to ship power to places that can't handle the load.

If the electric power industry is doomed to collapse in a shower of sparks, we'll find out soon enough. Regulators in California defied the Cassandras and declared that everybody can buy power from anybody, starting next January. Already advance men from all over the country have descended on the state. None seem particularly worried they'll be stuck in elevators.

If anything, the electric business will run better than before, says Michael Peevey, former president of Southern California Edison, one of the biggest utilities in the country. Under the existing scheme, electric companies go virtually unpunished for power failures, Peevey says, so power outages are far from rare. But Peevey noticed that when a Cal Edison subsidiary built and operated power plants for private customers and was penalized for down time, the plants ran smoothly 95% to 97% of the time--considerably better than Cal's regulated plants. "That's when I began to have creeping doubts about the wisdom of regulation," says Peevey. "I was like a fallen Catholic. I no longer believed." He quit and now runs New Energy Ventures in Los Angeles, which plans to help companies buy inexpensive power.

A QUIRKY INDUSTRY--REALLY

Not that anybody really knows how all this deregulation will work out. For all its apparent blandness, this is, believe it or not, a varied, quirky industry. Unlike the old Ma Bell, which seemed to spawn seven clones of itself at breakup time in 1984, each of the nation's 198 investor-owned utilities seems markedly different from the others in operations, culture, oddball problems, and long-range financial prospects.

How different? Ohio-based American Electric Power runs gigantic power plants right near coal mines in Ohio, West Virginia, and Kentucky, with boilers so vast they can fit the Statue of Liberty inside. Consolidated Edison in New York City has to run almost all its wires underground, at a cost eight times greater than stringing them on poles. Cinergy, an aggressive midsized utility in Cincinnati, is determined to be one of the five biggest energy traders in the country.

It's hard to say which private utilities will thrive. Each state will devise most of the rules governing the deregulation--and the fate--of its own utilities. In most states, though, regulators have barely begun to tackle deregulation. (The 3,000 or so electric cooperatives and government-owned utilities will be affected by the changes sweeping the industry, but they're exempt from deregulation.)

So in the absence of any simple declarations about the electric power business, herewith a guided tour of the problems, issues, and peculiarities of this soon-to-be-transformed industry.

LET'S REDECORATE!

One of the infuriating practices of most utilities has been their failure to economize. Why should they? Regulators routinely allowed them to earn a fixed rate of return on their assets. The result was a perversity known as "asset-based management." The more money a utility spent adding generators and other assets to its local power system, the more money the company made. Thus, for instance, cost overruns on nuke plants didn't cause too many sleepless nights for executives. Michael Peevey says overruns on Cal Edison's nuclear plants "doubled our assets and doubled our earnings." (As the CEO of Wisconsin Power & Light, Erroll B. Davis Jr. once remarked, "This is the only business in the world where you can increase your profits by redecorating your office.") Such gold plating should stop as competition heats up in the industry, particularly with generating equipment.

"BUT WE HAD TO BUILD IT"

The great nightmare for many utilities is what to do with all their high-cost plants once competition begins. It's not a problem now, when every home and business in a power company's franchise area has to pay for the power regardless of price. But Con Edison has an old generating station in Manhattan that produces power at an absurdly expensive 11.7 cents per kilowatt-hour; other utilities run nuclear plants whose kilowatts cost almost as much. What will those plants be worth if someone else can make power for 3 cents and send it to New York? If a plant becomes worthless because competitors can undercut its costs, do Con Ed's stockholders eat the loss, or will Gothamites?

Sorting out which costs were truly wasteful and how to pay for the rest is a major hot potato for state legislators and regulators and will probably delay the full effect of deregulation for years. Rather than label these costs "the tab for our boneheaded overbuilding," utility execs conjured up the academic-sounding term "stranded costs." They tend to blame 1970s-era federal policymakers, who encouraged nuke plants after the Arab oil embargo.

The bonehead/stranded stakes are huge. Early estimates of the write-downs utilities will have to take when competition makes many of their assets and supply contracts uneconomic range from $100 billion to $400 billion. In August, California-based Pacific Gas & Electric surprised many observers by paying above book value for a handful of generating plants sold by a New England utility. But that high price may be an anomaly: Problems at nearby power plants have caused a power shortage in New England, driving up the price PG&E can charge when it sells power to other utilities in the area. It's still not clear who'll pay what for old power plants as they come on the market, but Kit Konolige, an analyst at Morgan Stanley, says power generation assets may concentrate among a few huge companies.

THE VISIBLE, CLUMSY HAND

This won't come as a surprise, but in the past utility regulators occasionally goofed bigtime. About 20 years ago federal regulators mandated that certain kinds of new, private, unregulated generating companies (known as nonutility generators, or "NUGs") could sell their power to utilities. New York regulators foolishly declared that its utilities had to accept power from anyone who charged 6 cents or less. Scores of sharpies quickly calculated they could make power for far less, and forced 20- and 40-year supply contracts on New York utilities.

Now, with power sometimes available on spot markets for just 2 cents, power companies are screaming bloody murder. Con Ed in New York says the contracts are costing customers $530 million a year. Niagara Mohawk, an upstate power company, says the contracts nearly pushed it into bankruptcy. Before competition can begin in New York, utilities argue, they must be relieved of their overpriced contracts. As with uneconomic power plants, New Yorkers will be asked to pay up, probably through state-issued bonds; rate payers in California and other states can expect the same. It will cost billions.

REGULATION WAS OKAY...ONCE

Regulating utilities wasn't always a dumb idea. By the late 1920s, 50 years after Edison invented the light bulb, the industry was a mess. Three big holding companies controlled half the power made in the U.S., and another 13 companies held an additional 25% market share. Often they were byzantine in complexity and dubious in ethics: Subsidiaries paid huge management fees to their parents, asset values were inflated by sales from one subsidiary to another, and companies often issued worthless stock. Many collapsed in the 1929 stock market crash. In 1935 Roosevelt stepped in, breaking up the multistate holding companies, limiting power companies to compact, contiguous service areas, and preventing unregulated companies from selling power. Hit by both the Depression and more effective regulation, average power prices, which peaked at 32 cents per kilowatt in 1932 (in 1992 dollars), declined steadily for more than 40 years before rising again.

A MARKET EXPLODES

Even now, if you think your local utility is charging too much for power, you have no choice but to pay for it. By law, nobody else is allowed to sell power to you. Frustrating, eh?

Utilities themselves had a similar problem. When utilities can't or don't want to generate all the power their customers need, they often buy surplus power from other utilities. Problem was, the neighboring power company didn't have to sell. It didn't even have to transport power from a faraway utility if it didn't want to. So if a utility in, say, Tennessee, offered cheap electricity to a power-hungry utility in Florida, and asked a utility in Georgia to transport the electricity, the Georgia utility could refuse--and offer Florida its own, more expensive juice instead. All that began to change in 1992, when Congress ordered privately owned utilities to allow "wheeling," or transporting power from one utility to another across a third's transmission system, if it had enough capacity.

And the market for wheeled power exploded. There is an oversupply of generating capacity in much of the country, but the complexity of shutting down and starting up a power plant means that many have to run constantly, even if customers are few. Therefore, lots of power gets dumped on the market for far less than the average cost of production.

Experienced commodity traders, notably Houston-based Enron, jumped into the act. Enron, formerly a regulated gas pipeline company, made a fortune when the pipeline industry was deregulated in the early 1980s. Because many big gas buyers are electric companies purchasing generator fuel, Enron already knew the players and the market.

Now Enron traders are on the phone 24 hours a day, calling up power plant operators to see who needs power, who's selling it, which transmission lines are at capacity. They can slice a gigawatt of power into pieces and sell the parts faster than an Omaha hog butcher. A utility needs a steady 50 megawatts per hour all day tomorrow? Sold. Need 400 megawatts of reserve capacity in case a generator goes down next week? Got it. All kinds of companies have joined the fray--utilities, Wall Street firms (see box)--but utility executives seem to be in particular awe of Enron, which now buys and sells more power than anybody.

TECHNICAL DIFFICULTIES

On a map it looks so straightforward. The cheap power is made over here, in coal country; the big city over there is paying a fortune for its power. Can't they send a bunch of econo-gigawatts from the Midwest to New York? Yes, but not easily. Electric utilities all over the country are interconnected. Alas for would-be marketers, this interconnectivity was designed as a way to back up neighboring utilities during emergencies, not as a way to move power easily over long distances. Electricity can't be routed to a particular place like a phone call, and a lot of power gets wasted as heat when it's transmitted over long distances. As a result, a lot of the anticipated price competition among generators won't develop until delivering power gets easier.

Think of all those big overhead transmission lines as a web of interconnected lakes and canals, not as a switched telephone network. Dump enough extra water in your lake, and eventually water levels rise for everybody. Usually.

Say Cinergy, in Cincinnati, agrees to sell extra power to the New York Power Pool (a confederation of interconnected utilities), which sees a heat wave coming. Cinergy starts making more power than its own customers need. On paper, Cinergy's surplus power travels through Dayton Power & Light's wires, then on Ohio Edison's, then over Duquesne Light's, through the Penn-Jersey-Maryland (PJM) Power Pool's wires, and into New York. In reality, however, the power flows willy-nilly wherever it wants--usually over the path of least resistance (but sometimes on to a neighbor's already-full wires, causing them to overheat, and prompting a mad scramble by the neighbor to shut down generators and reroute power). Often, most of Cinergy's surplus power wanders into the lines owned by neighboring American Electric Power (AEP), whose turf extends toward Pennsylvania, eastern Ohio, and Virginia. The people at AEP, however, are displeased. Under current rules (no pun intended), Dayton Power and all those other utilities will collect a fee for carrying the load, even though most of it goes through AEP. "It's a pain in the neck," says E. Linn Draper Jr., AEP's CEO.

This is not a trivial problem. Since many utilities will have to sell their power plants and make money operating power lines, how will they be able to charge for wheeling a neighbor's power? Can they charge extra at times of peak demand? No final decisions have been made.

$32 MILLION PER MILE

If you think driving in New York City is tough, try delivering electrons there. Geography, history, and politics have made the place a power wheeler's nightmare. It sits at the bottom of funnel-shaped New York State, and all the upstate and out-of-state transmission lines that could bring cheap power must go underground at Yonkers, just north of the city, or run through tunnels under the Hudson and other rivers. So even if there are gigawatts of cheap power available elsewhere, little of it can make its way into the city. On a hot day, Con Edison needs 11,000 megawatts of power but can import only 4,500 and must generate the rest in the city.

That helps keep residential prices in New York City, now 16.2 cents per kilowatt, the second highest in the continental U.S., after nuke-beleaguered Long Island. Con Ed, like utilities in many big cities, can't burn cheap coal for environmental reasons and must use natural gas or low-sulfur oil. In addition, its generators are inefficient, and it pays a ton in state and city taxes. Why not just build more transmission lines? "It's easier to get permission to build a new generating plant than a new transmission line," says Jack Feinstein, a Con Ed vice president. Cheaper too: Running a new 345,000-volt power line underground from Yonkers to midtown Manhattan would cost $650 million, Feinstein says.

California has similar problems. Nearby states produce vast amounts of cheap power, but California has only two major links with outsiders: a tangle of wires coming down from Oregon and another link that runs from Arizona toward L.A. Only 12,000 of the 40,000 megawatts California needs during peak demand can come from out-of-state generators.

CALIFORNIA DIVES IN

On Jan. 1, Californians will be able to buy power from anybody who offers it. That puts California way ahead of almost all other states, which have, at best, allowed a few trial programs. But getting California utilities to sign on to the plan and drop threats of lawsuits required political horse-trading that exacted a high price: direct, producer-to-user price competition will be thwarted for years.

Here's what's happening in California. First, to make sure the state's utilities don't overwhelm would-be competitors on the generation side of the business, regulators have pushed the utilities to sell off their gas-fired generating plants. California also rolled back rates the big private utilities can charge homeowners to what they were in June 1996. At about a dime, that's better than the 12 to 13 cents Californians had been paying, so complaints are few. Lower rate freezes apply for commercial and industrial customers.

Are the utilities screaming? No, because regulators also devised a process to help them recover losses on those "stranded," or devalued-by-competition, assets. Their costs will drop sharply in the next few years. Remember that California utilities, like others elsewhere, were forced to sign contracts for overpriced power generated by independent producers; many of these contracts were already due to expire in the next few years. If, as expenses drop, it then costs the utilities, say, only 7 cents to deliver a kilowatt, they get to pocket the 3 cents and use it to write off their overpriced, stranded assets. They have four years to make, buy, and deliver power as cheaply as possible. In 2002, the fixed price disappears, and California's big three utilities--Southern California Edison, Pacific Gas & Electric, and San Diego Gas & Electric--will have a harder time recovering any remaining stranded costs. (Some version of California's plan will probably be adopted in other states.)

"Whoa," a California resident might say, "now that I can buy from anybody, why can't I buy some of that 2.5-cent power, instead of the 10-cent stuff from SCE or PG&E?" Simple. That 2.5-cent or so cost of generating power is only about a quarter of your total bill. The rest is pretty well fixed. The new laws say California homeowners will still have to pay their utility for: transmission (0.7 cents), the wires and poles distributing electricity to your house (2.4 cents), and state-mandated help for the poor (0.1 cents). Billing and other services typically add another 0.4 cents. And everybody will have to pay an additional 3 to 4 cents to help the power companies pay off their stranded costs.

CALIFORNIA AUCTION

Even if you wanted to, you might not find cheaper electricity. Under the new rules in California, that power company in Utah with cheap electricity has no incentive to sell it to you at a bargain. More likely, those in Utah will get a better price by selling it to the soon-to-be-created California Power Exchange (PX), a nonprofit clearing-house mandated by state officials.

Here's how it will work. Every day, the PX will take bids on the power it will need for each hour of the following day, and take the cheapest power offered. Anybody can buy or sell on the exchange. However, California's three big utilities must sell and buy all their electricity through the PX.

Let's say that a company we'll call Cheapo Electric offers and sells ten megawatts of power at a penny per kilowatt for 7 a.m. the following day. But for 8 a.m., demand is expected to rise to 15 megawatts. Cheapo won't be able to provide enough one-penny power to meet all demand, but Outtastate Heat & Light offers the additional five megawatts at the next lowest price: 2 cents. Under the PX rules, both Cheapo and Outtastate get paid 2 cents for that hour of power, even though one offered power at a lower price.

By 3 p.m., with hot winds blowing in off the desert, California will need all the power it can find, and the out-of-state transmission lines are full. So ElectroGouge Illuminating, a startup that bought old, inefficient power plants when the California utilities auctioned them off, offers $1.50 per kilowatt. If the PX pays ElectroGouge $1.50 per kilowatt for that last bit of power, everybody else, even Cheapo, will get paid $1.50. So in one day, exchange prices have fluctuated between $0.01 and $1.50.

LOWBALLERS FRUSTRATED

The Power Exchange is not great news for Enron, PacifiCorp, and other big power providers that hoped to come to California, offer cheap out-of-state power, and develop a cozy relationship with big industrial customers. Indeed, the PX is another inconvenient product of politics, a stopgap measure to help utilities cover stranded costs. "It will not be easy for a customer to beat the PX price," says Alex Miller, vice president for California operations at PacifiCorp, an Oregon utility with coal plants in several Western states. That's because with Edison and PG&E buying from the PX and tacking on the same transmission and stranded-cost charges as other providers, everybody's price will be about the same.

Lincoln Anderson, the head of Enron's operations in California, is rethinking how Enron will attack the California electricity business. He can't succeed for now, he says, by treating retail electricity as a commodity to be sold at the lowest price. Instead, Enron intends to build relationships with customers by delivering energy-related services. They can, for instance, finance and install new heating, cooling, and lighting equipment.

California's retail electricity business will change sharply in 2002, though, says Anderson. By then prices will move freely. The 3- or 4-cent surcharge to help the utilities pay stranded costs will disappear, and the PX may be disbanded. With rapidly fluctuating prices, he says, Enron will flourish. Want a guaranteed flat rate per kilowatt for two years? Want one contract price for your factory's steady electric load, and another that limits the top price you'll pay per kilowatt during peak periods? Enron, and others, will offer that.

BE PREPARED

Negotiating megawatts with a beady-eyed Enron trader won't be much fun for the average corporate facilities managers. So get ready now, says Catherine Luthin, a consultant whose work includes managing Columbia University's $11-million-per-year electric bill. Big commercial and industrial power users should analyze how their buildings and factories use electricity, she says. "You should have at least a year's worth of data, gathered in 15-minute increments." Most utilities will collect the information for a small fee. Of what use is this data? Power prices will probably fluctuate wildly, every hour, once competition starts. You may have negotiated a flat fee with Enron for up to two megawatts of power a day, but could have to pay a fortune for anything extra you use on a hot August afternoon. By studying how and when each facility uses electricity, a company will know how to cut power consumption appropriately or negotiate favorable power-supply contracts. Several firms already sell software that helps companies analyze their electricity usage.

THE MIGHTY MICROTURBINE

If you think the utilities get to relax once they've sold off their generators, cozy in the thought of all those billions' worth of power lines running down Main Street, you're wrong. There is a new threat: the microturbine.

In big cities, where the cost of providing electricity on wires below ground is eight times higher than providing it on poles, an overwhelming portion of every customer's electric bill is for distribution--the wires connected to your house or office. What if you decide you don't want to pay those distribution charges anymore?

AlliedSignal, the jet engine and auto parts company, hopes you will detach from the power lines and make your own electricity. The company has developed a line of small generators, including one for $15,000 that can produce power for 3.5 to 4.3 cents per kilowatt-hour. It appears to be a masterpiece of simplicity: a turbine, with one moving part, that emits virtually no noise or pollution and can burn natural gas. Heat from the exhaust can be used to boil water or warm a building. It probably won't be economical for a home, but a Taco Bell stand in Brooklyn, say, which probably uses 75 kilowatts an hour, could pay it off in two years, claimsTony Prophet, an Allied executive.

Executives at Con Ed pooh-pooh the threat. New York real estate is too valuable to waste on generator space, says one. Apartment dwellers wouldn't want a high-pressure gas line running to a rooftop generator, scoffs another. Con Ed's counterpart in Chicago, however, is not so sanguine. When the Allied generators are mass-produced next year, Commonwealth Edison's parent company will have an exclusive franchise to sell them in the territory of all rival utilities in ten neighboring states.

The electricity business hasn't changed much over the past 60 years, so it isn't surprising that there is still a strain of denial among those--certain utility officials in New York, say--who'd rather see things continue as they were. But when a supposedly quiescent, fossilized utility like Commonwealth Edison contemplates assaulting its neighbors, it seems inevitable that competition will wring every inefficiency from this long-protected industry. This is a revolution, it's already begun, and it's about time.