Utility Regulation, Then, Now, Tomorrow What You Need to Know to Understand How What You Do Fits Into the Utility Client

1. Utility Regulation, Then, Now, TomorrowWhat You Need to Know to Understand How What You Do Fits Into the Utility Client’s Business Success Allen W. Williams, Jr.

2. 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?

3. 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

4. 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?

5. 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

6. The Utilities’ Challenge: • 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

7. The Utilities’ Challenge: 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?

8. The Utilities’ Challenge: 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

9. The Utilities’ Challenge: • 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?

10. The Utilities’ Challenge: • 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

11. The Utilities’ Challenge: • 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?

12. The Utilities’ Challenge: 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

13. The Utilities’ Challenge: 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?

14. The Utilities’ Challenge: • 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

15. The Utilities’ Challenge: • 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

16. The Utilities’ Challenge: • 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

17. The Utilities’ Challenge: • 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

18. The Utilities’ Challenge: • 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

19. The Utilities’ Challenge: • 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

20. The Utilities’ Challenge: • 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

21. The Utilities’ Challenge: • 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

22. The Utilities’ Challenge: • 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

23. The Utilities’ Challenge: • 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

24. The Utilities’ Challenge: • 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

25. The Utilities’ Challenge: • 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

26. The Utilities’ Challenge: • 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

27. The Utilities’ Challenge: • Coal plants are likely dinosaurs, of sorts, and electric generation could move towards distributed sources, with electric storage and more interconnected grids

28. The Utilities’ Challenge: • 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

29. The Utilities’ Challenge: • 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

30. The Utilities’ Challenge: • 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

31. The Utilities’ Challenge: Headroom • Can the utilities get political headroom for the rate increases needed for earnings growth?

32. The Utilities’ Challenge: 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?

33. The Utilities’ Challenge: • 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?