California shock Market Sleuth 11/10/00 2:30 PM By Tom Kerr

There's a $5.7 billion question mark hanging over California utilities right now, and nobody seems to know how to make it go away. It's a strange case that involves complex deregulation issues, politics, consumer rights, high energy costs, and even business ethics.

The three publicly traded utilities that represent the majority of California's electricity market are collectively holding an unusual obligation worth approximately $5.7 billion as of September 30. These companies are Edison International (EIX), on the hook for $2.4 billion; PG&E Corporation (PCG), owing $2.9 billion; and Sempra Energy (SPE), owing $350 million. Trying to settle these obligations could have enormous ramifications on each company in terms of bond ratings, future expansion and growth plans, and their ability to pay dividends.

When it snowballed

It all started back in 1996, when California passed landmark legislation deregulating the electricity industry in that state. Part of the legislation called for freezing consumer rates at an artificially high amount. At the time, it was supposed to be a tradeoff for both sides. Consumers had to deal with a rate hike, but one that was fixed and wouldn't increase for a number of years. The utilities got a new infusion of money that would allow them to pay down their stranded costs (primarily old nuclear power plants), but were handcuffed to frozen rates that didn't take inflation or rising wholesale costs into account.

And that's exactly what happened this past summer, when wholesale electricity prices skyrocketed throughout much of California, as much as five times higher than the prior year. High demand, plus a shortage of electricity generation capacity, were responsible for the spike. (No new generation plants have been built in California for over ten years.) Now, the frozen rates that used to be a boon for the utilities are weights shackled to their ankles as wholesale costs are exceeding what they're reaping in consumer rates.

Funny money

Right now this negative difference between wholesales prices and consumer rates isn't affecting earnings of these utilities because this cash deficit is being held in temporary limbo accounts, referred to by regulators as transition revenue accounts [TRA], and are financed by short-term bank loans, commercial paper, etc. Sound too good to be true? Welcome to the world of regulated utility accounting. Because this deficit is expected to be recovered in the near future, it doesn't have to be immediately expensed, and can stay off the balance sheet.

Utilities have to hope that wholesale costs fall dramatically below the frozen rate levels this winter in order to reduce their outstanding TRA balances. But that's a big gamble considering California's wholesale generation market. If the situation stays as it is and utilities get no relief in the form of falling wholesale costs or hiked consumer rates, then they'll soon have to incur long-term debt to pay back these short-term loans, and thus the shareholder equity on their balance sheets will take a hit.

If things got worse

How would a worst-case scenario affect the two leaders in the field? Edison International, as of June 30, had $4.7 billion of common shareholders equity. If Edison were forced to absorb that entire $2.4 billion in its TRA, it would wipe out roughly half of its shareholder equity. With over $17 billion in debt on the balance sheet now, this doesn't bode well for its current debt ratings. In fact, on September 14, Moody's changed its rating outlook on Edison to "negative," which means a possible downgrade is coming.

PG&E also received a change in rating outlook from "stable" to "negative" at the same time. PG&E had $7.4 billion of shareholder equity as of September 30, which would take a 39% hit if the TRA amount was forced to be recognized. Total debt already exceeds $10 billion, so I wouldn't consider this to be a stellar balance sheet.

What next?

No one wants to see the state's two largest utilities go bankrupt, but neither can the state allow consumer electricity rates to quadruple overnight. The California Public Utilities Commission is not in the business of deliberately tanking its two largest utilities, so some effort will probably be made to help them recoup some costs. But California is a very consumer rights-oriented state, and raising rates above the earlier agreed-upon level to basically pay for the industry's miscalculations is a very touchy political subject. So some sort of compromise will have to be reached.

A whole new ball game

Utilities were once considered a safe haven for the widows and orphans set -- a nice 5% dividend yield and maybe an additional 5% stock appreciation per year, if they were lucky. But one only has to look at the history of utility companies' investments in non-utility businesses -- such as banks, drug stores, and sporting goods stores in the 1980's -- to be convinced that executives at utility companies are ill-prepared to operate any other business outside one that is regulated.

And now with this newly unregulated and wildly competitive environment, investing in these companies would definitely be a dicey proposition unless they brought in more savvy management. One can only hope they can manage their way out of this current dysfunctional situation with their stock prices intact.

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-- Martin Thompson (mthom1927@aol.com), November 10, 2000