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Low Utility Returns Drive Convergence

Low Utility Returns Drive Convergence

Convergence is going to continue in the energy industry because it is what customers and financial markets want; the market signals are unmistakable, according to an industry representative and an investment funds manager.

"Today's market is incredibly punishing for those companies that do not generate sufficient rates of return," said Michael Kerr, senior vice president at Los Angeles-based Capital Research Corp., who offered what he called a "buy-side perspective" of the energy industry. "Part of the result is that the utility industry has not been competitive for capital in the last 10 years."

"The performance of the electric industry (in terms of average annual returns on investment) has been absolutely terrible by any measure," he told regulators gathered for the National Association of Regulatory Utility Commissioners (NARUC) summer meetings recently. "The fault is not necessarily with the people who run those companies, but the rates of return and the ability to grow earnings in that business has been unsatisfactory."

Kerr noted that rates vary for different segments, but for all segments, there has been a "failure to perform. So the utilities have failed to attract capital." Kerr manages about $500 billion in predominantly equity investments for Capital Research.

Gas pipeline companies have done much better, Kerr said, but that presents other problems in a consolidating industry. Electric utilities because of their size tend to dominate mergers, so gas shareholders may have to give up their stock for less valuable electric shares.

His buy-side view of the gas/electric industry is that total returns for energy industry companies are woefully inadequate compared to the S&P 500 companies. The average compound rate of return for S&P companies over the last five years was about 25% or twice the 12% generated by LDCs.

"What fascinates me over the 1980s and 90s is that in the utility sector the average returns are going down whereas throughout the rest of corporate America the average returns are going up. The outcome has been very unsatisfactory for the shareholders of U.S. utilities."

Convergence, cost-cutting, diversification and better or more targeted customer service are the avenues utilities are using to improve their image and their bottom-line.

"One of the reasons we are moving to convergence is to allow us to keep our revenue streams, and the fact is that we have to find better ways to optimize our asset base and provide services to our customers at lower costs," said Chris Helms, president of CMS's Panhandle Pipeline. More than 95% of his contracts are discounted and contract terms are shorter and shorter. This means he is in the marketplace every day.

Michigan-based CMS has run a combined gas and electric utility, Consumers Energy, for decades. In the last year it picked up two major midwestern interstate pipelines, Panhandle Eastern and Trunkline, and grew E&P activities and an energy marketing unit. "The fact is we live in a competitive world and we are right in the middle of it. It is truly a converging operation. We have gone from a local Michigan utility to a regional and national, international player.

"Our traditional revenue streams are going down over time. So, what we have to be is more innovative-do more with less at a lower cost. We've had to figure out ways to provide one-hour firm transportation service. We are moving into an environment where we need to be able to price to fit the market."

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