SSB Warns of National Power Problems

The future is bright for investors in the power market, but rather dim for the nation's power users, Salomon Smith Barney (SSB) warned in a new report titled "The U.S. Electric Shock."

SSB said the power crisis won't be confined to California and the West for very long. Power shortages are going to spread to eastern states over the next few years not only because of delays in power plant construction but also because of delays in gas supply development and constraints on the gas pipeline grid.

"In our opinion, the investment community's media driven focus on California's electric power problems has led many to miss the bigger picture," the report stated. "The current U.S. economic weakness is masking electricity needs near term."

Current poor economic conditions mean power consumption from industrial customers, who account for 32% of the country's electric power usage, is below the trendline, according to SSB. As a result, reserve margins "look a bit healthier than they will once economic recovery ensues. Hence, we are likely to hear about more brownouts and rolling blackouts around the nation and not just Stage Three alerts in California. The warning signs are there but are being overlooked, in our view."

SSB said disparate state-by-state deregulation and the uncertainties surrounding timing and cost of fuel sources, have hindered generation construction. "[S]everal policies may be needed to encourage [generation construction], including allowing prices to spike short term as market forces act freely, creating incentives to speed new investment. In addition, environmental objections may need to be balanced against siting needs for new power plants. Some have even argued that pollution constraints may need to be relaxed near term so that coal-fired power can be used until the new gas-fired plants get completed."

Another thing to bear in mind is that forecasts have erred on the side of slower demand growth, SSB said. A key problem in the California crisis was that electricity demand had been forecast to grow only 1.8%/year by the North American Electric Reliability Council (NERC) in 1990. Annual economic growth in the state averaged 2%-3% while Californian power needs actually grew 4%-6%.

Reserve margins are plummeting nationwide. In the early 1980s, reserve margins nationwide got up to 30% but now have dropped to about 15%. New England, New York, New Mexico, Arizona, and southern Nevada in particular are areas of concern. "These areas are regions where generation reserve margins are not sufficient enough during peak load conditions usually associated with extended heat waves, but this does not fully build in the potential for industrial recovery, in our opinion. States in the Southeast, the Midwest, the West, and the Pacific Northwest could be affected by electricity shortages."

Recovery of the chemical industry also could trigger power shortages. Chemical processing alone accounts for nearly 10% of the nation's electricity use. States such as Texas, Oklahoma, Louisiana, and New Jersey would be most affected by a recovery in the chemicals sector, which is down 20% year over year currently.

"The Southeast could also be hit if the paper industry recovers," SSB said. "Moreover, should smelters be put back into production, we think that the Pacific Northwest and Arizona could experience additional power pressures. Plus, if manufacturing rebounds, the Midwestern U.S. could face challenges."

Another major hurdle will be continuing the transition to an electricity superhighway through formation of regional transmission organizations. Currently, 33% of electricity users are being served by an RTO with another 22% waiting for approval, according to the SSB report. By the end of the 2001, it is likely that as much as 80% of U.S. customers will be served by RTOs. The existing system, however, wasn't built to be a superhighway. It was meant to deliver supply from a generating facility to a set of customers, i.e., point to multi-point, not multi-point to multi-point. "In 1995," SSB said, "25,000 inter-regional transactions took place and that number hit two million in 1999; thus, many transmission lines are basically 'maxed out!' Thus, access to power becomes questionable."

One other factor is that FERC cannot use federal eminent domain powers to push through construction of power transmission in the same way it pushed through gas pipeline construction. State and local regulators have considerable control over the power transmission system. As a result energy policy changes are needed in this area on a broad scale.

NERC estimates that more than 10,000 MW of generating capacity will have to be added nationally every year through 2008 just to keep up with the 1.8% annual growth forecasts, "which could easily be too low," according to SSB. New gas wells, pipelines and power transmission lines must be built to keep up with the growth, and generators will need open access to the grid. A lot of work clearly needs to be done in a short period of time.

For information on the report, contact Salomon Smith Barney at (212) 428-5200.

Rocco Canonica

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