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Deregulation, Convergence Trends Grow Hand-In-Hand

Issue 7 and Volume 102.

Deregulation, Convergence Trends Grow Hand-In-Hand

By Ann Chambers, Associate Editor

Giant One-stop Energy Providers are Multiplying as Deregulation of the Electric Power Business

unfolds. The Btu convergence spawned by power deregulation dogging the heels of earlier gas industry deregulation is at the heart of an unprecedented series of proposed and completed mergers between natural gas pipeline/distribution companies and electric utilities. A stream of mergers, partnerships, alliances and other cooperative agreements is running rampant throughout the industry–the brand new Btu industry that is. As industry lines, and corporate lines, continue to blur and blend, those who are watching need scorecards to keep track of the players. A pencil with a good eraser would come in plenty handy, too.

Gas and electric companies seeking to join forces are experiencing growing pains along the way, as regulators take a close look at the altogether new, converged Btu business sector that is emerging.

“Ours is no longer a project business,” said Joseph Sutton, Enron International president and CEO. “We`re working on a vertically integrated energy industry. When we go into markets now, we look at what the economy`s long-term growth might be.” Convergence has ramifications for finance, development, engineering and operations. Survival requires a thorough understanding of these ramifications, plus the prerequisite strengths of a talented team and a long-term corporate commitment to a growth plan. Risks of failure are high. New strategies are needed to produce rewards adequate to justify the risks. As in the past, companies that are innovative, aggressive and persistent, with a long-term business approach, will succeed.

Selling energy and related services by the Btu promises to be the largest competitive U.S. enterprise spawned by the wave of deregulation that started in the 1970s.

With annual revenues approaching $300 billion, the Btu business will be larger than either airlines or telecommunications. As is frequently noted, electricity is the largest industry ever to be deregulated. As a result, regulators are being extra cautious to ensure that they don`t create a monster of anti-competitive giants with the potential to dominate regional electricity markets.

“Standing still in a deregulating industry is not a very smart position to take,” said Bill Coley, Duke Power president. “When we contemplated a future as a vertically integrated electric utility company, with competition coming in and eroding the franchise, we were not in a position where we could stand still and survive for long.

“Clearly, the first thing we needed to do was learn how to effectively trade and market various forms of energy, like coal, fuel oil and natural gas, not just electricity.” Duke first attempted to fill in gaps from within, but soon discovered that it was going to take too much time and energy to grow core competencies into all aspects of the Btu stream. Duke struck alliances to increase knowledge in a few key areas, then went after a merger with PanEnergy to secure a stronghold in natural gas.

“That`s not to say that our `gas-electric` merger is a silver bullet that`s going to solve all our problems,” Coley said. “We think our ability to bring various sources of energy together–or converge them–over time, location and form is the best way to serve our customers and grow our business.”

Duke is looking to use the heightened value of peak power over off-peak power to its advantage. “The energy companies that know how to simply take off-peak power and sell it during peak periods, will capture a tremendous amount of value by utilizing this time differential,” Coley said.

Duke is also using location to its advantage, storing gas in the Northeast and Midwest in the summer when the fuel is cheap and converting it to electricity in the winter when its value is at a premium. Moving gas and electricity from a region that enjoys low prices to a higher price region can also add margin. “For all intents and purposes, we move Btus in different forms from North to South and from West to East, adding value along the way,” Coley said.

Despite huge profit potential down the road, making money as a combined power and gas company may prove elusive at first. This is due in part to the premium being paid by the acquiring companies and also because the market is so new that no one is certain of the best way to tap the profit potential. Thus the smattering of pilot programs and customer choice offerings as utilities seek to find their way in the murky waters of restructuring.

The merger trend began in earnest in 1996 and the announcements continue to roll in as companies scramble to gather the resources necessary to become total energy providers.

Natural Gas Came First

Natural gas preceded electricity in the move away from rate-based, cost-of-service regulation in the United States, but the restructuring of the natural gas industry is not yet complete. In addition to fine-tuning the federal initiatives that started the process, the application of FERC Order 636 principles to promote competition and customer choice behind the city gate is a very active arena. Also, implementation of FERC Orders 888 and 889, which started the restructuring of the wholesale bulk power market, is yielding innovations useful to the gas industry and its regulators.

Although the gas and electricity markets have organizational and operational idiosyncrasies, the principles of a competitive market apply to both. The gas industry model of functional and services unbundling, and the elimination of the pipeline merchant function is being emulated. The process of one industry learning from another is inevitable as electricity and natural gas come to be traded in a nearly unified energy market. As their markets merge, two once-distinct industries are becoming much more alike, each borrowing the best features of the other.

For natural gas, interaction with the lagging but more rapidly deregulating electricity industry can provide cures to competitive imperfections that survived gas industry deregulation. The electricity industry`s concept of independent system operators (ISO), in particular, provides a model that the gas industry might use to remedy concerns about a competitive market for pipeline transportation capacity and associated services.

Another area in which the electricity industry has struck out on its own is use of the internet rather than the natural gas industry`s proprietary electric bulletin boards for the exchange of and access to market information. One reason for this is that the power industry works with very short lead times, so the utilities have historically worked very closely with each other to share critical operating information. Transmission for power companies is reserved at least a day ahead of delivery, but hourly adjustments to energy schedules are possible and common. This brought about the development of the Open Access Same-Time Information System (OASIS).

The gas industry is also looking at ancillary services, with ideas such as sales of fuel gas, parking, lending and other services coming from pipeline companies that might not be provided by a natural monopoly. There is a trend among pipelines to identify as many current functions as possible as “enhanced” or “value-added” services and charge separately for them. Much of this effort is motivated by the formation of a class of service providers as hubs or market centers. This effort can help the market by making it flexible and responsive to customers` needs. There is also the possibility of it hurting the market by creating unwarranted cost layers.

Both natural gas and electricity industry players are fighting to compete on a “level playing field” with unregulated competitors.

Acting in Anticipation

Merchant projects are springing up around the country in anticipation of open market competition. Developers are betting that these new projects will be more competitive in spot markets than existing, less-efficient capacity. Other companies are buying existing utility assets with plans to make money on the margin. The merchant facilities are almost unanimously gas-fired sites.

Not all existing generation will be uncompetitive, however. “Merchant markets are important for repowering opportunities,” said Michael Zimmer, Reid & Priest partner. “Look at the permitting benefits of using existing facilities. New is not necessarily best. Blending merchant power plants with repowering is a trend to watch.”

Replacing or renovating existing plants will be a huge market in the United States in the next decade. “Of the 700,000 MW of capacity in the United States, two-thirds will be replaced by 2010.”

Long-term sales contracts are disappearing, and so are long-term fuel contracts. Developers operating in a merchant market will not be able to commit to a fixed-price, long-term fuel supply agreement. Instead, they will need a long-term relationship with a fuel supplier willing to accept price risks, or possibly to take an equity position in the electric project.

More frequently, power and fuel infrastructure projects are being developed in tandem, with one supporting and justifying the other. A few fuel companies historically have been leaders in the global independent power business. These companies are finding increasingly willing partners in power developers. Aligning with fuel companies is a logical direction for power companies to turn–especially in merchant power markets, where low fuel costs mean the difference between profitability and bankruptcy.

The industry can expect more acquisitions, mergers and joint venture partnerships between power companies and fuel suppliers. Fuel companies will become significant equity sponsors, possibly emerging as dominant IPP players.

For large energy conglomerates or small developers, efficiency is the name of the game in competition. “In the big picture, the efficiency will be realized, and the worst producers will get eliminated. There will be breakage, with bankruptcies and losses, said David Goodman, United American Energy president and CEO. “There is tremendous efficiency to be gained on the margin. But it`s not a risk-adjusted business. You have to be very clever, very focused, and find a spot market to get in on the margins.” p

Btu Blending in Action

After nearly three years of intensive planning, Williams Companies has opened the doors to its new 300-position, 21,000 square-foot single-level energy trading floor. Electricity and natural gas are traded side-by-side on this floor, which is designed for specific trading regions and commodities. It features data walls comprised of two 30-foot futures exchange walls, two 70-foot proprietary data walls, and a 21-foot full motion video wall. All are strategically located where financial and physical traders, along with schedulers and risk analysts, can easily access information.

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Williams` new 300-position, 21,000 square-foot energy trading floor is equipped with more than 200 feet of data and video walls.