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New Industry Report Highlights Energy Companies’ Key Issues

Summer 2005 finds the financial burdens of many energy companies easing; however, new pressures are rapidly emerging. This is according to ScottMadden Inc.’s Summer 2005 Energy Industry Update, which was just released. ScottMadden Inc. is a general management consulting firm providing counsel and specialized business services to companies involved in the energy industry. This latest update is the firm’s most recent compilation of breaking news, emerging issues and recent developments in the energy industry. The consulting firm’s researchers have sifted through a plethora of information and organized their findings into “highlights of recent significant events and emerging trends in the energy industry.”

According to the update, energy companies are facing several new pressures. Natural gas and coal prices have risen significantly and are expected to remain high for the next few years. Increasing interest rates will burden companies that are carrying heavy debt loads. Although the United States did not join the Kyoto protocol, many coal-fired generators are feeling pressure to voluntarily address global warming while trying to satisfy environmental and return-on-rate-base concerns. In addition, the EPA has announced new rules on mercury, SO2 and NOX.

Other findings include a trend toward consolidation, several RTOs becoming active and renewed interest in expanding nuclear generation.

The update’s executive summary lists the following top five trends:

Satisfying Investors
Many utilities that have been working on improving their balance sheets for the past few years are now focusing on total shareholder return. They recognize that consistent dividend growth is the major reason investors buy their stock. Utilities are using measured, sustainable earnings growth, cost-cutting and share repurchases to grow dividends. They are trying to increase dividends while protecting balance sheet integrity and investing for long-term growth.

Industry Consolidation
Difficulties in the past few years have brought some industry players to a place where consolidation looks like the best avenue to future growth. According to Thomson Financial, $50 billion worth of unions among electric and gas utilities was announced in 2004, the third largest annual amount in the last 15 years (only 1998 and 1999 were higher). Merchant generators, in particular, seem ripe for consolidation as some continue to struggle with heavy debt and low long-term spark spreads. Some vertically integrated utilities are also seeking merger partners for a variety of reasons, such as building scale, competitive reach and/or financial strength. In addition, most companies are retreating from electric/gas convergence mergers.

Increasing External Cost Pressures
Most energy companies have successfully cut internal expenses; however, almost all are facing increasing external cost pressures. Rising interest rates, projected high fuel costs and increasing renewables mandates are some of the main pressures. These pressures may limit some companies’ ability to refinance outstanding debt and raise capital for growth opportunities. They may also create both spark spread (natural gas) and “dark spread” (coal) exposure and risk. It is also conceivable that the companies may rush investments in renewable energy or renewable energy credits.

Regulatory Engagement
Typically, utilities are seeing little earnings growth from the back-to-basics strategies many have adopted. Therefore, earnings growth is being sought through changes in rate designs, both wholesale and retail, resulting in increased interaction between utilities and their regulators. In addition, because current methods for recovering total and marginal costs may no longer be valid under current market conditions, utilities are filing more and more general rate cases. Fuel cost adjustment and rate based increases for T&D reliability investment, new generating capacity and environmental expenditures are some of the issues highlighted in rate case filings. Utilities are also developing alternative cost recovery mechanisms and seeking commission approval outside of general rate cases.

Environmental Focus
The industry is still waiting for federal lawmakers to agree on a national energy bill and, in the meantime, the EPA is enacting its own set of emission rules. Although utilities and electricity generators differ in their level of acceptance of science’s conclusions about the underlying causes of global climate change, many electric utilities are pursuing their own environmental agendas. Utilities are beginning to acknowledge climate change as a significant issue and have been incorporating some statement or acknowledgement of the issues in annual reports. Some Midwestern coal-burning utilities and utilities with large nuclear fleets are taking a lead in identifying potential impacts upon the business and in some cases strategies for mitigation and remediation.

The complete report contains detailed information on these five significant trends, as well as topics of interest to utilities and electricity generators. The complete Summer 2005 Energy Industry Update will soon be available at www.scottmadden.com.