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Prepared Witness Testimony The House Committee on Energy and Commerce
Blackout 2003: How Did It Happen and Why?
Full Committee on Energy and Commerce
Mr. Steve Fleishman
Thank you, Mr. Chairman, for the invitation to provide my views before your Committee on issues surrounding the blackout in the Northeast, Midwest, and Canada on August 14. My name is Steve Fleishman and I am an equity analyst covering the utility industry for Merrill Lynch. My primary job is to observe and study developments in the utility sector and of specific utility companies. I then make investment recommendations to clients on stocks of utility sector companies. As such, my comments to the Committee do not come as an advocate of a specific side of the table on the debate over future industry structure. Instead, I speak as an active observer of the industry and, more importantly, one who interacts daily with the institutional and retail investors who will ultimately be asked to provide the new capital necessary to build a more reliable transmission network. I have called the blackout on August 14 a "black eye" for the electric utility industry. This is an industry that prides itself on safe and reliable electric service to customers. The blackout was obviously a serious breach of this commitment. Despite this breakdown, there are many aspects of the system that did work. Utility workers performed admirably in returning electric service to all customers within days after the blackout. Moreover, the affected generation units and transmission lines are currently up and running with little to no permanent damage caused by the blackout. Electric Industry in Structural "Limbo" As of now, the exact chain of events that precipitated the blackout is not determined, nor are the exact causes known. Whatever the ultimate cause, the blackout has served to highlight many of the structural problems that the industry now faces. While many call it a "transitional" problem, it might better be called a long period of "limbo". Following are just a few of many examples of the lack of clarity that companies and investors face as they look to invest capital into this sector: 1) Approximately half of the states have deregulated their electric businesses and the other half have not. 2) In many regions, transmission is still owned by the utilities but controlled by independent system operators (ISOs) or other forms of regional transmission operators (RTOs). This split of ownership and control is difficult to make work and can be an impediment to new investment, unless there are very clear rules in place. 3) When a generator adds a power plant, it is not clear in some regions who is responsible for bearing the cost of the associated transmission additions, the generator, or the local utility (the participant funding issue). As President Bush aptly stated, the blackout is "a wake-up call" to the American people, the utility industry, and public policy makers that these and other structural issues need to be resolved. Need for Transmission Investment The blackout is also "a wake-up call" that there has been underinvestment in the transmission network during this period of structural uncertainty and that this trend must change quickly. It is not certain that a lack of transmission investment will prove to be the direct cause of the blackout. However, I suspect that more transmission capacity and better information technology on the grid could have helped to at least limit the scope of the blackout. Underinvestment in the transmission grid is not a new story. This has been an issue discussed within the industry for some time. According to a 2001 Edison Electric Institute (EEI) study, transmission investment grew by only 0.5% annually during the 1990s well below the 2.5%+ annual growth in peak demand. Transmission capacity relative to peak demand dropped by 17% during the decade and is projected to fall by another 12% based on projections for the next decade. In order to simply maintain transmission capacity relative to peak demand at 2000 levels, $56B of investment would be needed in the current decade, well above current expected expenditures of $35B. I believe the greatest impediment to transmission investment has been siting. While a power plant can often be located in a barren area or in an industrial zone, transmission lines in high-usage regions often need to be sited close to the population raising NIMBY concerns. A second issue has been the structural uncertainty of transmission. Will a utility control the transmission it builds? Will it need to be spun-off in a few years to a new company? With these questions overhanging the business, it has been difficult to commit significant funds, in my view. Incentive Regulation The FERC has recognized these barriers to investment in transmission and has recently been supporting higher returns for transmission investment (A Midwest utility was recently allowed a 12.88% return on equity). FERC has also supported incentives for even higher returns if the investor is independent from the regional generation or distribution companies. I commend FERC on these positive steps, though I believe that other forms of incentive regulation should also be considered. For example, sharing of cost efficiencies above a baseline return on equity would incentivize actions by transmission owners to increase efficiency. Incentives based on transmission reliability and safety would provide a balance to cost cutting. Finally, I would also encourage incentives tied to reducing congestion costs in the power markets. There remains significant inefficiency in the power markets as a result of transmission bottlenecks that limit customers' ability to access the lowest-cost supply. The resulting congestion costs are estimated in the billions of dollars. I believe that an incentive regulatory approach that would allow for a sharing of congestion cost savings between transmission builders and customers could be a win/win solution. This would also stimulate investment in transmission projects that would have the greatest economic benefit to customers. Moreover, since congested areas are also ones that are typically subject to more reliability risks, it would likely enhance system reliability. Challenges Facing Utility Investment Some may question whether incentive regulation is necessary to encourage transmission investment. My belief is that the recent investment climate for utility investors makes this even more important. The last few years have been very difficult for many utility stockholders and bondholders.
Public Policy Actions Are on the Table The good news is that public policy makers have taken actions and can take further actions to entice new capital to help resolve the infrastructure issues the industry faces. These include: 1. The reduction in taxes on corporate dividends. I believe this will be an important attraction for regulated utility investments and will also encourage more use of equity and less debt. 2. Incentive regulation to encourage new transmission investment. This has already been adopted to some degree by FERC and is also supported in the House Energy Bill (H.R. 6). 3. Tax incentives for transmission investment. Proposals in the House Energy Bill to accelerate depreciation of transmission assets for tax purposes (to 15 years from 20 years) would provide another incentive for transmission investment. Further, proposals to eliminate the tax liability for those selling or contributing transmission assets to independent buyers would help to accelerate the move to stand-alone transmission companies. 4. National Interest Transmission Lines. Even with the right incentives, near-term development of new transmission lines is constrained by siting difficulties. To address threats to reliability in the near-term, I support the process of determining National Interest Transmission Lines that would be identified through a joint process by the Department of Energy and regional states and utilities. Once identified, the DOE would work with the states and other federal agencies to streamline the siting process including determining whether part of such projects could be built on federal lands. Investment in these lines could be accelerated by support from DOE or appropriate incentive regulation by FERC. This process should only be followed for critical reliability projects. For the long term, the gas pipeline model for siting and regulatory approvals would be an appropriate one for electric transmission investment. This proposal would be similar to the siting provisions already contained in the House Energy Bill. 5. Mandatory reliability standards for transmission. This is already proposed in the House and Senate Energy Bills and would help to ensure that no parties fall behind on their transmission spending and operations. 6. Repeal of the Public Utility Holding Company Act. I believe that PUHCA repeal would provide more certainty to investors and reduce some barriers to investment by utilities. More significantly, it could make it easier for non-traditional utility investors, such as financial investors or private equity, to acquire and invest in utility assets such as transmission. Financial buyers have targeted billions of capital to the utility sector and will be an important source of capital in the future. Summary I would like to thank the Committee for the opportunity to share my thoughts on potential actions to help resolve issues raised by the recent blackout. While the blackout was a "wake-up call", the good news is that many of the constructive public policy initiatives that would enhance electricity reliability and promote new investment are already on the table in the proposed Energy Bill. Certainty is a critical driver for investment and I believe that it is an important time to increase certainty in the electricity business to encourage investment.
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