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Utilities vaccine against enronitis

unpublished, March 2002

By Anne Ku

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Human beings revert to black and white thinking in times of crisis. It's the fight or flight syndrome. After September 11th, people refrained from flying (and some even went fighting). After the Enron collapse, companies swerved to the other extreme, describing themselves as opposite as Enron as possible. But this does not prevent or cure the accounting plague called "enronitis."

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At the February EEI International Financial Conference in London, there was a concerted effort on part of the utilities to explain to the analysts and investors that they did not have "enronitis." The BBC defines enronitis as the impact of an accounting plague of the world's biggest ever bankruptcy on numerous different aspects of American life.

In a recent paper, the Edison Electric Institute defended the energy industry by pointing out that Enron's collapse was "primarily a financial - and not an energy-related - story about a single company." In the same paper, Pat Wood III, FERC chairman said "Enron's action would have led to the same result whether its core business focused on energy, grains, metals or books."

"We're not like Enron"
Nonetheless, this did not stop the utilities from going out of their way to explain why they were not like Enron. The spokesperson for the Southeast regulated Progress Energy even went as far as to describe themselves as "simple and basic."

In the extreme, you could show how different you are from Enron. The UK-based International Power explicitly presented a slide entitled "We are not Enron - we have visible debt." They had no special purpose limited partnerships loaded with debt, no operating leases, no investment grade triggers that could cause debt to be put or require equity to be issued, and so on. They gave various reasons why investors should not "enron-ize" them. Their 2001 gearing ratio of 50% is low compared to their peer group's average of 240%.

Such black and white thinking does a disservice to the industry, where there are thousands of utilities that don't fall into two camps, particularly with regard to business strategy.

"But we manage risk through diversification"
Not unlike Enron in its aggressive pursuit of portfolio diversification to manage risk, utilities are also following suit. Calgary-based TransAlta aims to be equally balanced in fuel mix (renewables, coal, gas) as in geographic presence (Canada, Mexico, US). In contrast, OntarioPower Generation of former Ontario Hydro, being strategically situated around Lake Michigan, plans to expand southward into the US, thus diversifying its geographic reach. Meanwhile Duke Energy International seeks diversity across regions and commodities while integrating trading capabilities and asset positions, that is, acquiring and constructing assets that can be used to trade and market multiple forms of energy. Michigan's DTE Energy related the dynamicism of its leadership team by presenting the diversity of places where they used to work.

No clear rules for full disclosure
Although "enronitis" can be treated with full disclosure of a company's activities, it is still not clear what this means. There is a grave lack of standardization on how best to disclose and describe company's past and present activities and future plans, other than the sort of financial indicators of past company performance that accountants, investors, and analysts use to determine whether to buy, hold, or sell.

Existing financial indicators are inadequate. Tony White, Head of European Utilities Research at Schroder Salomon Smith Barney in London, questions the logic of US utilities being valued on price earnings ratio given that the regulator allows reasonable return on assets. He argues that the "urge to merge" isn't always in the interest of shareholders because the power industry isn't like oil or pharmaceutical companies where you can cut back in exploration, gas stations, or R&D. Growth in size of company doesn't necessarily translate to increase in value. Instead, the returns depend on power prices which, in a fragmented market, would fall to marginal costs in the long run.

Tougher questions for transparency
Pursuing anti-Enron strategies, that is, asset-heavy acquisition, accrual-based accounting, avoidance of partnerships, and separation of auditor and consultants isn't sufficient vaccine against "enronitis" as analysts and investors ask tougher and tougher questions.

One analyst asked what synergies existed in Germany's RWE's acquisition of power, gas, and water assets in Europe and in the US. In other words, how could a multi-utility take advantage of single utilities in different (geographic) markets? Is this a pursuit of diversity with synergistic benefits or just for the sake of expansion only? That the question didn't get answered, that the presentation was more confusing than most, and that the meeting had to end because 30 minutes was up, leaves one to wonder if "enronitis" was lost in the translation.

When asked the rationale for its purchase of Orion in the US, Nobuya Minami, President of Tokyo Electric Power Company (TEPCO) replied it was to learn from the US experience. Although other companies have also acquired foreign utilities for the same reasons, "learning curve" is hardly an acceptable excuse for shareholders, argues White.

Responding to the crisis
The crisis of confidence from Enron's demise has created a series of crushing downgrades of energy merchants, readdressing of financial management and policies, cancellation or deferrals of new plant construction, and calls for greater disclosure and accounting requirements. Against this uncertain environment, David K. Owens, executive vice president of EEI, outlines an industry strategy to respond to the crisis. First, get market design right as vague rules and incomplete policies promote the uncertainty. Second, adopt ratemaking / pricing that promote infrastructure enhancement. Because transmission constraints impede competition and raise costs, there is a need to move to incentive rate (higher rates of return) to promote enhancements. Third, fix retail market problems by supporting price responsive demand and addressing Provider of Last Resort (POLR) issues. Fifth, enhance energy security by integrating cyber, physical and operations security. And finally, restore confidence in accounting.

A vaccine before a cure?
After the crisis in confidence subsides, we may leave the black and white thinking, and hopefully return to different shades of grey. But a vaccine against "enronitis" will take time to develop, namely in greater standardization of accounting disclosure rules and more aggressive probing on part of the analysts. It's the very convoluted and complex picture painted in an impenetrable mystique of both awe and disdain that the evil empire thrived until someone asked if the emperor really had new clothes.

References
Enron in Perspective: A Financial Story, Not an Energy story http://www.eei.org/issues/news/pdf/Enron_Perspective.pdf
Links to Enron articles, opinions, alumni sites http://www.analyticalQ.com/enron

[suggested illustration: Enron's big E available at http://www.enron.com striked out in EEI's logo available at http://www.eei.org]