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Insights: Investing

The California utilities mess is driving down utilities stocks nationwide, creating appealing bargains
Mario J. Gabelli, Tim O'Brien
From the Print Edition:
The Cuba Issue, May/Jun 01

(continued from page 1)

The California plan did not create a free market for electricity. Because it is nearly impossible to get a new power plant sited and approved in-state due to California's convoluted permitting process, power producers could not build capacity to cash in on higher prices. Since retail electric rates were frozen, consumers weren't economically motivated to conserve electricity, and demand continued to grow. The fatal flaw of the California deregulation plan was exposed when natural gas prices, the primary "feedstock" for generating electricity in California, ran up sharply in 2000. Wholesale electricity prices rose rapidly, but with retail rates frozen, the utilities were unable to pass on the higher costs to their customers. Obliged to keep the juice flowing to its customers, PG&E and Southern California Edison borrowed to finance the unrecovered wholesale power costs until they exhausted their credit in December 2000, and wholesale generators began demanding cash up front. In January, the utilities had to resort to rolling blackouts to ration available supplies.

The irony is that municipally owned utilities, such as the Los Angeles Department of Water and Power, that were allowed to keep all of their generating assets have had no difficulties providing service to their customers and have reaped windfall profits selling excess electricity into tight wholesale markets. The wholesale generating companies, which were thought to have overpaid for the generating plants they acquired from PG&E and Edison in 1997 and 1998, have been coining money.


The U.K. Formula

California could have avoided its rolling blackouts by looking to the United Kingdom for a utilities deregulation plan that made economic sense. The British deregulation in 1989 allowed power distribution companies to pass on wholesale power costs to their customers. It also permitted distribution companies to contract with power generating companies to mitigate commodities price risk.

Of course, the Thatcher government was not trying to simultaneously bail out the utilities and give customers a politically popular free lunch in the form of an up-front rate cut. Instead, British utilities deregulation created a liquid, transparent market and trusted it to send accurate price signals to buyers and sellers.

Plans with similar characteristics have helped 23 states usher in deregulated wholesale power markets that offer consumers freedom of choice and suppliers the opportunity to compete for business, while the utilities companies that bring consumers and suppliers together earn steady regulated returns on the monopoly distribution business. As a result, outside of California, electric distribution companies have generally survived rising energy prices without harm.

California's problems have cast a cloud over the utilities sector. Although utilities stocks prices have recovered somewhat from their sharp declines at the beginning of the year, they remain under pressure. That's fine. It gives us the opportunity to pick up more bargains.

The high wholesale price environment creates opportunities for companies with unregulated or excess generating capacity that can be sold into the wholesale market. Wholesale power generators such as Southern Co., Xcel Energy, Constellation Energy and El Paso Energy (all held in the Gabelli Utilities Fund) should benefit.

We continue to favor consolidation candidates¿small and mid-sized companies likely to be acquired by their larger neighbors. The bigger companies need increased size to cut unit costs and manage risk. Buying their smaller neighbors is the only way to get there. The smaller companies have limited growth potential and no real way to significantly reduce unit costs. This puts pressure on their managements to sell out to the bigger players.

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