yesterday’s gas explosion in Harlem and the economic structure of utilities

Yesterday morning a leaking 125-year old cast iron gas main in East Harlem, just east of Park Avenue in Manhattan, exploded.  The blast killed six (an equal number are still missing) and injured 60.  The two five-story buildings the main served were pulverized.  Debris even covered the nearby elevated train tracks, disrupting commuter train service to Connecticut and upstate New York.

I have a generator in my backyard because the electric power outages in my neighborhood ars so frequent.

After Superstorm Sandy, it was a month before the first Comcast trucks appeared on our street to restore internet and cable (Verizon was on the scene a day or two after the storm, causing virtually everyone to switch).

Why do things like this happen?    .

..welcome to the world of mature utility operation, one where, in the Northeast US at least,  “business as usual” is facing increasing citizen discontent.

background

Governments grant monopolies to electric, gas and water companies in a given service area.  They do so to avoid expensive and disruptive duplication in the buildout of infrastructure.  In return for their exclusive status, utility companies are subject to rate regulation by the local utility commission.  No matter what formula is officially used, the rate-setting ultimately comes down to the utility receiving a specified return on its net (that is, after subtracting accumulated depreciation) plant.

When the service area population is growing, the utility has smooth sailing.  Its net plant is continually increasing as it hooks up new customers.  The utility commission also grants a generous return on that plant, in order that the utility has no trouble getting money, by issuing stock or bonds or borrowing from banks, to pay for the new plant and equipment it needs.

When the service are matures, however, this favorable dynamic changes.  Because there are no/few new customers, the utility’s net plant growth slows to a halt.  Net plant may even begin to shrink, meaning so too does operating income.  In addition, the utility commission no longer sees any reason to keep the allowable return as high as it did in the past.  More than that, the utility is now “trapped” like any other highly capital-intensive business with a lot of sunk costs (think: a cement plant, or a supertanker).  It can’t rip up the lines and leave.  So it’s a price taker, meaning the utility commission can easily bow to pressure to keep utility rates low by reducing the return it allows.

So high returns on a rising base morphs into falling returns on a shrinking base.

How does the utility respond to reduction in its cash flow?  Shareholders want higher profits and higher dividends.  Management wants a higher stock price.  The only way to get higher net income  is to pare expenses.  This means replacing meter readers with machines.  It means cutting maintenance staffs and maintenance itself.  And it means trying to make aging plant last longer before replacement.

Personally, think we may be reaching a tipping point, where utilities have pushed cost-cutting too far and where business as usual becomes socially unacceptable.  Probably not good for utilities in ares that aren’t growing.

Investment significance?

There’s a long-standing dynamic in utility investing:  choosing between high dividends that are not growing and more modest payouts that have the potential to rise steadily.  To the limited degree that I buy utilities, my instinct has been to pick the higher current yield.  Why?  I’ve found the point where the growing dividend bridges the gap with the static one occurs too far in the future.  As utility service breakdowns continue to occur with come regularity in areas like the Northeast, that thinking is probably much less sound than I’ve realized.

One response

  1. This is an interesting review of the utility industry, and your last paragraph’s summation is illuminating. I would disagree with your last sentence’s question though – investing is agnostic (or it should be, although the PUC shouldn’t be agnostic at all and should hold utilities feet to the fire when it comes to maintenance). Therefore, I personally agree with investing with the high dividends – it it ends, it ends and you can re-deploy elsewhere.

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