public utilities and California wildfires

public utilities

The idea behind public utilities is that society is far worse off if a municipality has, say, ten companies vying to provide essential services like power and water to citizens, tearing up streets to install infrastructure and then maybe going out of business because they can’t get enough customers.  Better to give one (or some other small number) a monopoly on providing service, with government supervising and regulating what the utility can charge.

The general idea of this government price-setting is to permit a maximum annual profit return, say 5% per year, on the utility company’s net investment in plant and equipment (net meaning after accumulated depreciation).  The precise language and formula used to translate this into unit prices will vary from place to place.

The ideal situation for a public utility is one where the population of the service area is expanding and new capacity is continually needed.  If so, regulators are happy to authorize a generous return on plant, to make it easier for the utility to raise money for expansion in bond and stock markets.

mature service areas

Once the service area matures, which is the case in most of the US, the situation changes significantly.  Customers are no longer clamoring to get more electric power or water.  They have them already.  What they want now is lower rates.  At the same time, premium returns are no longer needed to raise new money in the capital markets.  The result is that public service commissions begin to reduce the allowable return on plant–downward pressure that there’s no obvious reason to stop.

In turn, utility company managements typically respond in two ways:  invest cash flow in higher-potential return non-utility areas, and/or reduce operating costs.  In fact, doing the second can generate extra money to do the first.

How does a utility reduce costs?

One way is to merge with a utility in another area, to cut administrative expenses–the combined entity only needs one chairman, for example, one president, one personnel department…

Also, if each utility has a hundred employees on call to respond to emergencies, arguably the combined utility only needs one hundred, not two.    In the New York area, where I live, let’s say a hundred maintenance people come from Ohio during a blackout and another hundred from Pennsylvania to join a hundred local maintenance workers in New York.  Heroic-sounding, and for the workers in question heroic in fact.  But a generation ago each utility would each have employed three hundred maintenance workers locally, most of whom have since been laid off in cost-cutting drives.

Of course, this also means fewer workers available to do routine maintenance, like making sure power lines won’t get tangles up in trees.

the California example

I don’t know all the details, but the bare bones of the situation are what I’ve described above:

–the political imperative shifts from making it easier for the utility to raise new funds (i.e., allowing a generous return on plant) to keeping voters’ utility bills from increasing (i.e., lowering the permitted return).

–the utility tries to maintain profits by spending less, including on repair and maintenance

The utility sees no use in complaining about the lower return; the utility commission sees no advantage in pointing out that maintenance spending is declining (since a major cause is the commission lowering the allowable return).   So both sides ignore the worry that repair and maintenance will eventually be reduced to a level where there’s a significant risk of power failure–or in California’s case, of fires.  When a costly failure does occur, neither side has any incentive to reveal the political bargain that has brought it on.

utilities as an investment

In the old days, it was almost enough to look at the dividend yield of a given utility, on the assumption that all but the highest would be relatively stable.  So utilities were viewed more or less as bond proxies.  Because of the character of mature utilities, no longer.

In addition, in today’s world a lot more is happening in this once-staid industry, virtually all of it, as I see things, to the disadvantage of the traditional utility.  Renewables like wind and solar are now in the picture and made competitive with traditional power through government subsidies.  Utilities are being broken up into separate transmission and generation companies, with transmission firms compelled to allow independent power generators to use their lines to deliver output to customers.

While the California experience may be a once-in-a-lifetime extreme, to my mind utilities are no longer the boring, but safe bond proxies they were a generation or more ago.

Quite the opposite.








dividend-paying stocks

Robert Rhodes of Rhodes Holdings LLC made one of his usual astute comments about my post last Thursday on utility stocks.  In this post, I’m going to elaborate on my view of buying stocks for their income.

Financial planning guides often mention that when selecting a stock because of its dividend, one should consider not only its current yield but also the potential for the payout to grow.  My impression is that the authors don’t just want to steer us away from too-good-to-be-true extremely high current yields, which are most often a sign that the market thinks the dividend is likely to be cut sharply or even eliminated.  I think they also believe it’s better for investors to pick a stock with, say a 3% current yield and the possibility of 8% annual growth in the payout vs. a stock with a relatively secure 6% yield and no dividend growth potential.

For a Millennial, who arguably has no business getting involved with income stocks, the expert advice is probably correct.  In contrast, for a senior citizen looking for income-generating investments to support retirement, the 3% yield + the promise of growth is certainly better than Treasuries.  But for a seventy-something a good argument can be made that the 6% current yield is the better choice.   At least, that’s what I’ve thought until very recently.

my reasoning?

The handy-dandy rule of 72 tells us that a 3% yield growing at 8% per year doubles in nine years (72/8).  It takes that long for the payout to equal the 6% dividend of the non-grower.  This also means someone who buys $100 worth of the 3% yielder collects $40.50 over the nine-year period, assuming the payout increases at a uniform rate.  The person who chooses the 6% yielder collects $54.  It takes the former another two years+ to draw even in terms of total income received.

Put a different way, the superiority of the 3% yielder with growth doesn’t come into bloom until over a decade after purchase.  That’s a long time.  It hasn’t been clear to me that financial planners fully appreciate how large/long the shift in income is away from the period a senior citizen may be young and healthy enough to enjoy the money.

Capital gains?  In theory, the steady-state 6% yielder has significantly less capital gains potential than the 3%er.  But who knows?  Arguably the senior citizen is more concerned with preservation of income than in making capital gains.  It’s also possible that the sprier utility won’t be able to sustain profit expansion for such a long time.

my change of heart

As I wrote last week, the negative effects of years of downward regulatory pressure on utility rates in mature areas, and the consequent corporate response of cutting maintenance/replacement are starting to become apparent.  It’s no longer clear to me that the dividend payments of no-growth utilities are as rock solid as I’ve been assuming.  So, yes, there’s a chance that the fast grower will slow down in short order.  But I now think there’s also a good chance that mature utilities will be forced to divert large amounts of cash flow away from shareholders in order to shore up creaky infrastructure.  So the mature utilities may be much riskier than they appear.