Transmission? Bet the Line!

Implications:  

The US is beginning a major building cycle for electric transmission assets.

The increase spending on transmission assets roughly $ 8MMM per year is up 16% from last year and nearly 65% from 2003, which was the year of the big blackout. Part of the effort is simply catch-up as the investment has been a low priority for many years. Now the potential rates of return have increased under FERC regulation for certain projects, and because increased transmission will result in increased revenue on a fixed cost base. Neil Kalton of A. G. Edwards the author of the report predicts increased returns on equity for transmission plant which will be in 11-14% range.

Part of the increased spending will be for enhance reliability and improvement in the grid for greater flexibility. Other investment is to integrate green assets into the grid, and also to allow easier movement of power between pools.

These projects represent a real sea change for the industry. Until very recently, nobody thought that it would be possible to build any new transmission in certain areas, which will have them now.

Analysis:

Up until very recently, the industry consensus was that there would be no major transmission projects east of the Mississippi for the foreseeable future. Part of the change was the ending of what was no more than a superstitious dread of high tension lines.

In addition to changes in attitudes, there has been a tremendous rationalization of the wholesale electric market. Before the ISOs (independent service operators), electric transmission between non-contiguous utilities was covered by rules which allowed piggy-back pricing and non-economic routing to increase profits: those days are gone. Also energy trading has devolved to a few big players creating a more orderly and efficient market than existed before the energy bust of 2001.

The first issue in the article is use of green energy which will come from non-traditional locations and will require new transmission. One instance of this will be Edison International wind and solar project in the Tehachapi Mountains in mid-state California, which will require a $1.8MMM investment in transmission plant alone. This project will provide 4,500 megawatts of capacity to help the state meet its 2010 goal of 20% renewable energy.

The cost of new power lines can be defrayed by the ability to buy lower cost power from other sources, which would be part and parcel with the goals of deregulation. AEP has identified $9 billion in important transmission projects, including $3 billion for a 550-mile line that would bring cheaper power to New Jersey from West Virginia. There are a number of other projects to improve general transmission effectiveness and remove bottlenecks, which have either caused blackouts or have been used for market manipulation. Two of the most interesting are in Michigan and Connecticut, which will greatly help the whole local power situation.

More interesting is who some of the major investors are. Berkshire Hathaway, through MidAmerican Energy has a joint venture with American Electric Power to build more transmission lines in Texas. The $1MMM will in part service and wind power project. KKR and other private investors have shown an interest in these projects.

The foregoing should adequately demonstrate that there is a seriousness of purpose and trust that the projects can be done, a great change from a few years ago, when no one believed such building was possible. More than presenting some solid investment opportunities, this new transmission will increase the value of some generators, and create new merger opportunities.

When deregulation became a serious issue, many companies lobbied the FERC to declare large sections of their FERC Form 1s competitive or sensitive information and not make it generally available, which did happen. Their rationale was totally bogus however. A given utility will know where other competing companies fit in the supply curve. The information rationing was aimed at the investor. Companies simply did not want to disclose what the capacity factors and costs associated with their plant, especially plant that had become marginally non-economic.

The authoress had written on Texas Utilities (TXU) and the perceived lack of benefit from deregulation in Texas, which I analyzed under a separate cover. The first issue was the drastic increase in natural gas prices, and the recovery mechanisms involved. The authoress writes much on this subject, but the effort was otiose. TXU had shifted almost entirely to nuclear and coal generation, and used gas very little because other sources were cheaper. Also the capacity factors for these plants were much higher than before deregulation. TXU was making superior profits because it was better able to utilize its plant.

The same thing will happen in the other areas mentioned. New Jersey will benefit from having power from outside of PJM available. Lower Michigan will be in better shape, and New England, especially Connecticut will benefit from the safety of a better more effective grid. Further it will remove bottlenecks that have been subject to manipulation.

There will also be an increase in merger interest as the comparative advantages of various companies change along with optimum generation mixes. It first has to be noted that many recent mergers are more driven by GAAP and tax accounting rules than by operating efficiencies or service areas.

The creation of First Energy was at least in part driven by the need to change relative asset values for book and tax purposes. This deal and others have a strong resemblance to a quasi-reorganization. Many companies have some plant that is obsolescent, but does not meet GAAP standards for impairment though such might be in the further. A merger allows both companies, on a consolidated basis to revalue all their assets on both a GAAP and tax basis.

The increase in available power sources will probably weaken regulator objections related to competition. More than a few times, PUCs have placed impossible burdens on companies to divest before a merger with another company, even one which was not even operating in the area, on competitive objections. Especially in PJM, these new transmission lines and great potential supply would diminish the power of those arguments while creating an environment where mergers from relative plant values would be even more attractive.

The transmission plant should be welcomed by all. It strengthens the grid and perhaps in time make it truly national. It will help reward more efficient generators. It will prevent market manipulation and finally permit mergers which previously died over competitive concerns. It will allow easier adjustment to changes in demographics and the economy. There will be a great deal of money made by people who truly understand the economics and cost structure of the industry.