Collapse of Utilities in 1929 Portends Financial Collapse in 2008

While going through my PhD thesis, I came across the following section written in 2005, which describes how the utilities helped plunge the US (and the world) into the Great Depression. It reads just like it happened now, but in the financial sector.

Do two things while reading this. Replace 'utilities' with 'financial firms and mortgage brokers' and you'll find out, how through the gaps in the regulatory process crisis occurs.

...This tight government regulation at the higher ‘state’ scale did not mean the private utilities lost out (public utilities stayed mainly within their municipal boundaries). In fact, as Samual Insull, one of the founding moguls of private electricity in America, remarked in 1913, “there is one great advantage that must follow regulation, and that advantage is protection” (Hirsh 1999: 30). There are a number of different reasons that the state enacted regulations over the industry forming a new consensus between government institutions and chiefly private electricity companies.

As a key element of the utility consensus, regulation [agreement by all parties for existence of a ‘natural monopoly’ and its regulation] constituted a social experiment typical of other reforms of the Progressive era. In drafting legislation that established state commissions, elite groups recognized the need to curtail abuses of large, technology-based companies that offered vital public services. At the same time, they realized that these companies could provide great value to society as a result of their size and technological prowess. The laws therefore reinforced the truth that companies were natural monopolies, and they outlined the commissioners’ responsibilities to enforce the obligations and maintain the rights of utilities (Hirsh 1999: 30).

By the early 1920s, two-thirds of states had established public utility commissions, in addition to the existing municipal authorities. Ever since, this division of powers in the US has come to play an important part in states maintaining regulatory control over electric companies.

States are closer to the electricity customers, sensitive to local economic and environmental concerns, the source of electric company franchises and rights of way, and… staffed sufficiently to regulate hundreds of electric companies (Kelly 1995: 127).

While there are advantages in this proximity of regulators and companies, there are also disadvantageous that involve the bounded geographic reach of states. At the same time that states erected regulatory commissions, the owners of electric companies continued their spatial-scale expansion throughout America, by establishing a complex maze of private holding companies with numerous local electricity companies.

Holding companies were initially created in the late 1800s to help smaller electrical companies purchase and operate the expensive equipment to generate electricity. In return for the equipment manufacturers (such as General Electric or Westinghouse Electric) or financial firms would receive bonds or stocks, and thus a stake in the new electricity companies. As these stocks were often bundled into one company, such as the Electric Bond and Share Company, these became known as ‘holding companies’(Hirsh 1999: 35), thereby financed against the capital investment of a company and not its projected income.

Involvement in a holding company, for smaller companies, held advantages. The larger holding companies would provide management and technical expertise that the smaller firms would not be able to afford on their own.

However, if two holding companies were merged and new securities issued the securitized value of the new holding company (and the stocks issued) could exceed the total capitalization of the operating firms. Despite this risk (and the harm it would later cause) investment bankers on Wall Street focused on the benefits for the smaller electrical companies. For GE and Westinghouse, they benefited from selling their products and through their investments. “Put simply, as more parties benefited from the existing structure of the utility system, they helped create substantial momentum” (Hirsh 1999: 37).

Eventually holding companies became known for their abuses, including the artificial inflation of stocks and the subsidization of rates in one state or region to allow lower rates in more competitive markets.

State regulatory agencies failed in efforts to track costs and profits that could be shifted across state lines, or into a blur of bookkeeping transactions between affiliated companies. [Companies] found that the largest profits were not to be made in the operation of power companies, but in padding out charges for financing, engineering, fuel and equipment services (Ridley 1996: 18).

A constant financial shell game developed between states so that by 1928, 16 major electric companies controlled 85 percent of the electricity produced in the US (Ridley 1996: 17). The utility entrepreneur Insull who pushed for state regulation to ensure monopoly status had also made another (short-term) winning assumption.
In the dizzying stock market climb of the late 1920s, speculation on utility stock ran wild. Some of the holding companies would trade stock back and forth between subsidiaries, inflating its value with each exchange. Based on rampant speculation, Insull’s personal fortune increased from $5 million in 1927 to $150 million in 1929. (Ridley 1996: 18)

The jurisdictional limit of state regulators was thus exposed. The establishment of state commissions had been seen as an effective way to regulate expanding utilities, but the continued scaling up of utilities and the development of national financial markets, exposed the jurisdictional limits of state regulators.

The financial and market shenanigans of private utilities, despite the oversight of state regulatory authorities, finally led to the federal government stepping in to fill the regulatory gap, triggered by the spectacular crash of utility companies at the start of the Great Depression. This put society on skid row, politicians up a tree and the economy in the gutter.

Investments, Investments, Investments

With all the grim news about the fall in the global economy it is very nice to see that there are positive developments in the energy sector. We can summarize the final year news as 'clean energy'. This bodes well for the future development in the market.

First we have the news that Romania finally got its act together and brought the different project partners together, with RWE in the lead, to build Unit-3 and 4 of the Cernavoda nuclear power plant (missing the size and dates). Then we have the news from this week that Slovakia will be going ahead with CEZ to build more units at the Jaslovske Bohunice nuclear power plant to build around 1,000 MW and 1,600 MW of generation capacity by 2020 (platts).

In Bulgaria they have signed a deal with AES to build the Sveti Nikola wind power 'park' for EUR 270 M with 52 wind power generators, and a total production capacity of 156 MW (Novinite.com). Go back a few months and Romania announced its intention to build with CEZ Romania 347.5-megawatt Fintinel project in Tulcea. Throw in more wind power and gas plants in Hungary and there is a very robust power investment portfolio that is not slowing down.

Overall, there is a lot to be optimistic about in the region. Even if the projections for growing consumption in the region turn out to be slightly off, there is still a significant amount of capacity that does need to be replaced in the region. The government and companies know these projects are still years away from becoming operational, but what better way to stay busy in a slowing economy that to be working hard at a project that will come online just when the economies are revving up and environmental restrictions begin to tighten.

I don't know about you, but I'm going into the New Year in a positive mood.

Crunching the Credit to Make Power

One casualty according to this article in the FT, is the lack of finance credit for energy projects in the UK, particularly nuclear. The point is made, and we should reflect upon this for the wider CEE market place, that the withdrawal of generation impacts on the ability of countries to meet their climate change goals.

“Generating capacity equivalent to nearly a third of current electricity demand will be made redundant by 2020. It will need to be replaced. We believe that in the current economic climate there is a high risk that the energy companies will not be able to raise the finance necessary to build this.”

The CEE region, needs to build an equivalent amount of generation by 2020 to replace the outdated plants (if not a little higher). Thus the topic of credit availability becomes a central issue for the CEE region for the next year or two.

There are two outcomes of the tightening credit markets for the CEE power region. The first is that the plants that are on the drawing board are built. The building of the Emfesz new 1600 MW gas fired power plant is proceeding with the first 800 MW now being built. This is privately financed (although MVM may have a stake in it) initiative, which indicates that the market is still seen as requiring this much supply.

This leads us to the second point, the failure of some countries to build generation will open up export and extra revenue opportunities for those that are able to build. Thus, the projected demand will no doubt drop slightly from projected amounts (although I would say not by much if conservative estimates were earlier taken into account), but with the decommissioning of plants and emissions goals, then newer plants will have an advantage. Especially, if there are less plants built. Thus, building a power plant in the CEE region, can still be advantageous if these scenarios are taken into account. Also the lead time that is needed still means they won't come on line until the economy begins to recover.

A worse case scenario does need to be considered, and the only one that I can think of is that the economy continues to soar and demand drops for longer than expected - say up to five years. But regardless, climate change goals will still be implemented, thus cleaner plants (with CO2 storage possibilities) remain and profits will flow to those cleaner and newer plants.

Despite Financial Crisis Investments will Continue in CEE NMS

The financial crisis is impacting the infrastructure investments needed for electricity generation. This brief article in the FT, indicates that there is a perceptible impact that will affect the security of supply and could threaten future generation expansion. As the article predicts, if current trends continue then,

when the recovery came and energy demand picked up, the shortfall in investment would lead to renewed problems of tight supply because of shortages of capacity in areas such as electricity generation and gas import facilities.

This fall of investment may bad for the short term and long term in the CEE region, however it may not actually be fully true. If we consider the economic expansion in the region. In particular, we use the basic idea that all the new CEE Member States (excluding dismal Hungary) will avoid recession next year, then it is clear that demand will continue to grow.

The drop in share prices by around half for most utilities in the CEE region, that these companies will be borrowing less. E.ON for example will not be out there building new power plants, such as the proposed joint venture with Enel in Romania. Maybe more marginal or speculative investments will be cut. However, here is why I think there won't be a 'large' drop off in investments.

The article as I see it, fails to appreciate the need for investment in New Member States (NMS). The avoidance of a recession by CEE and SEE (BG and RO), will mean that these countries which Old Member States are already active in, will view the region as a source of growth for the companies. This is historically true, and with declining profits from Germany, with the gradual break up of their monopolistic position, it can be seen that greater resources can be placed into the generation sector of NMS.

Control is already established in the distribution sector for many of these companies, and if we consider that they therefore have available suppliers willing to buy their owned produced electricity - then the decision to build new generation is easier to make and to finance. Throw into the equation the aging power plants and the current and projected generation shortfall in the region, along with efforts and tighter market integration then it bodes well for the LONG term, if not short term investment prospects.

Now, here is my warning, investments in the CEE region also must contend with the heavy political involvement of political considerations in setting price, not just for suppliers, but for generators as well. Therefore, while it may be built, if current political practices of strong arming lower genertion pricing (e.g. Bulgaria and CEZ Varna), then these investments will not occur. However, this is not because of the credit crunch or demand for electricity, but by political stupidity.

In every consideration of the future we must consider the efforts to cut CO2 and other greenhouse gasses. The new generation of generators need to be built with a large amount of financing. As the article cites,

Capgemini, the French consultancy, argues that the European Union needs to invest about €1,000bn ($1,250bn) between now and 2030 to meet energy demand and hit targets for cutting greenhouse gas emissions, but in the downturn it will be harder to finance that investment, and harder for companies to make the case that it is needed.

Now let's see how the credit crunch hits the CEE region. But in either case, there are still important reasons why in the CEE NMS investments will continue. Let's just start separating our analysis from OMS and the dynamic and infrastructurally deteriorated CEE region.