The utilities industry

You've probably noticed that the utilities industry is not quite what it used to be. Once considered the

quintessential safe widow-and-orphan stocks, electricity companies are undergoing big changes as they

respond to regulatory changes, demand fluctuations and price volatility and new competition.

In the past, big regional monopolies ran the whole show, all the way from power generation through to retail

supply. But we are starting to see some disintegration of the industry structures that once led the electricity

industry. Broadly speaking, the industry is breaking down into four supplier segments:

Generators: These operators create electrical power. While established utilities continue to build and operate

plants that produce electricity, a growing number of so-called "merchant generators" build power capacity on

a speculative basis or have acquired utility-divested plants. These companies then market their output at

competitive rates in unregulated markets.

Energy Network Operators: Grid operators, regional network operators and distribution network operators

sell access to their networks to retail service providers. Heavily regulated, they operate as so-called natural

monopolies, because investments made to duplicate their far-reaching networks would be not only overly

expensive, but also redundant.

Energy Traders and Marketers: By buying and selling energy futures and other derivatives and creating

complex "structured products," these companies do something very useful: they help utilities and powerhungry

businesses secure a dependable supply of electricity at a stable, predictable price. Traders can also

boost their returns by wagering on the direction of power prices.

Energy Service Providers and Retailers: In most U.S. states, consumers can now choose their own retail

service providers. In places where the electricity grid has been opened to third parties, new players are

entering the market. They buy power at competitive prices from transmission operators and energy traders

and then sell it to end users - often competitively bundled with gas, water and even financial services.

Expect consumption of electricity to swell as the world becomes increasingly electrified. The Energy

Information Administration projects that 355 gigawatts of new electric generating capacity - or more than

40% more than the industry currently supplies - will be needed by 2020 to meet growing demand.

While upward consumption growth is almost guaranteed over the coming decades, the short-term direction

of the market still remains a risky bet. Demand for electricity - whether it's used to run heaters or air

conditioners - fluctuates on a daily and seasonal basis. An unusually mild winter, for instance, can moderate

consumption and squeeze generator revenues. Gauging the appropriate level of investment in generation

capacity is never an easy task.

At the same time, wholesale electricity prices are no longer set by regulatory agencies; for the most part,

they are free to fluctuate with supply and demand. This heightens the risk of uncontrollable price increases.

Electricity typically costs $10 to $20 per megawatt hour. But if conditions are right, it can very quickly go to

$5,000 or $10,000 per megawatt hour. Wrestling with pricing risk is a full-time job for utility managers. In

a deregulated market, forwards and futures options provide energy buyers with the tools to help hedge

against unexpected price swings.

Despite efforts to loosen up the industry, authorities are still not completely comfortable leaving utilities alone

to the vagaries of the market. The U.S. wholesale market was deregulated in 1996, and the industry has

been further liberated on a state-by-state basis since. The process, however, is often marked by political

wrangling between consumer and other special-interest groups. Regarded by authorities as natural

monopolies, transmission and distribution operations will likely remain highly regulated service areas.

Legislators, sensitive to fall-out from unexpected price spikes, want to have a say on retail pricing.

Power generation is a lightning rod for environmental regulation. Approval for new coal-powered plants is

tough to obtain, despite much progress in developing so-called cleaner coal. Natural gas burns cleaner than

coal, but still creates some emissions. Nuclear plants, which supply about 20% of U.S. electric power, still

operate under the shadow of the Three Mile Island and Chernobyl accidents. The push for cleaner energy

ignites interest in renewable sources like hydro power but also solar, wind and biomass. Regulation and

environmental issues will likely remain at the top of utility boardroom agendas.