Private Equity and the Public Utility

The management of a competitive enterprise, acting at the behest of its private equity owners, would have the authority to select and decide:

• Service area
• Products and services to be provided
• Service quality levels
• Pricing of services
• Asset acquisition and disposition
• Capital structure that works best
• Stock and bond issuance
• Mergers and acquisitions
• Executive recruitment

Compare this with the decisions that management of a regulated investor-owned utility can make, whether the utility is owned by a single private equity firm or the utility’s equity shares are widely traded. Only the following two matters can be done without approval of the state regulator:

• Executive recruitment
• Rate case filing proposals – timing, and proposed (not approved) amounts

Some observers may note that the management of a utility controls the annual operations and maintenance expenditures. This could allow a utility management to lower maintenance expenditures to result in higher reported returns – at least in the short run. Yes, except regulators do follow service quality indicators and take action on validated complaints from customers which would reflect insufficient maintenance levels and evidence of poor or unsafe utility service quality. In addition, the return on equity (ROE) achieved by a utility is monitored by the regulator and evidence of excessive returns typically lead to the regulator issuing a “show cause” order initiating a new rate case to fix the problem.

The other regulatory tool of “affiliate interest” control, also called “ring fencing,” restricts financial relations between the regulated utility and entities owned by the same investors or holding company.  State regulatory orders can specify under what conditions and pricing arrangements a regulated utility can transact business with an affiliated company. One technique used for pricing, for example, is that a specified service can be provided to the utility by an affiliate only at the lower of “market price” or the allocated cost of service.  If there is evidence of pass through by the regulated utility to a non-regulated affiliate, there will be serious consequences.  For example, if the non-regulated affiliate “borrows” experts from the regulated utility at ratepayer expense, or the regulated utility pays an excessive amount for a service or product from the non-regulated affiliate, there can be significant fines levied against the regulated utility by the regulator. These fines can be increased if the regulated utility does not continue to abide by the terms of the “ring-fencing” established by the regulator as long as the utility remains in a corporate structure with non-regulated affiliates.

There’s also the matter of regulatory lag, which is a by-product of the requirement for due process and evidentiary hearings. A utility attempting to inflate the value of its rate base by excessive investments will find the regulator paying close attention to efforts to get those investments into rate base. Not only will the evidentiary process require months of hearings from advocates and opponents, but it may also be much longer (a year or more) if ultimately approved by the regulator before any return on investment appears in customer rates. And lastly, if that excessive investment by a new greedy private equity owner of the utility is deemed an unnecessary investment, then there’s a “prudence” remedy – and the new owner may get exactly nothing from the regulator for the unnecessary investment.

In sum, there are tools to protect the ratepayers, and regulators are alerted.  A private equity owner – a BlackRock, for example - of an investor-owned utility will have the same opportunity to earn an ROE based on the risk of the regulated utility and the results of the regulatory process just as any other owner would.  No special treatment or privileges will be available under regulation – and there’s certainly no hidden cash machine.