A shock to the system

Efforts by cities to transform the way electricity is bought and sold are providing a shock to the system.

Proponents argue that cities can provide less expensive power, since the cities are not obligated to pay dividends.

Cities that must build a power system from scratch find themselves at the mercy of the marketplace.

The energy industry in the United States is built on a monopoly system. For decades, investor-owned utilities (IOUs) have owned exclusive rights to serve customers in a designated service territory. Deregulation, which has been unfolding on a state-by-state basis since the mid-1990s, is slowly breaking down that system. In an ideal world, deregulation allows new competitors to emerge and offers innovative alternatives to the ways in which customers traditionally have received their electric service. In the real world, it is being blamed for skyrocketing rates and the California energy crisis.

In California, deregulation has resulted in rolling blackouts, rising electric bills and utilities that remain on the verge of bankruptcy. The state’s own governor, Gray Davis, has called it a “colossal and dangerous failure.”

As California attempts to resolve its energy crisis — and other states watch to determine how they will proceed with their own deregulation plans — a growing number of cities are pondering another option: municipalization of their electric systems.

Municipalization — the attempt by a city to assume an incumbent utility’s infrastructure and business and establish its own electric service system — is not a new concept. However, just within the last year, multiple factors, including fear of deregulation prompted by the California crisis; soaring electric rates; and/or general dissatisfaction with incumbent IOUs, have encouraged many cities to consider the concept.

High electricity prices, which traditionally have driven calls for national deregulation, also drive the movement toward municipalization. Cities that initiate attempts at municipalization typically do so to secure lower electricity prices for their residents.

Proponents of municipalization argue that cities can provide less expensive power to customers than IOUs, since cities are not obligated to pay dividends to shareholders or compensate well-paid executives. Additionally, municipal utilities often enjoy a tax-exempt status that is not available to profit-motivated IOUs. As a result of those differences and the desire to retain autonomous control over transmission lines and distribution facilities, cities that attempt to municipalize electric service often believe they will be able to reduce electric prices for customers by as much as 20 percent.

In addition, municipal utilities that are in existence when a state begins to deregulate often are considered exempt from that process. Thus, a municipal utility may have more control over its generation supply than an IOU, which could be forced to divest generation assets as a way to ignite competition. A municipal utility also may have more freedom to build new power plants and increase supply than would an IOU, which could be limited by regulatory agreements.

The California scenario

No large or medium-sized city in California has formed a municipal utility since 1947, when the city of Sacramento successfully formed its own electric system (which is still in operation today). The Sacramento Municipal Utility District (SMUD) and the Los Angeles Department of Water and Power (LADWP) represent the largest operational municipal districts in California. SMUD, in particular, has been recognized for charging customers rates that are 25 percent lower than those charged by the local IOU for the last 10 years.

Over the last year, a growing number of cities across California have looked at the success of SMUD and LADWP and expressed interest in joining their ranks. Using the recent high power rates in San Diego as a justification, several significant municipalization efforts now threaten the state’s three IOUs (Pacific Gas & Electric, Southern California Edison and San Diego Gas & Electric). For example, the California cities of Berkeley, Chula Vista, Davis, San Jose, San Diego and West Hollywood are discussing the idea of municipalization.

Also in California, the cities of San Francisco and Brisbane are looking at a joint municipalization effort, and many observers think their plan stands the best chance of succeeding. Backers of a plan to create a publicly owned power system in those cities recently received $754,250 in taxpayer money to study public power and related issues. The award of the funding to investigate municipalization in the area followed a petition submitted to city governments in June 2000, presenting 24,000 signatures calling for the creation of a municipal utility district. On Feb. 12, the San Francisco Board of Supervisors approved an initiative to put formation of a San Francisco/Brisbane municipal utility on the November ballot.

If the resolution passes, a locally controlled and non-profit MUD (the state’s third largest behind LADWP and SMUD) will be formed. The San Francisco/Brisbane MUD would acquire the transmission and distribution system of PG&E, the incumbent IOU in the area, at fair market value, as determined by a court.

PG&E has responded to the proposal by saying that its system is not for sale. However, the utility does note that the cities would have to spend about $1 billion to buy its assets — including power plants, utility lines and other infrastructure — twice what the cities estimate those assets to be worth.

The situation in Florida

Municipalization also has gained momentum in Florida, although high electricity prices are not at issue. Rather, clauses in the franchise agreements between cities and incumbent utilities — called “right to purchase” clauses — give cities the option of buying infrastructure from utilities.

Several cities are currently battling St. Petersburg, Fla.-based Florida Power over the utility’s refusal to acknowledge right-to-purchase options in the franchise agreements it has with the cities. The right-to-purchase option would essentially allow a city to buy the utility’s lines and equipment after an arbitrated valuation process (as opposed to a condemnation proceeding) and to purchase power from other providers.

The option is in most franchise agreements between Florida Power and the cities it serves. Cities such as Belleair and Casselberry have initiated litigation to validate their purchase options for acquiring Florida Power’s infrastructure, while other cities, such as Winter Park and Dunedin, await the outcome, postponing negotiations on new franchise agreements. A ruling by Florida courts on the matter will have tremendous impact, since as many as 50 Florida cities have 30-year contracts with Florida Power that will expire over the next few years.

Efforts in the Northwest

Other pending attempts at takeovers of IOU systems are being waged in the Pacific Northwest. In December 2000, Hermiston, Ore., was granted the right to acquire, by condemnation, the distribution facilities that Pacific Power uses to serve parts of the city. Hermiston has been trying to acquire those facilities since 1998, with the intent of forming its own utility to serve the 4,000 commercial and residential customers now served by Pacific Power.

(Even though that ruling represented a significant victory for the city, the case likely will remain embroiled in court for some time. The next phase of the case was scheduled to begin in March, with the value of Pacific Power’s facilities the first issue to be litigated.)

At least one Pacific Northwest city is backing off municipalization. In August 2000, the Lakewood, Wash., City Council unanimously voted to rescind its attempts to take over Bellevue, Wash.-based Puget Sound Energy’s (PSE) Lakewood system. That municipalization attempt, which was considered a hostile takeover by PSE, evolved out of the city council’s response to resident complaints of high rates and poor maintenance from PSE. According to PSE estimates, the condemnation and purchase of its power distribution system in Lakewood would have cost the city between $42 million and $60 million. The high cost was a factor in the city’s decision to discontinue its municipalization efforts.

Low success rate

Despite the renewed interest in municipalization in certain areas of the United States, history shows that such initiatives have an extremely low success rate. Although consultants and attorneys assisting cities in their municipalization plans espouse tremendous benefits, data from previous attempts indicate that the chances of actually achieving a contested takeover of an IOU’s system are slim.

In fact, there has been only one successful contested municipalization effort (meaning that the incumbent utility resisted the takeover) of any significant size in almost 20 years. That occurred in Massena, N.Y., in 1982 when the fact that the city could secure low-cost hydropower and tax-free financing made the municipalization attempt beneficial to customers.

Cities that launch a municipalization takeover soon realize that they are facing a herculean task. For a public agency to run its own power system, it must first conquer a formidable and often fiscally strong IOU. Then, the city must acquire the poles and wires that transport electricity and find ways to generate its own power. Those cities that must build a power system from scratch tend to find themselves at the mercy of the marketplace, along with its current high prices for wholesale power in some states.

In addition to the low success rate, municipalization attempts face some significant risks that often are not foreseen. First, consultant and legal fees can be high. Las Cruces, N.M., for example, spent nearly $6 million on feasibility studies and legal fees during an unsuccessful takeover attempt against incumbent utility El Paso Electric. Second, severance costs to separate a city’s new system from the IOU’s old system can be substantial and often can escalate as new engineering and reliability problems surface. Finally, pro-muni advocates often underestimate the value of the utility’s distribution system, downplaying or disregarding entirely such items as going-concern value and stranded costs (capital that the utility has invested in its infrastructure).

On average, roughly 65 percent of a new municipal utility’s expenses will be the cost of buying wholesale power to serve its new customers. In today’s volatile wholesale market, that can be a very risky proposition. Added to that is a new problem that municipal utilities face — the lack of “preference power” — meaning that cities may not have any greater access to cheaper power than their IOU counterparts.

LADWP and SMUD own generation facilities that were built when construction was cheaper and established long-term contracts with electricity providers at rates much lower than are currently available. Municipal utilities forming today most likely will face high rates for the power they must buy to serve customers.

Tacoma Power, a municipal utility operating in Washington, recently requested the right to charge its customers an unprecedented 86 percent surcharge to help pay for electricity prices. Because of a long dry spell that has lowered hydroelectric dam reservoirs, the utility has been forced to buy power on the expensive wholesale market.

Power that once sold for $20 to $50 per megawatt hour can now sell for thousands of dollars because supplies are so tight in California, which trades power with the Northwest on a seasonal basis. Tacoma Power could end up spending $2 million to $7 million a day buying power to sell to customers for only $450,000 at current rates. Seattle City Light also will be extending a monthly surcharge through 2002 and setting up a $100 million line of credit to help cushion the impact from unprecedented wholesale price swings.

Those risks often cause a decline in political and public support for the municipalization efforts. Once the economics become clear, many cities find that the politicians, lawyers, consultants and consumer activists who had supported the idea of municipalization on the front end have determined that the obstacles are insurmountable.

On the bright side

While, on the whole, municipalizing is a costly and typically unsuccessful process, some success stories are worth noting. LADWP has received a great deal of positive attention lately, and, in many ways, it can be seen as the shining star in the energy crisis currently unfolding in California. Straddled with $7.9 billion in debt only two years ago, LADWP has transformed itself into a strong municipal utility and one that, ironically, is not facing the supply problems that have damaged its IOU counterparts in the state.

Early on, LADWP President David Freeman made a critical decision for LADWP to opt out of deregulation. While the California IOUs began divesting themselves of generating facilities, LADWP elected to keep its power plants. Consequently, having retained its own generation assets, LADWP was one of an elite group of companies that capitalized on the disparity between supply and demand in California.

Partly because of LADWP’s success, California could prove to be the testing ground for a new wave of municipalization attempts. Should the San Francisco/Brisbane attempt be successful, it likely will inspire other cities. However, if the efforts are unsuccessful, it could validate the general conclusion within the energy industry that municipalization efforts stand little chance of overtaking an IOU system.

Will McNamara is a national energy consultant based in Albuquerque, N.M.