Utility Investors: Escape from New York

The Long Island Power Authority (LIPA) should be converted into an investor-owned utility to end poor management practices that exacerbated slow and halting repairs of blackouts from October’s Hurricane Sandy: That’s the conclusion of a recently concluded investigation commissioned by New York Governor Andrew Cuomo.

Winding up LIPA would be about as close as it comes to supreme irony in the electric utility sector. Mainly, the Authority was formed by terminating investor-owned utility Long Island Lighting in the late 1980s. And the prime mover was none other than the current governor’s father, then New York Governor Mario Cuomo. 

At the time, the older Cuomo was considered a rising star on the national scene and a prospective presidential candidate. He was also a staunch opponent of nuclear power, and particularly the plans of LILCO, as the investor-owned utility was popularly known.

LILCO began construction on the Shoreham nuclear power plant during the 1970s, with the goal of meeting then surging electricity demand and reducing dependence on oil-fired power plants. But after the Three Mile Island accident in 1978, the project ran into local opposition that soon mushroomed in the wake of the company’s widely criticized handling of Hurricane Gloria.

The company completed the plant in 1984, and the following year received federal approval to conduct low-power testing. Opposition to the full opening of the facility continued to grow, however, largely on the grounds that evacuation plans in the event of a Chernobyl-style meltdown were inadequate.

In the end, LILCO managed to beat back legal challenges to delay a full opening for Shoreham. But by then, some 74 percent of Long Island residents were opposed to the plant. And with $6 billion spent on construction and prospects for regulatory recovery of that investment bleak, the cash-strapped company elected to do a deal with Governor Cuomo.

The result was the permanent shutdown of Shoreham, including the eventual removal of the plant’s core. In return, LILCO was restored to solvency through a series of state-backed transactions, including the sale of natural gas assets to the former Brooklyn Union Gas–which later became Keyspan and was subsequently acquired by Britain’s National Grid (London: NG, NYSE: NGG) in the last decade.

LILCO’s electric assets were eventually acquired by the state, which has since farmed out management services to the private sector. In fact, its current operator is National Grid, and the contract is set to pass to New Jersey’s Public Service Enterprise Group (NYSE: PEG) on Jan. 1, 2014. Shoreham itself was purchased by the newly created LIPA for $1.

History in Reverse

The government takeover of LILCO and closure of Shoreham was a signature achievement of Governor Mario Cuomo. Similarly, privatizing LIPA would rank among the most dramatic actions for his son, Andrew Cuomo.

By any objective measure, LIPA has failed to live up to the expectations of those who created it. Customer rates are still among the nation’s highest, despite low natural gas prices that have driven down fuel costs and the fact that LIPA has only 100 employees. LIPA’s overall debt of $7 billion tops assets of $4 billion, and credit rater Moody’s recently questioned the Authority’s cash position.

Of course, worst of all is the company’s abysmal record for reliability and storm response, brought into graphic relief by Hurricane Sandy and its aftermath. At least partial responsibility can be laid at the feet of contract operator National Grid, which was already facing customer dissatisfaction for its response to previous storms. That sentiment resulted in National Grid failing to secure a new contract after proceedings held in 2011.

In other ways, however, LIPA’s woes appear unique to it–the result of decades of underinvestment as a government-owned entity. After all, National Grid was able to restore power to its other New York customers in a matter of days. And LIPA’s reliability funding problem could get considerably worse, as bills for Hurricane Sandy start to come due–and the state must decide between further weakening LIPA or a big boost in customer rates.

To be sure, not every investor-owned utility has a sterling record for disaster response. But not even chronic offenders such as Northeast Utilities (NYSE: NU) and Pepco Holdings (NYSE: POM) have records anywhere close to as poor as LIPA’s. Meanwhile, other utilities badly hit by Sandy–such as Consolidated Edison (NYSE: ED) and Public Service Enterprise–have generally received kudos for their responses.

These companies could still face some financial pain related to Sandy costs. The test case will be New York regulators’ response to a $1 billion plan by Con Ed to shore up the power network against future storms, which would raise rates 3.3 percent through 2016. Public Service has estimated direct costs from Sandy of $250 million to $300 million, 85 percent of which it hopes to recover in future rates.

Even in a worst case, however, clean-up costs and additional system investment won’t bankrupt either company. And the same definitely can’t be said about cash-strapped LIPA.

The main drawback of converting LIPA to an investor-owned system is financing costs will almost certainly rise, at least initially. That’s because LIPA is allowed to issue tax-advantaged municipal bonds.

LIPA’s 10-year bonds recently yielded just 2.27 percent. A privatized LIPA would almost surely pay a lot more, particularly with debt exceeding assets. In fact, a Brattle Group study conducted in 2011 estimated additional interest costs would climb by $438 million.

On the other hand, LIPA’s failure to provide reliable power even with this financing advantage is probably the best argument for conversion. The prospective value of shareholders’ equity would depend to a large extent on support of New York regulators, who have been unpredictable for decades.

It took a lot of assurances, many of them in writing, for then-Governor Mario Cuomo to move LILCO to the public sector in the 1980s. Governor Andrew Cuomo will surely have to do the same to ensure the success of taking LIPA back to the private sector. And there’s no indication yet that’s what he intends to do.

At the very least, however, the LIPA/LILCO story is a cautionary tale for state regulators across the US. First, utilities that underinvest in networks are vulnerable, both financially and to major storms that most forecasters predict will only get worse in coming years.

It may be tempting to cut utility rates for political purposes, by disallowing costs or cutting allowed return on equity. But eventually, the customer will wind up suffering more than shareholders for underfunding. Meanwhile, states that allow fair recovery of system investment will always see their lights come on faster when disaster inevitably strikes.

Second, underinvestment can take an even greater toll on a government-owned utility than an investor-owned one. Mainly, action is always up to politicians who are sensitive to customers’ natural dislike of rate hikes.

There are plenty of examples of successful public power in North America. But none of them are in states that insist on sacrificing long-term reliability for the short-term political gain from keeping rates low.

As for utility investors, LIPA/LILCO is yet another clear warning to stick with those that operate in states with long-term records of good regulatory relations. New York has met that criterion before and may do so again.

But like his father, the current Governor Cuomo’s first impulse seems to be punitive when it comes to utilities. And given recent statements calling for punitive measures against utilities–including the threat of revoking operating franchises–there’s more danger than opportunity now in the Empire State. Buyer and holder beware.

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