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Energy Deregulation Comes Home to Roost

By Steven Mufson
Washington Post Staff Writer
Tuesday, April 25, 2006

BALTIMORE -- For almost a year, they regularly faced each other across tables set up in concentric squares in a lecture hall at Baltimore Gas & Electric's offices. With hundreds of millions of dollars at stake, dogged negotiators represented more than a dozen groups, including BG&E itself, the state legislature, the Office of the People's Counsel and big electricity customers like Johns Hopkins University and major industries.

Their goal: to deregulate Maryland's utility industry to make it more efficient and competitive. When they reached an agreement on June 29, 1999, they all shook hands and called it a deal.

Some deal. Nearly seven years later, the same groups have been waving fists, not shaking hands, even after the accord to phase in rate increases that Gov. Robert L. Ehrlich Jr. struck on Friday. More than half of Maryland households, including those in Anne Arundel, Howard and part of Prince George's counties, still face sharp hikes in their electricity bills. Maryland politicians, many of whom have received contributions from the utility, face voter ire in an election year.

Even BG&E's parent company, Constellation Energy Group, has been sobered by the political hullabaloo. Sitting in his office last week, with a commanding view of Baltimore's harbor below, Constellation chief executive Mayo A. Shattuck III said that the month of talks with state politicians had been an "emotional roller coaster." He said, "It is very hard to draw everyone into a reasoned and rational debate based on the merits of the situation. There seems to be a large anti-business sentiment that overlays everything."

Other states are bracing for similarly bruising battles and trying to think of ways to avoid them. Virginia, Illinois and Ohio, like Maryland, made deals years ago that froze household electricity rates at levels far below current market rates, but the freezes end soon. In Virginia, a "fuel cost adjustment" will hit consumers next year, and rates will be deregulated starting in 2011.

Homeowners in some states have already taken hits, including hefty rate increases for Pepco customers in Maryland and Delaware and an 80 percent increase for customers of Texas's biggest utility.

"Everyone looks at [Maryland], and it's a frightening prospect," says Martin Cohen, director of consumer affairs for Illinois Gov. Rod Blagojevich (D).

At the center of the Maryland battle is Constellation Energy, one of the nation's 200 biggest public companies and considered by many to be a model for the electric power industry. In seven years, it has remade itself from the parent of a dull, predictable Maryland utility into what it calls an "energy merchant" that has pushed beyond old regulatory boundaries. It has become the country's largest seller of wholesale power, with big commercial customers like Ford, Wal-Mart and Wachovia in more than a dozen states. And it gets power from wide-ranging plants, from California to upstate New York to Texas.

Whereas BG&E was once the center of Constellation, this local utility, which only runs the substations, transmission lines and distribution lines for 10 counties in central Maryland, is now a relatively modest part of the parent company. BG&E gave its 12 power generation plants to other parts of Constellation, which last year earned 71 percent of its profits from the merchant energy business.

If Constellation completes a planned merger with Florida Power & Light Co., it will become the nation's third-largest nuclear operator, second-largest utility and one of its 75 biggest public companies.

But the company's success amid sharp increases in energy prices has focused debate over whether utility deregulation has worked. "We were told that this would benefit consumers. We were lied to. This was always about power companies breaking free from regulation to make much, much more money," said Tyson Slocum, director of the energy program at Public Citizen.

Regulation of the utility industry dates to the Depression. Spurred by financial scandals and the fact that just three holding companies controlled 45 percent of the electric power generated in the United States, Congress adopted the Public Utility Holding Company Act in 1935. To prevent utilities from speculating with ratepayers' money, the act barred utilities from doing business across state lines. The result was localized utilities that did everything from run power plants to bill households, with regulated returns on investments in the country's power infrastructure.

In the 1980s and 1990s, many analysts argued that the industry had become inefficient, thus hurting consumers. Some big industrial and commercial customers believed they could get cheaper rates by buying power from firms other than the local utility.

In 1992, a bill passed by Congress gave utilities and customers the limited ability to buy and sell power in a new wholesale power market. Last year, the Energy Policy Act of 2005 further freed up utility companies for restructuring and dealmaking.

Constellation's story shows how this works. BG&E has dutifully supplied energy to residential customers at the frozen rates, thanks in part to long-term supply arrangements.

Meanwhile, the rest of Constellation was changing. In October 2001, Shattuck became CEO. He had worked for Bain & Co., a high-powered consulting firm, and then for Deutsche Banc Alex. Brown, an investment banking firm. Shattuck quickly shed real estate, assisted living centers and leasing deals on airplanes to raise cash for the heavily indebted company.

He also changed the corporate culture. "You got the sense back in the 1990s that people here didn't know how to sell or market anything," Shattuck says. "Now there's an entrepreneurial idea."

Part of that new ethic came from buying out the half interest the Goldman Sachs Group Inc. had in an energy trading venture with Constellation for $355 million. At the time, after the 2001 Enron Corp. energy trading scandal, most companies were fleeing that business. In 2002, Constellation spent $250 million to buy New Energy, whose sales force marketed power to industrial clients in 22 states.

Shattuck decided not to spin off BG&E, keeping it as balance to the riskier merchant energy business. And he invested in the nuclear power business when many companies were shunning it. He acquired two nuclear plants in upstate New York to go with Constellation's one other.

By 2004, many industrial customers were buying power directly. That meant paying the local utility regulated transmission fees while making deals with generating companies, brokers or power marketing firms around the country. These deals were made at different prices and for different time periods. In this area, industrial customers or BG&E itself can buy power from any company whose generating stations are hooked up to the Pennsylvania-Jersey-Maryland regional transmission network. Of BG&E's large industrial customers, 87 percent are doing this, which is why the new rate increase won't affect many of them.

Constellation has benefited greatly in this new environment. Its revenue rose to $17.1 billion in 2005 from $4.7 billion in 2002. Its stock price bottomed out in 2002 at $19.30 a share; yesterday it closed at $54.40.

Residential customers, however, are just getting plugged into this new world, and they're feeling rate shock. To supply them, BG&E held auctions in January, February and March. The company says 16 firms submitted bids and that it chose several. Constellation says it was one of those bidders. The identity or other bidders or amount bid has not been disclosed, but Constellation is one of the biggest suppliers in the PJM network. Other bidders could be investment banks that trade energy but don't operate any plants.

And that has Maryland politicians and consumer groups crying foul. The auction, they say, is flawed because in a tight market some low-cost power generators (using coal or nuclear) might get higher prices (closer to natural gas prices) than they would in a regulated system. "You might as well be minting money," said Public Citizen's Slocum.

In Illinois, the attorney general is challenging the legality of the auction system. "The electrons will come down the same wires in the same way," says Cohen, the governor's aide. "What changes is who are the middlemen and what are we paying. This is not about how the power flows, but how the money flows."

What Shattuck calls the "perfect storm" of energy cost increases, the merger and election-year politics has affected his views. A year ago, he predicted that the utility industry would soon have fewer, more competitive and efficient players.

Last week, he was still worried about possible state legislature interference with the Florida Power & Light merger and talked about the feasibility of limited re-regulation.

"My view has changed," he said about the industry's future. "It is more difficult to get transactions done in this industry than in any other industry."

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