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Buy Stock Electricity Primer
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Utilities were once considered to be conservative investments. They were the preferred investments for "widows and orphans" because they were thought to be a safe way to generate income via dividends. That is no longer the case today.

Deregulation has changed everything for this former safe haven. Many utility companies have gone from operating regulated monopolies with guaranteed returns to operating in a highly competitive and volatile commodity market "with high fixed costs. Competition in the industry will only increase as deregulation continues to expand. The rules have changed, and the investment attractiveness of the entire sector has diminished as a result.

Electricity Primer

Though there are a handful of pure gas and water companies—Nicor and Philadelphia Suburban are two examples—utilities that provide electric service dominate the ranks of the publicly traded companies in the utilities sector.

The electric utility business can be divided into essentially three parts: generation, transmission, and distribution. For most of the twentieth century, utilities operated as regulated monopolies, and most had all three parts of the business integrated into one entity. But because of today's regulatory environment, many utilities have been forced to separate their operations into more focused components. Some utilities operating in states that have not deregulated still operate as essentially integrated entities, "while other utilities are focused on only one or two of the main functional areas.

Generation

These are the operations that run the power plants themselves: coal/natural gas/uranium in; electricity out. A 1992 federal law forced utilities to split their generating assets from the rest of their businesses, which set the stage for deregulation at the state level. Some states have full competition in electrical generation with rates set by the free market, while others still have fully regulated wholesale rates. In states with full deregulation, the distribution arm of the utilities often buys power from third-party providers who are in competition with their generation arm. In addition, some states such as Pennsylvania allow customers to choose their generators. A customer could, for instance, choose to pay a premium and get power purely generated from wind and solar. Generation is perhaps the area that has the greatest competition today be­cause electricity is a pure commodity, and the barriers to entry are comparatively low and falling. It is also the area that is furthest along in the deregulation process, opening the door for independent power producers. With competition heating up and profitability falling, it's becoming increasingly difficult to make a profit.

Transmission

Transmission is the business of transporting electricity over long distances— think tall hlgh-tension/hlgh-voltage wires. Some states have forced the utilities to sell their transmission assets to third-party operators who operate regional grids, but often the utilities keep their equity stakes in the transmission com­panies. Regardless of who operates or owns the grid, rates are regulated, and there is open access for generators. There was not always open access to the grid, and this is a cornerstone of deregulation creating more competition.

Transmission operations typically have fairly wide economic moats because there are huge barriers to entry due to large upfront costs as "well as the NIMBY (not in my back yard) effect. However, with rates and returns regu­lated, companies have a difficult time creating excess value.

Distribution

Distribution-related companies own and service the final mile of cable that brings power to the individual homes and businesses. Even in states where customers can choose their generator, the operators of the final mile still handle the customer service and billing, in addition to charging for use of their systems.

Distribution is where utilities have their widest economic moat because they tend to own monopolies with essentially no alternatives, even in deregulated states. But the natural monopolies here also lend this area to the most government control. This means the rates customers are charged are regulated and returns on investment capped, making it difficult for utilities to parlay their economic moat into excess returns. Without excess returns, creating shareholder value is an uphill battle.

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