The New Electric Power Industry.

BARRY FLEISHMAN

Responsible fore more than $200 billion per year in direct sales of electricity, with an estimated total product sale potential of one trillion dollars, the electric power industry is the fourth largest industry in the United States. For more than a century, it has been dominated by vertically integrated utilities and subject to intense regulation. But this manner of doing business is rapidly changing, and the consequences are expected to be staggering.

For the apartment industry, there are both opportunities to be grasped and pitfalls to be avoided in this new age of electric power sale and delivery. The obvious opportunity is to lower costs. Not so obvious, but perhaps even more important, is to acquire greater control over this aspect of the apartment business and to use that control to offer better and broader services at competitive rates to customers. Greater control, however, cannot be acquired without accepting increased responsibility and exposure to loss. Thus, it will be essential for apartment owners to minimize exposure and to insure against loss if they are to take full advantage of the opportunities presented by electric power deregulation.

In determining how to react to electric power competition, multifamily housing owners have many variables to consider. A short list of those variables includes:

What is the status of electric power regulation in your state?

Are utility costs the responsibility of the owner of the resident?

Are units separately metered?

Is the facility a new-build?

How many units are owned?

Do the residents have special electric power needs (seniors, physically-impaired, etc.)?

Is it time to replace key power-consuming products (heat pumps, air conditioning units, kitchen appliances, etc.)?

As states continue to adopt competition, most owners ultimately will have to come to grips with new business realities in purchasing power. Understanding what is happening and preparing for the changes is crucial.

HOW DOES THE POWER SYSTEM WORK?

The electric power system in the United States is made up of three basic components - generation, transmission, and distribution.

Generation of electricity takes place when an energy source (generally coal, gas, nuclear, or water power) is used to drive the operation of a turbine, which converts that energy into electric power. Electric power cannot be stored in large amounts; therefore, there must be a constant balance between the amount of electricity produced (generation), and the amount of electricity needed (load). Too much load and not enough generation can result in an outage; too much generation and not enough load can result in other catastrophes.

This constant need for balance between generation and load led to the development of an electric power grid covering large areas in the United States. The grid accepts power from a variety of generators in large amounts and acts like a reservoir, parceling out power to systems that need it. Historically, the grid was operated by the large utilities, which cooperated in supplying power to each other in order to avoid outages.

The movement of electric power from the grid to more local areas is referred to as transmission. Transmission lines are the 'interstate highways' of electric power. Disruptions in transmission affect large areas, such as the 1996 blackouts in the western United States. The ultimate delivery of power from the transmission drop-off centers to the customer is called distribution. These 'local roads' are the most susceptible to weather-related disruptions (ice storms, high winds, etc.).

Eliminating the distance between generation of power and its end-use, and reducing reliance upon transmission and distribution lines, goes a long way to minimizing disruptions in power. The advent of distributed generation - the use of smaller, less expensive generation units placed near the facilities that will use the power-has become a major factor in the choices available to large users. Thus, it will increasingly be of interest to large apartment owners.

WHAT IS BEING DEREGULATED?

The electric power industry developed as a vertically integrated, wholly regulated form of business. The power companies built the generation plants, produced the electricity, owned the transmission and distribution lines, and provided the service to the customer - all subject to rigid rate and service regulation by state and federal governmental agencies.

This monopolistic business structure resulted largely from two factors: the need to establish and to maintain a balanced power grid and the high costs of purchasing generation plants and building and maintaining transmission and distribution lines, which discouraged new entrants. In recent years, technological advances have greatly decreased the cost of building power plants, thereby encouraging new parties to compete in the power generation business.

Regulatory bodies at both the federal and state levels have encouraged (to varying extents) the development of competitive generation by forcing traditional utilities to open the grid to those who need to buy power from it and to those who wish to sell power into it. As a result, customers in states where competition is allowed now can buy power directly from generators, or from power brokers or other retail suppliers, and no longer are restricted to dealing with the local utility for the sale of raw power. However, traditional utilities still control the transmission and distribution components of the power system. Thus, customers may have to deal with several parties in their purchase and use of electricity.

Federal legislation establishing nationwide guidelines for electric power competition has been proposed and debated, but not passed. The table shows the present status of competition in individual states.

HOW WILL DEREGULATION AFFECT THE MULTIHOUSING INDUSTRY?

Residential customers provide 40 percent of the electric power industry's annual revenue. However, aggressive marketing of gas power and lower gas prices have whittled away its share of this market. For example, electricity's share in the home heating market dropped from 50 to 29 percent for new single-family homes, and from a dominating 70 to 44 percent for new multifamily homes.

One can expect the electric power industry to market aggressively to recapture market share both by responding to large owner bid requests, and by addressing concerns of individual users. The major battling will be on cost issues, and apartment owners potentially can negotiate very favorable rates either on their own on through coordinating their efforts with other owners.

One factor that may affect those rates is the fair degree of uncertainty in wholesale supply prices now being faced by the industry. Just this past February, short-term shortages of supply resulted in extraordinary price spikes in Midwestern markets that pushed wholesale prices as high as $7,000/MWh, and forced certain marketers and brokers to cancel their supply contracts. This and other similar price spurts can be attributed in part to the learning curve the industry is facing in dealing with power supply competition. However, some industry experts are predicting more wide-spread shortages in power that undoubtedly will affect both wholesale and retail rates. In addition, it is uncertain whether the very high level of reliability that has been a hallmark of the electric power system will be maintained during the transition to competition. In light of these uncertainties, apartment owners should be wary of both long-term price deals and arrangements that require owners to absorb fluctuations in wholesale prices.

On the brighter side, power suppliers would seem to have an interest in seeking to acquire a flexible load - one that can be subject to brownouts without much impact - in order to lessen the severity of power shortages. Thus, the apartment industry could be perceived as an attractive customer. This, in turn, could result in favorable pricing deals to the extent that the apartment owner is willing to be subject to reductions in power availability. However, apartment owners should consider such price advantages in tandem with the availability and cost of alternative power supplies for emergency service.

In addition to dealing with new cost issues, apartment owners will need to be aware that utilities increasingly will be competing in the provision of services other than the direct sale of power. The Electric Power Research Institute (EPRI), a research organization for the industry, sees residential electric power as a major opportunity area for new business and has established residential use as a key business target area. EPRI cites studies indicating that residential customers value services, such as assistance in technology selection and installation, as much as low cost, and argues that the provision of these additional services can be useful in strengthening and preserving market share. (The hope of the utility is that if you trust their service, you'll buy their power.)

The focus in the apartment industry likely will be on providing competitive services with respect to new-builds, heat pumps, air conditioning, electric appliances, and alternative power sources (such as distributed power). Technological advances will provide great opportunities for apartment owners to provide a wide assortment of new age services for residents that will result in energy efficiencies and lower energy costs. For more information, EPRI's Web site can be found at www.epri.com.

Finally, there will be opportunities for apartment owners to enter the electric power industry directly as power marketers and brokers, or even as generators supplying excess electricity back to the grid from their distributed generation units. It indeed will be a brave new world.

WHAT LIABILITY AND INSURANCE ISSUES SHOULD BE CONSIDERED?

The regulated utilities historically have been protected from legal liability for power disruptions. In large part utilities only could be held liable if they were grossly negligent.

This is likely to change in at least three ways. First, risk factors will be negotiated as part of power purchase contracts. Utilities no longer will be able to place all of the risk should be an essential point of negotiation in the purchase of power.

Second, many more players will be involved in the power delivery system, including new generators, power brokers and marketers, and independent operators of the electric power grid. This will result in unprecedented legal disputes to determine who is at fault, and who will be liable, for outages. Even customers may face liability to the extent that they are operating their own generators or otherwise affecting the power system.

Third, new legal standards will likely develop, particularly with respect to product liability and warranties of merchantability, that will affect parties' exposure to liability. The historic changes in business relationships resulting from the introduction of competition in the electric power industry can be counted on to raise new legal issues that will require time, and judicial decisions, to resolve.

For this reason, it is important for apartment owners to focus on electric power issues in the course of reviewing the adequacy of their insurance. Of particular importance are limits of liability, business interruption exclusions or limitations, and other clauses that may limit coverage for losses resulting from power disruptions.

CONCLUSION

This article merely scratches the surface in describing the enormity of the changes that will result from the introduction of competition into the electric power industry. Apartment owners will need to be well-informed and well-prepared in order to take advantage of the opportunities and avoid the pitfalls of this new period in the development of the electric power industry.

Fleishman is a partner with Dickson, Shapiro, Masin & Oshinsky, Washington, D.C.