Prepared by: Hunaid Sulemanji, Erdal Ermas, Steve Lauritson

Nature of Electric Industry:

The purpose of the electric industry is to generate, transmit, and distribute electric power at retail rates to several different classes of customers and at wholesale rates (for purpose of resale or manufacturing) to large industrial and commercial customers, state and local government owned utilities, public utility districts, and rural electric cooperatives. The emergence of early electric systems dates back to the late 1800’s, and at that time these companies were somewhat inefficient and redundant in the services they provided.

The financial framework of electric companies suffers from high fixed costs as a result of heavy investments needed to finance central generating plants, electric power transmission from generating plants, and distribution systems to a final point of delivery. In comparison, the operating or variable costs are relatively low. Therefore revenues are generated by spreading out fixed costs and this is accomplished by having more customers on the system.

One of the largest problem with electric companies is establishing an appropriate price for electricity. Since electricity cannot be stored the idea is to find the right mix of customers to utilize and maximize the generating capacity for each day. Electric companies have therefore adopted a concept called demand-side management, which measures customer’s electric demand, or the "share" of fixed costs required for usage, as well as the actual energy for kilowatt-hour (kWh) used. Fixed costs reflect the fixed amount of investment that must be paid, regardless of output, and include power plant and equipment investments. Variable costs are those that vary with the level of electric output and include fuel expenses (for generation).

Electric companies are natural monopolies regulated by state agencies, who establish rates and set service standards. Government regulations allow electric utilities to function as a natural monopoly because a single company providing electric service was more economically efficient, and it eliminated duplication of service and equipment. However, the government imposed certain common characteristics on electric industries such as:

• Assignment of franchise or service territory - a franchise allowed utilities to serve customers within a designated geographic area, also known as service territory, for a specified period of time.
• Obligation to serve - in return for its franchise, electric utilities are required to serve all existing and future customers equally and at reasonable costs (regulated by states).
Although the purpose of the electric utilities is to provide power to customers, many have subsidiaries that invest in selling other services or products. For example Potomac Electric Power Company (PEPCO), a local utility in the Washington, DC area, has a wholly owned subsidiary called Potomac Capital Investment (PCI) that invests in non-utility activities such as airline leasing, wireless telecommunications, energy management services, underground cable construction and maintenance contracting. Recently, PCI formed a joint venture with Residential Community Network (RCN) to provide bundled services such as telephone, cable and internet services to compete in an increasingly competitive environment. Although these ventures are relatively small, they attract opportunities in the growing technologies sectors and offer a strong potential for long term contribution to earnings.

Changes in the Industry:

The major change in the past few years has been a change in the vertically integrated structure of the electric industry with the introduction of the Public Utilities Regulatory Policy Act (PURPA) of 1978 and the rise of Power Marketers. PURPA required utilities to buy power from non-utility generators that employed renewable energy sources or co-generation (uses steam both to generate power and heat adjoining buildings). The primary goals of the act were to reduce dependence on imported oil and encourage renewable energy sources. In addition, PURPA played a major role in promoting competition in the power generation. Although PURPA required purchases at prices that were supposed to reflect utilities’ expected cost of own generation, the calculated prices determined artificially high purchase prices because the independents were able to produce power at lower costs through reduced capital costs and efficient generation.

Power marketers act as independent middlemen who buy and sell wholesale electricity at market prices. Power marketers typically do not own electrical generation, transmission, and distribution assets but are affiliated with electric companies and have vast experience competing in the energy markets. Sales growth in the power marketing sector has grown dramatically in the last three years, and continues to grow at a rapid rate.

The imminent change in the future is the deregulation of the electric industry. A few states currently have deregulation laws in effect, while many others plan to have laws in effect in the next few years. Deregulation will result in the division of existing electric utilities into two parts, namely, transmission, which will continue to be regulated to some degree and generation, which will be completely unregulated. The customers will be free to purchase power from any generation sources and have this power transmitted and distributed, over "regulated" lines to their facility or home. In the long run, deregulation promises reduced electricity costs for industrial, commercial, and residential customers alike. In the short run, however, the promises of reduced electricity costs appear to extend only to industrial or large commercial facilities.

In fairness to electric utilities that are bounded by the "obligation to serve" law by the government, state regulators have realized that these electric utilities have invested in the infrastructure of power generation, transmission, and distribution. These programs include energy conservation, low-income energy assistance, alternative fuel use, and mandatory power purchases under PURPA. These costs are referred to as "stranded costs", and range from $50 billion to $300 billion. These costs were incurred with the assurance of regulators that they would be recovered over the long run. Competitive businesses operate differently because they expect to recover capital costs quickly and are not required to delay recovery of costs for up to 30 years. Stranded costs are legitimate costs and must be paid by someone, and recovery is necessary for efficient competition in this industry. The Federal Energy Regulatory Commission (FERC), who has jurisdiction in these matters, is working on an equitable and fair system to protect the electric industry investments under the old regulatory bargain. In addition, this cost recovery plan was affirmed in the 1996 Economic Report of the President. The recovery of legitimate stranded costs is necessary to prevent cost shifting from large customers onto small business and residential consumers.

Cost Management:

Electric utilities today are looking for more effective systems and methods to control costs, increase profits, and improve productivity. In addition, costs are associated with operations and administration activities which provide these three core services of generation, transmission, and distribution. Traditionally, electric utilities (due to lack of competition) have not realistically allocated costs among strategic units, processes, or service. Therefore, electric utilities have been making decisions based on inadequate and/or misleading data.

Electric utilities have begun using advance cost management tools such as activity-based costs, target costs, absorption and variable costs, and job order costs to remedy this problem. Costs are now allocated based on functions or activities rather than an arbitrary measure. Costs are further allocated by "cost drivers", thus directly linking costs, services, and benefits. Utilities can pinpoint costs that add value and eliminate those that do not. The cost data can also be used to make informed decisions on services and pricing. Simulating the data has also helped utilities to evaluate new ways of producing the service and capital investments. Utilities can now cut costs because they can identify and connect them with specific processes or services. Advanced cost management tools (such as activity-based, target, etc.) has given utilities the ability.

International Competition:

The average price of electricity in the US is among the lowest in the industrialized world. The US industrial firms pay less than a quarter of what their Japanese counterparts pay and less than half of what their European counterparts pay. And while most countries have experienced an increase in electricity prices, prices in the US have decreased. Since 1982, the electricity price in the US, adjusted for inflation, has dropped steadily, declining over 25 percent. This downward trend can be attributed to the following factors:
 

• increase in operating efficiencies and improvements in generation.
• decrease in the cost of fuel used for generation.
• introduction of additional new cost-effective entry of power plants entering the market.
• increasing number of power plants have been fully depreciated.

Conclusion:

The energy sector is undergoing sweeping transformation, which holds the promise of increased reliance on market forces and competition, with potentially large dividends for customers and business. To facilitate such transformation, advanced accounting systems and cost management tools must be integrated into the management structure of the industry (in addition to regulatory and competition policies). Unnecessary accounting principles must be reformed to better address the industry where monopoly power has persisted for so long.

References:

1. Ingram, Albright, Hill. Managerial Accounting: Information for Decisions. South-Western College Publishing, 1997.

2. Electric Power Research Institute: http://www.epri.com.

3. Edison Electric Institute: http://www.eei.com.

4. Potomac Electric Power Company: 1996 Financial Statements and Annual Report (pepco.com).