After the Storm

After the Storm

May 24 - Electric Perspectives

Over a six-week period beginning August 13, 2004, four hurricanes struck Florida. The landing of so many hurricanes in a single season was unprecedented in the state's history. So was the scale of the destruction. According to some estimates, one in five homes in Florida suffered some type of damage.

The impact on Florida's shareholder-owned electric companies was equally destructive. The hurricanes required them to replace more than 3,000 miles of wire-enough to reach from Tampa to San Diego- almost 32,000 poles and more than 22,000 transformers.

The combined storm costs totaled more than $1 billion for FPL and Progress Energy. That total worried Wall Street: Standard and Poor's revised its outlook for Progress Energy from stable to negative, citing "uncertainties regarding the timing of hurricane costs" as one of the triggering events for the revision. Moody's also put the company's ratings under review for possible downgrade, citing the timing of the recovery of storm costs as one of their concerns.

The logistics associated with restoration efforts can be daunting. In addition to deploying their own crews, utility crews from around the country are called in, and the "host" utility picks up the tab for wages, equipment rental, transportation, hotel rooms, meals, and even laundry.

FPL fared better. It went into the hurricane season with about $345 million ($211 million in cash and $134 million in deferred taxes) set aside in a special storm reserve fund that it had established in the 1940s. Even so, FPL was left with a repair bill of an additional $545 million. Fortunately for the company, the Florida Public Service Commission (PSC) allowed it to carry the remainder of the unpaid storm bill as a negative balance in its storm fund, thereby negating the earnings impact of the loss. (The Florida PSC also allowed Progress Energy, Tampa Electric, and Gulf Power to carry negative balances in their storm reserve accounts.) Questions remain about how this bill will get paid and how the storm reserve will get refunded to provide a cushion for the next time a hurricane strikes.

It is no small irony that whenever a major storm strikes, the affected utility must mobilize a huge workforce to repair the storm damage as quickly as possible, with little or no consideration being given to the cost of the restoration effort. Utilities use several different methods to mitigate the financial impact of these costs. Unfortunately, there is little consistency in how these methods are applied throughout the industry, or even within a company, from storm to storm. This creates uncertainty and invites political intervention. A more formalized and uniformly applied structure for mitigating the financial impact of major storms is needed.

When large storms damage their electric systems, utilities launch massive, round-the-clock restoration efforts to restore power as quickly as possible. The logistics associated with these restoration efforts can be daunting. In addition to deploying their own crews, utility crews from around the country are called in, and the "host" utility picks up the tab for wages, equipment rental, transportation, hotel rooms, meals, and even laundry. And then there are the equipment costs: miles of new wire, thousands of new poles, new transformers, cross-arms, fuses. The list goes on and on, and so do the costs.

But the key is restoring power as quickly as possible-utilities mobilize outside resources at additional costs because they want to minimize the duration of power outages. Still, the utility gets a bill that can be financially devastating.

In other instances, there appears to be an unwritten rule that when storm costs become "significant" the utility will be allowed to petition its utility commission to recover its prudently incurred storm costs-usually by assessing its customers a surcharge or paying for the costs out of earnings over a fixed period of time, usually two to five years. There are also a number of companies whose commissions authorize the creation of special storm reserves that are credited each month. When large storms strike, these funds are supposed to act as a form of insurance, mitigating the onetime financial impact of the storm.

We need to look beyond Florida to assess the impact that major storms have on the broader electric utility industry and provide insight into how to pay the heavy price tag incurred as a result of these storms.

Historical Perspective on Major Storm Costs

We considered data from 14 companies for 81 major storms that occurred from 1994 to 2004. The total company-calculated cost for these storms approaches $2.7 billion, and most of this has occurred since 2000.

For the entire period, the average annual cost of major storms per company was $48.7 million, with the highest annual cost incurred by a single company being $890.0 million. If the five largest of these costs are not counted, however, the average decreases by over 60 percent to $18.2 million. Four out of the five most expensive storms identified in the survey have occurred since 2000, and three of those four were hurricanes.

Take it from another perspective. Consider that, on average, utilities spent $2.97 million a day to repair their systems, but several storm costs exceeded the $10 million a day range. In any event, the magnitude of storm restoration costs appears to be random and varies greatly with storm type and severity. Moreover, utilities mobilize substantial-and in some cases enormous-amounts of resources to repair their systems after major storms.

Also, average utility storm restoration costs are significant from both a customer's and a utility's perspective. If you compare the total costs of a storm to the peak number of customers affected by it, the average cost per customer from 1994 to 2004 was approximately $87-about the same amount of revenue that a utility receives each month from a typical residential customer.

Strange to say, but at an aggregate industry level, little is known about the financial impact of major storms on a utility company. But on the face of it, just based on press accounts, the potential financial impacts are substantial, even catastrophic.

To get a good gauge, we measured the impact on four companies of very large storms (or sets of storms) that have occurred since 2000. (see Table 1.) In some instances, storm costs exceed a company's total earnings and transmission and distribution (T&D) expenses for the entire year.

Indeed, when you look at all 14 companies reporting a major storm or set of storms between 1994 and 2004, you find that storm costs could have a significant impact on a utility company's earnings if all storm cost was written off against current earnings. The average for all companies in the survey was 13 percent of net utility operating income.

TABLE 1

STORM COSTS AND FINANCIAL IMPACTS

The aggregate 1994-2004 T&D data provide another indication of the significant financial impact a storm can have on a utility's financial condition. Major storm costs averaged 40.4 percent of what the company spent during the year to operate and maintain its entire T&D system.

The general criteria for classifying a storm as "major" appear to revolve around whether the storm has a significant impact on a company's customers-that is, whether a substantial number of customers are without power for a significant period.

Paying for Major Storm Restoration

Many regulatory commissions allow accounting policies and special rate treatments that minimize or smooth out the unpredictable nature of major storms and their potentially significant financial hit. These policies can play a major role.

Almost all utilities distinguish between "normal" and "major" storms. While the methods for determining severity vary, the general criteria for classifying a storm as "major" appear to revolve around whether the storm has a significant impact on a company's customers- that is, whether a substantial number of customers are without power for a significant period. Baltimore Gas & Electric, for example, defines a major storm as one in which 10 percent of its customers are without power for a day or more. Public Service of New Hampshire defines a major storm as one that results in either 10 percent or more of customers losing power, resulting in 200 or more reported troubles; or 300 or more reported troubles. Storms not classified as major fall under normal accounting rules; major storms often receive special accounting treatment.

After last summer's hurricanes, Wall Street's relatively measured reaction would have likely been much different If the Florida utilities had been required to expense the o&M cost component in 2004.

In the case of a major storm, the utility separates expenses into capital and operations and maintenance (O&M) components. For the most part, utilities treat capital costs (such as pole and transformer replacements) similarly. They go into a company's books as depreciable assets, which in most cases are eligible for inclusion in a utility's rate base and therefore can be recovered through rates. In a few instances, companies incurring extraordinary storm costs have been allowed to defer capital costs and recover them through a special custo\mer surcharge.

While the ratio of capital to O&M costs can vary significantly from storm to storm, here's a general rule of thumb: The capital component of a major storm's costs is approximately 20 percent to 25 percent of total storm costs.

Recovering storm-related O&M costs is much different. For many companies, expensing major storms costs in the period in which they occur could result in a huge financial burden that could jeopardize the company's financial standing. After last summer's hurricanes, for example, Wall Street's relatively measured reaction would have likely been much different if the Florida utilities had been required to expense the O&M cost component in 2004. Even the possibility of having to incur such a charge could significantly change the level of risk that bondholders and stockholders perceive for a company and increase its overall financing costs.

Utility Storm Reserves

To mitigate the financial consequences of major storms, some regulators allow their shareholder-owned utilities to apply different accounting treatments for the O&M component. (Rural electric cooperatives and municipal utilities, by the way, are eligible to recover 75 percent of their O&M costs through the Federal Energy Management Agency.) One treatment is a special storm reserve account. Of the 28 electric companies contacted, 12 said that their commissions allowed them to establish such accounts.

As an accounting technique, the storm reserve smoothes out the earnings impact of major storms. For the most part, the reserve is not funded with cash (though FPL's reserve is an exception), so it does not serve to lessen the cash-flow impact when the utility has to pay for the storm.

When a utility establishes a storm reserve, it credits a fixed amount each year to the reserve through monthly accruals-most companies appear to accrue less than $5 million year; the highest annual accrual among the 12 utilities was FPL's, at $20 million. The reserve deducts these accruals from the current month's earnings even if no actual storm costs are incurred. When a major storm strikes, the storm costs are charged against the balance in the account. The reserve, however, provides no cash to pay the actual storm costs.

The big benefit of this accounting treatment is that when a big storm strikes, the only charge to earnings the utility incurs is its normal monthly accrual to the reserve account, assuming that it has a balance there.

With the 2004 hurricanes, FPL, Gulf Power, Progress Energy Florida, and Tampa Electric all incurred storm-related O&M costs that exceeded their balances. (See Table 2.) To avoid charging these non-accrued amounts against current earnings, the Florida PSC allowed the companies to account for the excess as a negative balance. The commission indicated that it viewed the negative balance as a temporary solution until "an alternative accounting treatment for recovery of prudently incurred storm damage costs" could be established. This treatment allowed all four companies to avoid taking a charge to earnings in 2004 for the full storm costs and helped the companies maintain their credit ratings.

TABLE 2

EXCEEDING RESERVES IN 2004

Had these reserve funds not been in place and had the commission not signaled its willingness to work with the Florida companies for recovering prudently incurred storm costs carried as negative balances in reserve accounts, it is likely that the companies would have suffered a much greater financial impact, jeopardized their ratings, and seen increased financing costs.

Special Deferrals

Another accounting technique is to defer all or a portion of storm-related O&M costs. Unlike credits to storm reserve accounts, deferrals typically are not routine events-they require the utility to ask its commission for special accounting treatment after a major storm. (See Table 3.)

Major storms between 1994 and 2004 caused $2.5 billion in damage to electric utility systems. That's a big number, but it is only a fraction of the regional economic losses resulting from being without power in each storm's aftermath.

With a deferral, O&M costs are amortized over an extended period, usually two to three years, but the costs may or may not be recoverable from customers. In many instances, the company recoups deferred costs through a surcharge on each customer's bill until the storm's bill is paid off. Some utilities, however, must pay off the deferred costs out of their earnings.

Even though not technically a deferral, one special accounting treatment that Conectiv and BGSiE receive from the Maryland PSC allows them to include an average of historical storm costs in the test year they use for rate cases. This treatment essentially allows the companies to prepay at least a portion of storm costs by collecting revenues from their customers to pay for storms that have not yet occurred. One shortcoming of this technique is that it does little to smooth out the earnings impact of severe storms such has Hurricane Isabel, which struck in 2003 and required both companies to incur significant charges to earnings that year.

TABLE 3

EXAMPLES OF DEFERRED TREATMENT FOR STORM COST

A substantial portion-76.9 percent-of all storm costs between 1994 and 2004 were recovered through existing storm reserves or were eligible for deferred accounting treatment. The remaining storms' costs are expensed. While the costs of those storms were significant, they appear "manageable." On average the major storm costs that were expensed equaled 4.4 percent of net operating income- about a third of what the average would have been if the storm costs eligible for storm reserve and deferred accounting treatment had been included. Also, only a handful of the expensed storms were significantly above the 4.4-percent average.

Paying for the Greater Good

There are no assurances, however, that utilities will continue to receive the favorable regulatory treatment for recovery of storm costs that they received in the past. The whole issue has become more politicized. For example, last November FPL and Progress Energy requested permission from the Florida PSC to amortize the negative balances they were carrying in their reserve accounts over a two- year period. This would result in surcharges-beginning in January 2005-of $2.09 per month for FPL'S customers and $3.81 per month for Florida Progress". The Florida office of public counsel and the Florida Industrial Power Users Group then filed motions with the PSC requesting that it deny the petitions.

Storms are expensive. As our survey showed, major storms between 1994 and 2004 caused $2.7 billion in damage to electric utility systems. That's a big number, but it is only a fraction of the regional economic losses resulting from being without power in each storm's aftermath. With this kind of societal impact, it is clearly in everyone's best interest to restore power as quickly as possible.

The industry knows that large storms will occur, and it knows that the financial consequences of these storms could be significant and in some cases catastrophic. In spite of this, recovery of costs for most major storms is dealt with on an ad-hoc, after-the-fact basis. This makes it difficult for utility managers to plan and creates uncertainty on Wall Street.

What is ironic, given the importance of storm restoration, is that more established and consistent policies regarding storm cost recovery are not in place. From a cost recovery standpoint, why is recovery of storm restoration costs any different than recovery of insurance premiums? Both represent a cost item for operating a modern utility. Yet, the industry has vastly different philosophies regarding cost recovery between these two cost items.

Given the lack of commercially available storm insurance at affordable rates, it seems only appropriate that the industry adopt some type of self-insurance mechanism for storms, either within individual companies or on an industry basis. Looking at the establishment of a storm reserve with regulatory approvals for monthly reserve accruals or even cash deposits would seem to be a good starting point.

Storm reserve funds do what they were intended to do-minimize the financial impact of major storms at an affordable cost (20 cents a month for a typical FPL residential customer, for example). It seems only prudent that commissions consider establishing reserves as a type of "rainy day fund" for the time it becomes necessary to offset the serious economic impact of future storm restoration.

HURRICAN ALLEY COSTS

FPL'S service territory encompasses almost the entire east coast of Florida making it particularly vulnerable to damage from hurricanes. To mitigate the financial impact of a catastrophic storm, FPL funds its storm reserves with cash payments invested in interest-bearing accounts. The utility appears to be unique in this regard. This "funded" reserve provides a source of cash to pay for storm costs.

Until Hurricane Andrew in 1992, commercial insurance was widely available at affordable rates to protect against catastrophic storms. FPL had a transmission and distribution (T&D) system policy with a limit of $350 million per occurrence. The 1992 premium for this policy was $3.5 million. After Hurricane Andrew, commercial insurance carriers stopped writing such policies altogether or made them so expensive that they could not be justified. For example, the quote FPL received in 1993, the year after Hurricane Andrew, was for $23 million for a T&D system policy with an aggregate annual loss of $100 million.

In lieu of paying for expensive storm insurance, FPL elected to self-insure. It currently funds its st\orm reserve account at a level of about $20 million a year. This amounts to about 20 cents a month for a typical residential customer.

HOW BIG STORMS GET BIGGER

In addition to storm frequency and severity, another major driver in storm costs is customer growth. As populations expand, of course, utilities must expand their electric systems to serve more new customers. As a result, even if the severity and frequency of storms remains consistent with historical levels, storm costs can be expected to increase simply because there is more electric equipment subject to damage from storms.

For example, during the 10-year period from 1994 to 2004, Florida utilities expanded their electric systems to serve approximately 1 million additional customers. This 20-percent increase in customers likely contributed significantly to the total costs Florida utilities incurred to repair their electric systems after the 2004 hurricanes.

Brad Johnson is president of ACN Energy Ventures LLC, an independent energy consulting service based in Falls Church, VA. This article is based on a report sponsored by Edison Electric Institute. For a copy of the complete report, visit www.eei.org .