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The Shock Of Electricity Deregulation

Are you ready for electricity deregulation?

"I do not have the slightest idea what it means to our business," says one shopping center developer. "I have read a lot about it, but I cannot understand it."

Join the crowd. The process of electricity deregulation has managed to confuse all but the closest observers.

As the electric-power industry restructures, many commercial customers will pay higher or lower rates for electricity, depending on their geographic allocation.

In the state of Washington, for example, commercial customers may pay more as low-priced hydroelectric power mixes with higher-cost power from neighboring states. Those users will need to seek ways to stem a rising tide.

On the other hand, electric-power users in states where electricity costs have traditionally been high may find opportunities to cut electricity bills.

At the same time, new relationships with new electricity providers will challenge traditional landlord-tenant relationships as each seeks the lowest possible prices.

Why is the electricity industry changing? Since the late 1970s, the federal government has moved to deregulate one industry after another. Five industries have gone through the process: airlines, long-distance telephone communications, trucking, railroads and natural gas. In each case, the results included initial confusion for users and eventually lower costs.

The process now is under way in the electric-power industry. In 1992, Congress passed the Energy Policy Act, or EPACT. This legislation required utilities to sell power to wholesale customers, who would then resell power to other utilities facing capacity problems.

EPACT also permitted individual states to allow choice of electricity suppliers to industrial, commercial and residential customers. Retail wheeling is another term for such open access.

An important point to remember is that allowing open access is a state decision. Unless a state has legislated choice, through open access or through a limited pilot program that may lead to open access, users must continue to buy electricity from their current utility company.

As of mid-April 1998, only one state - California - has moved to full open access or electricity deregulation for retail customers. Other states, including Pennsylvania and Massachusetts, will follow soon.Altogether, more th an a dozen states have enacted legislation requiring utilities to offer choice by some specified future date. These states, as well as many of the remaining states, have pilot programs designed to introduce and test the concept of choice.

A handful of states in the Southeast and upper Midwest have yet to address the issue.

How will open access lower costs? In California and in the other states that will soon deregulate, retail customers face a maddening welter of confusing price offers. In California, for example, more than 200 companies have registered to resell electric power at the retail level.

As a result, competition for customers is gaining intensity. Many of these companies are pitching prices that are 30 percent to 50 percent lower than current prices.

Consultants uniformly caution against taking such claims seriously. Prices will go down, but not by that much.

According to George R. Owens, president of Energy and Engineering Solutions Inc., a Columbia, Md.-based energy consulting firm, and a former engineering director for The Rouse Co., electricity costs in the United States range from 3.5 cents to 12 cents per kilowatt-hour (KWH).

"Deregulation will affect only a portion of these electricity costs," he says. "There are three components of cost for electric power. First, generating electricity carries a cost. Second, sending the electricity over transmission lines has a cost. And third, the transmitted power must be distributed to users over other lines.

"Before deregulation, the regulated utilities owned all three of these systems," Owens continues. "After deregulation, the regulated utility will own the local distribution company, for sure, and may own other arms of the process through separate companies."

Only the cost of electric power, the generation portion of the cost, is being deregulated, Owens explains. The costs for transmission and distribution will remain under regulatory control.

What portion of the total cost per KWH covers the electricity itself? The cost to generate power differs from utility to utility around the country. As a rule of thumb, many consultants say, generation accounts for approximately 25 percent of the total KWH cost. In some cases, it may be more; in other cases, it may be less.

The point is, electricity providers offering extraordinarily high discounts may be talking only about the electricity portion of the bill. A 30 percent discount for electricity probably refers only to the 25 percent of the bill that accounts for power generation. Thirty percent of 25 percent comes to 7 percent of the total bill, which is within the range of savings predicted.

"My guess is that early deregulated costs will provide savings between 5 percent and 15 percent of the total electricity bill," Owens says. "Still, that can produce substantial savings across a portfolio of shopping center properties. A large developer with 40 to 50 properties may pay $50 million to $60 million per year for electricity. A 5 percent savings can total $2.5 million to $3 million per year."

Later, savings may increase as utilities pay off what are known as "stranded costs." Stranded costs stem from construction of new power-generation facilities that may not be used fully in an era of deregulation.

Nuclear power plants, for example, produce high-cost electricity. Who wants to buy high-cost electricity from producer A if producer B has low-cost power to sell?

Nevertheless, the loans and bonds issued to build these facilities must be paid. Deregulation threatens to strand those costs. Each state legislature must develop a plan to cover stranded costs.

In some cases, these costs will show up as a fourth component of a deregulation-era utility bill. Once stranded costs have been recovered, it is reasonable to expect that competition will drive electricity prices lower.

Deregulation now Perhaps the biggest problem with deregulation is getting from here (a partially deregulated environment) to there (the fully deregulated environment). Full deregulation may not come about for five or 10 years.In the meant ime, buyers must come to grips with electricity costs that are deregulated in one state, approaching deregulation in other states, and still regulated in the remaining states.

In a deregulated or deregulating environment, aggregation has emerged as the basic strategy for buying electricity. Aggregators buy large quantities of electricity and receive volume discounts.

Shopping center owners as well as national retailers can aggregate the buying power of their properties in individual states and join other commercial buyers to expand buying power even more. Aggregating groups can buy directly from electricity providers, or they can push the savings envelope by dealing with power brokers, which buy even larger volumes of electricity for resale.

However, aggregation has practical limits. "Today, you can't aggregate an entire portfolio because of the different environments in different states," says Larry Hunt, vice president for center management and business initiatives for The Taubman Co., Bloomfield Hills, Mich.

Taubman owns or operates 28 properties in 13 states. According to Hunt, such a portfolio requires developing a state-by-state plan to address deregulation.

"We're developing load profiles for each center and a standardized request for proposal [RFP] to use in bidding out electric service," Hunt says. "Depending on the number of centers we have in a particular state, we may aggregate centers under one contract. In California, for example, we have five centers, all under one contract. At this point, we don't do this in any other state."

Chicago-based General Growth Properties Inc. owns or manages 118 properties across the country. Stan Saddoris, senior vice president and director of operations, follows deregulation developments in each state and has created a plan to react immediately as developments occur.

"We react within a state when that state develops plans for deregulation," Saddoris says. "So far, I've signed two contracts for aggregation. The first is in California, where we have 13 properties and which has deregulated. The second is in Pennsylvania, which is planning to deregulate very soon."

Saddoris has negotiated these contracts by issuing RFPs to three or four different providers and taking the best deal that meets the provisions of the RFP.

"An RFP lists properties in the state, along with their locations and sizes," Saddoris says. "It also provides a complete profile of electric power consumption at these properties in terms of loads by time of day, including peak demand times. Essentially, you include your utility bills for the past 12 months, and the bidders use that information to figure out what you need. They develop a proposal to provide you with electric power in that state at a certain price."

In each of the two contracts signed by General Growth, the provider earns a percentage of the savings to the developer. Just what the savings will be remains unclear at this point. In the California deal, for example, Saddoris expects to save 5 percent to 7 percent in the course of the year. The broker's fee is 20 percent of whatever the savings turn out to be.

The term of the contract is one year, and a key clause in the agreement says that if General Growth can find someone else to provide power at a lower cost, the provider must match that savings or General Growth can cancel the deal.

"That's an important clause," Saddoris says. "At this stage of deregulation, you do not want to get involved in long-term agreements. Today, I would not sign a contract like this for a term longer than a year."

On the other hand, what constitutes a short-term contract depends on the deregulation plans of individual states. In Iowa, where General Growth will open a new mall this July, Saddoris recently signed a five-year agreement with the local power company for electricity.

"I know that deregulation won't come to Iowa for about seven years," he says. "For the course of this contract, I'm going to save 10 percent or about $40,000 a year. If I'm wrong about the seven years and lose a year, I'll still be far ahead."

Other commercial users have followed a similar pattern to deal with deregulation. St. Louis-based May Department Stores Co., for example, signed a contract in March 1997 to cover its 43 facilities in California. The contract took effect March 31 of this year.

This contract contains another clause holding general interest. Under California's current law, municipal-owned utilities are not deregulated. "We have structured our contract in California to account for this [nuance]," explains Chris Albrecht, director of supply side energy for May Department Stores. "If a municipality serving one of our properties, such as the Los Angeles Department of Water and Power, opens up its system, we have the option of bringing those properties in under the contract we have already signed or buying elsewhere, whichever makes the most economic sense."

May also has made deals in two states running pilot projects to study deregulation. "We have a store in Peoria, Ill., that has been operating under a state pilot program for two years now," Albrecht says. "The savings in this program are extremely high, over 30 percent. That level of savings is not at all typical. In my opinion, the rates are so low because providers are trying to get known early in the market. In addition, the utility serving this area is not collecting any stranded costs, which has also held rates down."

Seven May stores in the Chicago region also are participating in a pilot program set up by the local utility, Commonwealth Edison. "The utility negotiated a deal with the Illinois Retail Merchants Association, IRMA, under which association members in that service area receive an automatic 15 percent discount," Albrecht says.

New landlord-tenant relationships Department stores such as those operated by May typically negotiate and purchase their own electric power. Deregulation will not change this.

On the other hand, in-line stores may purchase their own power directly through an individual power company meter or use master-metered power supplied by the shopping center owner.

Depending on the center, General Growth centers have both kinds of hook-ups for in-line tenants. "In cases where we have a master meter, our plan is to aggregate the electricity purchase and pass the savings through to the tenants, taking 5 percent of the savings as a fee for our administrative services," Saddoris says.

"In cases where the tenants buy directly from the power company, we will try to get them to sign up with us, because together we will have more buying power. We haven't done this yet, but we plan to try it in our Pennsylvania centers this year."

According to Elizabeth Bassett, president of Solutions On Site, an Indianapolis-based utility consultant, the possibility of landlord-tenant lease disputes will increase as deregulation becomes more widespread.

"Tenants will find themselves in leases stating that all services provided by the center owner must be used by the tenant," Bassett says. "Generally those services are spelled out. Current leases are probably silent on the subject of electricity. As a result, a retailer and owner may have different perspectives on whether electricity service is one of the services provided by the center."

In a center with 200 tenants, many might want separate electric suppliers, especially national retailers with their own ability to buy large volumes of power at low costs.

Alternatively, center managers will resist the idea of having dozens of different meter-readers moving around a property. Managers may prefer an arrangement that allows the center to supply electricity at aggregated rates.

"This is becoming a big issue," Bassett says. "As a tenant, I want the lowest-cost electricity. As a landlord, I want to control the property and also get the lowest-cost electricity. These similar but separate interests create conflicts in lease language preferences."

Bassett has experimented with lease language aimed at getting around this problem. One reasonably successful option involves a clause stating that the tenant has the right to negotiate for electric service. If, however, the landlord can provide service at a rate equal to or lower than what the retailer can negotiate, the tenant will use the service provided by the landlord.

"In some cases, this kind of language has worked," Bassett says. "In other cases, owners or tenants have objected for one reason or another."

All in all, no one can predict all the problems that deregulation will eventually raise. The only defense is to understand what deregulation means to individual properties located in different states - not only in today's partially deregulated environment but also in tomorrow's completely deregulated world.

General Growth's Saddoris advises anyone with multiple properties in several states to make a state-by-state study of deregulation plans. They should become familiar with both actual legislation and pilot programs aimed at testing deregulation concepts.

"Deregulation can be very complex," he says. "We have knowledgeable in-house staff, and we also hire consultants to help us out in certain states.

"For example," he continues, "I'm about to sign a contract with a consulting firm that will monitor electricity consumption via modems connected to meters at 40 of our malls in states where deregulation legislation is getting close.

"When deregulation does happen in those states, we'll be ready."

Will you?

"For the foreseeable future, how you use electricity will be more important than how much you pay for electricity," says Frank Cassidy, president and CEO of Energis Resources Inc., an Edison, N.J.-based energy and energy services provider.

Cassidy says increasing efficiency can cut electricity costs for commercial and industrial customers by as much as 25 percent, compared to the 5 percent to 10 percent savings on deregulated electricity costs predicted by most observers.

Retailers and shopping center owners can realize these kinds of efficiency savings by installing new high-efficiency lighting and heating, ventilating and air conditioning systems.

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