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a n e c o n o m ic re v ie w b y th e F e d e ra l R eserve B a n k o f C hicago Electric p o w e r problems and prospects A m ple supplies o f electric power at gradually declining prices have played a vital role in postw ar eco nom ic growth. In recent years prices o f electricity have risen sharply and the industry has faced a m ounting host o f problems. B y explaining the distinctive characteristics o f the elec tric power industry and by reviewing historical and recent developm ents, this article attem pts to provide the general reader w ith a better un derstanding o f the system that provides this essential service. IN D E X FOR 1 9 7 4 Month Pages April June August November 8-12 8-13 3-7 8-12 February March September November 3-23 3-12 3-12 3-7 April May July July September December 3-7 3-8 3-7 8-13 13-15 3-15 Agriculture and farm finance District farmland values s o a r .............................................. Concern for growing farm debt............................................ Agricultural review and outlook.......................................... Dwindling world grain reserves.......................................... Banking and credit Banking developments (a regular feature) The perennial issue: branch banking................................. Toward more uniform reserve requirements..................... Commercial banks and mortgages...................................... Interbank lending—an essential function......................... Economic conditions, general The economy, the Midwest, and C h icago......................... Our turbulent economy........................................................... (R. P.) Mayo testimony on inflation ................................... The trend of business............................................................. “New Math” of inflation—a 7 cent dollar?....................... Electric power—problems and prospects........................... International trends Global interdependence and energy.................................... Trends in U.S. international trade...................................... International banking— structural aspects of regulation June August October 3-7 8-12 3-11 May 9-15 Government finance The new Federal Financing Bank Business Conditions, December 1974 3 Electric power— problems and prospects In the past several years, particularly in 1974, the financial and operating problems o f the electric utility industry frequently have made the front pages. Seldom newsworthy in the past quarter century, electric utilities increasingly have been the center o f controversies concerning pollu tion abatement, restrictions on choice o f fuel, construction o f new generating stations, proposed rate increases, and even billing practices. Other electric utility problems have in cluded fuel shortages associated with the oil embargo, soaring fuel costs, temporary shutdowns o f nuclear plants, sharply ris in g c o n s tr u c tio n co sts, in c r e a s in g customer delinquencies, and record high interest rates. Some electric utilities have experienced difficulties in selling new securities and in arranging short-term credits. Different electric utilities have been affected by these developments in varying degrees, but none have been com pletely immune. In 1974 a new dimension w as added to the uncertainties facing electric utilities. Dem and for electricity merely equaled the 1973 total, thereby ending a 27-year string o f substantial annual increases. Slower de m and for electric power in the past year (declines in some regions) reflects conser vation program s initiated during the energy crisis, substantial increases in rates, and the sluggish economy. In view o f recent trends, some utilities have adjusted downward their projections o f increases in demand for electricity in the decade ahead. This fact, together with severe financial pressures on some com panies, has resulted in an unprecedented wave o f slowdowns, postponements, and cancellations o f capital spending projects for increasing electric generating capacity. M oreover, som e utilities, like some railroads, have been forced to pare outlays for ongoing m aintenance and rebuilding. These actions have raised questions as to the future adequacy and dependability o f supplies o f electric power needed for econom ic growth and progress. T h is a r tic le o u tlin e s th e characteristics o f the electric power in dustry and reviews historical and recent developments. It attempts to provide the general reader with a better understanding o f this vast and com plicated system that provides an essential service. Past and present Growth in the use o f electric power has been rapid, and virtually continuous, since Thom as Edison established his first com mercial plant in M anhattan in 1882. Elec tricity has supplemented or supplanted other form s o f energy in an ever-widening array o f uses. Harnessing electricity has made possible the development o f new in dustries and products—television, for example—and modern living standards. Few sectors o f the econom y have shown such continued rapid growth as electric power. Long-term growth has been approxim ately 7 percent per year. Sur prisingly, this 7 percent annual growth rate holds fairly closely for the past decade, for the period since World War II, and even for the past h a lf century. From 1920 to 1944 electric power output declined on a year-toyear basis only in 1921, 1930-32, and 4 Growth in electric power usage flattened in 1974 kilowatt-hours per capita Federal Reserve Bank of Chicago output was up 17 times. Real GN P per capita in 1973 was 2.4 times the 1929 level, while KWHs used per capita w as almost ten times as large. These data suggest the enormous changes in Am erican industry and econom ic life in the past 45 years, es pecially the proliferation o f business and consumer products and services produced with increasing quantities o f energy and relatively fewer man-hours. Distinguishing characteristics 1938—all years o f severe recession. Power output also declined in 1945 and 1946 as the econom y converted from war produc tion. From 1946 until 1974 electric power output increased every year, with recession years showing only smaller increases. From 1946 through 1973 growth in electric power averaged 7 percent annually compared with a rise in “ real G N P ” 1o f just under 4 percent. A similar relationship between the rise in electricity and the rise in total output—almost two to one—also applies to the past 50 years. A growth rate o f 7 percent per year means that electric power output has doubled every ten years, and generating capacity has necessarily grown commensurately. In 1973 net production o f electric energy was 1.95 billion kilowatt hours (KWH). This compares with 307 m illion in 1947 and 117 m illion in 1929, the peak before the Depression. In 1973 total real GN P was about four times the 1929 level, while electric power ■ The gross national product adjusted for price changes. Electric utilities have characteristics that set them apart from m anufacturing and commercial enterprises—even from gas and water utilities. To a large extent the current problems o f the industry reflect these special features. Unlike tangible commodities, even water and gas, electricity cannot be stored. Transm ission o f power to the point o f use is p r a c t i c a l l y in sta n ta n e o u s. E le ctric utilities, therefore, are virtually unique in that their capacity must be adequate to supply peak loads at particular points in time. Investments in electric plants and transmission facilities are very large relative both to w orking capital and to revenues. Unlike utilities distributing water and natural gas, electric utilities produce the product they distribute. A n nual revenues o f electric utilities are about one-fourth as large as total assets. In all manufacturing, revenues average about one and one-half times as large as total assets. Moreover, about 90 percent o f elec tric utility assets consist o f fixed assets, plant and equipment, compared to less than 35 percent in m anufacturing. Longlived assets imply reliance on long-term financing, either equity or bonded debt. Long-term debt accounts for about 45 per cent o f combined liabilities and net worth o f utilities, compared to an average o f less than 17 percent for manufacturing. Heavy debt suggests large interest payments, par- Business Conditions, December 1974 General price indexes have outpaced electricity prices percent, 1967 = 100 cents per KWH ticularly so after several years o f very high rates. In 1973 interest accounted for 13 per cent o f gross operating revenues o f utilities, com pared to 1 or 2 percent for the average manufacturer. Unlike m ost rapidly grow ing in dustries, electric utilities typically pay out a relatively large share o f their net earn ings in the form o f dividends. This fact, together with their leveraged capital struc tures, means that their financial health is dependent on relatively stable growth in revenues and profits, at least if new capital is to be attracted. Fuel costs o f electric utilities are very heavy because fuel is their raw material. Fuel bills averaged 25 percent o f total operating revenues in 1973, up from 15 per cent ten years ago. A further sharp rise in fuel cost occurred in 1974. Fuel is only a tiny fraction o f revenues in most other businesses. Finally, virtually all electric utilities are regulated by both state and federal agencies. M anagers’ freedom o f ac tion to d eterm in e prices, operating procedures, and construction programs, therefore, is closely circumscribed. 5 Rates and regulation Electric utilities, like m ost other u tilities, are “ n a tu ra l m o n o p o lie s” o p e ra tin g under state or municipal charters granting them exclusive rights to provide service in designated areas. Hav ing no direct competition, they are closely regulated—particularly as to the rates that they m ay charge and the services they must be prepared to render, but also as to their methods o f accounting, billing prac tices, new construction, and operating procedures. For the m ost part, regulation is by state public service com m issions, but in terstate transm ission o f power is regulated by the Federal Power Commission, con stru ction a n d opera tion o f nuclear facilities by the Atom ic Energy Commis sion, and financial practices both by the states and by the Securities and Exchange Commission. In recent years the utilities also have been subject to rulings by state and federal environm ental agencies con cerned with air, water, and even “ visual” pollution. Actual or proposed changes in electric utility rates usually are newsworthy because adjustments affect virtually all households and businesses in the area covered. Today, m ost com m ission rulings are not contested by the utilities. In the past, rate d e cisio n s considered un favorable to the utilities often were appealed by them to the federal courts as “ confiscatory,” in effect taking private property without adequate compensation to the owner. The right to regulate rates was es tablished in the nineteenth century, but the general principles for determining rates were argued for m any years, culminating in a 1944 decision (the Hope Case) that prescribed no single method, but required that rates be “ just and reasonable,” and that returns on equity should be (1) commensurate with returns in other industries o f com parable risks and 6 (2) sufficient to allow utilities to obtain needed debt and equity funds. Interpreta tion o f these principles in particular cases, obviously, can reflect wide differences of v judgment. In recent years a grow ing volume o f litigation involving electric utilities has been initiated by consumer or environm en talist groups. These actions have question ed rate decisions, billing practices, pollu tion controls, and the siting o f new facilities. Most states attempt to set rates that allow a given return on a determined “ rate base” —assets devoted to serving the public. Consideration usually is given to a utility’s capital structure, especially the proportions o f equity (com m on stock and surplus), preferred stock, and long-term debt. This is because the cost o f carrying existing debt and preferred stock is known, and regulators concentrate on the effect changes on rates charged for service may have on returns to equity, which should be adequate but not excessive. Even more than for nonregulated com panies, the return on equity affects the ability o f utilities to sell bonds. Bond rating agencies and bond investors are vitally interested in returns on equity, which determine the m argin o f safety for interest and principal. Moreover, state rules often require specific earnings “ coverage” o f interest expense. The trend of prices Average prices o f electric power trend ed downward from the 1920s until 1969. From 1947 to 1969 the average residential price dropped from 3.09 cents per kilowatt hour to 2.09, while the Consumer Price In dex rose 64 percent. For the m ost part, this lower average price resulted because larger quantities o f power were used by the average household, rather than from reduced rates. Some o f the decline, however, resulted from rate reductions re Federal Reserve Bank of Chicago quired by regulatory agencies. Promotional rate structures provide for a lower average price as the quantity consumed increases. A dditional blocks o f power bear lower prices because these amounts can be supplied at a lower average cost per KWH. For large com m er cial and industrial users, the average cost o f power was about 10 percent lower in 1969 than in 1947, although the Wholesale Price Index rose 40 percent in the same period. Average prices paid by large users o f power are significantly lower than residential prices because o f econom ies o f scale and because power sold to large users may be subject to curtailment in periods when total demand presses on capacity. Recently, conservation and consumer oriented groups have been pressing to in crease rates charged to large users relative to those paid by small users. Electric rate increases have been granted with increasing frequency since 1969, both for residential and commercial and industrial customers, and the average price for such users has increased every year. Moreover, the rate o f increase has accelerated, especially in the past year. In September 1974 the price o f power for residential users averaged over 2.9 cents per KWH, up 23 percent from 1973, and the highest level since 1949. Increases have been much larger for customers o f utilities heavily dependent on oil. Industrial prices for power averaged 35 percent higher in September than in 1973, and were at the highest level in the postwar period. Except for regulatory lags, power prices, at least for residential users, would have moved even higher. The process o f obtaining rate in creases is com plicated and m ay take several months to a year or more, par ticu la rly if strong public opposition develops, as it often has in the past two years. Interim rate increases frequently are allowed, pending final decisions that m ay require refunds. M any utilities have Business Conditions, December 1974 been able to pass through increases in rapidly rising fuel costs. But, because they are based on the experience o f previous periods, such passthroughs m ay involve lags o f several months, during w hich time higher fuel costs will have accumulated. Meeting peak loads Electric utilities attempt to maintain generating capacity at levels that will ac com m odate expected peak loads, plus a m argin o f safety to provide for normal m aintenance, possible breakdowns, and underestimates o f demand. Consequently, h u ge amounts must be invested in facilities that operate well below potential most o f the time. Until the early 1960s, peak loads for most electric utility systems occurred in the winter. Usually, the peak developed on some evening in the week before Christ mas when demand for lighting was at a maximum, perhaps augmented by power for street railways. Various factors, but most im portantly the spread o f air con ditioning, gradually altered this pattern. For the past ten years, the peak load has oc curred sometime during the summer, usually during a heat wave in July, A u g u st, or even ea rly Septem ber. Moreover, the spread between the winter peak and the summer peak has widened, and the national average now approaches 20 percent. To even out these peaks somewhat, certain utilities have continued to urge the use o f electric heat to balance loads and use generating facilities more ef ficiently. Other attempts to encourage use o f electricity, once quite vigorous, have largely been abandoned. The problem o f required capacity varies from one utility to another depend ing on the nature o f its markets and the availability o f purchased power. Because peak loads o f individual utilities vary sub stantially, data for the nation as a whole indicating capacity over “ non-coincident” 7 peak loads are not an exact measure o f the a v a ila b le c a p a c ity . N evertheless, it appears that a com fortable average margin o f electric capacity over peak summer load is about 20 percent nationally when measured this way. For individual utilities a high value is placed on accurate projections o f dem and because excessively generous reserves are costly. N ationally, the m argin o f capacity over and above peak summer load dropped from 25 percent in 1964 to less than 17 per cent in 1969. Some critics said the electric utilities had seriously underestimated de mand. The resulting upsurge in construc tion outlays helped to push the margin o f capacity to 21 percent by 1973 and also created, or m agnified, the industry’s finan cial problems. When a particular utility finds that its electric “ send out” is approaching the capacity o f its full-time stations, a number o f steps m ay be taken. Normal procedures activate supplementary “ peaking units” that are m aintained on a standby basis. These m ay be either high-cost, obsolescent, and usually smaller units or they m ay be sp e cia lly a cq u ired m odern turbines operating on gas or oil. Another com m on step is the purchase o f power from other utilities who are partners in a “ grid,” or, in an em erg en cy , from interconnected utilities located hundreds o f miles away. In addition, “ interruptibles,” usually manu facturers who buy power at low rates on the understanding that power m ay be cut off p e rio d ic a lly , m ay be informed that transmissions will be reduced or stopped. Public appeals m ay be made to all customers to voluntarily curtail usage. Finally, voltages m ay be cut somewhat, perhaps resulting in a partial “ brownout.” Too large a cut in voltage can endanger cer tain electrical equipment operated by businesses and consumers. At rare intervals m assive breakdowns o f generating equipment or switching devices can cause m ajor power failures. 8 The most prominent case was the famous blackout that hit an area o f 30 m illion peo ple in New York City and the northeast for several hours in 1965. Except for customers w ith th eir ow n standby generating facilities, lights went out, subway trains and elevators stopped, and all electrical equipment became inoperable. Citizens were suddenly confronted with the farreaching consequences o f a cessation of electric services. Procedures for dealing with power shortages give the electric in dustry needed flexibility. There can be no substitute, however, for continued large in vestments to m aintain and augment total capacity in line with growth in demand. Federal Reserve Bank of Chicago Private utilities produce the bulk of U.S. electricity percent of total Producers and users Investor owned utilities produced about 74 percent o f the nation’s total sup ply o f electricity in 1973. The remainder was divided am ong federal agencies (TVA is the largest), 11 percent; municipalities and cooperatives, about 10 percent; and in dustrial firms, about 5 percent. Some o f the power produced by private utilities, and a major share o f the power produced by federal agencies, is supplied to m unicipally owned utilities or to cooperatives for resale. The bulk o f U.S. electric generating ca p a city always has been privately o w n e d .2 The investor owned utilities’ share o f the total output rose from 67 per cent to 75 percent in the 1920s, as in dustrial firms relied more heavily on purchased power. Expansion o f federal power program s (m ainly hydro, initially) in the 1930s and early 1940s and growth o f state, municipal, and co-op facilities reduc ed the private utilities’ share o f electric out put to 67 percent just after World War II. Their share remained at about this level until the 1960s when it began a gradual 2This contrasts with most other countries, capitalist as well as communist, where generating capacity is publicly owned. rise, reaching 74 percent last year. In Seventh District states the private utilities’ share o f electric power output is much higher, ranging from 83 percent in Iowa to 97 percent in Illinois. The share o f power produced by government owned utilities and co-ops rose to 21 percent in the mid-1950s and has remained at that level. The share o f power produced by industrial com panies for their own use declined fairly steadily from 17 percent o f the total just after World War II to 5 percent in 1973. Since 1969 private power production has declined absolutely as well as relatively. Revenues o f electric utilities, public and private, totaled $32 billion in 1973—42 percent residential, 29 percent commercial, 25 percent industrial, and about 4 percent “ other,” m ainly street lighting and other municipal services. In terms o f KWH, h ow ever, the proportions are quite different—residential, 33 percent; com m er cial, 23 percent; industrial, 40 percent; and other, 4 percent. In the past decade the proportions o f electric utility revenues from the various groups o f customers have not changed significantly, but, in terms o f KWH, the in dustrial share has declined while shares o f 9 Business Conditions, December 1974 com m ercial and residential customers have increased. These trends indicate first, that average prices paid by large in dustrial and commercial users have been, and continue to be, lower than rates paid by residential customers, but that prices paid by large users have increased faster than prices paid by residential customers since the late 1960s. Most m anufacturing companies use substantial amounts o f electricity, but the biggest users are the metals and chemicals industries. Especially large amounts are used in producing aluminum and copper and in the electric furnaces used to produce steel. Availability and cost o f electric power is a m ajor factor in locating aluminum and copper refineries. En v iron m en ta l considerations have en couraged the use o f electric furnaces in m any industrial installations in recent years, especially in foundries. Commercial use o f electricity has ex panded sharply because o f the rapid in crease in the number o f new shopping centers and highrise office buildings that require ample lighting, air conditioning, and, often, electric heating. Residential use has expanded with the proliferation of appliances, large and small. The big uses o f electricity in the typical home are for air conditioners, lighting, ranges, dryers, freezers, refrigerators, and television. When dwellings are electrically heated, this use m ay be the largest. Perhaps 10 per cent o f all U.S. dwelling units are now elec trically heated and the total is growing rapidly. Perhaps h a lf o f new units and con v ersion s com bined are now electric. Despite its high cost in most regions, elec tric heat in dwellings has been encouraged by its cleanliness and flexibility and by the fact that some gas utilities and oil dis tributors have had to restrict new service because o f limited supplies. Purchase o f electric power by all users was 2.5 percent o f GNP in 1973, up from 2.3 percent in 1964. Because electric power prices rose faster than other prices in 1974, this proportion increased. The number o f residential electric customers has in creased steadily to about 70 million, currently. Virtually all year-round homes, and most vacation homes, are served by electric utilities. In 1973 the average residential customer used 8,080 KWH and paid a bill o f $192. Electric bills accounted for 1.7 percent o f total consumption expen ditures in 1973, up from about 1 percent in the 1930s and 1940s, but about the same as in the early 1960s. This ratio increased somewhat in 1974. The proportions o f con sumption expenditures going for telephone bills and tobacco, by coincidence, also were 1.7 percent in 1973. Sources of electricity While total energy used in the United States in all form s has grown about 4 per cent annually since World War II (as fast as real GNP), the proportion o f total energy converted to electric power has grown steadily. It now accounts for about 30 per cent o f the total. All electric power is converted from a primary energy source— hydro (falling water), “ fossil fuels” (coal, oil, and gas), or uranium. Nuclear power plants are steam plants with heat generated by nuclear ac tion, rather than com bustion o f fossil fuels. Large steam plants are located near an am ple supply o f water needed to condense the steam after it has passed through the tur bines. Increased use o f cooling towers is underway. Electric power generated by hydro plants from a head o f water, usually con trolled by dam m ing rivers, has a major ad vantage in that there is no fuel cost. However, invested capital requirements are high, the volume o f power generated varies with seasons and rainfall, and power sites are often far removed from markets. Hydro plants supplied over 30 percent o f U.S. electricity just after World 10 W ar II. A lthough output o f hydro electricity has continued to increase ab solutely, it has declined relatively and ac counted for less than 15 percent o f the total in 1973. Opportunities for further develop ment o f hydro-electricity in the United States are limited. M any sites are fully developed, and ecological problems and the desire to preserve scenic beauty preclude development o f other sites. About h a lf o f U.S. electricity has been generated from coal since World War II. This proportion was 45 percent in 1973. Two-thirds o f all U.S. coal w as used for electric power generated in 1973, up from one-third 20 years ago. Over the years coal has been used more and more efficiently, in terms o f KWH produced per ton o f coal. Coal-fired plants in m any areas came under severe criticism in the 1960s for caus ing air pollution, particularly through em issio n s o f sulfur dioxide. Strong pressure was placed on utilities to avoid us ing high sulfur coal and to shift to other fuels, including low sulfur coal and oil. These shifts have worked to boost prices of the more desirable fuels sharply, thereby increasing operating costs o f affected utilities. A highly controversial issue, cur rently, revolves around a m ove to require installation o f high-cost “ scrubbers” at coal-fired plants to reduce sulfur-dioxide emissions. The United States has vast reserves o f low-sulfur coal, but these deposits are m ainly in the Western states, and involve high transportation costs. Moreover, ex ploitation o f these reserves has been hampered by opposition to strip m ining operations. In any case, available coal is currently in short supply, and new mines, especially deep shaft mines, take years to develop. Natural gas-fired plants, m ainly in the Southwest, produced 18 percent o f U.S. electricity in 1973, down from a peak o f 24 percent in 1970. Use o f gas for electric power has declined absolutely as well as Federal Reserve Bank of Chicago Coal continues as the largest source of electricity percent of total relatively since 1971. Although gas is desirable as a clean-burning fuel, its con tribution to electric generation is almost certain to decline further. Alm ost one-fifth o f all gas produced in the United States has been used for generating electricity in re cent years. Supplies o f gas are restricted and home heating has priority. Oil-fired plants produced 17 percent o f U.S. electricity in 1973, and used 9 percent o f all oil products. The proportion o f elec tricity produced from oil rose rapidly from 6 percent in 1964, largely because o f pressure to reduce air pollution from coal, but also because o f increased availability o f low cost imported oil. Utilities on the East and West Coasts are particularly large users o f oil. Such plants, which were most threatened by the Arab oil embargo, often paid three times as much for oil in 1974 as in the pre-embargo period in 1973. To reduce dependence on foreign oil, the Adm inistration has urged that the largest utilities eliminate the use o f oil by 1980, but the feasibility o f this goal has been questioned. Domestic production o f crude oil has declined in recent years. Current vigorous attempts to increase supplies (including the Alaskan pipeline) 11 Business Conditions, December 1974 are expected to reverse this decline, but only after a period o f years. The nuclear promise The vast potential o f peaceful uses o f atom ic energy received widespread atten tion in the years follow ing World War II. Initially, the m ain interest was in a cheaper source o f electric power. Since the 1960s, however, increasing emphasis has been placed on projections o f the inade quacy o f conventional sources o f energy to supply a grow ing econom y, and the role that nuclear power m ight take in over com ing this deficiency. In 1960, after m any years o f planning, Com m onwealth Edison’ s Dresden station, southwest o f Chicago, began to generate electricity. This was the first commercially owned and operated nuclear plant in the United States. A s other plants came on stream, the nuclear share o f the nation’s electric power output rose to 1 percent in 1969 and 4.5 percent in 1973. This propor tion will increase rapidly in the years ahead. About h a lf o f all new electric plants starting operation, currently, are “ nucs.” The Midwest has continued to lead the na tion in nuclear power and about 30 percent o f power-generating capacity o f utilities in Illinois, M ichigan, and W isconsin is now nuclear. The push for nuclear power gathered strong momentum in 1966 after the dependability and econom y o f the first nuclear plants was demonstrated. In 1967 the AEC predicted that h a lf o f U.S. power w ould be nuclear by 1980. Various developmental problems and delays in dicate that the actual proportion in 1980 will be about 25 percent. In M arch 1973 the AEC forecast that 60 percent o f U.S. power would be nuclear by 2000. In 1973 and 1974 some utilities sw itch ed planning from nuclear to coal-fired plants because o f the lengthened lead times on designs, approval, and construc tion o f nuclear plants. Operating problems in existing plants, and delays and uncer tainties caused by litigation, usually ini tiated by consumer groups, also were fac tors. Nevertheless, the trend to nuclear power has strong momentum. Construction costs o f nuclear plants are greater than for conventional plants, but this is more than balanced by the fact that their fuel costs are only a fraction of the costs o f coal and oil-fired plants. Moreover, the m argin o f difference in operating costs has increased in favor o f nuclear plants since 1973. Various utility executives have commented favorably on the dependability, as well as the economy, o f their nuclear installations as compared to those fired by fossil fuels. Most Euro pean countries are even more deeply com mitted to nuclear power for the future than is the United States, partly because their supplies o f mineral fuels are even more limited than ours. The longer-term future holds the possibility o f still greater economies either through “ fast-breeder” reactors, which create their own nuclear fuel, or fusion plants that use heavy hydrogen obtained from water as fuel. The scientific feasibility o f the fastbreeder reactors has been demonstrated, but considerations o f safety and high costs o f construction suggest to some experts that this type o f installation be “ leap frogged” in favor o f a further advance. Generation o f electric power from atomic fusion, as opposed to fission, m ay require m a n y a d d ition a l years o f scientific research and engineering development. However, if the practicality o f fusion power can be demonstrated, the goal o f unlimited supplies o f cheap power m ay yet be realiz ed in this century. Capital expenditures Investor owned electric utilities ap parently spent almost $18 billion on new plant and equipment in 1974, according to 12 the Department o f Commerce, up from less than $4 billion in 1964. Outlays have in creased by at least 10 percent each year in this period, and by over 20 percent in some years. Capital spending by electric utilities will account for almost 16 percent o f the total for all industry in 1974, compared to 8 percent ten years ago. In the decade, generating capacity about doubled. About h a lf o f electric utility capital spending is for generating capacity, with the remainder m ainly for transm ission and distribution facilities. A governm ent report released last August indicated that almost 9 percent o f electric utility capital spending in 1974 would be for abatement o f air and water pollution, compared to 6 per cent for all U.S. industries. A governm ent survey released in January 1974 indicated that electric utilities would spend $18.8 billion on capital outlays in 1974, up from $15.9 billion in 1973. Starting last spring, various utilities began to announce reduc tions in construction budgets for 1974, 1975, and subsequent years. In December the governm ent estimate had been reduced to $17.7 billion, despite greater than ex pected increases in construction costs. Planned outlays by manufacturers rose from $44.4 billion to $45.8 billion between January and December. In N ovem ber a M cG raw -H ill su rvey in dica ted that manufacturing firms planned to increase capital outlays 21 percent in 1975, but that electric utilities, despite expected further sharp increases in prices, planned no rise at all. In official announcements, reductions in planned capital outlays by electric utilities have been variously attributed to a com bination o f reduced estimates o f de mand, problems in raising funds, and the soaring costs o f construction. Problems o f raising funds appear to be the predomi nant reason for construction cutbacks. One com pany that stopped work on pro jects well underway in 1974 warned that Federal Reserve Bank of Chicago service may have to be curtailed in 1975. Contracts for new generating stations are am ong the largest contracts reported by F. W. Dodge. Aw ards o f over $100 million for individual projects are com mon, and several have been for over $500 million. Usually, these projects take nearly a decade to complete. Obviously, decisions to go ahead or cancel are momentous. Raising funds Despite curtailed expansion plans, in vestor owned electric utilities necessarily will continue to raise huge sums in the capital markets. Planned outlays for several years to come are very large, and inflation doubtless will continue to raise construction costs. Working capital needs o f these utilities are relatively small and short-term borrowin g , m a in ly th rou g h b a n k lo a n s, traditionally is used only on a temporary basis, pending the issue o f securities. Therefore, long-term financing over the years about equals outlays on plant and equipment—summed up as “ construc tion.” O f the $108 billion capital structure o f private utilities at the end o f 1973,35 per cen t w as represen ted b y com m on stockholders’ equity, 12 percent was preferred stock, and 53 percent was long term debt. These proportions have been fairly stable over the past decade, while capitalization has more than doubled. Long-term financing is either “ inter nal” (depreciation and retained earnings, the latter adding to stockholders’ equity) or external (sales o f stocks and bonds). The heavy investments o f utilities during the p a st d eca d e have greatly increased dependence on external financing. In 1964 and 1965 internal sources (three-fourths depreciation) accounted for 59 percent o f all long-term funds. Internal funds have continued to rise in absolute terms, but the proportion has declined. In the period 197073 internal sources supplied only about 30 13 Business Conditions, December 1974 percent o f long-term funds, with the remainder com ing from sales o f securities. In each o f the three years 1971-73, elec tric utilities sold over $9 billion o f securities, net o f retirements, up from $1.5 billion in 1964. Because security sales by other corporations declined in the 1971-73 period, the proportion o f electric utilities issues to the total rose from 24 percent to 43 percent. Bond issues alone totaled $5 billion per year from 1970 through 1973, ac counting for about 40 percent o f all cor porate bond sales in the latter year. In the first h a lf o f 1974 issues o f utility bonds were about 95 percent larger than in the same period o f 1973, while total corporate issues were up 80 percent. The flood o f new debt, coupled with lower earnings, caused private agencies to lower the quality rating o f m any utility issues in the past two years. Yields on new bonds rose to record levels and some issues were withdrawn. Charters com m only pre vent utilities from selling bond issues if the earnings coverage o f interest charges falls below a prescribed level, a factor o f only academ ic interest until recently. Just after World War II, yields on out standing utility bonds were about 2.5 per cent, the lowest level o f the century. These yields rose gradually to about 4.5 percent in the early 1960s, and then increased sharply late in the decade, averaging over 8 p ercen t in 1970. After declining som ewhat from the 1970 peak, yields rose again and in the fall o f 1973 new issues o f the highest grade issues bore yields o f over 10 percent, and yields on less highly regarded issues were even higher. High rates on new bonds in 1974 and problems in m arketing new issues resulted in relatively heavy use o f temporary bank loans. In m id-November 1974 outstanding loans o f large commercial banks to utilities (m ainly electric) totaled $8 billion, up 50 percent from a year earlier, and up 140 per cent from N ovem ber 1972. M any o f these loans bore interest above the prime rate, Securities supply a growing share of utility funds billion dollars which has been even higher than the rate on new bond issues this year. Because o f large existing debts, the average rate paid on outstanding long term debt by electric utilities has remained below market rates. Nevertheless, this “ embedded” interest cost is now close to 6 percent, up from 3.7 percent ten years ago. Total interest expense rose from 8 percent o f gross revenues in 1964 to 13 percent in re cent years. Stock prices decline Electric utilities have had trouble sell ing new stock, despite the desire to do so to keep their debt-equity ratios from rising. In the years 1971-73, they sold about $2.5 billion in com m on stock, and almost $2 billion in preferred stock, each year. Sales o f com m on stock have had the effect o f diluting the value o f existing stockholders’ equity because most market prices have been well below book value. Common stocks o f electric power com panies were almost all held by holding com panies prior to the mid-1930s. The Public Utility Holding Com pany Act o f 14 Yields on new utility bonds hit record highs in 1974 percent 1935 required that m any o f these issues be distributed to the public. Utility stocks soon acquired a reputation as sound in vestments, virtually equivalent to bonds, for purchasers interested in incom e and price stability. From the end o f World War II to the mid-1960s, prices o f utility com m on stocks trended upward, although not so rapidly as industrial stocks. Standard and P oor’s average o f 35 electric utility stocks reached a peak in 1965, while average prices o f in dustrial stocks led by the “ glam our” in dustries continued to rise to record levels in January 1973. Prices o f industrial stocks averaged 29 percent higher in 1973 than in 1965, while electric utility stocks averaged 36 percent lower. The stock market decline o f 1973-74 hit electric utilities even harder than most in dustrials. At the end o f N ovem ber 1974, the S and P electric utility group w as 60 per cent below the 1965 level, while industrials were 17 percent lower. Market yields on electric utility stocks were 10.4 percent at the end o f November, compared to 3.2 per cent in 1965. For industrials, these figures were 4.8 percent and 2.9 percent. Market declines have pushed prices o f Federal Reserve Bank of Chicago most electric utility stocks far below book values. In 1965 stock prices averaged more than double book values. Recently, prices o f m any utility stocks were only h a lf o f their book values. The financial health o f investor owned utilities is far more closely related to stock market prices than are industrial com panies. This is because funds must be rais ed through sales o f both bonds and stock, and a favorable market for bonds is depen dent, in large degree, on ability to sell stock. Earnings on com m on stock equity o f investor owned utilities were about 12 per cent in the mid-1960s, and this ratio has declined only to 11 percent in recent years. But investors are cautious o f earnings reports o f electric utilities if they include a substantial “ allowance for funds used dur ing construction” (AFDC). In m ost states this amount must be capitalized and add ed, both to the asset rate base and to sur plus on the right-hand side o f the balance sheet. AFD C rose from 4 percent o f total earnings on com m on stock in 1965 to 35 percent in 1973. Moreover, in the face o f large increases in profits for most cor porations in the first nine m onths o f 1974, m any investor owned utilities reported lower earnings—despite AFDC. A brighter future? Some analysts have suggested that the problems o f the electric power industry will moderate in 1975 and in the years ahead. Lower interest rates and a leveling o f fuel prices, widely expected, would alleviate two o f the difficulties that have caused the financial squeeze o f the past year. Speedier action on needed rate in creases, and a slower pace on pollution con trol measures would help m any com panies. Even the generally expected slower growth in demand for power, partly because o f escalating prices, would ease the pressures o f raising funds and the Business Conditions, December 1974 15 special problems sometimes involved in bringing new units into service at a specified time. The electric utility industry m ay also benefit in 1975 from an increase in the in vestment tax credit. Utilities have been allowed a 4 percent credit, instead o f the 7 percent credit available to other busi nesses. Some support exists for raising the investment tax credit to 10 percent, both for utilities and for other businesses. The problems o f the utilities were spotlighted in April 1974, when C on solidated Edison o f New York passed a dividend for the first time in its long history.3 This com pany, particularly hard hit by the various problems facing the in dustry, is by no means typical. But its deci sion to sell generating facilities to the state o f New York suggests the possibility of public subsidies or public ownership to maintain needed service. Demand for electric power is virtually certain to grow in future years, although probably not at the traditional 7 percent per year. F u rth er im provem ent in Am erican life and in industrial efficiency apparently, requires steadily expanding capacity to generate kilowatts. Doubtless this job will remain largely in the hands of the private companies, whose financial health is a matter o f concern to govern ment and the public. 3“Con Ed” subsequently resumed quarterly dividends at a reduced level. George W. Cloos M orton B. Millenson The authors thank the following companies in the states of the Seventh District for the information they fur nished for use in this study. Illinois: Central Illinois Light Co., Peoria; Central Illinois Public Service Co., Springfield; Commonwealth Edison Co., Chicago; Illinois Power Co., Decatur. Indiana: Indiana & Michigan Power Co., Ft. Wayne; Indianapolis Power & Light Co., Indianapolis; Northern Indiana Public Service Co., Ham mond; Public Service Co. of Indiana, Plainfield; Southern Indiana Gas & Electric Co., Evansville. Iowa: Interstate Power Co., Dubuque; Iowa Electric Light & Power Co., Cedar Rapids; Iowa-Illinois Gas &Electric Co., Davenport; Iowa Power & Light Co., Des Moines; Iowa Public Service Co., Sioux City; Iowa Southern Utilities Co., Centerville. Michigan-. Consumers Power Co., Jackson; Detroit Edison Co., Detroit. Wisconsin: Lake Superior District Power Co., Ashland; Madison Gas & Electric Co., Madison; Northern States Power Co., Eau Claire; Wisconsin Electric Power Co., Milwaukee; Wisconsin Power & Light Co., Madison; Wisconsin Public Ser vice Co., Green Bay. We also extend our thanks to the Edison Electric Institute, New York City. Subscriptions to Business Conditions are available to the public free of charge. For information concerning bulk mailings, address inquiries to Research Department Federal Reserve Bank of Chicago, P. O. Box 834, Chicago, Illinois 60690. Articles may be reprinted provided source is credited. Please provide the bank’s Research Departm ent w ith a copy of any m aterial in w hich an article is reprinted.
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