Proposed sale of PGW raises concerns on rates

Like death and taxes, you can count on a rate increase from Philadelphia Gas Works as one of life's certainties - no matter who owns the utility.

Opponents of Mayor Nutter's proposed $1.86 billion sale of PGW say a private buyer, needing to extract profits from the government-owned utility, will inevitably raise prices after a rate freeze expires in 2018.

UIL Holdings Corp., the Connecticut company that has agreed to buy PGW, agrees.

"We do need to implement some higher rates at some point, and that would be in the 2018 time frame," James P. Torgerson, UIL Holdings' chief executive, told analysts March 3, the day his company announced the purchase agreement.

But often overlooked in the debate is that PGW has signaled a need to raise rates by $50 million in 2018 if it remains under municipal ownership. The forecasts are based on the predictable upward trend in its operating costs.

Where PGW's rates will go under private ownership - and where the buyers might find efficiencies in the utility's operations - are likely to come under critical examination in the coming debate before City Council, which must approve any PGW sale. Council has said it will hire its own experts to evaluate the deal.

Unions, advocates for low-income customers, and environmental groups were quick to predict cuts in jobs, service, and subsidies as a consequence of privatization.

"The first thing on the agenda with this employer is trying to cut health care, trying to cut pensions, and trying to cut jobs," said James F. Runckel, the attorney for the 1,140-member gas workers' union.

Nutter and UIL officials say they believe the sale will lead to an increase in employment because UIL plans to invest more in infrastructure replacement. They also anticipate greater industrial development after PGW is free to forge more private partnerships.

UIL has pledged not to lay off PGW employees during the first three years and not to allow employment levels to dip below 1,350 during that time. PGW currently employs 1,650 people.

"Some people equate efficiencies with cuts," said Michael A. West Jr., UIL's director of corporate communications. "There's not a direct correlation."

West said fear will subside as UIL's plans come into focus. "There's a natural apprehension," he said. "We're just getting to know Philadelphia, and Philadelphia is just getting to know UIL."

UIL executives told analysts that they see significant savings opportunities in combining back-office activities, such as information systems built around SAP software.

"We will look to target efficiencies from combining existing systems, such as our SAP system, look to improve capital allocation across all the entities, and to get the scale benefits related to fuel costs and other products and services that we'll purchase for the enterprise as a whole," Richard J. Nicholas, UIL's chief financial officer, told analysts.

UIL executives pointed analysts to a 2012 financial report on PGW by Lazard Frères & Co. that identified several scenarios under which a private buyer, particularly a company that owned other utilities, as UIL does, might realize savings.

In the "moderate synergies" case that UIL identified as its model, Lazard anticipated a 14 percent reduction in nonfuel operational expenses phased in over two years, including health-care expenses for current employees, but not pensions, retiree health care, and bad-debt expenses.

Some critics suspect that UIL would shut down PGW's customer-service call center, which employs about 90 people. But the Mayor's Office noted that UIL has maintained call centers at three gas utilities it acquired in 2010, though management for all of the centers was consolidated under one executive.

UIL will not have to pay the $18 million annual fee to the city that PGW now pays. But a privately owned PGW will have to pay income taxes, from which the municipal entity was exempt.

Despite the advantages of municipal ownership, PGW's rates are the highest in the state. Its last rate increase was granted in 2009, after the utility was forced to seek emergency relief from the Pennsylvania Public Utility Commission during the national financial meltdown.

Experts on utility mergers say that efficiencies from combining operations are realistic.

"On average, there do appear to be real synergies to be gained," said David A. Becher, an associate professor of finance at Drexel University who was coauthor of a 2010 study analyzing 384 mergers in the electric- and gas-utility sector in recent decades.

In an interview the day the merger was announced, Nutter downplayed the certainty of a rate increase.

"We don't know what will happen three years from now," he said.

No matter what happens, Nutter said, the utility's owners will need to justify a rate increase with the PUC.

"It's not like they can just raise their rates," he said.

There are no comparable privatizations of large municipal electric or gas utilities in the modern era, according to the American Public Power Association and the American Public Gas Association, which represent public energy companies.

Some municipal water utilities have been sold to private investors in recent decades, often by local officials who were unable to raise rates to upgrade long-neglected treatment systems. Private owners inevitably sought rate increases to pay for improvements.

One private-ownership fact of life that creates anxiety among public ownership advocates is that an investor-owned PGW will need to earn a profit for its shareholders.

In PGW's current world, the PUC sets its rates based on a cash-flow methodology designed to pay reasonable operating expenses and cover PGW's debt payments.

Under private ownership, the PUC would set rates designed to recover operating expenses and allow the owners to earn a return on invested capital.

Regulators typically base rates on the depreciated value of a utility's property, plant and equipment. UIL estimates that PGW's rate base - the value of its hard assets - is about $1.2 billion.

In UIL's home state, the Public Utilities Regulatory Authority recently allowed the UIL subsidiary Connecticut Natural Gas to get a 9.18 percent return on equity, rather than the 10.25 percent requested. The utility previously was allowed a 9.41 percent return.

UIL made it clear to analysts that it views PGW as an infrastructure-investment opportunity. PGW has 1,500 miles of aging cast-iron mains that the PUC is pressuring the utility to replace at a quickened pace.

"From our perspective, it is a rate-base opportunity with replacement of the infrastructure," UIL's Torgerson told investors.