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Executive Speech

Speech by Thomas F. Farrell II
President & CEO - Dominion

NARUC Roundtable Discussion
Washington, D.C.
February 19, 2007

Good morning.  I am delighted to join you today. The timing of today’s discussion is felicitous.

“Felicitous” is a term often associated with Thomas Jefferson. It was once used to describe his writing style – although more in the sense of his remarks being “well said” than my reference to today’s topic as being “well suited” or “apt” to what is going on in our industry.

I should tell you that we have a rule in Virginia that any speech with at least one reference to Jefferson is, by definition, a good speech. And given that I am an alumnus of Mr. Jefferson’s university, it has become a running joke at my company that I never make a speech without at least one reference to him.

So there it is. I have now fulfilled the requirement.

But the word “felicitous” really is appropriate in the present instance.  Last fall, I gave a speech in which I described the potential for an “energy train wreck” looming ahead for our country if we do not grapple with some serious challenges. I cited four key issues:

  • First, a growing imbalance between energy supplies and consumer demands;
  • Second, our congested and inadequate energy transportation network;
  • Third, rising environmental costs and uncertainties;
  • And, fourth, the nation’s aging fleet of electric generating stations.

Today, I want to expand on that theme.

Unfortunately, all of those challenges are still there. If we do not rise to meet these challenges – and do it soon – our country’s economy could derail. No 21st-century economy can move forward unless it is running along a strong, dynamic and reliable energy infrastructure. When the power stops flowing, both the knowledge economy and the information superhighway shut down.

This means that those of us in the electric industry have quite a bit of “track” to lay in the next few decades in the form of new transmission lines. We also have many “engines” to build in terms of new power stations. And we need to determine how to make those engines run cleaner and more efficiently to meet ever-tightening environmental requirements.

Most of all, the people in this room – that includes regulators, staff members and industry representatives – will have to work together wisely and innovatively to ensure the capital resources are there to get the job done.

I am confident we can do it. We have done it before. But if we do not work together, the challenges may not be met. And then, I am afraid, the energy train wreck could be inevitable.

So just how big is the problem? Let me try to quantify it. Nationally, projected demand for energy is expected to jump about 50 percent over the next 25 years.  That means our nation will need 245 gigawatts of new electric generating capacity by 2030, according to the Energy Information Administration.  A gigawatt is, of course, a thousand megawatts, or enough to power almost 800,000 homes. 

In the Dominion service area in Virginia, we expect to see demand increase by 4,000 megawatts over just the next 10 years.

Conservation and demand-side management programs must and will be a part of this equation, both nationally and in Virginia. But there has been no indication so far that even the best such policies will be able to put much of a dent in the nation’s growing appetite for electricity.

Add it all up nationwide, translate it into dollars, and the industry estimates that it could cost more than $275 billion in new generation to meet this growth. 

Additional tens of billions will be required for transmission and distribution – big wires, small wires, transformers, cross arms, poles, you name it.

And there is more: Environmentally, the emissions limits continue to tighten.  The industry projects about $50 billion in compliance costs for NOx, SO2 and mercury from now through 2025. 

We should expect federal regulation of greenhouse gases in the not-too-distant future, a view reinforced by policy statements from the leadership of both major political parties. Controlling carbon dioxide emissions from fossil fuels will be very expensive.  The bottom-line impact on power generation in the United States for carbon limitations may range anywhere from $70 billion to $300 billion.

Now total up all of those dollars – new generation, improvements to transmission and distribution, emissions controls and now carbon – and the number is staggering. Total investment required by our nation’s electric industry could be somewhere between 400 and 650 billion dollars over the next 25 years.

CERA last week issued its own estimate for capital expenditure requirements for the power industry across all of North America.  It is just as daunting, maybe more so.  CERA estimates that the CAPEX spending in the U.S., Canada, Mexico and elsewhere on the continent could top $800 billion in just the next 15 years.

Let me put our own nation’s predicament in perspective another way: The market capitalization of all of the investor-owned electric utilities in the United States is about $550 billion, give or take a few billion. That is the total value investors place on the shares of all of the publicly owned electric utility companies – and this number includes some like Dominion that have natural gas distribution companies, oil and gas exploration and production units, and other assets.

So the investment that electric utilities will need to make over the next 25 years is about equal to their entire worth on the stock market in 2007, maybe substantially more. That is an astounding challenge.

If we are given the tools, I am convinced we can get the job done. Our industry has always been good at designing, engineering and constructing the infrastructure to meet the needs of our customers. But we have to get the money to buy the tools so we can lay the track and build the locomotives.

What we are facing – potentially – is a crisis in capital. As I said, it will take a huge investment to meet the energy needs of our country … 400 to 650 billion dollars. Some of it will be debt; some of it will be equity. Yes, the spending will be strung out over 25 years, but it is still a substantial sum of money – even for a country the size of the United States.

Remember, too, that we will not be alone in looking to the capital markets for new funding. Electric utilities compete every day with airlines and computer makers and home builders and every other sort of business to get investors and lenders to look our way. At the end of the day, investors and lenders want only the best risk-based return for their dollars. They cut us no slack just because we provide a basic public necessity.

To ensure that a crisis in capital does not ultimately lead to that energy train wreck, I believe the key is a partnership among the people in this room. It will require us to work together. We must put in place the kind of innovative and dependable regulation that will continue to protect and provide for our customers and – at the same time – allow the industry to attract the billions of dollars it needs to add the necessary infrastructure.

To borrow a phrase, the electric industry needs regulation that is not focused on the “Tyranny of the Immediate.” It is a phrase that has been used numerous times over the years to describe many situations. In this case, I mean it to say our industry needs regulation that is not focused on just the current rate case. We need regulation that is as much an energy policy designed to avoid the energy train wreck as it is to make sure that each utility’s authorized return on equity is calculated properly down to the right decimal.

I am not proposing a radical shift to some completely new regulatory model. I think the framework of the traditional cost-of-service model that is more than a century old works well – but could work better with some important modifications. I offer three suggestions.

First, the regulatory model employed by any state should recognize that ROEs should be set at levels that are not only fair to customers but also allow electric utilities to compete with every other industry in the market for debt and equity capital – certainly at least as well as similarly situated utilities.  This includes providing incentives for efficiency and innovation on the part of the utility by allowing returns above the authorized level.

We are a capital-intensive industry that is facing dramatic increases in planned capital expenditures.    Money flows freely across industries and across promising new global markets, as each of us is keenly aware.  And the smart money will flow to the smartly regulated.

Incentives for efficiency and innovation will benefit the customer in the long term. Utilities that know they can keep at least part of the benefits from efficiencies and innovations will strive to create them.

Second, the regulatory model should also recognize that utilities cannot be held hostage to years-long regulatory lag in recovering the cost of their projects. In the case of a new nuclear unit, we are talking about billions of dollars. No matter how large a utility is, it cannot afford to provide a loan of that size to its customers and not see any cash for four or five years or more. Coverage of construction work in progress in current rates not only reduces the stress on a utility’s capital structure; it also reduces the rate shock experienced by customers.

Finally, the regulation should provide some sense of certainty as to what has been or will be determined.  Advance approval for a specific project, its regulatory treatment during its construction and its regulatory treatment during commercial operation goes a long way toward providing this certainty.

In the current issue of Edison Electric Institute’s “Electric Perspectives” magazine, there is an article about a panel discussion among utility finance experts. The lead sentence states: “The one thing everyone can agree on is the need for certainty.” Later in the article, one participant says he hears debt and equity investors both say over and over that the one thing they want is certainty.

There are several examples I can cite of some innovative regulatory solutions that are allowing utilities to move forward to meet the demands of their customers.

One is in Florida. The Florida Public Service Commission last week approved a rule involving utilities planning new nuclear units. The utilities may request that they begin recovering some of the costs incurred in developing new nuclear projects before the stations enter commercial operation. The commission had very sound reasoning for this decision. First, it said that this will encourage Florida utilities to invest in much-needed baseload generation, ultimately benefiting customers. Second, the commission said easing the cost of a new nuclear unit into rate base would minimize rate shock. 

This is an example of looking out beyond just the current rate case, beyond the tyranny of the immediate. It recognizes that long-term rate stability and long-term reliability are not always best served by holding down the current rate case to the lowest penny possible while leaving tomorrow to fend for itself.

Moving from the Sunshine State to Wisconsin, where just seeing the sun this time of year is cause for celebration, there is another example. Wisconsin Power and Light’s Alliant Energy subsidiary filed an application this month with the PSC to build a 300-megawatt coal unit.

Under the 2005 Wisconsin Act 7, Wisconsin utilities may request that the PSC establish – in advance – the principal financial terms and conditions that will apply irrevocably to a new electric generating facility.   Similar laws exist in Iowa and Nebraska.  Virginia also has one under consideration.

This kind of rate-making provides the certainty that the capital markets are demanding and a rate of return that can justify a long-term investment. Please keep in mind that when we build a new baseload power station – be it coal, nuclear or whatever – we are asking investors to tie up money for a very long time. They have no crystal ball to predict what interest rates and inflation levels will be in 10, 20 or 30 years.

A third example comes from outside the electric industry – natural gas storage.

As you may know, along with being an electric utility and power generator, Dominion’s businesses also include a major natural gas pipeline and North America’s largest gas storage operation.  Our Cove Point LNG import facility is about 50 miles southeast of here, along the Chesapeake Bay in Maryland.

Because of an innovation by FERC, Cove Point is the first facility to have both cost-of-service and market-based rates. An expansion of the LNG facility now under way is covered by market-based rates, while the existing Cove Point facilities are under cost-of-service rates.

FERC finalized the rules last spring. They are intended to mitigate natural gas price volatility by encouraging development of new natural gas storage capacity as part of the Energy Policy Act of 2005. The so-called “Hackberry rates” – named after a storage facility in Louisiana where the rates were first proposed – provide incentives for the development of much-needed storage capacity while ensuring just and reasonable rates.

So, here are three examples – two from the states and one from FERC – where traditional cost-of-service regulation has been modified to provide the three things the traditional model does not always provide:

  • ROEs that encourage development of necessary infrastructure and make the financial markets comfortable with long-term commitments,
  • Reduced regulatory lag, and
  • Certainty that once a decision is made by the utility and the regulators, it will not be reviewed at some future date, possibly altering everyone’s expectations.

In all three cases regulators still have a great deal of latitude and power to act in the public’s best interest. But working in concert with the industry, they have guidelines that ultimately benefit everyone.

It can be done. It is being done.

In closing, I will give you another piece of Virginia lore that is apropos to my presentation.

The first recorded song to ever sell a million copies was called the “Wreck of Ol’ 97.”  The ballad was based on a train wreck that occurred more than 100 years ago in Danville, Virginia.  It killed 11 people and received a great deal of national publicity.

The Ol’ 97 was running behind, much like the electric utility industry is starting to feel in terms of meeting future demand.   The engineer tried a little too hard, too late to make up for lost time.

As a favor to all, I will not sing the lyrics – just recite them:

“He was comin’ round the bend doing’ 90 miles an hour” … so goes the lyric … “and he was found in the wreck with his hand on the throttle.”

I have no interest in duplicating the events of the Ol’ 97 in our industry.  But I fear it.  I fear it because we may once more fall prey to the tyranny of the immediate and the possibility of an energy train wreck.  Now is the time to start laying “track” and getting our “engine” up to speed.  We need innovative regulation and legislation to do just that.

Thank you.

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