New Utility Subsidiaries Worry PUC : Unregulated Ventures Under Umbrella of Parent a Big Concern

Pacific Telesis, the San Francisco-based holding company whose main subsidiary is Pacific Bell, unveiled yet another new business venture this month that--unlike the giant phone utility--operates free of state and federal regulation.

This new unregulated offspring, PacTel Spectrum Services, uses an electronic device that enables the company to guard private phone networks, such as those used by banks to link automated teller machines, against breakdowns.

Such unregulated ventures gathered under the umbrella of a holding-company parent--even though they’re small, compared to Pacific Bell’s regulated telephone service--have become a major cause of concern for the California Public Utilities Commission as well as for its counterparts across the nation.

Exploiting Assets

Regulators worry that, in seeking to increase earnings for shareholders, such entrepreneurial flights may end in crash landings injuring utility customers. Moreover, they wonder, what’s to stop a parent company from exploiting its utility subsidiary’s assets, in large part created by revenue from utility customers, without fully paying for their use?

The PUC currently is pondering an application by San Diego Gas & Electric to create a holding company over the utility much like Pacific Telesis Group. SDG&E;’s shareholders this month approved the reorganization, pending PUC approval.

The PUC public staff division, whose task is to represent utility customers, has recommended rejecting SDG&E;’s plan as unlikely to contribute to the company’s financial strength, enhance its attractiveness to investors or, most importantly for the PUC, serve utility customers better. On the other hand, the staff maintains, diversification of the utility under a holding-company parent is sure to provoke migraines in PUC auditors seeking to isolate utility costs and profits in order to set rates fairly and ensure that utility customers are in no way subsidizing unregulated ventures.

PUC Had No Say

The commission had no say in the creation of Pacific Telesis Group--or in the parent’s creation of PacTel Spectrum Services or its growing roster of other unregulated PacTel companies. Pacific Telesis was one of seven regional holding companies that emerged from the complex settlement of a federal government antitrust lawsuit against American Telephone & Telegraph. Pacific Telesis inherited Pacific Telephone’s local phone network and Yellow Pages directory businesses as well as new permission to diversify into unregulated businesses, subject to federal court approval, as long as such ventures were kept separate from local phone operations.

Still, the PUC must act as a watchdog for the public to ensure that Pacific Bell assets are not expropriated for the benefit of the unregulated ventures. And the launching of PacTel Spectrum Services illustrates some of the questions that bother regulators as they contemplate a growing desire among utility companies to diversify their operations beyond their core business of providing monopoly services to the public. For example:

- Did Pacific Telesis in any way exploit Pacific Bell resources to produce PacTel Spectrum Services’ proprietary network-monitoring device and, if so, was the utility fully paid for its contribution?

- Since about 40% of PacTel Spectrum Service’s initial employee roster of 60 are veterans of the old Bell System, should Pacific Bell be compensated for having trained them?

The answers to such questions hinge on a new regulatory concept called, variously, “imputed cost” or “imputed royalties.” This concept seeks to assign a monetary value to such intangibles as transfers of technology and personnel from the utility to an unregulated venture.

In hearings last month, the PUC was advised to determine and collect such imputed values “up front” as part of approving any diversification application from a utility company. Faced with the SDG&E; application to form a holding company, the commissioners directed their staff to produce recommendations within the next two months.

Turn Back Clock

Commissioner Victor Calvo, who presided over the two-day session, sought to soothe the startled utility company officials who crowded the San Francisco hearing room. “No one’s going to suggest that we turn back the clock,” Calvo said.

On the other hand, Calvo acknowledged, he casts just one vote on a five-member commission, where three votes on a given day are sufficient to set regulatory policy in the state. And “turning back the clock” is just what the PUC’s public staff recommended at the hearing.

“There are hardly any benefits to utility customers from increased utility diversification,” asserted William A. Aherne, public staff director. “Instead, increased diversification, especially within a holding-company structure, presents myriad opportunities and temptations to holding-company headquarters and affiliates to milk the resources of the utility. . . .

“Not only should diversification not increase, it should be reversed, particularly where utilities purchase gas and other fuel supplies from vertically integrated subsidiaries or affiliates,” Aherne testified. Further, he contended that, when dealing with supply companies under the same corporate umbrella, “utilities are not aggressive in trying to make the best deal possible for the ratepayers.”

The PUC public staff urged the commission to deny SDG&E;’s application to create a holding company and any others that might arise; to deal harshly with abuses that result from transactions between utilities and affiliated companies under existing holding companies, and to permit diversification only into fields closely related to utility operations, thus making better use of utility investments, and then only through subsidiaries wholly owned and controlled by the utilities.

So far, only two major California utilities operate under holding-company structures, though most other utilities have diversified to a limited extent in such fields as real estate development and financial services. The two are Pacific Telesis, which became operative Jan. 1, 1984, and Pacific Lighting, created in 1886 and the corporate parent of Southern California Gas Co.

Despite Pacific Lighting’s century-long existence, the company only began diversifying about 20 years ago, Lloyd Levitan, executive vice president and chief financial officer, told the commission.

“Pacific Lighting’s (holding-company) structure is designed to put a moat around the utility with only two bridges,” Levitan testified. “One bridge connects the utility with its parent holding company, and the other with its (federally) regulated affiliates.” These are gas-supply affiliates regulated by the Federal Energy Regulatory Commission, he explained, and “not really a part” of Pacific Lighting’s diversification program.

(Nonetheless, these affiliates represent the “vertical integration” that the PUC public staff found objectionable. Federal regulation of the supply companies assures utility customers fair rates, Levitan maintained.)

Easily Regulated

Continuing the metaphor, he said the commission “can easily regulate what goes on inside the utility and can monitor the minor traffic on the two bridges.” And no “bridge” connects the utility and Pacific Lighting’s diversified businesses, he added. Nor need the commission “concern itself with regulation of traffic that stays entirely on the non-utility side of the moat,” Levitan insisted, echoing a common theme sounded by utility executives at the hearing.

“In the 20 years of diversification, I know of no problems with this commission with respect to our diversification program,” he said.

Commission Frederick R. Duda supported that assertion, commenting: “Pacific Lighting has taken a very conservative approach with respect to the holding-company concept.” Not only are unregulated activities maintained as separate corporations reporting to the holding company, he noted, but each maintains a separate board of directors and separate accounting books.

David H. Dounes, a professor at the University of California’s School of Business Administration in Berkeley, warned the commissioners, however, that the corporate benefits of diversification can prove elusive.

“There’s no free lunch here,” he said. Diversifying into competitive markets increases a company’s risk, he said, “and returns are based on the absence, not the presence, of risk.”

Creating a holding company to keep regulated and unregulated subsidiaries separate may increase corporate overhead, Dounes said. Moreover, he said, risks and benefits flowing from diversification are unlikely to be shared evenly by shareholders and ratepayers.

‘Be Very, Very Careful’

“My advice to the commission,” he said, “is to be very, very careful. “The commission should not deny them (the opportunity to diversify), but it should not encourage them either.”

Dounes urged the commission to be sure that utility customers were paid at the outset for the use of any assets by the unregulated new venture. This might come in the form of “imputing” costs for personnel trained by the utility and transferred to an unregulated subsidiary, for example, as well as actual costs--including overhead and a profit--of any assets or information transferred, he suggested.

San Diego Gas & Electric believes diversification is necessary because “the times are changing and we must change with them,” said Dick Korpan, SDG&E; senior vice president for finance. Large utility customers now have the means of generating their own power or creating their own networks, eroding what traditionally has been the exclusive preserve of utilities, he said. These developments, along with energy conservation programs and the emergence of more energy-efficient appliances, have flattened the demand for energy, Korpan said.

SDG&E; can either watch its market erode or seek to maintain and expand it, he said. “Our decision is to participate,” he said. “It would be irresponsible management for us not to respond to the changing markets.”

Pacific Telesis’ view of diversification is similarly defensive, according to John R. Gaulding, vice president for corporate strategy and development. “Most of our efforts today are focused on trying to regain some stability in the marketplace,” he said, citing rapid and unsettling developments in telecommunications provoked by changes in technology, regulatory policy, increased competition and a growing diversity of demand for services.

“We’ve constructed a virtual Iron Curtain between our basic network services and everything else we do.”

Public Demand

That assertion drew a strong rebuttal from telecommunications consultant Lee Selwyn. He argued that Pacific Bell’s network construction budget, which anticipates spending about $2 billion a year for the next 10 years--$20 billion in all--aims at creating “a new standard . . . whether or not there is any public demand for that new level of service.

“Pacific shareholders would not make such an investment,” Selwyn maintained. “All ratepayers, large and small, will be forced to pay for it, whether or not they use it--and a majority won’t.”

All the same, said PUC President Donald Vial, “this diversification threat is one we are not going to be able to stop. We must try to make it work for the ratepayers.”

Commissioner Calvo said the full commission, with the SDG&E; holding-company proposal due for decision, will have to decide soon just how to accomplish that goal. “I see it as a very fine balance we have to strike,” he said.