PGW: The price of politics

Harry A. Connelly, a punctilious and bespectacled PGW vice president, testified to an audience consisting mostly of unoccupied metal folding chairs that an emerging class of natural-gas marketers was plotting to steal PGW customers as utilities opened up to competition.

Connelly said his biggest fear was Peco Energy Co., the utility that sells electricity to city residents and whose suburban gas mains run up to the city's boundary.

As members of the Philadelphia Gas Commission fidgeted, Connelly said the competition would first target PGW's biggest customers, offering them cheaper prices.

Then the marketers would spread out from the city's affluent neighborhoods like a virus consuming PGW's base of 519,000 customers. He said PGW could be left serving primarily customers who could not afford to pay their bills.

When would the erosion occur? "Are we talking about 10, 15 years away?" someone asked.

"I would anticipate within a year or two, if that," Connelly replied.

The gas commission fell silent. Someone suggested Connelly's comments be stricken from the record so that competitors might not be tipped off.

But it is too late to hide: PGW, the nation's largest municipal gas company, is in danger of being toppled.

PGW is at a crossroads. The tumult that has engulfed it during the last year as it skirted financial crisis and hunted for its first permanent chief executive since 1989 is only a sample of things to come.

PGW's new managers, installed last month, are taking command of a half-billion dollar enterprise that remains politicized, debt-ridden and larded with giveaway programs, even after a year of cost-cutting by a turnaround firm.

With the highest rates in the region, PGW is ill-prepared to compete. If it fails to shape up, a profitable asset for the city government could be turned into a burden on every city taxpayer.

PGW threatens to become "a long-term drag on Philadelphia's future" unless it operates more like a privately owned business, said a December study by the Pennsylvania Economy League, a nonprofit government-improvement organization.

In a rapidly changing environment influenced as much by events in Washington as in City Hall, PGW is trying to catch up with other energy suppliers.

The new chief executive, James Hawes 3d, a former telecommunications executive from Nebraska, says he is well aware of the competitive challenge ahead. He said he hopes to expand PGW's market, perhaps even pushing beyond the city's borders with new ventures.

But Hawes acknowledged that "our first goal will be to get this place running on all cylinders."

That will be a tall order, demanding a rapid cultural change at an organization that for most of its 161-year history operated in a protected market and could afford to be slothful.

PGW suffers from "a certain institutional lethargy," said E. Talbot Briddell, the head of Phoenix Management Services, the Chadds Ford turnaround firm that has operated the utility for 14 months. "People tend to think in terms of millennia around here."

The result is an organization that critics say has a confused mission aimed as much at serving political masters as serving PGW's customers.

"Without shareholders, PGW has returned dividends in the form of influence to its stakeholders: the politicians and interest groups," said Rotan Lee, the former school board chief who was named to head PGW's board of directors in 1994.

PGW has squandered the competitive advantages it enjoyed under municipal ownership.

"You'd think that with tax-exempt financing and without the need to pay shareholders, we could run this sucker and provide gas at a lower cost," said Ben Hayllar, the city finance director, who estimates those municipal benefits are worth $75 million annually to PGW.

Not so.

With no clear mandate to watch costs, PGW developed into an organization that tolerated inefficiency. A consultant last year said that even after 17 percent of PGW's workforce took early retirement and the staff shrank to 2,027 employees, PGW still employed more people than other utilities of similar size. PGW has never done a companywide study to determine the right staffing levels.

It is a system that tolerated abuse. An audit last year discovered that 333 city employees had signed up for low-income discounts at a cost of about $1 million. Only about $250,000 of that has been recovered from ineligible employees - the remainder covered by the vast majority of customers who pay their bills.

And it is an organization that condoned pilferage. When PGW hired a sleuth to look into its transportation department last year, purchases of auto parts suddenly fell from $115,000 a month to $35,000. Four employees were later fired for alleged thefts.

PGW also has a history as a source of political patronage, though officials such as mayoral chief of staff David L. Cohen say the utility is far less of a hiring hall than it was during the reign of Mayor Frank Rizzo.

In 1972, Rizzo ousted the private firm that had managed PGW for 75 years. The mayor claimed the city could do the job for less. He created a nonprofit board of directors to manage the utility.

That paved the way for Rizzo to launch a hiring spree that continued even after he left office. In 1984, during the Goode administration, Rizzo became head of PGW's security and hired 32 retired police officers. Their function was never entirely clear even to PGW's managers.

Most of the officers took buyouts last year. And with PGW's workforce shrinking these days, it is hardly the reliable source of jobs that it once was.

Politicians still have some measure of influence, however.

Ann Land, a former city councilwoman and member of the gas commission, was appointed in 1992 as PGW's community-relations manager. Her main duty was to handle customer complaints directed to City Council members. Her $53,000-a-year job was targeted for elimination last year but was spared, sources said, after City Council President John F. Street called PGW officials. Land's new title is manager of city affairs. "I'm doing the same thing I've done since coming here, which is mostly constituent services," said Land, who referred other questions to PGW.

The utility also hires its share of politically connected contractors and law firms. It is spending $2.3 million this year for legal costs, about two-thirds of it to outside law firms, many of which contributed generously to Mayor Rendell's re-election campaign.

But PGW's biggest political costs are not the contracts it gives to the well-connected or the jobs it has doled out to retired politicos.

Rather, PGW's biggest political costs are the discounts it gives its own customers at the behest of elected officials.

About 11 cents of every dollar collected by PGW pays for social programs to subsidize the poor and the elderly. Those costs may address legitimate social concerns, but they increase the utility's rates and exposed its flanks to competition.

Rizzo was largely responsible for one action that represents the type of social patronage that continues to cost PGW customers millions of dollars each year.

In 1973, under pressure from an organization of senior citizens, Rizzo and the City Council voted to give 20 percent discounts to people aged 65 and older. PGW is the only utility in the country that gives such a discount without regard to a customer's income.

The cost of the senior discount was downplayed at the time. Nor did the city emphasize who would pick up the tab: other PGW customers.

But in the 22 years since the discount went into effect, PGW customers have paid $223 million in discounts for senior citizens - not counting an estimated $17 million this winter.

The discount will cost the typical PGW residential heating customer about $30 this year. Because seniors are not required to report their income, middle-class customers who pay PGW's full rate are, in effect, subsidizing their wealthier neighbors who might be older than 64.

Few City Council members express eagerness about taking on the political risks of challenging the senior discount. "We politicians are terrified" of senior citizens, said City Councilman W. Thacher Longstreth, who is 75 and opposes the discount.

The senior discount is not the only example of the city's political leaders' extending benefits to a broad class of PGW customers.

Two years ago, the Philadelphia Gas Commission, whose five members include three elected officials, moved to restructure a discount program for poor people who had fallen behind in their payments.

Led by City Councilwoman Happy Fernandez, the gas commission quietly approved a new program that attempted to curtail abuses by customers who repeatedly re-enrolled in the program, only to default again.

In correcting the program, the gas commission extended the discounts to all low-income customers - regardless of whether they had payment problems.

PGW did not have to conduct an advertising campaign to spread the word about the new program.

By the end of its first year, more than 60,000 customers had signed up for it, nearly double the number of customers who had been enrolled in the program it replaced. The new program limits a customer's payments to 7.35 percent of monthly income; the poorest customers pay a minimum of $30 a month.

The enrollment topped out at nearly 70,000 customers last summer before PGW began examining the rolls and eliminating customers who earned above the income limits. That's how PGW discovered 333 city employees in the program.

PGW estimated that the discount program would cost other customers $38 million for the fiscal year that began Sept. 1.

The gas works estimated that the total cost of social programs has swelled to about $58.5 million a year, including the costs of a $3.5 million conservation program that is still struggling to become cost-effective in its fifth year. That amounts to $105 a year for the average residential customer with a total bill of $924.

PGW has always blamed its problems on external causes: As an older utility, it faces higher costs to repair aging pipes, and its urban location means it has a lot of poor customers who don't always pay on time.

All that is true.

But much of PGW's excessive costs have as much to do with how it does business as where it does business.

PGW's managers permitted it to amass a huge debt rather than confront its escalating costs. Its debt-to-equity ratio is nearly double that of other utilities.

It also accepted excessive overtime, sick time and absenteeism as standard costs of doing business.

Until last year, the department that manages customer-service operators and PGW's district offices budgeted on the assumption that 20 percent of its workforce would not show up each day. "That was one of the points that alarmed us," said Mitch Arden, an executive with Phoenix Management Services.

PGW not only employs more people than most utilities its size, but its 2,027 employees cost an average of $58,033 a year in wages and benefits, $6,366 more than the average of 10 other utilities, according to a study last year.

Labor leaders say that PGW's bloated management ranks are the cause of the high personnel costs - the utility had one manager for every three union members before last year's buyout reduced the ratio to four-to-one.

"The real problem is they got so many people here who have no gas experience who were put in by politicians," said Joseph G. Given, the head of the Gas Works Employees Union.

PGW also costs more to be regulated than other utilities. PGW ratepayers this year will absorb $2.1 million for the gas commission's budget, a cost that is basically dictated by the commission without public debate. The cost was $1.3 million two years ago.

If PGW were regulated by the Pennsylvania Public Utility Commission, the cost would amount to $1.2 million this year, according to the PUC's funding formula. As a municipal utility, PGW cannot be regulated by the state without a legislative act.

One of PGW's biggest costs resulted from its own sloppy collection practices, which PGW often complains were imposed upon it by politicians on the gas commission.

PGW wrote off $87 million in bad debts in the last two years. Eight cents of every dollar paid by PGW customers covered the cost of old, unpaid bills of their neighbors. Two cents is considered high by industry standards.

It is impossible to calculate precisely how much PGW's practices cost its customers.

But a typical Philadelphia residential heating customer pays $127 more a year for natural gas than a suburban Peco customer using the same amount of gas, even though Peco pays out 13 cents of every dollar it receives in various taxes and 11 cents in profits and dividends.

City Hall long could afford to neglect the utility as long as it generated a reliable stream of profits: PGW pays the city treasury $18 million a year regardless of its performance. The city also gets a discounted gas rate that saves it about $900,000 a year.

But those benefits are guaranteed only as long as the utility is healthy. And as Harry Connelly told the gas commission last summer, competitive forces already are pushing against the barriers that PGW has erected.

"It is not necessarily possible to keep putting fingers in the dikes sufficient to keep the dikes from being breached by the onslaught," he said.

In the last decade, changes imposed by the Federal Energy Regulatory Commission have deregulated the prices of natural gas at the wellhead, as well as the cost of transmitting the fuel up pipelines from the gas-producing regions along the Gulf Coast and in Appalachia.

Meanwhile, state regulatory agencies are relaxing rules that give exclusive monopolies to utilities, allowing increasingly smaller gas customers the freedom to choose their energy suppliers.

While PGW is not controlled directly by state regulators, it is nonetheless affected by these outside forces. Some of its customers have demanded lower rates or threatened to move their operations elsewhere.

PGW has already seen much of its industrial load flee for cheaper alternatives. Almost all of its large customers buy their gas from brokers, whose costs are lower than those of regulated utilities such as PGW.

PGW's latest fear is that brokers will consolidate groups of smaller customers and sell them gas. It's already happening in suburban areas, particularly in New Jersey, where brokers can form groups as small as five customers to sell them gas: five restaurants under the same owner, for instance.

All PGW gets from a broker is a "transportation fee" for delivering the fuel through its pipes. Connelly said he is concerned that PGW's revenue will shrink because of competition, but PGW's fixed costs will not. PGW would be forced to recover its costs from fewer customers - pushing rates up at a time when the markets are forcing them down.

It's a slippery slope that Steven P. Hershey, the Community Legal Services attorney who serves as the public advocate, calls a "death spiral."

Another competitive threat is called a bypass. It occurs when a large customer taps directly into the interstate pipelines that typically carry gas to local utilities such as PGW.

A large customer that builds a bypass can avoid any payment to the local utility whatsoever. In recent years, federal regulators have lifted restrictions on bypasses.

Utilities typically respond to a bypass threat by cutting their prices to large customers. But each time a utility cuts its charge, it shifts the burden to other customers.

By dropping its price, PGW last year averted a bypass by the Grays Ferry Cogeneration Project, the gas-fired expansion of the Schuylkill Station power plant at 26th and Christian Streets.

The Grays Ferry project will increase PGW's gas volume by 20 percent, but it will contribute less than $3 million a year to the utility, less than 4 percent of operating income.

Papers filed with federal regulators in connection with the Grays Ferry project indicated that Sun Co. Inc. also has considered bypassing PGW to supply its South Philadelphia refinery.

Not just big customers may bypass utilities in the future in the free-market free-for-all envisioned by some energy experts.

Connelly said he feared that smaller customers may try to buy gas from a neighboring utility.

One current PGW customer, Chestnut Hill College, is considering replacing its oil-fired boilers with an efficient natural-gas heating and air-conditioning system.

But PGW would need to build a new gas main down Germantown Pike to supply the volume of gas that the college needs. PGW has balked at the cost.

There is a much closer supply: Peco operates a medium-pressure gas main beneath Northwestern Avenue, less than 100 yards from the college.

So far, Peco has declined to serve Chestnut Hill College without PGW's permission.

In an interview, Peco senior vice president Robert Patrylo said the suburban gas utility has no intention of extending its gas lines into the city to nab PGW customers.

But PGW officials said they fear that in the not-so-distant future utilities such as Peco may not be so respectful of neighboring turf.

Connelly was questioned about the potential of an intrusion last summer.

"Do you know whether or not Peco has any plans either on the shelf or more concretely to enter the Philadelphia gas market?" asked Hershey, the public advocate.

"At the moment, I'm assured that they do not," Connelly said.

"Do you accept those assurances?"

Connelly's response: "No."