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11:16am EDT August 26, 2003
In the mid '90s, electric utility companies feared -- then welcomed -- deregulation of the industry, knowing it was inevitable.

"The deregulation charge was led by large industrial users who wanted to expand the market where they get power," says Alan Schriber, chairman of the Public Utilities Commission of Ohio. "The electric companies jumped in to cover themselves."

By January 2001, deregulation was a fact, and residential, commercial and industrial power users had a choice of where to buy power.

American Electric Power, based in Columbus, was poised to make the most of deregulation after proactively launching its wholesale trading division in the mid '90s. But AEP Chairman, President and CEO E. Linn Draper says it wasn't just deregulation that led the company to begin its wholesale operation.

"We launched an aggressive wholesale growth strategy in order to successfully compete for capital with companies ostensibly offering high growth rates for the future," Draper says.

Those were the days before the dot-com and tech stock bubble burst, Draper says, when AEP was competing with the likes of Microsoft and IBM.

"Investors were clamoring for growth back then," he says, "even in the relatively stable energy industries."

Following deregulation, AEP didn't lose a large number of customers, due to its abundance of power and low prices. According to Schriber, the biggest hit, not unexpectedly, came from commercial and industrial users.

"Twenty percent of the commercial and industrial load throughout the state switched to alternate power sources," Schriber says. "And in Northern Ohio, where the prices were higher, 20 percent of the residential load switched."

In the rest of the state, the percentage of residential load that switched sources was near zero.

"We've not lost very many customers," confirms Thomas Shockley, AEP's vice chairman, "because our prices were very competitive to begin with."

Shockley says after deregulation, new companies called Retail Electric Providers were formed to supply end users. And many of these purchase power from wholesalers.

"Trading is basically a tool or technique where, instead of just generating electricity, you have the ability to buy it from third parties and sell it to third parties, and the power is not tied to your assets," Shockley says.

One benefit of trading is that the company could buy power from other suppliers when it was cheap and use or sell it during periods of more expensive peak demand.

"We used trading to minimize our risk and for profit," Shockley says. "We could get power when it was low in price and sell it to others when the price went up."

Then the bubble burst

In the early years of AEP's wholesale business, life was good.

"AEP's wholesale operations -- including power generation, associated assets and related marketing activity -- were highly profitable for the company for several years," Draper says.

Then two major events -- the California energy crisis and the collapse of Enron -- caused huge upsets in the industry and a general loss of confidence in wholesale energy markets.

"The collapse of wholesale energy markets began with California's ill-conceived restructuring plan that was vulnerable to manipulation," says Draper, referring to California's deregulation plan. "A supply/demand imbalance, a severe drought and other factors led to extreme price volatility in California and the bankruptcy of the state's largest electric utility [Pacific Gas & Electric Co.]."

While AEP had few business interests in California, Draper says it still felt the effects in the form of dwindling wholesale income. Then the situation went from bad to worse with the unfolding of the Enron scandal.

"The demise of Enron devastated wholesale electricity and natural gas markets," he says. "Many participants found it nearly impossible to get credit and left the market or scaled back activity drastically."

Draper says total volumes of power traded on the Intercontinental Exchange hit a peak of 385 million megawatt-hours in March 2002 before declining to just 51 million megawatt-hours in December 2002. This decline both in the United States and abroad cut significantly into AEP's wholesale earnings.

Draper says it became painfully clear in late 2002 that the market was rethinking its demand for high-growth stocks.

"Investor expectations and goals changed," he says. "It was clear that the market would no longer reward the scope and scale of our trading and marketing business. Instead of demands for growth, investors developed an appetite for stable earnings and the reliable, traditional strengths and rates of return of regulated utility operations."

In August 2002, the Securities and Exchange Commission requested information from AEP regarding any "wash" or "round-trip" trades -- simultaneous, prearranged buy/sell trades of energy with the same counter-party, at the same price and volume, over the same term, resulting in neither profit nor loss to either transacting party. In April of this year, the company received a subpoena from the SEC for additional information as part of its ongoing investigation of power trading activities nationwide.

The company has complied with SEC requests and reviewed its trading activities from Jan. 1, 1999, through March 31, 2002, and says that less than approximately one-quarter of 1 percent of total trading transactions could fall into this category. The company believes that substantially all of these transactions involve economic substance and risk transference and do no constitute "round-trip" or "wash" sales.

At the end of 2002, despite slow, steady growth (about 1 percent a year) of regulated utility revenue, the company reported a loss of 12 percent in income and an ongoing loss of 14.5 percent in earnings per share. So it steeply downsized its marketing and trading operations, only trading in areas where it would maximize the value of its physical assets, namely where it can maximize power generation and gas pipeline operations. And it is returning to its roots: regulated power and energy supply.

"The business of producing, transmitting and delivery of electricity continues to be a solid business, despite the soft economy," Draper says. "And it's a business in which we have always excelled."

AEP comes full circle

When Draper says the company is refocusing, he isn't kidding. All of its businesses, except those that produce, transmit and generate electricity, are for sale.

"The assets we are seeking to divest include international and domestic unregulated generation, as well as natural gas pipelines, a coal mining business and a communication business," says Draper.

But the company is taking divestiture one step at a time.

"This isn't a fire sale," he says. "We will undertake our divestitures in a disciplined, orderly fashion."

Draper says proceeds from the sales will be used to reduce the company's debt.

So where will future growth come from? Draper expects to see a lot of industry consolidation in the next few years.

"As our financial picture continues to improve, I imagine we would look for opportunities to grow our earnings, perhaps through mergers or acquisitions in our core business," he says. "AEP is the largest generator of electricity and one of the largest distributors of electricity in the United States, yet we only have 5 percent market share."

AEP also launched a thorough expense-cutting program.

"We examined every part of the company and sought input from every employee to identify ways to save operation and maintenance costs," says Draper.

Any item that didn't jeopardize employee safety or the reliability of the system was open for cost-cutting discussion.

"There were no sacred cows," he says.

The result was the reduction of AEP's work force by nearly 5 percent -- approximately 1,300 positions -- and outside service expenses by $125 million. The company also reduced its capital expenditures by more than $200 million and suspended 2002 bonuses for the senior executive management team.

Still, it faces many challenges. Its stock price is low compared to previous years, although it has rebounded somewhat.

"Although SEC inquiries and other issues related to our industry have affected investor confidence in AEP and other companies in our sector, things seem to be improving," Draper says. "Our stock was up 40 percent between March 15 and June 16, which would seem to indicate that consumers and investors have increasing confidence in the value of investing in our company."

And when Draper retires in April 2004, the new CEO will face the continued evolution of the industry and myriad new environmental regulations.

"The challenge will be to help AEP grow in a logical way that increases shareholder returns while maintaining the attributes that have served this company, its employees and shareholders well for nearly 100 years," Draper says. "I look forward to watching what happens from the sidelines." How to reach: American Electric Power, (614) 716-1000 or www.aep.com; Public Utilities Commission of Ohio, (800) 686-7826 or www.puc.state.oh.us