The US electric power industry is finally having to accept what NC WARN and allies have been telling them for years: Their days of forcing captive customers to bear the economic pain and pollution from old technologies are numbered. The industry’s own trade group is now warning of factors that “are potential game-changers” to that old business model.
In January 2013, the Edison Electric Institute published a report titled Disruptive Challenges: Financial Implications and Strategic Responses to a Changing Retail Electric Business. It states: “…the pace of [electric industry] change is increasing and will likely increase further as costs of disruptive technologies” continue to decline.
“Disruptive technologies” is how the report describes distributed power sources such as solar on the roofs of homes and businesses. The falling price and rapid growth of rooftop solar is one of the “game-changing” factors Edison cites, along with energy-saving advances, long-term economic slowdown and rising electricity rates.
The executive summary of the Edison report appears below. See the Disruptive Challenges report in its entirety here.
Disruptive Challenges: Financial Implications and Strategic Responses to a Changing Retail Electric Business
Edison Electric Institute, January 2013
Recent technological and economic changes are expected to challenge and transform the electric utility industry. These changes (or “disruptive challenges”) arise due to a convergence of factors, including: falling costs of distributed generation and other distributed energy resources (DER); an enhanced focus on development of new DER technologies; increasing customer, regulatory, and political interest in demand-side management technologies (DSM); government programs to incentivize selected technologies; the declining price of natural gas; slowing economic growth trends; and rising electricity prices in certain areas of the country. Taken together, these factors are potential “game changers” to the U.S. electric utility industry, and are likely to dramatically impact customers, employees, investors, and the availability of capital to fund future investment. The timing of such transformative changes is unclear, but with the potential for technological innovation (e.g., solar photovoltaic or PV) becoming economically viable due to this confluence of forces, the industry and its stakeholders must proactively assess the impacts and alternatives
available to address disruptive challenges in a timely manner.
This paper considers the financial risks and investor implications related to disruptive challenges, the potential strategic responses to these challenges, and the likely investor expectations to utility plans going forward. There are valuable lessons to be learned from other industries, as well as prior utility sector paradigm shifts, that can assist us in exploring risks and potential strategic responses.
The financial risks created by disruptive challenges include declining utility revenues, increasing costs, and lower profitability potential, particularly over the long-term. As DER and DSM programs continue to capture “market share,” for example, utility revenues will be reduced. Adding the higher costs to integrate DER, increasing subsidies for DSM and direct metering of DER will result in the potential for a squeeze on profitability and, thus, credit metrics. While the regulatory process is expected to allow for recovery of lost revenues in future rate cases, tariff structures in most states call for non-DER customers to pay for (or absorb) lost revenues. As DER penetration increases, this is a cost-recovery structure that will lead to political pressure to undo these cross subsidies and may result in utility stranded cost exposure.
While the various disruptive challenges facing the electric utility industry may have different implications, they all create adverse impacts on revenues, as well as on investor returns, and require individual solutions as part of a comprehensive program to address these disruptive trends. Left unaddressed, these financial pressures could have a major impact on realized equity returns, required investor returns, and credit quality. As a result, the future cost and availability of capital for the electric utility industry would be adversely impacted. This would lead to increasing customer rate pressures.
The regulatory paradigm that has supported recovery of utility investment has been in place since the electric utility industry reached a mature state in the first half of the 20th century. Until there is a significant, clear, and present threat to this recovery paradigm, it is likely that the financial markets will not focus on these disruptive challenges, despite the fact that electric utility capital investment is recovered over a period of 30 or more years (i.e., which exposes the industry to stranded cost risks). However, with the current level of lost load nationwide from DER being less than 1 percent, investors are not taking notice of this phenomenon, despite the fact that the pace of change is increasing and will likely increase further as costs of disruptive technologies benefit further from scale efficiencies.
Investors, particularly equity investors, have developed confidence throughout time in a durable industry financial recovery model and, thus, tend to focus on earnings growth potential over a 12-to 24-month period. So, despite the risks that a rapidly growing level of DER penetration and other disruptive challenges may impose, they are not currently being discussed by the investment community and factored into the valuation calculus reflected in the capital markets. In fact, electric utility valuations and access to capital today are as strong as we have seen in decades, reflecting the relative safety of utilities in this uncertain economic environment.
In the late 1970s, deregulation started to take hold in two industries that share similar characteristics with the electric utility industry—the airline industry and the telecommunications industry (or “the telephone utility business”). Both industries were price-and franchise-regulated, with large barriers to entry due to regulation and the capital-intensive nature of these businesses. Airline industry changes were driven by regulatory actions (a move to competition), and the telecommunications industry experienced technology changes that encouraged regulators to allow competition. Both industries have experienced significant shifts in the landscape of industry players as a result.
In the airline sector, each of the major U.S. carriers that were in existence prior to deregulation in 1978 faced bankruptcy. The telecommunication businesses of 1978, meanwhile, are not recognizable today, nor are the names of many of the players and the service they once provided (“the plain old telephone service”). Both industries experienced poor financial market results by many of the former incumbent players for their investors (equity and fixed-income) and have sought mergers of necessity to achieve scale economies to respond to competitive dynamics.
The combination of new technologies, increasing costs, and changing customer-usage trends allow us to consider alternative scenarios for how the future of the electric sector may develop. Without fundamental changes to regulatory rules and recovery paradigms, one can speculate as to the adverse impact of disruptive challenges on electric utilities, investors, and access to capital, as well as the resulting impact on customers from a price and service perspective. We have the benefit of lessons learned from other industries to shift the story and move the industry in a direction that will allow for customers, investors, and the U.S. economy to benefit and prosper.
Revising utility tariff structures, particularly in states with potential for high DER adoption, to mitigate (or eliminate) cross subsidies and provide proper customer price signals will support economic implementation of DER while limiting stress on non-DER participants and utility finances. This is a near-term, must-consider action by all policy setting industry stakeholders.
The electric utility sector will benefit from proactive assessment and planning to address disruptive challenges. Thirty year investments need to be made on the basis that they will be recoverable in the future in a timely manner. To the extent that increased risk is incurred, capital deployment and recovery mechanisms need to be adapted accordingly. The paper addresses possible strategic responses to competitive threats in order to protect investors and capital availability. While the paper does not propose new business models for the industry to pursue to address disruptive challenges in order to protect investors and retain access to capital, it does highlight several of the expectations and objectives of investors, which may lead to business model transformation alternatives.