Solar power and other distributed renewable energy technologies could lay waste to U.S. power utilities and burn the utility business model, which has remained virtually unchanged for a century, to the ground.
That is not wild-eyed hippie talk. It is the assessment of the utilities themselves.
Back in January, the Edison Electric Institute — the (typically stodgy and backward-looking) trade group of U.S. investor-owned utilities — released a report [PDF]:
that, as far as I can tell, went almost entirely without notice in the press. That’s a shame. It is one of the most prescient and brutally frank things I’ve ever read about the power sector. It is a rare thing to hear an industry tell the tale of its own incipient obsolescence.
I’ve been thinking about how to convey to you, normal people with healthy social lives and no time to ponder the byzantine nature of the power industry, just what a big deal the coming changes are. They are nothing short of revolutionary … but rather difficult to explain without jargon.
So, just a bit of background. You probably know that electricity is provided by utilities. Some utilities both generate electricity at power plants and provide it to customers over power lines. They are “regulated monopolies,” which means they have sole responsibility for providing power in their service areas. Some utilities have gone through deregulation; in that case, power generation is split off into its own business, while the utility’s job is to purchase power on competitive markets and provide it to customers over the grid it manages.
This complexity makes it difficult to generalize about utilities … or to discuss them without putting people to sleep. But the main thing to know is that the utility business model relies on selling power. That’s how they make their money. Here’s how it works: A utility makes a case to a public utility commission (PUC), saying “we will need to satisfy this level of demand from consumers, which means we’ll need to generate (or purchase) this much power, which means we’ll need to charge these rates.” If the PUC finds the case persuasive, it approves the rates and guarantees the utility a reasonable return on its investments in power and grid upkeep.
Thrilling, I know. The thing to remember is that it is in a utility’s financial interest to generate (or buy) and deliver as much power as possible. The higher the demand, the higher the investments, the higher the utility shareholder profits. In short, all things being equal, utilities want to sell more power. (All things are occasionally not equal, but we’ll leave those complications aside for now.)
Now, into this cozy business model enters cheap distributed solar PV, which eats away at it like acid.
First, the power generated by solar panels on residential or commercial roofs is not utility-owned or utility-purchased. From the utility’s point of view, every kilowatt-hour of rooftop solar looks like a kilowatt-hour of reduced demand for the utility’s product. Not something any business enjoys. (This is the same reason utilities are instinctively hostile to energy efficiency and demand response programs, and why they must be compelled by regulations or subsidies to create them. Utilities don’t like reduced demand!)
It’s worse than that, though. Solar power peaks at midday, which means it is strongest close to the point of highest electricity use — “peak load.” Problem is, providing power to meet peak load is where utilities make a huge chunk of their money. Peak power is the most expensive power. So when solar panels provide peak power, they aren’t just reducing demand, they’re reducing demand for the utilities’ most valuable product.
But wait. Renewables are limited by the fact they are intermittent, right? “The sun doesn’t always shine,” etc. Customers will still have to rely on grid power for the most part. Right?
This is a widely held article of faith, but EEI (of all places!) puts it to rest. (In this and all quotes that follow, “DER” means distributed energy resources, which for the most part means solar PV.)
Due to the variable nature of renewable DER, there is a perception that customers will always need to remain on the grid. While we would expect customers to remain on the grid until a fully viable and economic distributed non-variable resource is available, one can imagine a day when battery storage technology or micro turbines could allow customers to be electric grid independent. To put this into perspective, who would have believed 10 years ago that traditional wire line telephone customers could economically “cut the cord?” [Emphasis mine.]Indeed! Just the other day, Duke Energy CEO Jim Rogers said, “If the cost of solar panels keeps coming down, installation costs come down and if they combine solar with battery technology and a power management system, then we have someone just using [the grid] for backup.” What happens if a whole bunch of customers start generating their own power and using the grid merely as backup? The EEI report warns of “irreparable damages to revenues and growth prospects” of utilities.
Utility investors are accustomed to large, long-term, reliable investments with a 30-year cost recovery — fossil fuel plants, basically. The cost of those investments, along with investments in grid maintenance and reliability, are spread by utilities across all ratepayers in a service area. What happens if a bunch of those ratepayers start reducing their demand or opting out of the grid entirely? Well, the same investments must now be spread over a smaller group of ratepayers. In other words: higher rates for those who haven’t switched to solar.
That’s how it starts. These two paragraphs from the EEI report are a remarkable description of the path to obsolescence faced by the industry:
The financial implications of these threats are fairly evident. Start with the increased cost of supporting a network capable of managing and integrating distributed generation sources. Next, under most rate structures, add the decline in revenues attributed to revenues lost from sales foregone. These forces lead to increased revenues required from remaining customers … and sought through rate increases. The result of higher electricity prices and competitive threats will encourage a higher rate of DER additions, or will promote greater use of efficiency or demand-side solutions.Did you follow that? As ratepayers opt for solar panels (and other distributed energy resources like micro-turbines, batteries, smart appliances, etc.), it raises costs on other ratepayers and hurts the utility’s credit rating. As rates rise on other ratepayers, the attractiveness of solar increases, so more opt for it. Thus costs on remaining ratepayers are even further increased, the utility’s credit even further damaged. It’s a vicious, self-reinforcing cycle:
Increased uncertainty and risk will not be welcomed by investors, who will seek a higher return on investment and force defensive-minded investors to reduce exposure to the sector. These competitive and financial risks would likely erode credit quality. The decline in credit quality will lead to a higher cost of capital, putting further pressure on customer rates. Ultimately, capital availability will be reduced, and this will affect future investment plans. The cycle of decline has been previously witnessed in technology-disrupted sectors (such as telecommunications) and other deregulated industries (airlines).
One implication of all this — a poorly understood implication — is that rooftop solar fucks up the utility model even at relatively low penetrations, because it goes straight at utilities’ main profit centers. (It’s already happening in Germany.) Right now, distributed solar PV is a relatively tiny slice of U.S. electricity, less than 1 percent. For that reason, utility investors aren’t paying much attention. “Despite the risks that a rapidly growing level of DER penetration and other disruptive challenges may impose,” EEI writes, “they are not currently being discussed by the investment community and factored into the valuation calculus reflected in the capital markets.” But that 1 percent is concentrated in a small handful of utility districts, so trouble, at least for that first set of utilities, is just over the horizon. Utility investors are sleepwalking into a maelstrom.
(“Despite all the talk about investors assessing the future in their investment evaluations,” the report notes dryly, “it is often not until revenue declines are reported that investors realize that the viability of the business is in question.” In other words, investors aren’t that smart and rational financial markets are a myth.)
Bloomberg Energy Finance forecasts 22 percent compound annual growth in all solar PV, which means that by 2020 distributed solar (which will account for about 15 percent of total PV) could reach up to 10 percent of load in certain areas. If that happens, well:
Assuming a decline in load, and possibly customers served, of 10 percent due to DER with full subsidization of DER participants, the average impact on base electricity prices for non-DER participants will be a 20 percent or more increase in rates, and the ongoing rate of growth in electricity prices will double for non-DER participants (before accounting for the impact of the increased cost of serving distributed resources).So rates would rise by 20 percent for those without solar panels. Can you imagine the political shitstorm that would create? (There are reasons to think EEI is exaggerating this effect, but we’ll get into that in the next post.)
If nothing is done to check these trends, the U.S. electric utility as we know it could be utterly upended. The report compares utilities’ possible future to the experience of the airlines during deregulation or to the big monopoly phone companies when faced with upstart cellular technologies. In case the point wasn’t made, the report also analogizes utilities to the U.S. Postal Service, Kodak, and RIM, the maker of Blackberry devices. These are not meant to be flattering comparisons.
Remember, too, that these utilities are not Google or Facebook. They are not accustomed to a state of constant market turmoil and reinvention. This is a venerable old boys network, working very comfortably within a business model that has been around, virtually unchanged, for a century. A friggin’ century, more or less without innovation, and now they’re supposed to scramble and be all hip and new-age? Unlikely.
So what’s to be done? You won’t be surprised to hear that EEI’s prescription is mainly focused on preserving utilities and their familiar business model. But is that the best thing for electricity consumers? Is that the best thing for the climate?
We’ll dig into those questions in my next post.
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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
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 cap
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 s
takeholders 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 re
sponses 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 pot
ential 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
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 regul
atory 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 wi
ll 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 o
n 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 i
nvestor 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 20
century. Until there is a significant, clear,
and present threat to this recovery paradigm, it is likely that the fina
ncial 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
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 fro
m 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
So, despite the
risks that a rapidly growing level of DER penetration and other disruptive challenges may
impose, they are
currently being discussed by the investment community and factored into the valuation
calculus reflected in the capital markets. In fact, electri
c 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
In the late 1970s, deregulation started to take hold in two industries that shar
e similar characteristics with the
electric utility industry
the airline industry and the telecommunications industry (or “the telephone utility
business”). Both industries were price
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. B
oth 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 busin
esses 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 t
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, inves
tors, 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 custome
rs, 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
of DER while limiting stress on non
DER participants and utility finances. This is a near
action by all policy setting industry stakeholders.
The electric utility sector will benefit from proactive assessment an
d 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
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 disruptiv
e 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 businessmodel transformation alternatives.