Jun 29, 2017 – from Investor Insights

Are Utilities Losing Power?

Solar panel fieldHouston residents are marveling at a new energy-efficient home that features everything from a solar panel-lined roof to smart thermostats. The kicker? The home was built by a utility company. Why would Reliant Energy, a firm that makes money on power, provide a way for consumers to use less of it? (And in Houston, of all places?) Because the rise of price-competitive renewable energy has forever changed the game for utilities. In their next act, they will no longer be able to make money by investing in ever-more fossil fuel-burning plants—but will instead have to find a way to provide value to consumers while staying ahead of new competition.

The utilities sector has always adhered to a simple principle: The more you invest, the more you earn. Due to prohibitive fixed costs, the sector operates as a natural monopoly consisting mainly of regional players. These firms are heavily regulated by state-run public utility commissions, which control virtually every part of a utility’s business—from signing off on investments to setting rates of return. Because utilities are allowed to generate a fixed rate of return on their assets, more assets mean greater returns. This model is particularly advantageous at a time of declining interest rates and earnings yields. It’s little wonder why since 2004, annual capex by U.S. investor-owned utilities has more than doubled—and why investors have flocked to these stocks as bond alternatives.

The sector suffered an initial scare coming out of the Great Recession, when utility professionals feared that rising energy prices would incentivize consumers to switch to renewable energy. At issue were the forced “buy­back” programs by which consumers who generated their own power could sell it back to the utility. (Fully 42 states plus Washington, D.C. had implemented such programs in 2010.) Sure enough, as energy prices spiked and ever-more consumers adopted solar power systems, utilities like Arizona Public Service and Denver-based Xcel Energy began asking regulators to reduce incentives or impose new charges on consumers who installed solar rooftops.

Naturally, when fossil fuel prices plummeted in late 2014, utility execu­tives breathed a sigh of relief. No longer would renewable energy hold a compar­ative advantage over fossil fuels.

Or so they thought. In the years since, it has become jarringly evident that the game has changed for utilities—and there is no going back.

In spite of falling energy prices, the shift toward renewables has not only continued—but has accelerated. Global renewable capacity rose by 9 percent YOY in 2016, powered largely by solar. For the second consecutive year, renew­able capacity accounted for more than half of all capacity added worldwide. Fully 1 million solar installations took place in the United States last year, a figure that the Solar Energy Industries Association expects to double by the end of 2017. Renewables have truly arrived in green states like California, where regulators antic­ipate that 85 percent of consumers will be getting at least some of their electricity from a source other than an investor-owned utility by 2020.

How has this happened? For one, productivity gains in renewable energy generation are pro­ceeding so rapidly that renewables remain price-competitive no matter how low fossil fuel prices go. According to Greentech Capital Advisors partner Jim Long, “In 2010 we financed a 15-megawatt solar plant in southern California that cost $55 million to build…This year we have done another one the same size in the same area that has cost $15 million and will produce at least 40 percent more energy.” Moreover, continued advances in energy storage have made it ever-easier—and ever-cheaper—for consumers to go “off the grid.” (See: “Energy Storage Powers Up.”)

Another factor is generational change. America’s rising appetite for renewable energy is being fueled by Gen Xers and Millennials—each for different reasons. For individualistic Xers, renewables promise self-sufficiency: If the grid goes out, a backup generator or solar power could mean the difference between life and death—or at least between comfort and hardship. This generation’s prepper, me-against-the-world mentality is the same one that has brought “survivalism” into the mainstream. (See: “I Will Survive.”)

Meanwhile, renewable energy is a natural match for Millennials who value sustain­ability and urban living. Pew Research finds that consumers ages 18 to 29 favor the development of alternative energy sources over the expansion of fossil fuels by 54 percent­age points, by far the widest margin of any age group. The mere mention of fossil fuel elicits a negative reaction from young Millennials: According to Ernst & Young, 16- to 18-year-olds have a much less positive perception of natural gas (40 percent positive) and oil (25 percent) than older consumers (60 percent and 35 percent, respectively).

Attitudinally, Millennials are interested in living sustainably and leaving a small carbon footprint. Their land-use patterns reinforce this worldview: This generation’s affinity for urban living naturally leads to less dependence on utilities. Because of the compactness of city life, the average New York household uses less than half of the electricity consumed by the average U.S. household (4,700 kWh compared to more than 11,000 kWh).

Does this shift toward renewables mean lights out for utilities? Not quite. Fossil fuel-generated power still creates 85 percent of the world’s energy, a share that will not disappear overnight. Clearly, however, fossil fuels are no longer a growth driver for utilities. Instead of investing ever-more heavily in fossil fuel-powered plants in order to generate a profit, the sector must find another revenue stream.

Best-practice firms are betting that consumer-facing services will be their next cash cow. The average consumer spends only 20 minutes each year interacting with their energy provider. Utilities want to extend and deepen this relationship—even if it means offering services that encourage less power consumption. Southern California Edison offers a digital home energy advisor tool that provides tailored recommendations for reducing household energy usage. Duke Energy and American Electric Power are now market-testing a new mobile app that offers everything from bill pay to real-time outage updates. Accenture global managing director Tony Masella says that, “Utilities are really beginning to realize that the world has shifted…It’s not something that will happen in five years. It’s happening now.” An industry trade survey found that only 5 percent of utility professionals say that their business model does not need to evolve.

While becoming “energy-service providers” may garner firms some much-needed favor among consumers and state regulators, there’s no guarantee that this strategy will pay off. Utilities are monopolies in energy provision, not in service provision. Their direct access to consumers’ homes and their knowledge of the power business does give them an early advantage. But unless utilities can use that head start to build a truly meaningful relationship with consumers, they may be marginalized once third-party tech companies with vastly more experience in digital IT begin competing in the space.

Takeaways

  • Beware: The utilities sector’s old way of doing business is no longer viable. While utilities tradition­ally have grown their top line by investing in more physical capital, fossil fuel plants will no longer be a growth driver for firms. Why? Technological advances have made renewable energy cheaper than ever, which has incentivized consumers to go green. With the U.S. grid adding more renewable capacity than fossil fuel capacity, utilities must find another driver of revenue growth. Some are betting on consumer-facing services—a path that, while promising, will only get tougher as tech-centric competitors enter the field.
  • Recognize that renewables are now affordable—even without subsidies. The federal solar Investment Tax Credit (ITC), which since 2006 has allowed con­sumers and corporations to deduct 30 percent of the cost of solar installation from their taxes, has spurred rampant growth in solar energy adoption. But sur­prising­ly, the tax’s expiration in 2022 is not expected to slow down this industry’s growth. According to the Institute for Energy Economics and Financial Analysis, renewable energy costs are falling so rapidly on their own that by the early 2020s, even unsubsidized wind and solar will be cheaper than coal and natural gas.
  • Understand that the cost of renewables has been falling faster than anyone projected. In 2010, Inter­national Energy Agency projections suggested that there would be 180 gigawatts of installed solar capacity worldwide by 2024. Actually, there were nearly 300 gigawatts by 2017. In 2011, the Department of Energy predicted that utility-grade solar power would fall below $1/watt by 2020. Actually, it fell below $1/watt earlier this year. The quick shift toward renewables is happening abroad as well. The EU is on track to meet its goal of generating 20 percent of its power from renewables by 2020, while China added 35 gigawatts of solar capacity last year, an amount on par with Germany’s total capacity.
  • Watch for more states to ease the regulatory bur­den on utilities. In response to disappointing profits brought on by slow sales, lawmakers in some states are exploring legislation that would open up new revenue streams for utilities. One is New York and its “Reforming the Energy Vision” (REV), which (along with the stated goal of modernizing the grid) will enable utilities to earn money on their consumer-facing business lines beyond the mere cost of service. In the future, for example, a utility could earn additional revenue through performance incentives or software-as-a-service offerings. Likewise, Illinois is reportedly pursuing similar legislation addressing the utility business model.