TODAY’S STUDY: THE FORCES OF NEW ENERGY GATHERING AGAINST UTILITIES

Disruptive Challenges: Financial Implications and Strategic Responses to a Changing Retail Electric Business

January 2013 (Edison Electric Institute)

Executive Summary

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 demandside 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 “marketshare,” 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.

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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.

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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…

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Disruptive Threats—Strategic Considerations

A disruptive innovation is defined as “an innovation that helps create a new market and value network, and eventually goes on to disrupt an existing market and value network (over a few years or decades), displacing an earlier technology. The term is used in business and technology literature to describe innovations that improve a product or service in ways that the market does not expect, typically first by designing for a different set of consumers in the new market and later by lowering prices in the existing market.”

Disruptive forces, if not actively addressed, threaten the viability of old-line exposed industries. Examples of once-dominant, blue chip companies/entities being threatened or succumbing to new entrants due to innovation include Kodak and the U.S. Postal Service (USPS). For years, Kodak owned the film and related supplies market. The company watched as the photo business was transformed by digital technology and finally filed for bankruptcy in 2012.

Meanwhile, the USPS is a monopoly, government-run agency with a mission of delivering mail and providing an essential service to keep the economy moving. The USPS has been threatened for decades by private package delivery services (e.g., UPS and FedEx) that compete to offer more efficient and flexible service. Today, the primary threat to USPS’ viability is the delivery of information by email, including commercial correspondence such as bills and bill payments, bank and brokerage statements, etc. Many experts believe that the USPS must dramatically restructure its operations and costs to have a chance to protect its viability as an independent agency.

Participants in all industries must prepare for and develop plans to address disruptive threats, including plans to replace their own technology with more innovative, more valuable customer services offered at competitive prices. The traditional wire line telephone players, including AT&T and Verizon, for example, became leaders in U.S. wireless telephone services, which over time could make the old line telephone product extinct. But these innovative, former old-line telephone providers had the vision to get in front of the trend to wireless and lead the development of non-regulated infrastructure networks and consumer marketing skills. As a result, they now hold large domestic market shares. In fact, they have now further leveraged technology innovation to create new products that expand their customer offerings…

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Financial Implications of Disruptive Forces

As discussed previously, equity investors expect and will value an equity security based upon growth attributes as a major component of the expected total return investors require. Growth in utility earnings has historically been realized by a combination of increased electricity sales (volume), increased price per unit of sales (higher rates), and/or expanded profit margins on incremental revenues achieved between rate cases reflecting the realization of operational/overhead efficiencies. Earnings levels and growth are also impacted by changing costs of capital due to market forces—this is currently a depressant on utility earnings per share (EPS) levels due to the sector-wide decline in authorized returns on equity (ROE) realized over the last several years.

First, let’s review the current climate for the utility sector. While valuations are near all-time highs, the headwinds facing the sector are significant. Concerns start with the anemic electricity demand, which has been primarily impacted by the overall economic climate but also impacted by demand-side efficiency programs and the emergence of DER. Next, there is the need to deploy capital investment at almost twice the rate of depreciation to enhance the grid and address various regulatory mandates. Soft electricity demand plus increasing capital investment lead to rate increase needs and the investment uncertainty created by a future active rate case calendar. While sell side analysts are expecting EPS growth of 4 percent to7 percent overall for the regulated sector, this is likely to be quite challenging. If investor expectations are not realized, a wholesale reevaluation of the sector is likely to occur.

So, what will happen when electricity sales growth declines and that decline is not cyclical but driven by disruptive forces, including new technology and/or the further implementation of public policy focused on DSM and DER initiatives? In a cost-of-service rate-regulated model, revenues are not directly correlated to customer levels or sales but to the cost of providing service. However, in most jurisdictions, customer rates are a function of usage/unit sales. In such a model, customer rate levels must increase via rate increase requests when usage declines, which from a financial perspective is intended to keep the company whole (i.e., earn its cost of capital). However, this may lead to a challenging cycle since an increase in customer rates over time to support investment spending in a declining sales environment (due to disruptive forces) will further enhance the competitive dynamics of competing technologies and supply/demand efficiency programs. This set of dynamics can become a vicious cycle (See Exhibit 3) that, in the worst-case scenario, would leave few(er) customers remaining to support the costs of a large embedded infrastructure system, some of which may be stranded investment but most of the costs will continue to be incurred in order to manage the flows between supply and customers.

When investors realize that a business model has been stung by systemic disruptive forces, they likely will retreat. When is the typical tipping point when investors realize that the merits of the investment they are evaluating or monitoring has been forever changed? Despite all the talk about investors assessing the future in their investment evaluations, it is often not until revenue declines are reported that investors realize that the viability of the business is in question.

An interesting example isthe story of RIM, the manufacturer of the Blackberry handheld information management tool. From its public start in the 1990s thru 2008, RIM was a Wall Street darling. Its share price was less than $3 in 1999 and peaked at $150 in 2008. The company started to show a stall in sales in 2011, and, now, despite a large cash position and 90 million subscribers, the market is questioning RIM’s ability to survive and RIM’s stock has plummeted from its high.

What happened to this powerful growth company that had dominant market shares in a growth market? The answer is the evolution of the iPhone, which transformed the handheld from an email machine to a dynamic Internet tool with seemingly unlimited applications/functionality. When the iPhone was first released in 2007, it was viewed as a threat to RIM, but RIM continued to grow its position until the introduction of the iPhone 4 in June 2010. The iPhone 4, which offered significant improvements from prior versions, led to a retreat in RIM’s business and caused a significant drop in its stock price.

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It seems that investors have proven to be reasonably optimistic on selected industries even though the competitive threat is staring them head-on. However, if we can identify actionable disruptive forces to a business or industry, then history tells us that management and investors need to take these threats seriously and not wait until the decline in sales and revenues has commenced to develop a new strategy or, in the case of investors, realize their loss.

As discussed above, investors in the utility sector seek increased certainty (or less risk) than in other industries and have confidence in the consistent application of ratemaking recovery models to provide a lower degree of investment risk. As a result of this confidence, when instances have occurred in the past that have not provided consistent application of expected cost recovery models, investors have responded and have caused significant adverse impact on entities’ ability to raise incremental capital.

But, with the exception of the California energy crisis in the early 2000s, these events reflected embedded cost issues that had defined exposures and time frames. Disruptive changes are a new type of threat to the electric utility industry. Disruptive changeslead to declining customer and usage per customer levels that cannot be easily quantified as to the potential threat posed to corporate profitability. This type of problem has not been faced before by the electric industry and, thus, must be understood asto the strategic issues and alternatives that are raised.

The new potential risk to utility investors from disruptive forces is the impact on future earnings growth expectations. Lost revenues within a net metering paradigm, for instance, are able to be recovered in future rate cases. However, without a shift in tariff structures, there is only so much of an increase that can be placed on remaining non-DER customers before political pressure is brought to bear on recovery mechanisms. Once the sustainability of the utility earnings model is questioned, investors will look at the industry through a new lens, and the view from this lens will be adverse to all stakeholders, including investors and customers. While we do not know the degree to which customer participation in DER and behavior change will impact utility earnings growth, the potential impact, based upon DER trends, is considerable (as stated earlier, industry projections propose that 33 percent of the market will be in the money for DER by 2017, assuming current tax and regulatory policies).

Today, regulated utilities have seen allowed returns on equity decline to around 10 percent, a multi-decade low point, as a result of declining interest rates (See Exhibit 4). The cost of equity has also been growing. However, the risks in the business have never been higher, due to increasing customer rate pressures from capital expenditures required to upgrade the grid and address environmental mandates, inflation, low/negative demand growth from active customers, and the threat of load lost due to the rapid development of DER and disruptive forces. The impact of declining allowed returns and increasing business risk will place pressure on the quality and value of utility investments. How large of an impact on investment value will be a function of the impact of disruptive forces described herein. But, lower stock prices will likely translate into lower levels of capital spend, lower domestic economic growth, and fewer grid enhancements…

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Summary

While the threat of disruptive forces on the utility industry has been limited to date, economic fundamentals and public policies in place are likely to encourage significant future disruption to the utility business model.

Technology innovation and rate structures that encourage cross subsidization of DER and/or behavioral modification by customers must be addressed quickly to mitigate further damage to the utility franchise and to better align interests of all stakeholders.

Utility investors seek a return on investment that depends on the increase in the value of their investment through growth in earnings and dividends. When customers have the opportunity to reduce their use of a product or find another provider of such service, utility earnings growth is threatened. As this threat to growth becomes more evident, investors will become less attracted to investments in the utility sector. This will be manifested via a higher cost of capital and less capital available to be allocated to the sector.

Investors today appear confident in the utility regulatory model since the threat of disruptive forces has been modest to date. However, the competitive economics of distributed energy resources, such as PV solar, have improved significantly based on technology innovation and government incentives and subsidies, including tax and tariff-shifting incentives. But with policies in place that encourage cross subsidization of proactive customers, those not able or willing to respond to change will not be able to bear the responsibility left behind by proactive DER participating customers. It should not be left to the utility investor to bear the cost of these subsidies and the threat to their investment value.

This paper encourages an immediate focus on revising state and federal policies that do not align the interests of customers and investors, particularly revising utility tariff structures in order to eliminate cross subsidies (by non-DER participants) and utility investor cost-recovery uncertainties. In addition, utilities and stakeholders must develop policies and strategies to reduce the risk of ongoing customer disruption, including assessing business models where utilities can add value to customers and investors by providing new services.

While the pace of disruption cannot be predicted, the mere fact that we are seeing the beginning of customer disruption and that there is a large universe of companies pursuing this opportunity highlight the importance of proactive and timely planning to address these challenges early on so that uneconomic disruption does not proceed further. Ultimately, all stakeholders must embrace change in technology and business models in order to maintain a viable utility industry.

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