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Apr 9, 2014

Caveat Investor

The financial implications of potential grid defection

 

The electricity industry has been abuzz with talk of an impending death spiral brought on by distributed solar and, to a lesser extent, efficiency. The case is incomplete, but there is emerging evidence to suggest utility investors should proceed with caution. The tale of total collapse is still a rare one (though a recent example from Australia might give pause), but recently the Economist profiled the loss of half a trillion investor dollars in European utilities. Our colleague Amory Lovins explained why this is a sign of progress in the transition to a clean, resilient, and economic electricity system. 

Though the broader implications may be encouraging, it is no less painful for the investors who are suffering losses, including pension funds and other long-term investors. And now, some countries like Germany and Austria are enacting changes (such as extremely low feed-in tariffs and charges for self-consuming solar) that might have the unintended long-term consequence of pushing customers to avoid grid connection altogether, further debilitating grid regulatory models focused on cost re-allocation for recovery.

However, while mentions of the demise of utilities abroad are becoming more prevalent in the media, evidence of impending doom among U.S. utilities is challenging to find in stock and bond price and volatility. Utility stocks are routinely defined as boring, low-risk, dividend-bearing, and safe (many would call them “widow and orphan stocks” for this reason). Their consistent dividend has led to some institutional investors treating them like bonds (with the occasional volatility attributed to being traded like bonds).

A look at two large utility exchange-traded funds (i.e., ETFs—funds that are diverse like mutual funds but trade like stocks) shows the healthiest of stories: Utilities Select Sectors SPDR (XLU) has a consistent 3.75 percent dividend and has appreciated by over 50 percent in the past 5 years.  This ETF is the largest utilities ETF in the world, and represents all of the utilities stocks in the S&P. A Vanguard Utilities ETF, which includes small- and medium-sized utilities, has returned even better, at over 65 percent over the last 5 years.

The shifting landscape of utility investment

So, what might the outlook for U.S. investors look like in light of the events in Europe, as well as distributed resource cost trends explored in our recently released report, The Economics of Grid Defection? While regulators and utilities have had some success in stabilizing utility bottom lines from current threats like grid-tied solar and efficiency, a new threat is emerging: the possibility that customers could cut the cord from the utility entirely. Our report shows that, within the decade for a growing minority of the country and well within the 30-year cost recovery period for most of the rest, customers will be able to invest in solar-plus-battery systems that could allow them to defect from the grid entirely, for comparable cost and similar reliability levels to grid-tied prices.

The results of our analysis surprised us by highlighting the speed at which this new disruption is emerging, and should be a call to action for utilities, regulators, technology providers, and governments to accelerate their efforts pioneering new rules and business models. In the future we will need a two-way, transactive grid that sees these distributed technologies for the assets they are, not the threat they might be. We don’t advocate for defection, but we do worry that this disruptive alternative, if not managed proactively, will lead to an unnecessary combination of losses for shareholders, ratepayers, and/or taxpayers. 

Why “this time it’s different” is true

One reason investors haven’t seemed particularly phased by the emerging disruption lies in the compensation structure for the typical regulated utility. A traditional utility business model for cost recovery from the customer base is basically an equation with three variables: customers, time, and volume. Specifically, utilities recoup large initial investments over an extended timeframe (typically 30 years) through volumetric purchases of electricity by customers. Since regulators ensure stable cost recovery (e.g., by allowing periodic price adjustments to ensure the right amount of money comes in), utilities in the U.S. have been an astonishingly stable investment that acts more like a bond than a stock. If customers buy less volume, regulators let utilities charge a bit more. That’s why, from an investment perspective, grid-tied disruptions like solar and efficiency at their current levels have not been viewed by investors as a significant threat to capital repayment for distribution investments (though their impact on central generation investments has been more mixed).

More assertive regulatory action to protect utilities has taken various forms: revenue decoupling to ensure cost recovery and help align incentives between efficient customers and utilities selling bulk power, reductions or limits on the amount of distributed resources that can be installed, and a shift toward increased fixed charges. As long as customers are buying some of their volume from the grid, investors see a reliable path to profits through regulated rate-based cost recovery.  Customers, after all, will always need to be tied to the grid, right?

But the potential for complete customer defection is at the heart of this new disruption, which is driven by cost declines in batteries as well as solar. The potential for grid defection introduces a new type of competition at the point of the meter, shifting the potential outcomes of various changes to pricing and service delivery. If utility rates creep too high, or if fixed charges become too onerous (a potential dis-incentive for grid-tied customers to invest in efficiency and renewables), or if mandatory feed-in tariffs move too low (as we’ve seen in Europe and Australia) customers can choose to buy their own “utility in a box” and cut the cord from the grid. Their personal utility can be totally clean (solar power), have predictable price dynamics (driven by third-party financing and a lack of any variability that fossil fuel might introduce), and meet their full current or projected load. 

Our analysis shows that the economics for this utility-in-a-box solution will be here for parts of the U.S. within the decade and for the vast majority of customers within the 30-year cost recovery period of utility investments being made today. To be very clear, we don’t think this outcome is a good or preferable one. Still, the implications of this coming period of customer choice are profound. Distributed investments create value, both for customers and the grid, and utilities that move to harness that value are likely to maintain a healthy (and even potentially growing) balance sheet, while those that fight these investments risk the loss of customers.

Investors, meanwhile, aren’t flying totally blind in the face of distributed disruption of utilities. They can look to parallel past cases in order to gain some insights on these trends. For example, this can be seen as a transition from a monopoly environment to a non-monopoly one, with the personal utility as a new customer option.  In other industries (e.g., recording industry, phone service), transitions away from a monopoly environment have yielded enormous benefits, adding value and new opportunities, but have often accompanied periods of high volatility for investors.

What might the foreseeable future of utility investment look like for investors?

Emerging volatility and cost of capital: ingredients for a “debt spiral”?

Electric utilities enjoy one of the lowest average costs of capital (the interest rate they pay to raise money for investments) of any sector: an astonishing 6.5 percent or so, according to public databases like this one from Washington state. This allows them to invest huge sums in central generation, transmission, and distribution, with the expectation of long-term payback from captive customers. As their service areas grow, they can cheaply raise capital to make additional investments. Solar (and likely solar-plus-battery systems) currently has a 50 to 100 percent higher cost of capital: 9–11 percent or so for third-party-financed systems. We know the cost of capital in solar is declining rapidly, but it’s hard to predict what will happen to electric utilities.

What has happened in other post-monopoly industries, however? The same Washington state filing is revealing: telecoms are above 8 percent (with wireless technology slightly higher), air transport at 8.2 percent, and railroads all the way up at 10.5 percent. While we can’t predict what will happen to electric utility borrowing costs, if they truly face customer choice around self-provision of power, borrowing costs have nowhere to go but up. For such a capital-intensive industry, volatility’s impact on cost of capital needs to be seriously considered.

While the current low cost of capital for utilities is another reason that U.S. investors might feel complacent about solar and efficiency, if utilities were to follow the trends of other post-monopoly industries, it is quite possible that volatility and uncertainty could spur an upward climbing “debt spiral” that reinforces and accelerates the rate-reallocation “death spiral” dynamics induced by distributed resources.

A better long-term outcome

Even though the potential for grid defection represents a disruptive threat to legacy business models, distributed investments can and should ultimately add more value to the grid and the companies that operate it. Progressive utilities will look to customer investment in both generation and storage as an opportunity, and their investors are likely to be rewarded for this forward-leaning stance. Distributed generation and storage could, for instance, stabilize peak demand, provide voltage regulation, and allow deferred investments on feeders nearing capacity. Utilities could even package integrated solutions for customers, in the same way that some currently provide efficient appliances or even finance solar. In many cases, these new opportunities can have returns much higher than a regulated 6–8 percent.  After all, most of us pay much more for phone service now than we ever did in a regulated wires environment (when we paid per minute), and are much happier with the new services. Wireless providers finance the handsets, changed voice pricing, and branched into a much broader array of services. 

And while this transition has been tumultuous, with investors needing to pick winners and management needing to be creative, this transition has had a happy ending for investors, too. Return on equity for telecom has shot up from 13 percent in 1984 to 29 percent in 1995, and giants like AT&T and Verizon today both have return on equity higher than 20 percent. So, like the current disruptions in Europe, we should celebrate the opportunity in the U.S. to transition to a sector that will deliver better customer value, and ultimately better investor value; in the meantime, caveat investor.

Image courtesy of Shutterstock

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