2015 Utilities Trends
Companies in the utility sector should consider how to restructure financially, while navigating new regulations, distributed generation, and the evolving customer interface.
Over the past several years, utilities in the United States have contended with a wide range of challenges. The industry lived through a sharp decrease in power demand during the recent recession and has experienced only sluggish growth since then. Moreover, the industry has navigated regulatory uncertainty for years now, as a range of environmental and market policy measures have been first proposed and then often rescinded through litigation.
Since the move to competition in the 1990s, however, the sector has not faced such potentially fundamental shifts in its business and operating models as it is now confronted with. The extent and nature of these shifts vary from market to market. But, in many markets, their intensity is making their influence transformational rather than incremental.
Moreover, the biggest changes affecting utilities — and the ones that companies take lightly at their own peril — involve the boom in renewable, off-the-grid energy installations and distributed power systems. The gains made in these areas have altered the business equation sufficiently that the customer is rapidly becoming the dominant force, a huge change for an industry that has traditionally been led by firms with virtual monopolies that held sway over customers.
Viewed broadly, the causes of the significant industry disruptions — and their possible resolutions — can be found in four trends that, in our view, will define the U.S. utility landscape in the coming year: ongoing financial restructuring; technology shifts such as the rise of distributed generation; the need to respond to new regulations, most notably the Environmental Protection Agency’s (EPA’s) latest effort to regulate carbon emissions; and the evolution of the customer interface.
Although these changes will affect utilities in different ways, we expect that in 2015 all sector leaders will need to at least consider how to respond with a flexible but robust strategic approach that maximizes the opportunities while managing the risks.
Financial restructuring. The slowdown in demand for electricity has put many “hybrid” utilities in a bind. Low prices for power are crimping revenue growth in their unregulated, competitive generation business, which in turn is dragging down the performance of their traditional regulated distribution operations. And that displeases both utility investors looking for stable returns at low risk and those willing to take on more risk in exchange for higher returns.
Many utilities have moved to break up their portfolios through various kinds of carve-outs.
As a result, many utilities, including NiSource, Duke Energy, and NextEra Energy, have moved to break up their portfolios through various kinds of carve-outs, including spin-offs, asset sales, and the creation of bond-like investment vehicles called yieldcos that hold generating assets with long-term supply contracts. The goal: to let separate entities, participating in different aspects of the utility business, focus on creating the specific products and strategies that will enable them to succeed in their markets, and on Wall Street. Individually, a carved-out company may produce higher sustained returns than it did as an integrated utility.
We believe that such moves will become even more prevalent in response to continued competitive pressure and investor demand. Increases in the cost of generating electricity as a result of new carbon emissions regulations will only encourage more utilities to divorce generation from distribution.
And the greater strategic flexibility this would give distribution companies would allow them to play a larger role in, and better manage the movement toward, distributed generation. They could also concentrate more fully on how best to engage their customers and provide them with the advanced online and mobile services they are demanding — and even enter new businesses further removed from the relatively staid activity of generating electricity.
New regulations. Perhaps the greatest immediate uncertainty the industry faces is the EPA’s new Clean Power Plan (CPP). Proposed in June 2014 under Section 111(d) of the Clean Air Act, the plan includes ambitious CO2 reduction targets for each state, designed to achieve by 2030 a 30 percent nationwide decrease in CO2 emissions over 2005 levels. CPP leaves it up to the states to determine how to reach this goal, rather than mandate compliance at the plant level.
The ultimate shape that this plan will take — including how CPP will be implemented, how stringent the requirements will be, and what it will cost to comply — is expected to be decided in 2015 by the states; it will be greatly affected by a variety of factors over which the industry has little or no control, such as the politics of local legislatures.
One likely impact on utilities will be an acceleration in the retirement of coal-fueled power plants, most of which are already economically imperiled. We expect that in 2015 an additional 19 gigawatts’ worth of capacity in coal plants will be mothballed, on top of the 34 gigawatts represented by plants that have been shut down over the past decade, to be replaced by just 14 gigawatts of new coal capacity.
This shortfall will be largely made up for by the increased use of existing and new natural gas combined cycle (NGCC) plants, which will heighten the industry’s vulnerability to volatility in natural gas prices.
The EPA’s relatively low initial estimates for the cost of complying with CPP legislation rest on a number of assumptions about increased energy efficiency, reductions in power demand, and the adoption of renewable energy sources — all of which may or may not come to fruition.
Moreover, the cost estimates do not account for the capital expense of new NGCC units to backstop intermittent renewable sources. Most critically, the EPA analysis assumes that the entire U.S. nuclear power plant fleet will be maintained. We expect, however, that between 11 and 22 gigawatts’ worth of capacity in nuclear units, many of which are financially threatened, will face early retirement over the next 10 years. In addition, the rest of today’s nuclear facilities will likely be shut down by 2050, and only a handful of new units are expected to come on line.
The cost of compliance could be quite different from EPA forecasts.
All of this means that the cost of compliance and the impact of CPP could be quite different from EPA forecasts. We expect that industry executives will spend a significant amount of time in 2015 considering the impact of the regulation on their businesses and what the optimal strategic response should be. Given the uncertainty over the precise timing and implementation of the regulation, companies should take an if–then scenario-driven approach to determining how they respond.
Distributed generation. A further area of unpredictability — and even a potential game-changer — is the rapid growth in some regions, such as California and the Northeast, of localized power generation, primarily solar photovoltaic panels at customer sites. Much of this activity is being driven by federal and state subsidies, but even when it isn’t, in many markets, power supplied locally is often cheaper than power supplied via the traditional electrical grid.
Utilities have become increasingly concerned about this transition — understandably, given that even relatively low rates of penetration of customer-sited generation can significantly affect company earnings. One study suggests that a penetration rate of just 5 percent could lead to a reduction in earnings for utilities of between 4 and 9 percent.
So far, individual utilities have responded quite differently, depending on their mix of fuels, their assets, and their rate structures. Arizona Public Service, for instance, recently came out ahead in a hard-fought battle with the solar industry over net metering policies in the state, and has now unveiled a plan to provide and own residential solar panels, and to bring the power they generate directly onto its grid — a model that a number of other utilities have successfully used when leasing panels to commercial enterprises.
In New York State, regulators have proposed a new initiative, “Reforming the Energy Vision,” in hopes of modernizing the state’s generation and distribution systems. Goals include building many more smaller generation stations and incorporating new technology into grid and network operations, in part to bring residential solar power onto the grid. The effort has the potential to force utilities to operate as so-called “distribution system operators.” How individual utilities respond to distributed generation will depend on their specific circumstances, the speed at which their markets move to distributed generation, and the regulatory environment in which they operate.
The evolving customer interface. Distributed generation is only one of a variety of new technologies that are transforming how utilities engage with their customers. Smart metering and the smart grid, as well as products like Google’s Nest thermostat, for example, are giving consumers far greater control over the amount and timing of the energy they use.
As homeowners become more and more connected, and more environmentally aware — and by necessity utilities become more customer-centric — they will seek even greater control over critical matters such as choosing their energy supplier and the source of their energy. And a variety of players from outside the industry — including solar companies, Internet firms, and even cable operators — are looking to provide energy and communications services to the utilities’ traditional customers.
Much will change in 2015 and beyond when it comes to home services and the customer interface; it is not yet clear how it will end up, but it will likely result in a crucially different role for every utility.
Even as greater customer control over usage threatens to drive down demand for energy (and potentially even disintermediate traditional utilities), the utility companies themselves have much to gain in this transition — if they manage it right. In 2015, they will need to better understand customer demands for greater access to information, control over usage, and self-service, and use that information to devise new products and services to satisfy those demands.
Utilities underperformed the market over the last five years despite their relative advantages in the low-interest-rate environment. In 2014, they recovered from their lows, thanks in part to market volatility that enhanced their traditional role as a safe haven. But in order to increase shareholder value and drive much-improved performance in 2015 and beyond, utilities will need to find growth. In an environment in which demand for power is slipping, this will mean maximizing the opportunities available.