The world is transitioning from an industrial age model of electricity generated from large-scale power plants to a blended energy model including distributed electricity generation from local and regional renewable energy projects.
Prior to the advent of IT systems and cleantech, the major developments of the energy industry over the past two centuries were largely focused on coal, gas and nuclear electricity, petrochemicals, the combustion engine and associated oil refinery technologies. We are still working off 20th-century electricity technology and, in fact, there are still some 19th-century electricity cables in use in London.
The Evolving Business Model for Electricity Utilities
The incumbent utility and electricity suppliers were typically formed as large, vertically integrated monopolies by the state. These companies had fixed cost agreements with the state for fossil fuels and they owned the generating plants, the supply chain and the relationship with the end consumer. Having a monopoly was important to ensure there was a steady customer base to pay for and manage the risk of spending vast sums of capital on generation and distribution infrastructure and the marginal cost of fossil fuels to generate the electricity.
Renewable energy on the other hand only has the fixed cost of generation and in some cases distribution. The marginal cost of providing renewable electricity is largely operations and maintenance costs, which are typically close to zero on a kWh basis. In a decentralized model, where utility companies are purchasing energy from many off-grid electricity generators, the end customer is effectively buying a subscription to an allocation of renewable electricity capacity.
The Powerful Effects of Deregulation on Distributed Energy
The Public Utilities Regulatory Policies Act (PURPA) of 1978 was the first piece of legislation that required public utilities to purchase energy from Independent Power Producers (IPPs). PURPA spurred competitive bidding of electricity generation. This signified further growth and fueled the competitiveness of investor and independently-owned electricity generation and supply. The combination of power purchasing agreements, guaranteed commitments from utilities and commercial customers, and feed-in tariffs from the state further encouraged the implementation of off-grid electricity generation and the proliferation of renewable energy projects globally.
As you can see from the graph below, electricity markets in the United States underwent further, progressive, electricity de-regulation in certain states from 1995-2007. Each state has it’s own public utility commission ( PUC) that regulates distribution, retail activity and in some cases pricing.
The case for further deregulation over the coming decades is ongoing and you can read this interesting debate in the Wall Street Journal where Prof Andrew Kleit points to the need for deregulation to further innovation and stabilise the grid. Further deregulation is enevitable in the future and will provide another boost to emerging technologies across the distributed energy market segments outlined below.
The US Electricity Market is now Dominated by Investor Owned, Publicly Traded Utility Providers
In the two charts below, you can see that a relatively small number of investor-owned utilities (6% of total entities) serviced 68% of customers in the US (2014). Public Power providers are publicly-owned electricity providers that service and supply a municipality or region.
The same market information is represented in $’s in another chart below, from the EIA, for the qualitatively inclined. Note that the %’s in the public power infographic above only relate to full-service sales into the end customer.
We will investigate the role of power marketers in more detail in the next post.
The Investor-Owned Utilities are Going Through a Period of Intense Disruption
The chart below shows the top 10 US electricity utility companies ranked based on market value. Utility stocks historically exhibit lower volatility than the greater market. While an aggressive investor may only have 5% of a portfolio represented by the industry, a conservative investor may allocate up to 25%. Citing past performances and correlation with GDP, many investors consider utilities as a more stable asset within a portfolio. However, this belief may change for investors if the challenges of integrating new era, distributed business models become prohibitive.
Have a quick look back at the outcome of the German utility providers EoN and LWE, in the previous blog post on an electric future, to get an idea of what is possible. Germany was a first mover in nationwide renewable deployment so Eon and LWE had less time to react to changes. However, the same challenges exist for all traditional, vertically integrated, electricity providers.
You can see in the graph below that the average revenue of these 10 companies has been growing and the EPS is relatively stable over the past 5 years.
One example of a US energy provider that has declined agressively is Cloud Peak Energy (NYSE:CLD), represented below. Cloud Peak Energy was one of the early casualties of the evolution from the use of coal to cleaner fuel sources for electricity generation due to cost competitiveness.
What are utility companies that are overly reliant on uncompetitive fossil fuel energy generation sources doing to compete over the coming decade?
Enter the New World of Distributed Energy Resources (DER’s)
The introduction of technology, data-driven supply, and demand models and distributed renewable generation and storage has created the following market segments, as described in this report below from GTM Research.
As a highly territorial business, access to end users for the sale of electricity is often limited. Over time customers may reduce their consumption of energy from the centralized grid in favor of cheaper and more flexible energy produced onsite or regionally. With the advent of these new offerings, customer expectations regarding service level and customization are increasing dramatically. This is largely why a whole slew of new entrants using digital services and innovative products are creating their own access and disrupting the industry in the process.
Virtual power plants are one such disruptive creation. DERs such as battery storage and solar generation can be aggregated and used to provide multiple services, and thus several layers of cash flow over the entire project lifespan. For the customer, these technologies can reduce costly peak demand charges on electricity bills, as well as electricity consumption itself with better usage analytics. Aggregated power producers and battery storage management firms are becoming critical to the distributed energy vision. Companies such as the nation’s largest networked storage company STEM and publicly traded NRG Energy can sell stored power, from excess renewable production, into wholesale electricity markets at times of peak pricing.
NRG is one example of an investor-owned utility that has been actively investing into and acquiring companies along the value chain of distributed energy resources. A list of the other publicly traded utility companies acquiring most aggressively have been included in the table below.
This activity has been gathering pace over recent years as can be seen in another table from the same GTM report below.
NextEra Energy, Exelon, and Duke Energy are other good examples of major utilities embracing new technology. NextEra derives roughly 22% of its 2016 revenue from renewable means and has acquired several DER providers. Exelon has been the most aggressive company in the M&A space with the following investments and acquisitions over the past few years.
Both NextEra and Exelon stocks have been outpacing the DJU over the past year as can be seen in the stock chart below.
So, like everything in life, this transition will provide winners and losers. Weaning their core operations and infrastructure off centralized generation and distribution will continue to be a major challenge for the industrial era utilities.
Let’s look at the case in Germany. In 2010 centralized generation was €7.5 billion. Bain & Company estimated that by 2020 centralized generation will decline 20 percent and result in €2.5 billion in profit loses. On the other hand, they predict €3-€4 billion in distributed energy profits over the same period. While investing directly in distributed energy may help recapture some of their losses, smaller energy service and tech companies with a good head start will inevitably capture a significant portion of that value as well.
Two strategies to consider in order to take advantage of this transition are:
- Keep an eye on the publicly traded utilities eagerness to adopt new technology and new distributed capacity assets and technology.
- Keep an eye on the private DER companies that are in growth mode to either look for direct investment opportunities or to gauge which of the publicly traded utilities are investing or acquiring effectively. You can see some more relevant companies at Green Tech Media and i3 to keep an eye on in this market.
It would be worth checking if the utility companies in your portfolio are embracing new era technology and investing effectively into the new segments of distributed energy. As always please discuss any decisions you intend to make with your investment professional.
The next post is going to focus on power marketers and the key players and opportunities when marketing energy to wholesale purchasers or directly to the end consumer.
Thanks for reading and let us know if there is anything you disagree with, we welcome contrarians.
The information provided is for informational purposes only. It should not be considered legal or financial advice. You should consult with an attorney or other professional to determine what may be best for your individual needs.