Electric utilities are facing an unprecedented set of challenges. Demand for electricity, which had risen in a fairly steady manner for decades has flattened. Some of this can be attributed to the lack of economic growth. Increasingly, however, this has been caused by growth in energy efficiency and distributed generation. Another important dynamic, but one getting far less attention, is that while demand may have flattened, the demand for infrastructure investment is growing rapidly.
The notion that distributed solar represents an existential threat to utilities has been well chronicled. The price of power from distributed solar has begun to drop below the price of delivered power from some utilities (in some cases this is incentive supported solar, in other cases the actual cost without subsidies has reached parity with the delivered price of electricity). This starts a cycle: as more distributed power is installed within a utility’s system demand for the utility’s drops, requiring a higher cost per kwh of power delivered, which in turn makes distributed options more competitive. While solar is clearly a key piece of this evolving dynamic, a broader suite of point-of-consumption technologies makes this an extremely challenging dynamic for the traditional electric utilities regulation-mandated business model.
Beyond the distributed generation challenge there is another threat to the utility business model that is getting far less attention, but is critical to understanding the shifting electricity landscape and particularly dangerous for electric utilities in light of the potential challenges created by the distribution of the electric system. Aging utility infrastructure is creating the need for unprecedented capital investment. General upkeep and reliability upgrades are increasing in both frequency and cost. Repairs and upgrades to manage increased storm intensity are requiring massive amounts of additional capital. Adding to these capital demands is the need to address growing security concerns, specifically that the power grid is adequately protected from cyber attacks.
All of these investments necessarily raises price of delivery for power (rates are set in part by calculating the return of and on capital invested into the utility system), which stretches the ability to recover necessary rates to support costs and shareholder returns.
We were given a preview of this on July 18. Fitch Ratings downgraded the credit rating for Potomac Electric Power Co. (Pepco) from BBB+ to BBB, and also downgraded the short term outlook for Pepco’s parent Pepco Holding. The downgrade was based specifically on the very large amounts of planned spending to address reliability challenges that have plagued Pepco for some time (highlighted by the furious ratepayer responses to widespread and long outages following 2011’s “Snowpocalypse” and 2012’s derecho in the metropolitan Washington, DC area) and doubts over whether the DC and Maryland public service commissions will support the necessary rate increases to cover these expenditures, which they have been hesitant to do.
The regulated utility business model, which requires an enormous amount of capital, works because it allows a high level of confidence that invested amounts will generate reasonable returns (and debt recovery is effectively certain) based on a guaranteed recovery through rates established by the local public utility commission, all of which allows for the relatively low cost use of money to build and maintain the system. If this assumption begins to get questioned based on the need for significant investment to maintain reliability and security at the same time that new technologies are starting to erode demand then maintaining access to the necessary capital will become more difficult and more expensive. These new challenges mean that it is time for real strategic vision and innovation by electric utilities – their survival (and our certainty of reliable electricity) is in the balance.
Elias Hinckley is a strategic advisor on energy finance and energy policy to investors, energy companies and governments. He is an energy and tax partner with the law firm Sullivan and Worcester where he helps his clients solve the challenges of a changing energy landscape by using his understanding of energy policy, regulation, and markets to quickly and creatively assemble successful energy deals.
Republished with permission from Energy Trends Insider
