US Climate Report (released in the auspiciously during thanksgiving day) tells us that US can lose up to 10% of its GDP by climate change- if we do nothing. Snippet from the executive summary of the report-
"Our Nation’s aging and deteriorating infrastructure is further stressed by increases in heavy precipitation events, coastal flooding, heat, wildfires, and other extreme events, as well as changes to average precipitation and temperature. Without adaptation, climate change will continue to degrade infrastructure performance over the rest of the century, with the potential for cascading impacts that threaten our economy, national security, essential services, and health and well-being."
As scary this is, this provides us electric utilities with the "wild west" of growth opportunities. The antiquated electric grid system needs to be revitalized to make it adaptable to climate change. Here's some of my thoughts on how it can be achieved.
Understanding electric utility firm behavior
In terms of investment theory, electric utilities in the US are often considered a mature industry. A typical electric utility operates with a tried and true business model with a regulatory compact allowing some form of monopoly with a guaranteed rate of return. As long as the utility continues to provide electricity often through large generating assets that are depreciated over decades, the return the utilities get on their equity does not change much. This "un-exciting" but reliable firm behavior allows a stream of guaranteed dividends that are attractive to many risk averse investors.
Firm behavior because of low growth potential (boring but my rational revolves around this)
A comparison of the "return on assets" on these electric utilities with the other firms (for instance software firms) shows the stark contrast in firm behavior. The software firms, often are considered to have high growth potential and these firms enjoy return on assets on median of 15%. Electric utilities who are not really considered to have any growth potential enjoy about 6% return on assets. I am including return on assets, rather than return on equity because the return on equity is affected by leverage. Electric utilities often have high leveraged (high debt and equity ratio) compared to software firms.
This return on assets difference then affects the plowback ratio- which is how much firms decided to invest their profits back on the firm rather than giving out dividends. Electric Utilities have low plowback ratio, giving out much of its earnings back to the investors. Software companies often do not pay out their profits as dividends, instead, they reinvest all of their profits back into the firm, since they can continue to grow.
kWh sales
Almost a cliche- "electric utility gets its electricity by amount of kWh sales". This is true, and however many states have tried to revert away from this model (revenue decoupling, increased competition), they cannot completely get away from it, as fundamentally, this will continue to remain true. However lets look at that closely - "to make money the utility has to sell kWh" - if the power lines are down, the utility wont make money. If the transmission lines goes out, the utility wont make money. If the entire town burns down (like the town of Paradise, of the city goes underwater- like NYC during Sandy), the utility will not make money.
So the utility and the utility regulators need to open its eyes and break from the traditional norm allowing investments in resiliency.
What the utility do to-
Utilities are seeing this across the states, are they are going back to the same old play-book. They come back to the regulators with a billions of dollars of resiliency plan, with startling amount of money. Any regulator in the right sense of mind will not approve of such high cost resiliency plans that requires astronomical increase in electricity prices.
The utility need to take it from to software firms play-book, and increase its plow-back ratio so that it can invest itself in making the grid resilient. A billion dollar resiliency plan cannot be funded solely by plow back ratio, but it shows the regulators that the utility understands the severity of the situation and is committed to making long term change.
Instead of going to the regulator will a multi billion dollar resiliency investment plant - and asking for 9% to 12% return on investment. The utility needs to prove that it really understands the needs for resiliency, and is committed to make improvements in the grid not just to get greater return, but to make sure that the grid will continue to operate in the future of climate uncertainty.
Start with pilot projects - The utility needs to be proactive. It can start by using the its profits back into investments in resiliency as pilot projects, or making certain critical improvements. These pilot projects will not need lengthy regulatory approval since the utility is using its own profits. And it should not expect return on these investments. However, these projects will help the regulator understand the need for such investments and make them more favorable to such investments in the future.
What will happen to the stock price?
But you might say- Achyut that makes no sense, if the dividends are decreased, then the utility stock will fall. Well that is not necessary true. Stock prices are calculated based on the future value of the earnings. Any long term investor will welcome this opportunity since the investment in resiliency will further cement the utility's financial position in the future. Investors are not looking to investment in utilities for capital gain! They should not be. If the stock of electric utility is going up as software firms then something is not right! Investments in electric utility are low risk, and commensurate stable return.
The immediate stock price may go down, but that is fine, utilities are in for the long haul. Utility firm cannot have be on the same mind-set thinking about the quarterly earnings.
What can utility regulator do?
Utility regulators are in tremendous position to make change. This change can effectively happen if the regulators decided to include the cost Carbon and resiliency costs are included in the LCOE and benefit cost calculations.
Many regulators are binded by the legislation (often on "lowest cost" states), but even then, revision of the what is meant by the 'lowest cost" is required. Should the customers pay the lowest kWh for 5 years, and then after the grid goes down, pay all the astronomical cost to put it back together?
Someone has to pay for the utility upgrades, and the portion of the money will be recovered from the kWh sales. Balancing this act is the duty of the regulator. But the regulator cannot be blinded to every grid modernization proposals that the utility puts forward. The utility should make a good faith effort in making sure it understands the critical need for new infrastructure- for its customers, not just to appease shareholders. The regulators should bind the return on investments on conditions of increased reliability that goes beyond typical reliability indices (SAFI, SADI- discussed on next blog post).
All challenges are opportunities- but only if we make them to be.
The best of writings require several edits, this article has not been edited. While all the errors are my own, it is not representative of the best of my writing ability.
