March 28, 2024

STRATEGIC CHALLENGES FOR THE ELECTRICITY INDUSTRY OVER THE NEXT FIVE YEARS

by By Dwight Allen, Deloitte Research
What do the next five years hold for the North American electricity industry?For many industry executives, the answer is straightforward.They believe the future can be seen from here, and it isn’t all that different from today.There will surely be challenges, but the business conditions utilities will face during the rest of the decade won’t deviate much from the trends that prevail today.

The majority view may turn out to be right.However, utilities working on strategic plans should consider other possibilities.Surprises may lie just around the corner in areas such as electricity demand, rate regulation, capital availability, and environmental policy. The potential for surprises emerged from interviews with 20 industry executives and 20 people with other perspectives on the issues, including regulators, investment bankers, and issue advocates.Some of those interviewed cited credible reasons for anticipating developments at variance with the conventional wisdom.And recent events bolster the notion that it’s a good idea to question the industry’s mainstream view.

Electricity Demand
A key question for the industry looking out to 2010 is the rate of power consumption.Will the economy continue to expand, increasing electricity use, or will there be a slowdown?
Generally people in the industry expect demand in coming years will grow at current rates or better, driven by steady economic expansion.As a utility CFO said during an interview:“Technology keeps evolving, and technology uses electricity.”The director of an energy users’ association agreed:“I’ve seen nothing except projections that electricity demand is going to continue to grow at the same pace that it’s been growing.”

Support for the optimistic view can be found in projections by the U.S. and Canadian governments, the International Energy Agency, and U.S. Energy Information Administration.All expect at least moderate economic expansion and concomitant growth in electricity consumption.

However, there are more dismal scenarios for the North American economy, which could curtail electricity demand.Some industry executives express concern about the effects of rising interest rates and higher energy costs.

Some outside the industry are much gloomier.They contend budget deficits, trade deficits, and international financial imbalances are jeopardizing the U.S. economy.Those sounding the alarm include the Comptroller General of the U.S., the director of the Congressional Budget Office, the Concord Coalition, and the Committee for a Responsible Federal Budget.The dangers they see are discussed at length in the books Running on Empty, by former U.S. Secretary of Commerce Peter Peterson, now Blackstone Group chairman, and Restoring Fiscal Sanity, by two former U.S. budget officials now at the Brookings Institution in Washington.Former Federal Reserve chairman Paul Volker finds it worrisome that there is no sense of urgency among political leaders, and says “it is more likely than not that it will be financial crises rather than policy foresight that will force the change.”

Rate Regulation
How will state and provincial regulators respond to utilities seeking to add assets to their rate base and raise rates?Many industry executives are confident as they look ahead five years.“I don’t worry too much about risks on the regulatory side,” said a utility COO who was interviewed.“We always get to where we have to be.”

Some have made favorable regulatory treatment a key component of their corporate strategy.A utility CEO expects the regulated side of the business to provide the “principal increment in shareholder value” between now and 2010.Another company’s CFO said, “the top growth prospect is to make that investment and to secure a regulatory return on that investment.”

An investment banker calls attention to environmental investments:“The states have now decided that putting scrubbers and other pollution-control equipment into rate base is a good thing.”

Some regulators endorsed this view.One commissioner said she and her colleagues are working to make it easier for utilities to upgrade facilities and cut emissions.“The traditional rate case is becoming less important because we’re allowing more pass-throughs and up-front investment recoups.”

Another regulator argued that today’s energy prices are still cheaper than they were 25 years ago, and stated, “We are not yet at the breakpoint where we say, ‘We cannot afford these prices.’”

Others interviewees are less sanguine.They see rising fuel costs exhausting customers’ tolerance for increases in their electricity bills, and causing adverse reactions from regulators and government policymakers.In his interview, the CFO of a distribution utility was particularly frank:

We’re coming towards a head-on collision.The regulators are saying, ‘We know your fuel costs are going up, and we understand that part of the bill’s going to have to go up.But a distribution increase?’ What worries me is that you’ll see a lot of utilities like ourselves take one on the chin.
A private equity fund partner concurred:“Regulators are going to feel a lot of pressure if rates go up because of rising fuel prices.Adding assets to rate base and raising rates will be very politically sensitive.”

A commissioner said that in his state the governor’s office and legislators are considering ways to shield ratepayers from rate shock despite earlier decisions to give market forces more play.“Commissions and governor’s offices are going to be rather nervous about letting utilities fully recover because of the real concern about what electricity prices are going to be,” he predicted.

Capital Availability
The interviews found executives generally optimistic about the reaction of capital markets to utilities embracing the back-to-basics approach.The majority thinks lenders and investors will be highly supportive of the stable, low-risk returns offered by the traditional utility template.

A CFO said, “Most utilities are going to be focusing on the old model, of investing in ratebase and ensuring a regulated return.”A CEO was unapologetic:“There’s nothing wrong with being a utility.”The gains posted by utility stocks over most of the past two years tend to support this view.

Others believe adverse developments could dim the investment appeal of utilities, such as difficulty in recovering costs or high interest rates that make bonds more attractive.If such developments coincided with an economic slowdown they could tarnish the image of utilities as a safe and sane alternative in troubled times.A CEO warned, “To the extent you’re getting stingy rate relief and your [fuel] costs aren’t going down, that’s going to have some credit quality implications.”This dovetails with pessimistic views regarding the economy and regulators’ decisions if fuel costs continue to climb.

Still others believe the next five years will bring a resurgence of investor demand for growth.If the economy is robust, this expectation could be borne out.Countering the sentiment that there’s nothing wrong with being a utility, a CFO predicts, “The capital markets are going to get impatient with utility companies just being utility companies.”And a CFO speculates that, “We probably have a couple more years – maybe – of the value of the dividend and the value of back to basics.We will move to a cycle where they’re going to expect growth.And then the challenge will be:Where does that growth come from?

Greenhouse Gas Restrictions
As of early 2006 the Canadian and American electricity industries operate within different environmental policy frameworks.The Canadian government has agreed to lower greenhouse gas emissions as stipulated in the Kyoto Protocol.The United States has declined to sign on and relies on voluntary emission reductions and programs to promote new green-energy technology.

Will the distinction still prevail in 2010? Will the U.S. move closer to Canada’s approach even though it isn’t a Kyoto signatory and opposes a successor global climate pact?

Many U.S. utility executives foresee no change. When asked about emission restrictions, a utility CFO responded:“In the next five years, I’d put it at the lower end of the list.” Others concur, such as the state commissioner who said:“I don’t see global warming as a top policy issue coming out of the governor’s office or the legislature in the next five years.”

Skeptics anticipate lots of talk about greenhouse gas restrictions, but doubt the federal government will adopt any mandates, at least not before the decade closes. Some cite concerns about hurting economic growth, some question the credibility of global warming science, and others simply think it would take longer than five years to bring about any reversal of U.S. policy.

That isn’t the future others see.Referring to the skeptics, a state commissioner commented, “It’s going to be more rapid than these executives are anticipating.”“There will be some form of carbon management in U.S. energy policy over the next few years,” a utility CEO agreed.“Our company will embrace it as most utilities will.”

An environmental group’s senior attorney argued many factors are coalescing to produce change:“There’s so much momentum.You’ve got lawsuits, you’ve got PUCs imputing carbon, you’ve got shareholder pressure, and then you’ve got big players in the industry saying mandatory caps are inevitable, saying we support a carbon tax – that does change the dynamics.”

Another factor:Action by state governments.“You may see more state initiatives than anything else in the short term,” suggested a commissioner.Over half the states have already approved measures that seek to limit greenhouse gas emissions in one way or another.In Statehouse and Greenhouse, University of Michigan professor Barry Rabe contends that states are building an “alternative policy architecture for greenhouse gas reduction that could be expanded to other states, the nation, or even other countries.”

Among other things, the proliferation of state programs and policies creates complexity that could be a problem for utilities with operations in multiple jurisdictions.A state commissioner thinks this could lead the industry to lobby for federal preemption:“A lot of the utility companies are concerned that there won’t be a level playing field unless the federal government takes charge.”

Strategic Implications
In summary, this research shows that among electricity industry executives there is substantial agreement that the outlines of the business environment of the next five years are observable today, albeit with some dissenting views.However, the research also shows that the minority views are hardly unfounded.To the contrary, they are sufficiently accepted, corroborated, and plausible to warrant serious attention in strategic decision-making.

Utilities with strategies keyed to the majority view of what the next five years will bring may be preparing for the wrong future.Executives ought to be asking themselves “what if,” and thinking about what would happen to their organization if any of the minority views turns out to be right.

The problem is that there is no way of knowing for sure which view is the better bet.Corporate strategy requires a foundation of assumptions about how the marketplace will evolve in coming months and years, and yet uncertainty obscures what lies ahead.

How to resolve the strategy dilemma?Make some degree of preparation for each scenario, using contingent investments that provide the ability to increase ownership in those that turn out to be well-suited to the conditions that materialize, or to reduce or abandon ownership in those that represent bets on futures that don’t arrive.To the extent this entails extra expense, it can be viewed as the price of an option that is worth the additional flexibility it confers.

Making contingent preparations for multiple futures does require special capabilities.For example, a company will need sophisticated asset management capabilities to properly operate assets that are there because they represent a hedge against potential future market conditions rather than because they are best for today’s business environment.By the same token, it would be a departure from conventional practice to sell an asset that is doing well in today’s environment because the head office sees indicators suggesting the marketplace is shifting to a different scenario and wants to shed assets maximized on the status quo.And this approach assumes the organization can identify and analyze developments that furnish clues as to which way the business environment is evolving relative to the different scenarios.

Although there are thus special demands associated with this approach, the situation calls for methods of making decisions and managing organizations that allow companies to leverage uncertainty to their benefit rather than ignoring or denying it.The next five years are obscured by complex possibilities, and it is best to embrace that reality.

This article is based on Which Way to Value?
The U.S. Utility Industry, 2005-2010, which is available for download at http://www.deloitte.com/research under Energy and Resources