Nearly a century ago, seismic changes established the utility franchise monopoly and a regulated return on equity business model. Encouraging socialized costs to make electricity affordable for all, this model performed very well to incentivize utilities to build power plants and electrify the entire country.
Today, we are standing on the precipice of another seismic shift. In a world where energy efficiency and distributed resources have taken a measurable toll on traditional business, utility executives are wrestling with how they can meet expected revenue growth requirements. This issue is complex and must be addressed on multiple fronts if electric utilities want to be relevant and lead the industry through this change. Utilities must simultaneously work to pivot internally and externally across four dimensions in order to survive the accelerating needs of society relative to energy management. These four dimensions are:
- Adapting to new business models (current article)
- Reviving utilities’ innovation culture
- Restructuring utilities to become customer focused
- Adapting policy and redefining the boundaries of regulation
As we struggle to find the right solution, the first question that is lingering is, do electric utilities play offense (create new products and business models) or defense (ensure regulations maintain their current hold on the market) in this increasingly technology-driven world? The answer – both.
Finding the Lost Utility Value Proposition
A new norm began to emerge about 10 years ago – energy efficiency. Driven by carbon conscious stakeholders who were able to push the requirements into state laws and regulations, energy efficiency became a mainstream utility focused effort. As this effect took hold, we saw for the first time since electricity was widely distributed, a decoupling of electric consumption and economic growth. What this meant for utilities is that the business model that had funded the growth in customers and revenues for decades was beginning to tire out.
Once utilities realized this outcome, the frequency of rate cases increased and a focus on leaner operations became the core strategy to manage rates and increase capital spending. This was meant to help maintain earnings growth even if top line faltered. Utilities, regulators and stakeholders converged on the revenue growth problem and have attempted to offer up solutions including the following:
- Decoupling revenue streams of the utilities from energy consumption, which removes the disincentive to offer energy efficiency programs.
- Net benefits or savings sharing models that provide rich margins for utilities that exceed energy savings targets.
- Performance-based rates that focus on aligning customer and stakeholder goals better with the utility than the traditional return on equity model.
All of these ideas have been tried for several years and have succeeded in creating the right short-term objectives. The problem is that they don’t solve the top line GROWTH problem, only defend the existing revenue model. This is a fundamental miss. Alone, electricity has become nothing more than a public commodity – essential to life and economies today but doesn’t add value in itself. To correct this, we now need to step back and ask the question, what is the new utility value proposition in today’s world?
New World, New Revenue Growth Strategy
It is an unfortunate truth that utilities can no longer depend on the return on equity model to sustain top-line growth. Utilities that serve in a market that has significant population growth may feel less pain given that per capita consumption still offsets the natural growth of the customer base. Many utilities today don’t have that luxury, but the financial and operation expectations of lower rates and higher reliability remain. So how do we solve this dilemma and achieve real growth that can also fund improvements in reliability? It is time to examine other ways utilities can use rate structures to incorporate increased revenue while simultaneously lowering rates for their customers.
Now, what if a premium source of revenue like home energy management was brought into the mix? Imagine, if a utility typically earns $525M of revenue in a flat growth scenario. Blended average rates are thus about 11.7¢/kWh. In this case, leadership targets a near-term goal of creating new premium businesses that would achieve 10% of core utility revenue. As they examine the impact of dedicating internal resources to this effort, the net effect would take out $34M of core resources and end up reducing this utility’s revenue requirement to $492M. Not only that, it would also have the benefit of lowering rates for the customer to 10.9¢. The new businesses would need to absorb these costs profitably while adding an incremental $19M of additional costs and expected return. The new business is targeting 36% margins vs. the core utility 17% net margins.
When achieved, the net result of such a business plan would be a 4% increase to overall revenue and an 11% increase to net margins. This would be a healthy gain for a utility in a world where demand for their core product is flat and/or declining. The secondary benefit of this model is that overall rates are lowered for the utility customers which is a positive stimulus in the local economy. Take a look.
But what happens when in a regulated world, the utility shareholders aren’t allowed to leverage their utility brand and capture higher returns from supplementary businesses?
In some cases, regulators may allow a utility to provide these services either through a special rate offering or through feeding margin back to base rates from the services. In the case of establishing special rates, the traditional rules of regulated return on investment will likely apply and could inhibit the utility’s willingness to deploy a business where the risks are not fully rewarded with ample return. This is something regulators will need to work on as utilities search for new business models.
One of the reasons utilities earn below average returns on equity is the lower risk of the utility model. Regulators and stakeholders will need to grapple with the realities of the need for new business models and the balance of returns, fairness of rates, the restraint of utility monopoly power and how it can affect the players in a particular related market.
In the second case, consider the earlier example of a new business and the effect it would have if earnings from that business were plowed back into base rates. In this example, if the utility and stakeholders believed that 10.9¢ per kWh is a fair rate for the local economy, then some additional benefits will ensue. So, assuming that the utility and regulator negotiate the outcome of sharing 50% of the premium business’s margin as return offset with utility customers, the following would result.
The outcome creates a scenario where the utility still increases revenue, nearly hits the original target margin AND has created headroom to increase capital spending for the future by 125%. Original capital spend would be $75M under a utility-only example and in this new world, up to $169M in capital could be spent without increasing rates beyond the new low 10.9¢. The result of this scenario is that the utility has a healthier set of financials that increase revenue, margin and return on sales from the original base case.
Take the state of Michigan, here the legislature has encouraged open innovation to enable services such as these to exist. In late 2016, the Michigan Legislature passed Public Act 341 which clarified the code of conduct and rules necessary for utilities to implement “value-added” services. Given regulatory oversight, this opens the door for creative ways Michigan utilities can serve their customers while adding to the top line of the business.
The benefit of this scenario is that the utility will be able to accelerate investment in the grid, reliability, and stability of the system at an overall lower cost to the utility customer. In addition, the utility is able to provide premium services that enhance its brand and customer satisfaction if executed well. Finally, if the utility is allowed to press into new services, given the customer trust that exists, new markets can be opened and accelerated that will actually benefit the industry players in this space. In all, utilities offering these kinds of services create win-win-win scenarios for regulators, utilities and customers, that cannot happen if regulations or legislation put too many barriers in front of the utility to earn fair returns on innovation.
Making New Opportunities a Reality
With so many forces at play rapidly changing the landscape and chipping away at current revenue, the utility business model will need to evolve in order for the industry to remain healthy. Enabling utilities who already have deep customer trust with the ability to lead the way to new innovative services will accelerate if allowed. Legislatures and regulators across the country need to take notice and understand that enforcing models that cause revenue declines will not help anyone. The utility franchise does require trade-off, but if that franchise becomes less valuable due to no growth, the core of the model itself is at risk.
The time to begin this new approach is now and the risk of waiting is increasing the risk of utilities hitting a financing wall that will eventually damage infrastructure investment. However, another key dimension of this dilemma is the structure of the utility itself. A path will need to be cleared within the utility organizational structure and culture, which calls for further transformation. This is what is addressed in Driving Top Line Growth, Part 2: Transforming the Utility Business Culture.