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The Rise of Distributed Generation Threatens Utilities

In the late 1980s, the band R.E.M. achieved pop music fame by claiming, it's the end of the world as we know it. Utilities should heed their warning. Distributed generation (DG) could be the end of utilities as we know them today. Or, as we at Morningstar like to say, DG could destroy utilities' economic moats.

Warren Buffett first coined the term economic moat to conceptualize a firm's competitive advantage or lack thereof. We now assign ratings as wide, narrow, or none to the more than 1,500 companies we cover worldwide. Firms with the widest economic moats demonstrate strong competitive advantages that produce sustainable, above-average returns for investors. Firms with no economic moats have a limited ability to control the returns they earn for investors. Utilities tend to fall in between those two extremes. We typically assign them narrow economic moat ratings. In most cases, utilities' centralized networks and regulation prohibit competition, but their capped rates limit investors' returns. In the long run, we expect most utilities will earn returns in line with what investors should expect from firms with similar risk profiles.

But DG is breaching utilities' economic moats. The electric utilities industry group Edison Electric Institute (EEI) recently identified DG as the largest disruptive threat to utilities' business models and financial health. We agree. Utilities' centralized network monopolies break down when customers become self-sufficient competitors. The cost-of-service regulatory model that allows utilities to earn at least their cost of capital in the long run also breaks down when fewer and fewer customers pay for maintaining the centralized network. For power producers, centralized baseload generation loses its value as DG saps network demand.

DG leads to the so-called death spiral. As more customers adopt DG, utilities' costs to maintain and operate the grid are spread across a smaller demand base, raising customer rates and increasing customers' economic incentive to cut the cord. Ultimately, utilities' earnings and cash flows will shrink, making interest and dividend payments less certain. This death spiral ends when investors — equity and credit — are left holding a purse of dormant power plants and copper wires.

Timing is a key part of the rating system. Public policy and regulation are key factors that affect how long a utility can maintain its economic moat. Net metering, tax benefits, and technological innovation support DG adoption and could dramatically shorten utilities' competitive advantage periods. Utilities in areas with DG-friendly net metering rules could find their economic moat closing more rapidly than utilities in areas with less-accommodating net metering policies. Many European utilities have suffered from shrinking competitive advantages as renewable energy feed-in tariffs, emissions caps, and anti-nuclear sentiment explicitly or implicitly subsidized DG. U.S. tax policy is a key variable in the coming years. 

So what should utilities do? Amid the doom and gloom, we think there are opportunities for utilities to protect or even widen their economic moats:

Extract value from the centralized grid. Utilities' centralized grids remain a key part of the DG value proposition. DG users must be connected to a centralized grid to collect net-metering revenues, a critical offset to DG installation and maintenance expenses. DG users also need connections to centralized grids for backup power if they don't have energy storage. A typical solar DG user relies on the grid for energy during most hours of the day, with a relatively small period of time when it is a net seller.

Utilities can also extract value from their centralized networks by helping integrate DG. Infrastructure-support revenue, which utilities could collect from DG users, would help mitigate lost revenue from falling demand. German utility RWE is pursuing a similar strategy after renewable energy and DG growth decimated its legacy power generation earnings. It now aims to help customers manage and integrate renewable energy rather than invest in centralized generation. 

Improve regulation. In the near term, the best way for a utility to protect its moat against DG is to work with regulators to create constructive rate structures and educate regulators about the threat DG poses. Regulators in Arizona, California, and Colorado have shown willingness to address DG, specifically net metering deficiencies. Those policies could serve as templates for other states as DG spreads. 

Vertically integrate. Some utilities have embraced DG through investments in rooftop solar, DG financing, and self-generation technology. Utilities can offer competitively priced clean-energy options that prevent customers from seeking these services elsewhere. Utilities' strong balance sheets and existing customer relationships should give them an advantage against smaller newcomers. 

The technical challenges of incorporating DG will likely slow the erosion of utilities' economic moats in the near term. Converting the electricity grid from one-way flows to two-way flows to support net-metering will be expensive and time-consuming. Without careful management, power flowing onto the grid will cause fluctuations in voltage and frequency, creating reliability problems and safety concerns. But as we look out to the next decade, utilities that refuse to adapt could find themselves singing their swan song.

Lead image: Danger sign via Shutterstock

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