Utility’s Future Often Lies in its Past – But This is Changing

Wishing all our GSEF colleagues, supporters, readers and participants a very Happy New Year. This my 60th article since we began the monthly Newsletter in Oct 2018. Time certainly files when you are in the good company of practitioners who are all passionate about energy systems. Please keep your comments and feedback coming.

As the New Year begins, many pundits are busy predicting what lies ahead for the economy, businesses and society. This is no different for the utility sector. Its business operates in the domestic economy and its service territory affordability issues are influenced by collective public sentiments (via policies and regulation). Cost transparency and affordability plays a big part in such collective sentiments and is often reactionary.

Forward-looking financial performance trends are conducted using Fundamental Analysis and/or Technical Analysis (if listed). Fundamental Analysis is a detailed bottom-up examination (macroeconomics, timelines, ratios, valuations, etc.). Technical Analysis tracks the utility stock’s investor sentiments (buy and sell) as a collective market wisdom with little regard to the company’s actual performance. Often the result of one methodology is tested by the other for confirmation.

The utility business model is a mixed bag. While it operates within the general economy (material, labour, interest-rates, taxes, etc.), its revenue requirement is set by the regulator (about every 2-4 years) after a formal rate application by the utility. The rate hearing process is a tribunal (with an eye on public impact and affordability) with direct public inputs (intervenors). Hence, its forward-looking financial performance is more complex.

Many large utilities (vertically integrated or not) are public listed companies. Such listing allows for easier access to capital (debt and equity) duly acknowledging that revenues are determined through a regulatory process. A “utilities sector” (much like financial sector, mining sector, etc.) allows for limited comparison amongst utilities, as each utility is uniquely anchored in its capital investments, regulatory jurisdiction, different service territory conditions (urban/rural) and different weather impact (hot/coastal/hurricanes/rain/flood/snow).

Due to limited comparability (and regulatory differences), utilities are valued very conservatively by the market (price-earnings and price-book). Also due to its higher debt levels, utilities are sensitive to prevailing interest rates. Its dividend payout (from profits) is the important common thread linking revenue to its operational efficiency. ?

A utility’s internal mantra is always about delivering a steady performance with improvements in financial metrics and dividend payouts. It is said, a utility’s past performance determines its future bell-weather outcomes. Any radical deviation is viewed by investors as risky/uncertain maneuvers. The following examines these “coupling effects”:

1.????? Past Regulatory Performance: Since the utility’s top-line is determined here, its regulatory confidence and smooth performance over the decades is a big part of its future. Unfounded and aggressive submissions and/or regulatory decisions resulting in drastic cuts/disallowance, is a reflection of the utility’s weakness and future financial uncertainty.

2.????? Past Debt Management: Given their higher debt-equity structure, long-term debt service becomes a vital part of its financial performance. Any debt service “shock” is amplified in its unprofitability. Rating agencies keep a sharp eye on this area.

3.????? Past Dividend Payout: Given their monopolistic business models (ROA), utilities are expected to provide steady dividends in various economical situations. It is not uncommon for a utility to maintain its dividend even during a general economic recession. Additionally, a steadily rising dividend is their best valuation metric (PEG ratio).

4.????? Past Rate Increases and Improving KPIs: The trendline of past rate increases duly corelated with inflation and improving operational KPIs (upper quartile performance), is a very big factor in rate-payer and industrial/consumer confidence in that utility. Once these sentiments turn negative (perception or factual) it takes a lot of effort and years for course-correction.

For decades now the utility’s past has determined its future. But this is changing driven by recent events that are not mimicking the past. These areas are new, recent, unsettling and beginning to pose uneasiness in consumer sentiments as to whether they can depend on their utilities in managing these prudently. These are:

1.????? Managing Climate Change: ?Regardless of whether climate change and natural disasters are already affecting a utility’s service territory, a futuristic plan to manage this and lower people’s potential impact should be articulated as a part of a utility’s regulatory filing. Alerting policy makers, regulators and the consumers on the implications of not taking any proactive measures is a vital part of communications. For example, mitigating floods, wildfires, storms, etc. need to be proactively brought up in such planning discussions. Another example would be the need for dynamic thermal management of assets as ambient temperatures have risen in the past decades (relative to the older ambient temperature standards).?

2.????? Maintaining Services During Pandemics:? The recent Covid pandemic was a wake-up call for delivering essential services. It was a set-back for many utilities in managing its maintenance activities effectively. The 100% return to office is still a few years away and being debated by many. While one cannot predict the nature of the next pandemic, utilities would be well advised to have a backup plan of identifying, selecting and managing groups that can work remotely in smaller teams and yet be cohesive in its operational efficiency.

3.????? Implication of Increased Renewables:? Utilities are on different progress paths on increasing access to renewables in their network. This includes not only the T&D grid but also enabling such access behind the meter for customer’s own deployment. High renewable penetration beyond a threshold, without sufficient energy storage, moves the discussion towards a probabilistic reliability model. This penetration level will differ within each utility due to their T&D network architecture. Such potential impact should be articulated as a part of a utility’s regulatory filing.

A few large US utilities in recent years are actively positioning themselves to mitigate wildfire /floods /hurricanes /ambient temperature impacts in their future plans. The utility sector’s unique monopoly position puts it in a bind between delivering on its past trend-line and managing new threat vectors. These discussions will be disruptive and will test current regulatory rigor. For example, the need to underground going forward has little or no bearing to the old practices of overhead lines. A similar argument can be made for dynamic thermal management of T&D assets.

Such new builds and conversions will strand older assets resulting in asset write-downs and operating losses in the short term while seeking offsetting rate increases in the medium term (to avoid drastic rate increases).

?As 2024 unfolds expect more of the futuristic agenda related to climate change mitigation, pandemic management & renewable energy penetration. As the saying goes, a utility’s future often lies in its past. But this is changing

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