How Utilities Are Coping With Disruption

 | Feb 11, 2013 | 6:00 PM EST
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A free market can be a beautiful thing. Buyers and sellers are systematically paired while prices reflect various levels supply and demand. One of the most interesting markets is found in the power industry. But traditionalists are perplexed. They love the idea of free markets. They also love the idea of utilities. Unfortunately, free markets and utilities cannot coexist.

It is a simple concept that eludes many. When the power market conducts an auction for energy, the auction is only about power. Since electricity is perfectly fungible, the market is indifferent toward the sourcing of the energy. The market doesn't care if the energy came from a coal plant, a nuclear plant, a solar plant, a wind plant or your neighbor's exercise cycle. The market only cares about the commodity and its delivery.

This is a new problem for utility companies such as Exelon (EXC), Entergy (ETR), NextEra Energy (NEE) and Dominion Resources (D). Their legacy has been fine-tuned to develop and operate generating resources that address regional policies, economics, reliability and safety.

The energy market does not care about nuclear safety, regional economic policies or stewardship. The market only cares about the day-ahead and spot prices, and it rewards providers that deliver the commodity at the lowest possible price. Period.

For the typical utility, the challenge is the market price. It is often too low. While auction results frequently allow generators to recover production costs, many times they cannot recover their total costs.

Some utility managers seem surprised to learn the market is indifferent toward their capital, maintenance, interest, ad valorem tax, depreciation, amortization, income tax and other indirect costs. Typically, all these costs were captured in the rate base. In the free markets, they are not.

Michael Porter of Harvard Business School puts it best when he argues that cost leaders in profitable markets are the winners. In addition, Porter's "Five Forces Framework" helps explain why utilities operating in free markets are threatened.

Two of Porter's five threats are about new competition and substitution. In the power industry, new competition is the big surprise. We frequently hear about this threat from Exelon. The company has been outspoken about its concerns over wind power. Specifically, Exelon complains that wind is disrupting the power markets.

It's not true. The markets have been behaving rationally. Energy providers, which use wind and solar, are delivering the commodity to the market at lower costs.

It turns out that nuclear and large coal plants are disrupting the markets. They ignore market signals, and they continue producing even when their product is not economic or needed. They have to. They were not designed to follow the markets.

Substitution is the biggest threat. As more wind and solar are offered to the markets, more substitution and displacement take place. Wind and solar displace marginal units, which are the market's most costly units. Unfortunately for traditionalists, older coal or natural gas plants are the assets most frequently displaced. Sometimes it is a nuclear plant.

In 2012, Dominion decided that it had had enough. It is selling or retiring most of its merchant fleet and focusing on regulated assets. In its long-term planning process, it allowed for the option of leaving the power markets. Today, after writing down and selling several generating assets, it is left with large, unregulated asset: a two-unit nuclear plant operating in New England's power market.

NextEra also maintained optionality. While it has not made an overt move to unload its unregulated assets, doing so would not be a surprise. If NextEra does make some adjustments, they would not be terribly damaging to its balance sheet.

Exelon and to some degree Entergy are caught in a different situation. Their options are limited. Most of their massive assets are anchored in the deregulated markets. (Entergy does own some nuclear and other plants in regulated states.) In a fight-or-flight scenario, their only practical option is to fight. That is exactly what they are doing today.

But a new threat is on the horizon, though many sneer at it and discount it: energy efficiency.

Going back to Porter's Five Forces, energy efficiency increases consumers' bargaining power, because new market rules are anti-discriminatory. The markets require energy-efficient assets to be treated equally with power-generation assets. Anti-discrimination is a simple concept with huge repercussions. Energy efficiency also intensifies the competition within the market. Investors should take energy efficiency very seriously.

Viewed through the eyes of the market, huge changes are taking place. The market is leveling the playing field and empowering consumers. But the market is also short-sighted.

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