The Industry Handbook: The Utilities Industry

You've probably noticed that the utilities industry is not quite what it used to be. Once considered the quintessential safe widow-and-orphan stocks, electricity companies are undergoing big changes as they respond to regulatory changes, demand fluctuations and price volatility and new competition.

In the past, big regional monopolies ran the whole show, all the way from power generation through to retail supply. But we are starting to see some disintegration of the industry structures that once led the electricity industry. Broadly speaking, the industry is breaking down into four supplier segments:

• Generators: These operators create electrical power. While established utilities continue to build and operate plants that produce electricity, a growing number of so-called "merchant generators" build power capacity on a speculative basis or have acquired utility-divested plants. These companies then market their output at competitive rates in unregulated markets.
• Energy Network Operators: Grid operators, regional network operators and distribution network operators sell access to their networks to retail service providers. Heavily regulated, they operate as so-called natural monopolies, because investments made to duplicate their far-reaching networks would be not only overly expensive, but also redundant.
• Energy Traders and Marketers: By buying and selling energy futures and other derivatives and creating complex "structured products," these companies do something very useful: they help utilities and power-hungry businesses secure a dependable supply of electricity at a stable, predictable price. Traders can also boost their returns by wagering on the direction of power prices.
• Energy Service Providers and Retailers: In most U.S. states, consumers can now choose their own retail service providers. In places where the electricity grid has been opened to third parties, new players are entering the market. They buy power at competitive prices from transmission operators and energy traders and then sell it to end users - often competitively bundled with gas, water and even financial services.

Expect consumption of electricity to swell as the world becomes increasingly electrified. The Energy Information Administration projects that 355 gigawatts of new electric generating capacity - or more than 40% more than the industry currently supplies - will be needed by 2020 to meet growing demand.

While upward consumption growth is almost guaranteed over the coming decades, the short-term direction of the market still remains a risky bet. Demand for electricity - whether it's used to run heaters or air conditioners - fluctuates on a daily and seasonal basis. An unusually mild winter, for instance, can moderate consumption and squeeze generator revenues. Gauging the appropriate level of investment in generation capacity is never an easy task.

At the same time, wholesale electricity prices are no longer set by regulatory agencies; for the most part, they are free to fluctuate with supply and demand. This heightens the risk of uncontrollable price increases. Electricity typically costs $10 to $20 per megawatt hour. But if conditions are right, it can very quickly go to $5,000 or $10,000 per megawatt hour. Wrestling with pricing risk is a full-time job for utility managers. In a deregulated market, forwards and futures options provide energy buyers with the tools to help hedge against unexpected price swings. (For more insight, read Fueling Futures In The Energy Market.)

Despite efforts to loosen up the industry, authorities are still not completely comfortable leaving utilities alone to the vagaries of the market. The U.S. wholesale market was deregulated in 1996, and the industry has been further liberated on a state-by-state basis since. The process, however, is often marked by political wrangling between consumer and other special-interest groups. Regarded by authorities as natural monopolies, transmission and distribution operations will likely remain highly regulated service areas. Legislators, sensitive to fall-out from unexpected price spikes, want to have a say on retail pricing.

Power generation is a lightning rod for environmental regulation. Approval for new coal-powered plants is tough to obtain, despite much progress in developing so-called cleaner coal. Natural gas burns cleaner than coal, but still creates some emissions. Nuclear plants, which supply about 20% of U.S. electric power, still operate under the shadow of the Three Mile Island and Chernobyl accidents. The push for cleaner energy ignites interest in renewable sources like hydro power but also solar, wind and biomass. Regulation and environmental issues will likely remain at the top of utility boardroom agendas. (To learn more, read Clean Or Green Technology Investing.)

Key Ratios/Terms

Power Purchase Agreements (PPA): A contract entered into by a power producer and its customers. PPAs require the power producer to take on the risk of supplying power at a specified price for the life of the agreement - regardless of price fluctuations.

Megawatt Hour: The basic industrial unit for pricing electricity, equal to one thousand kilowatts of power supplied continuously for one hour. One kWh equals 1,000 watt hours. One kWh = 3.306 cubic feet of natural gas. An average household uses 0.8 to 1.3 MWh/month.

Load: The amount of electricity delivered or required at any specific point or points on a system. The load of an electricity system is affected by many factors and changes on a daily, seasonal and annual basis. Load management attempts to shift load from peak use periods to other periods of the day or year.

Federal Energy Regulatory Commission (FERC): Regulation in the U.S. electricity industry is provided by the Federal Energy Regulatory Commission, which oversees rates and service standards as well as interstate power transmission.

Public Utility Holding Company Act: Enacted during the Great Depression, this act was designed to prevent industry consolidation. Utility executives speculate that the act's repeal will unleash a wave of mergers among publicly traded utility firms.

Analyst Insight
The allure of utility and power as investment safe havens has faded as new and riskier business models populate the industry. Utility monopolies once attracted investors with reliable earnings and fat dividends; today the same companies, operating in open markets, divert cash into expansion opportunities while they try to keep growth-hungry competitors at bay. As the utility industry evolves, as markets grow more volatile and as regulations change, investors can expect more lucrative opportunities. Simultaneously, they must learn to embrace more risk.

Firms that make the bulk of their money from wholesale trading, arguably carry the highest risk. Their shares react instantaneously to wholesale energy markets' wild price swings, credit ratings, and news headlines. Power trading companies can make a lot of money for investors, but they can also lose them a lot. They demand close investor scrutiny.

Risk-averse investors should, for the moment, seek out players with features that best reflect those of the old fashioned monopolies: power transmission and distribution. Still regulated, these companies are largely buffered from wild swings of commodity trading and prices. On the other hand, they offer - at best - only modest returns.

Investors ought to keep an eye on debt levels. High debt puts a strain on credit ratings, weakening new power generators' ability to finance capital expenditure. Poor credit ratings make it awfully difficult for traders to purchase energy contracts on the open market. Leverage, measured as debt/equity ratio, offers a good instrument for comparing indebtedness and credit worthiness. Rating agencies like Moody's and Standard & Poor's (S&P) say 50% is a prudent ratio for merchant power operators. Companies in more stable, regulated markets can afford debt/equity ratios that are a tad higher.

While utility stocks are no longer synonymous with big dividends, that doesn't mean that dividends no longer matter. Utilities still go to great lengths to ensure distribution of cash to shareholders; relative to others, the industry offers good income potential. Dividend yield, measured as the annual dividend/market price at the time of purchase, probably offers the best tool for gauging the income generated by utilities stocks. Besides, a solid dividend yield suggests a more attractive proposition for conservative investors.

Don't ignore the good old price-earnings ratio (P/E) P/E ratio. It remains the key yardstick for comparing players in the industry.

Value in the utilities industry will be determined not only by the health of the companies' balance sheets and income statements, but by their corporate reputations as well. In an industry that is under constant scrutiny by regulators, environmentalists and ordinary people, corporate image really matters.

Porter's 5 Forces Analysis

1. Threat of New Entrants. Incumbent utility players enjoy considerable barriers to entry. Setting up new generation plants carries high fixed costs and new power producers need a lot of upfront capital to enter the market. Gaining regulatory approval to build new plants can be a long and complicated process for merchant generators. Achieving brand-name recognition and the trust required to convince consumers to switch from incumbent utility providers is not just costly but also time consuming. Meanwhile, once a power plant is built and a market established, the cost of serving one more customer or offering one more kilowatt-hour is minimal. This is a barrier because new entrants can only hope to realize similar unit costs by rapidly capturing a large market share. There is also a relative shortage of talented, experienced managers for which new entrants must compete. Nonetheless, the structural unbundling trend does offer entry opportunities, especially at the trading and retailing end of the market where upfront capital requirements are less onerous.
2. Power of Suppliers. The power systems supply business is dominated by a small handful of companies. There isn't a lot of cut-throat competition between them; they have significant power over generation companies. Meanwhile, as the industry's vertical structures dissolve into a chain of generation suppliers, network suppliers, traders and retailers expect the leverage of any one of them to be reduced. As profits are spread over more players, each one's share will shrink.
3. Power of Buyers. The balance of power is shifting toward buyers. Because one company's electricity is no different from another's, service can be treated as a commodity. This translates into buyers seeking lower prices and better contract terms from energy providers. Commercial and industrial customers, in particular, have great leverage. Long-term power purchasing agreements, for instance, are now the norm for commercial buyers; by replacing more traditional short-term contracts, these shift much of the risk associated with wholesale pricing from buyers and onto utilities. Meanwhile, consumers are forming online communities and buying groups and cooperatives in bids to bolster their market power. As the industry becomes more competitive, customers ought to enjoy more power over utilities.
4. Availability of Substitutes. Power doesn't have a substitute; it is a necessity in the modern world. Short-term demand for power is inelastic. This means that price hikes do little to diminish consumption, at least in the near term. However, while there are no existing substitutes for electrons or natural gas, there are alternative ways of generating them. Industrial groups have launched programs to develop small generators. Microturbines and fuel cells are on the market horizon. These small generators could allow users to bypass traditional power grids altogether, or to limit the use of the grid when prices rise too much over time. (For more insight, read Economics Basics: Elasticity.)
5. Competitive Rivalry. Rivalry among competitors is getting increasingly fierce. Utilities must fight for market share in order to create the economies of scale needed to lower costs and remain competitive. Because nearly everybody already uses a utility, competitors are forced to rely mainly on lower prices and to capture market share. This tends to drive industry profitability down. Competitors try to break out of commoditization by trying to differentiate services, segmenting the market and bundling value-added services. However, the characteristics of the electricity market threaten to neutralize such efforts.

Key Links

• Platts Global Energy - A comprehensive source of online business new/analysis
• Energy & Utilities Review - Published by the Financial Times - online news and analysis/special reports
• McKinsey Quarterly - This energy, resources and materials page contains useful articles covering industry issues