Why Barclays' Call On Utility Bond Pricing Is Misguided

 |  Includes: TAN
by: EnerTuition


Barclays' downgrade of all US utility bonds is poorly thought out.

The problem affects only a small subset of the utility space in the near term.

Technological issues and possible countermeasures from utilities make Barclays' concerns needlessly alarmist.

According to Barrons, Barclays downgraded the entire US utility bond sector to underweight, saying the utilities face long-term challenges from solar energy. Barclays claims that bond risk premiums for the electricity sector indicate investors are ignoring these risks.

While there is a grain of truth in what Barclays says, we find Barclays' report to be needlessly alarmist and not particularly well thought out.

Lest readers take us for luddites unaware of the solar revolution, we want to point out that we are believers of solar industry and have written about various aspects of solar in these forums, including how the utilities are likely to respond to the solar industry growth. Before we get into the details of how we believe the utility evolution is likely to play out and the long-term impacts, we recommend that readers review our earlier note on this topic.

To understand the specific issue raised by Barclays, we need to look at this potential solar problem from at least two key perspectives - a) the capabilities of solar technological solutions, and b) the likely impact on utilities.

First, let's look at the technology aspect. There is a fundamental misunderstanding in the Barclays report that solar panels coupled with battery storage can replace the grid. Here are some of the basic problems with this theory in terms of solar technology capabilities:

1. While solar is a great source of energy, it is intermittent and subject to climate/weather changes, panel degradation, and environmental degradation. Adding multiple days of storage to a solar system to overcome these problems, while not prohibitively expensive, is not economical. And commercial deployment of solar in the future will be largely driven by economics and not subsidies. Any solution that is not economical is unlikely to get much market traction.

2. The solar system is also not robust compared to a utility grid in the sense that panels, inverters, and other power electronics may fail, and recovering from the problem may require considerable amount of down time - something that is an anathema to energy customers in developed countries. In the West, we are used to a model where we flick a switch and the desired outcome happens. Power outages and energy rationing are not likely to be acceptable to much of the Western society.

3. In any normal residential, commercial, or industrial setting, there is a wide dynamic range of energy usage on any given day and at any given time of the year. Consider how a typical user's energy needs can change on a hot summer day or a cold winter day, compared to a mild fall or spring day. Or, consider how the load characteristics can change when a high-powered equipment turns on and off. And, imagine how much energy you may use in a house on the day when you have a large gathering, compared to a day when your family is on a vacation. The point is that the dynamic range of electric usage can be very large. So, how does a customer size a system to meet all these needs? If a customer sizes the system based on maximum usage, then the customer very likely has a highly uneconomic system, where much of the generated energy is wasted. On the other hand, if the customer sizes the system based on average demand, then the customer may not have enough power available to meet his or her basic energy needs. Customers, especially in the western world, are creatures of comfort and will not sacrifice their comfort level.

Given the above technology limitations, a connection to the grid is not only desired, but required. Unfortunately, Barclays' entire thesis seems to depend on the dubious assumption that battery + solar replaces grid.

Now let's look at the same problem from the utility provider's perspective. A utility provider, on any given day and time, sees an amalgam of energy needs from a large customer base. When the entire customer load is put together, the energy patterns are predictable. A utility has a very good understanding of the peaks and valleys of energy use on any given day. Aggregation substantially reduces the energy usage variability. The utilities have generators that provide "baseload" power to satisfy the baseline usage, and they have generators that provide "peaker" power to address the manageable high points. This is a model that works.

What the introduction of solar, this model is somewhat disrupted. Customers can generate power from an intermittent source, whose power generation may not match the power consumption patterns of the customer base. This energy production/consumption mismatch distorts the well-known aggregated utilities' energy consumption patterns, and leaves the utilities searching for answers to issues that they have never seen before. This is already happening in Germany and Hawaii, and is beginning to happen in California.

The solutions to these problems are not that difficult, but require time and money to analyze and implement. Market-based solutions are difficult to implement in many situations because of regulatory restrictions. It does not help that stodgy bureaucracies at the utilities have gone into a defensive mode and are showing signs that they are unprepared for the rapid growth in solar. However, that is no excuse for not anticipating a problem and planning preventive solutions as the solar growth explodes. If left unchecked, rapid growth in solar systems can significantly disrupt the operation of the energy grid. This can lead to a huge customer outcry, and governments and customers may find solutions that the utilities may not like. The utilities need to get in front of the solar deployment issues and take a leadership role in developing proactive solutions. Otherwise, the problems that utilities are seeing in Germany, Hawaii, and California are harbingers of what is likely to happen if the solar deployment is not managed.

One key thing to observe here is that the problem discussed above is not a universal problem with utilities, and not all affected utilities are facing a similar burden. The amount of solar resource and the pervasiveness of solar solutions can vary dramatically by region, and the problem facing the utilities can change significantly from utility to utility. The regulatory and market-based solutions available for any utility can also vary significantly.

There is no doubt that different utilities will need different solutions, but it appears that adding local battery storage at each solar energy generation site may be a good engineering solution in many situations. In other words, solar with battery is not a major threat to utilities, but a great way for utilities to modulate the energy profiles of customers. The battery helps utilities better manage the peaks and valleys of the system energy loads, while reducing waste and improving the economics for customers and utilities.

Centralized storage approaches may be acceptable alternatives in some situation. However, these approaches may not be an economical deployment option today. We believe that affected utilities should rapidly embrace this local battery storage approach. Mandating a local storage solution would lead to a managed and orderly growth of solar, and help avoid some of the problems seen in Germany and Hawaii. In other words, what Barclays sees as a problem is, in fact, a solution to a problem.

Does that mean that solar does not pose challenges to utilities?

The answer is subtle and nuanced. Firstly, the increase of solar deployment is a threat only to a utility with energy generation assets. If the utility does not have any energy generation assets, then solar growth may be a good opportunity to build and charge for a smart solar-capable grid. So, the problem that Barclays pointed out is already narrowed to one class of utilities - the utilities with energy-producing assets.

Even in this class of utilities, the problem is not imminent and there is considerable variation in impacts, depending on the customer base of the utility. Considerations such as the mix of customers and environment (affluence of the customer base, single-family homes vs. apartments, the ages of houses, the types of roof structures, the terrain and greenery, etc.) determine the rate of solar penetration.

For a vast majority of utilities, there will be a considerable amount of time before the utility needs to phase out the excess energy-producing assets. A planned, well thought-out retirement of energy-producing assets may not be detrimental to either shareholder or bondholder needs.

And, even in the scenario that the loss of revenues is significant, utilities have many tools at their disposal to restructure their rates and fees to minimize the impact. The utilities also have extended amount of time to restructure their operations and repurpose them to the evolving grid architecture, with renewables as the center piece. In essence, we are talking about incremental adjustments to the utility model over many years, with potential opportunity to add value in an emerging renewable-based grid. Whichever way one looks at this problem, the Barclays report is an overblown simplistic hyperbole, and needlessly alarmist.

And finally, once you consider that virtually none of the solar being deployed today includes a storage component, it is clear that the problem of solar + battery is far from imminent, but almost non-existent. On top of that, if one were to consider the terawatt hours of storage necessary to meaningfully alter utility dynamics, and the limitations and availability of necessary Lithium battery to enable this transformation, the absurdity of Barclays' thesis becomes evident.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.