This is our fourth article in a series of articles about Yieldcos - specifically TerraForm Power (NASDAQ:TERP) and NRG Yield (NYSE:NYLD). For an introduction to Yieldcos and our view of the energy industry please refer to the previous articles here, here and here.
To summarize earlier articles, utilities are facing a confluence of several major threats:
1. Solar technologies are driving down the cost of electricity to customers. Solar penetration has two negative effects for utilities: it reduces the amount of energy that a utility delivers to its customers and it reduces the value of each unit of energy delivered by the utility.
2. Advances in battery technologies are starting to cause disruption at the commercial level. Storage solutions benefit from tariff arbitrage cutting away utilities from a lucrative source of income. In the near term, battery technologies will increasingly impact the utilities' commercial revenue streams. In the long term, batteries also pose a threat to utilities' residential revenue streams.
3. Power generating nanogrids have a heightened potential to siphon away utilities' high volume customers. Once a customer implements a nanogrid a utility is likely to lose that customer's business forever. In many cases, the utility may not even have the leverage of grid connection.
In this article we discuss various ways in which utilities have responded to these threats and why the responses fall far short of changes necessary to sustain the utility business models. We then look at some business model changes that are necessary for utilities to effectively counter the upcoming threats.
Utilities' current response to Solar + Battery + Nanogrid threats; how are the utilities likely to respond to these threats?
Utilities for the most parts are stodgy, bureaucratic structures. They are slow-moving, lack a sense of competition, and live and breathe regulation. This is true to a large extent even when one looks at the various investor-owned utilities. The problem with utilities is that they see customers as locked-in "ratepayers." The utilities' expectation is that they set the rates and the customers pay. As organizations utilities do not yet appreciate that customers can defect. This thinking, if left unchanged, may end up being the downfall of many utilities.
So far the response to the emerging threats from utilities has been consistent with their nature and very predictable. After initially ignoring the severity of the threats, utilities have used regulatory, legal, political, and public relations tools at their disposal to stem the tide. The most effective defense so far has been in the form of delay tactics and revisions of tariff structures. Changing tariff structures can increase payback period for solar deployments and reduce the storage arbitrage. While these utility responses could be semi-effective short-term measures, they are unlikely to be effective in the long term.
Getting Deeper Into Utility Challenges
To prosper in the new world utilities need to understand their customers' needs and be prepared to do what it takes to retain their customers. (As an aside, the rapidity with which a utility phases out the word "ratepayer" may be a good indication of the adaptability of a utility to this new world.)
To retain customers, utilities first need to understand the root cause of their customer problem: Many customers, especially the ones with high energy bills, have always had the need to reduce their energy costs but have never had the means to fulfill that need. In most jurisdictions, customers do not have the option to choose their energy provider and cannot shop for low cost alternatives. The arrival of solar, wind, and low cost NG power generators changes this dynamic. As costs of these options decrease, increasing numbers of utilities' customers will be able to choose between utility provided power and locally generated power alternatives.
Solar power is of specific concern to the utilities because solar power generation coincides well with peak energy consumption and high energy rates. Utilities lose their high margin peak time revenues with solar and will not be able to make up for the revenue shortfall by raising energy rates (KWH pricing). Because raising the rates would further accelerate the penetration of solar and result in a more rapid downward spiral. The dynamic drastically and irreversibly diminishes the pricing power of utilities.
Utilities, however, can reduce the attractiveness of solar solutions by assessing connection fees, flattening out tariffs, reducing net metering benefits, etc. While these solutions will likely have some impact, they may not be very effective. As such, any effort by utilities to impose connection rates and tariffs that are artificially high would be detrimental to the long-term utility business model. Any effort from utilities to restrict customers' choice is likely to fan negative sentiment and increase the desire on customers' part to sever from the grid completely. This dynamic makes it unlikely that utilities can stop the large amounts of new DG capacity that is coming online.
From the discussion so far, it should be clear that the measures that utilities have taken to date are short term and do not address the fundamental problem of declining solar cost curve. The reason for this is simple!
Utilities cannot directly confront these threats because, with their current business models, there is no way for the utilities' cost structure to keep up with the declining solar cost curve.
As solar penetration increases, utilities will increasingly face a peculiar dilemma: What is the value of energy when pretty much every one of utilities' customers can produce energy?
Readers should also note that the tinkering tariffs and the other solutions we have discussed so far are unlikely to materially slow down nanogrid deployment as a nanogrid customer may choose to bypass the grid.
A case for utility business model change
The cold reality here is that as an increasing percentage of utilities' customers become energy producers, the massive centralized power generating assets that utilities and utilities suppliers' own start becoming less valuable. The drop in value of these power generating assets is likely to be continuous and there is not much these asset owners can do to reverse the trend. Not only are customers going to need less power from the utilities but they will be expecting to pay prices that are far lower than the cost structure possible with older centralized power generation infrastructure.
To successfully compete in this new regime, utilities need to continually reduce the cost of energy they produce (or procure) so that the energy they sell can be price-competitive with alternate sources available to the customer. This price competitiveness is essential to reduce customer incentive to either install new DG capacity or buy energy from an alternate provider. In this emerging world, the distribution and management assets of a utility will be much more valuable than any power generation assets that a utility may hold.
In terms of power generation, the solution for many utilities in this new environment is starkly clear:
- Reduce the dependency on any in house energy generation assets - Sell them, spin them off, write them off, or do whatever it is necessary to ensure that they do not drag down utility bottom lines.
- Procure power at costs that are competitive with the continually lowering market rates
Utilities that own power generation assets would be mistaken if they believe that the event horizon is far along and they can continue to maximize the value of these assets in the interim. As long as the utilities hold on to their power generating assets, they will likely be trapped into taking steps that maximize their short-term power generation revenue instead of the long-term sustainability of the utility business model. Even if the utilities do not believe that the power generation returns will collapse in the short term, utilities would be well advised to start alienating these assets.
The utilities that do not depend on internal power generation assets are not completely off-the-hook either, especially if they continue to be in the business of buying energy under long-term contracts priced based on carbon era pricing. This pricing will soon become unsupportable in the context of future solar energy pricing. In the new regime where the costs of energy are decreasing constantly, it is undesirable for utilities to enter into long-term contracts with energy generators. However, utilities may be in bit of a catch-22 situation. Given the investments necessary to build new power plants, utilities may not be able to procure the power they need without long-term contracts with their vendors. In such cases, to reduce long-term risk, there are several ways utilities could price their energy sourcing contracts. For example, utilities could:
a) Construct PPAs with reasonable price reductions built-in to the model. In other words - a de-escalator (which is the opposite of how many PPAs are written today)
b) Construct floating PPAs with energy prices tied to well-defined forward-looking energy rate indexes
These alternatives are not difficult to implement but will take time - especially in the slow-moving regulated world of utilities.
The event horizon may appear far sooner for utilities in the Sun Belt and there is an urgency to update the utility business models in these solar resource rich regions. Utilities that serve customers in areas with less attractive solar resources have more time to react but even these utilities should not underestimate the power of the solar technology cost curve.
We believe that utilities that do not adjust their models in time are likely to underperform or go out of existence in the next decade or two. In the context of Yieldcos, investors should note that the time period we discuss here is within the term of many of the current PPAs.
With this industry backdrop, we are skeptical of Yieldcos or other yield vehicles that depend on PPAs from utility and DG industries. Some of the Yieldcos that rely on long-term utility PPAs include: Pattern Energy Group (NASDAQ:PEGI), NextEra Partners (NYSE:NEP), Abengoa Yield (NASDAQ:ABY), Hannon Armstrong (NYSE:HASI), Brookfield Renewable Energy Partners (NYSE:BEP). We urge the readers intending to invest in these and other similar Yieldcos to use caution.
In the next series in this article, we look at how utilities could address the threat of nanogrid and the overall impact of utility business model changes on Yieldcos.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.