Q1. What is the purpose of this article?
A1. The purpose of this article is to begin to examine the threat to the revenue stream of electric utilities from the combined impact of solar, home batteries and what I will call "bad ratemaking." This bad ratemaking can include: (1) "bad" net metering policies and prices, and (2) "bad" retail rate design policies and prices. [I use the term "bad ratemaking" to emphasize that ratemaking should be economically rational, properly reflecting cost causation; i.e., cost causers should be responsible for costs that they cause.]
The hypothesis under consideration is whether electric utilities face significant competitive threats from distributed resources, such as solar and home batteries.
In this article, I will focus on SolarCity Corporation (NASDAQ:SCTY) and Tesla (NASDAQ:TSLA) and their business activities in solar and home batteries, respectively, because I suspect that solar combined with home batteries could become a major threat to electric distributors. I would suggest, however, that SCTY and TSLA investors should not assume that the current subsidies flowing to net metering customers will persist indefinitely.
SolarCity's business model is based on selling most of their solar systems to end-use customers using a power purchase agreement (PPA) or lease. Customers sign a long-term agreement to buy energy from the developer, with SolarCity owning the system on the customer's roof. Sunrun (NASDAQ:RUN) and Vivint Solar (NYSE:VSLR) use a similar PPA business model. Readers should note that I have not done any valuation analysis for these stocks, and I recommend that readers do their own due diligence.
Tesla's Powerwall is a home-based battery that is expected to be used to store electricity and serve as a backup generator. [Coincidentally, SolarCity's Peter and Lyndon Rive are cousins of Tesla Motors' Elon Musk.] Solar-generated electricity, obviously, is intermittent - it's only available when the sun is shining. In combination with a home-based battery, however, solar generated electricity could be stored for use at night, raising the possibility that a home with solar and a battery could sharply reduce its dependence on electricity produced by the electric grid. However, if a net meter customer can sell solar-generated electricity to the electric utility at artificially high prices, there wouldn't be much of an incentive to store electricity, other than for curtailment periods when electricity isn't available from the electric grid.
The combination of solar and bad ratemaking has already led to a situation where households with solar receive a subsidy from the general body of utility customers, and it's possible that home batteries could make the situation worse. In Nevada, the Public Utilities Commission of Nevada (PUCN) recently took steps to begin to revise NV Energy's net metering rates, finding that net metering customers have received a subsidy from other customers. The PUCN quantified the subsidy resulting from the shift of fixed costs from net metering customers to other customers at $623 per year and $471 per year in southern Nevada and northern Nevada, respectively. [Note that I have not done any independent analysis of the PUCN's quantification of the subsidy to net metering customers.] NV Energy's parent company is Berkshire Hathaway Energy, a privately-held company. Rather than being based on the avoided wholesale cost of electricity, Nevada's net metering tariffs had the effect of simply reversing the direction of the meter when electricity was sold to the electric utility, allowing net metering customers to avoid the entire cost of taking service from the utility during the period.
The problem for SolarCity and other purveyors of solar based on PPAs is that they assumed that the current subsidies to net metering customers would persist long into the future. Once Nevada rationalized their net metering tariffs, however, SolarCity announced its plans to exit from Nevada. It seems possible SolarCity and other solar companies in Nevada announced the exit as part of an effort to attain a more favorable outcome from the PUCN and/or the state legislature. SolarCity may even be in a position to use its customers as unpaid lobbyists, something that Uber (Private:UBER) has been able to do. It is at least possible that SolarCity is using its threat to exit Nevada as a bargaining chip with the PUCN and to mobilize its customers, perhaps seeking a long transition period before the new net metering rates go into effect. [It's not clear at this time exactly how SolarCity's existing customers in Nevada will be affected by SolarCity's announced departure from Nevada.]
Q2. Could electric distributors go the way of the horse-drawn carriage?
A2. No, but investing in electric utilities isn't as simple as it used to be. Electric utilities face the threat of lost revenues resulting from their customers' use of solar, batteries and other distributed resources. The "lost revenue" challenges that utilities face may not lead to a "death spiral" as retail customers are likely to continue to be connected to the grid, but could become a major problem if the lost revenues problem is accentuated by bad ratemaking.
It isn't entirely the case that electric rates are set in an economically rational manner in the U.S. Utility rates are supposed to be "just and reasonable" so that retail customers' rates reasonably reflect the cost of the services that the utility provides to them while treating utility shareholders fairly. As a general matter, utility rates can be said to be just and reasonable based on the utility's prudently-incurred costs including the forward-looking opportunity cost of equity capital. But there can be exceptions, such as net metering rates that subsidize utility customers with solar at the expense of utility shareholders and the general body of ratepayers. The problem with bad net metering rates is minor when few retail customers have solar or other distributed resources, but would become major if household solar becomes commonplace.
The largest U.S. electric utility parent companies include (1) American Electric Power (NYSE:AEP), (2) Avangrid (NYSE:AGR), (3) Consolidated Edison (NYSE:ED), (4) Dominion Resources (NYSE:D), (5) Duke Energy (NYSE:DUK), (6) Edison International (NYSE:EIX), (7) Exelon Corporation (NYSE:EXC), (8) NextEra Energy (NYSE:NEE), (9) PG&E Corporation (NYSE:PCG), (10) PPL Corporation (NYSE:PPL), (11) Public Service Enterprise Group (NYSE:PEG), (12) Sempra Energy (NYSE:SRE), (13) Southern Company (NYSE:SO), (14) Wisconsin Energy (NYSE:WEC) and (15) Xcel Energy (NYSE:XEL). Readers should note that I have not done any valuation analysis for these stocks and I recommend that readers do their own due diligence.
Solar, batteries and "bad ratemaking" could become a particularly toxic combination for investors in electric utilities. Solar can allow homes and businesses to produce electricity for their own use and to sell back to the electric grid, home batteries can allow solar to be stored during the day to be used at night, and bad ratemaking can mean that electric distributors cannot recover some or most of the costs of serving customers that have solar and/or batteries.
Electric utilities still have a franchised monopoly, but they also have a state public utility commission (PUC) to deal with. If the PUC doesn't set rates in the right way, then electric utilities could soon be in financial trouble.
With economically rational electric utility rates, solar and home batteries wouldn't be a big problem for the electric utility. Economically rational electric utility rates would (1) set "net metering" prices based on incremental costs (i.e., the wholesale cost of electricity), and (2) allow an electric distribution utility to recover the fixed costs of serving residential customers in a flat charge and variable costs in a per-kWh charge.
Investor ownership of electric distributors can succeed if the electric distributor and the state utility regulator work together to solve the lost revenue problem. The goal should be to ensure that the electric distribution "platform" works to deliver electricity services to customers at a reasonable cost, both for customers that have solar, batteries and other distributed resources and those that don't.
Q3. Are new-school quasi-monopolists a potential competitive threat for electric distributors?
A3. Maybe, and it's possible that SCTY and TSLA could become quasi-monopolists in the context of solar and home batteries, especially if they are able to build solid relationships with their customers. One way of building relationships with their customers might be to collect data on electricity usage and use that data to help their customers reduce their carbon footprint and/or their utility bills. Once they've built solid relationships they may be able to follow in Uber's footsteps and use their customers to help them reduce regulatory barriers into the distributed resource (e.g., solar or home battery) market.
The economics of integration are such that there will likely always be a role for electric utility distributors, whether investor-owned, cooperative or public power. The danger comes from the (potentially) toxic trio of solar, batteries and bad ratemaking. There already is some evidence that advocates for solar, batteries and other distributed resources view what I would call bad ratemaking as a major part of the value proposition for their customers. These advocates for distributed resources seem to want bad ratemaking to artificially subsidize their customers at the expense of customers that don't switch to distributed resources and distribution utility investors.
As a recent New Yorker article has pointed out, Amazon (NASDAQ:AMZN), Facebook (NASDAQ:FB), Google (NASDAQ:GOOG) (NASDAQ:GOOGL) and LinkedIn (NYSE:LNKD) may have unregulated quasi-monopolies in retailing, social networking, search, and business networking, respectively. A quasi-monopolist can be defined as a dominant supplier in a market.
According to Nicholas Lemann's article in the New Yorker:
Hoffman's new world of online platforms, marketplaces, and networks produces companies that emerge from the brutal competition among startups as big top-down organizations with quasi-monopoly status: Amazon in retailing, Facebook in social networking, Google in search, LinkedIn in business networking. Once network effects really kick in, they create a powerful barrier to entry for potential rivals: the more effort you've put into your identity on Facebook or LinkedIn or YouTube, the more difficult it becomes for you to switch to a competitor. One of Peter Thiel's favorite bad-boy notions is that competition is "antipodal to capitalism": once a company becomes successful, it should try to establish a monopoly position, so that it can charge the kind of prices and make the kind of profits that are available only to companies without meaningful competitors.
Note that quasi-monopolists don't operate in a market that is a "natural monopoly" - competitors can economically compete to serve the market (i.e., having one monopoly supplier isn't the best solution for customers). In the new era of platform competition, a company like Amazon provides a platform for customers to buy goods from vendors and also competes with other vendors to sell goods. Having a "platform" that is attractive to customers may cause customers to stick to a platform, e.g., staying on Facebook because your friends are on Facebook. For many people, Google is the preferred search engine, allowing Google to generate most of its revenues, income and cash flows from advertising.
Milton Friedman thought that the three ways to deal with a monopolist are private monopoly, public monopoly or private regulation, and, of the three, he preferred an unregulated private monopoly, believing that competition would eventually reduce an unregulated monopolist's market power. In modern competitive markets, market power can quickly erode. Joseph Schumpeter wrote about creative destruction, which describes the "process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one."
Quasi-monopolists face antitrust scrutiny but aren't regulated. In the late 1990s, for example, there was a serious effort by the U.S. Department of Justice to break up Microsoft, which eventually ended up being settled. Microsoft's Windows operating system may have been "dominant" in the 1990s, but that is less and less the case with the advent of alternatives.
Peter Thiel argues that competitors should seek a quasi-monopoly position, but assumes that the company will be able to decide what prices to charge its customers, i.e., he assumes that there is no regulator that decides this. For Warren Buffett, it is "all about monopoly power, not management."
One of the distinctive attributes of new-school quasi-monopolists may be their ability to use their customers to induce more customers to join the network. These customers also may be willing and able to help to reduce legislative and regulatory obstacles to increasing the size of the network. Notably, Uber has used its customers to reform and reduce legal obstacles to Uber competing in the "ride sharing" market.
Disclosure: I/we 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.
Additional disclosure: Author of The A to Z of Public Utility Regulation (Vienna, VA: Fortnightly, 2015). See: http://www.fortnightly.com/ATOZ.