The Utility Industry's Battle Against Time

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Includes: DUK, EIX, FSLR, PCG, SPWR, TSLA, VSLR
by: Simple Investment Ideas

Summary

The utility industry has faced little to no competition over the last century.

With the rise of solar PV, utilities may find themselves face increasingly at odds with the distributed generation industry.

The traditional advantages of centralized generation are falling away with the rise of cost-effective solar PV technology.

The utilities' lack of an innovation culture should compound the exponentially growing threat of solar PV, making the utility industry woefully unprepared for rapid change.

The utilities have enjoyed a virtual monopoly over the energy industry for over a century. A major reason for this is that there has never been an electrical generation model comparable to centralized generation. Even today, centralized generation consists of more than 99% of the United States' total electricity generation. The complete utility dominance over the electricity industry has led to a somewhat stagnant business culture, with a woeful lack of innovation. In fact, it is often said that if Thomas Edison were alive today, he would be able to recognize the electrical grid immediately. Utilities like PG&E Corporation (NYSE:PCG) or Edison International (NYSE:EIX) have been around for over 100 years, and experienced little to no competition over this huge time span.

This innovative stagnation characterizing this industry is hardly the fault of the utilities themselves, as innovation only comes with competition. Since the discovery of electricity, there have been no alternatives to centralized electricity generation that have even come close to its cost-effectiveness. With the emergence of distributed generation though, the utilities' complete domination of the electrical industry may change rapidly come to an end. Although distributed generation currently provides for less than 1% of total U.S. electricity generation, such small figures are extremely deceptive.

Challenge to Centralized Generation

Of course, centralized generation has dominated the electrical industry up until now for good reason. For one, it is much cheaper to buy fuels wholesale than for individual locations to buy fuels separately. In addition, it is much more efficient to burn fuels in large quantities and then to distribute the resultant electricity, rather than to burn small amounts of fuels in distributed locations. Imagine how much more cost-effective it would be to burn 10,000 tons of coal in one giant power plant as opposed to have to burn these 10,000 tons in thousands of separate locations with miniature power plants(if there is such a thing). Without even mentioning all the safety concerns this would bring, distributed fossil fuel electricity generation is obviously inferior in cost-effectiveness to that of centralized generation.

The emergence of solar PV technology has changed the whole dynamic of distributed generation. Rather than requiring costly fuel-burning infrastructures, i.e. power plants, solar PV only requires some space to place energy-generating modules. This removes a whole host of problems associated with distributed fossil fuel electricity generation. With solar panels, there will be no need to build individual infrastructures to burn fuels and no safety concerns associated with such a thing. While utility-scale solar does posses a cost edge due to scale of installations, i.e. labor costs are significantly lower for utility-scale installers than for distributed solar installers, this is more than negated by the massive grid infrastructure costs associated with centralized generation.

Such massive fuel burning power plants are only made possible in a centralized grid structure. Solar PV should make all of this irrelevant, which would take away the traditional advantages of centralized utility generation.

Source: wvpublic

Exponential Growth

Solar PV technology has allowed for economical decentralized generation for the first time in over a century. There are many reasons to think that solar PV will be the technology to bring distributed solar to the forefront. While other sources of generation, such as wind, thermal, etc, all are good distributed generation sources, solar PV enjoys the benefit of improving at an exponential rate. The simple reason for this is that Solar PV is essentially a semiconductor technology, which means that it shares an extreme amount of resemblance to integrated-circuit technology.

Semiconductor technology has been shown to increase in exponential fashion, which has so far played out in solar PV's case. Since the inception of solar, the solar PV's cost/watt has halved every ten years, although we have seen somewhat of an acceleration in the past decade. At Solar PV's current rate of improvement, it will only be a matter of time before distributed solar PV begins to take over as the main electricity generation source. Even at around .5% of electricity generation, distributed solar will start to impact utilities much faster than expected.

Utility Business Culture

To compound the problem of solar PV's natural exponential growth path, utilities generally do not have much experience with innovation. Innovation will be key for the utilities' survival, and yet the utilities have had almost no need to innovate for the past century. Besides the occasional power plant efficiency or grid durability upgrades, there is precious little innovating going on(if you can even count such activities as innovation).

At .5% of generation, distributed solar is only a few doubling away from significantly impacting the utilities' bottom line. This means that despite the utilities relative inexperience on the innovation front, the utility industry will suddenly have to start innovating in order to maintain market share. On top of this, such innovation must be done on an extremely restrictive timeline, which could very well spell disaster for many utilities.

While there are some utilities, such as Duke Energy (NYSE:DUK), that have at least shown some signs of innovativeness and initiative, most utilities are woefully unprepared for the rapid coming change. Some utilities have specifically gone the route of monopolistic abuse, notably APS, rather than innovation. While distributed solar companies like SolarCity (SCTY) have been innovating since their inceptions, the majority of utilities have not even been aware of distributed solar's potential threat until very recently. Some of the utilities still seem to think that distributed solar poses no threat at all.

The Storage Variable

No matter how much more solar PV technology advances, or how much more cost-effective distributed generation becomes, distributed solar generation will always be dependent somewhat on utilities' grids when the sun is not shining. Battery storage technology should solve all of this, but battery storage technological improvements are much less predictable than solar PV improvements. Battery storage is a macro-technology that is unfortunately not as affected by exponential improvement.

Fortunately for distributed generation, and unfortunately for the utilities, many are working feverishly on battery storage technology. Tesla (NASDAQ:TSLA), for instance, is planning to make battery storage that should be economical for distributed solar in less than a decade. With cost-effective battery technology, distributed solar PV can operate entirely independent of the grid. This means that distributed generation could bypass the grid, and therefore grid costs, altogether. The emergence of cost-effective storage for distributed generation will almost certainly disrupt the electricity industry. This is the one area where the future is not so certain for distributed solar, which is good news for the utilities.

Fundamentals Breakdown

While distributed solar companies and centralized utility companies have the same basic function of providing consumers with electricity, distributed solar stocks have many ways to go about this. SolarCity, for instance, gives consumers the option of either buying, leasing, or loaning solar systems. Utilities like PG&E only have the option of selling electricity, as these companies use centralized methods of energy generation. Already, distributed solar companies give centralized utilities a run for its money in terms of consumer options.

On the financial front, utilities like PG&E have P/E ratios that usually hover between 10-20. Because distributed solar companies are not a great point of comparison(in terms of P/E ratio) due to their long-term business models, one can look at solar manufacturers/developers such as SunPower (NASDAQ:SPWR) or First Solar (NASDAQ:FSLR) to get a better comparison. Surprisingly, these solar stocks have respective ttm P/E ratios of 22 and 15, which is nearly equivalent to those of Duke Energy and PS&G. This is extremely surprising given the fact that solar still has plenty of room to grow, while centralized fossil fuel based utilities have already saturated the electricity market.

Distributed solar companies like SolarCity and Vivint Solar (NYSE:VSLR) would offer the best point of comparison to centralized utilities, but the methods of comparison for these two industries are messy at best. With that being said, retained value, which is a metric meant to capture distributed solar companies' long-term lease/PPA/loan value, may be the best way to compare distributed solar companies to centralized utilities.

Both SolarCity and Vivint Solar have market capitalizations that stand around two times their retained values, which suggests that investors are either not giving enough credit to distributed solar's growth potential, or that investors think that the retained value assumptions made by these companies are overblown. Even if retained value assumptions were to be taken more pessimistically, a market capitalization to retained value ratio of 2 still seems way to low. Because of this, distributed solar companies like SolarCity or Vivint Solar seem to offer much greater upside than centralized utilities such as PS&G or Duke Energy.

In addition, distributed solar companies have the ability to sell their products nationwide, or even internationally. On the other hand, centralized utilities are confined to localized areas due to the limiting nature of grid infrastructure. This alone gives distributed solar energy an advantage, not to mention the fact that distributed solar companies can grow 100-fold without fully saturating the current addressable market. Distributed solar companies like SolarCity and Vivint Solar should be considered superior investment choices to stagnant utilities like PS&G or Duke Energy.

Conclusion

The utility industry will definitely face some huge challenges in the coming years, with a questionable ability to deal with such challenges. The extraordinarily low contribution of distributed electricity to total electricity generation is extremely deceptive in appearance. While .5% may seem to be an insignificant figure, the key point to remember is that solar PV adoption has been roughly doubling every two years. A simple calculation will show how disruptive such change can be in a mere few years.

Utilities like PG&E will likely have a grim future in the coming decade. On the other hand, distributed solar companies such as SolarCity or Vivint Solar should prosper at unprecedented rates. Utilities will essentially be fighting against time in its battle with the distributed solar companies.

Disclosure: The author is long SCTY.

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.