Gloomy Future Prospects For Electric Utilities

|
Includes: DUK, EEA, EIX, NRG, PEG
by: Simple Investment Ideas

Summary

The vast majority of centralized electric utilities have valuations that do not properly reflect increasing future risks.

The mounting expenses associated with grid maintenance/repair, coupled with the increasing cost-effectiveness of distributed generation will likely devastate the electric utility industry in the mid/long-term.

While electric utilities could remain relevant by transforming into service companies, it is unlikely that they will be able to maintain their past/present levels of profitability moving forward.

Centralized electric utilities have dominated the electricity generation industry for over a century. As centralized electricity generation has been, and still is, the most cost-effective means of electricity generation by far, this does not come as a surprise. Despite centralized electric utilities' complete control over the electric industry, their dominance is much less certain in the mid/long-term future. As distributed forms of generation become more cost-effective, there will undoubtedly be profound changes in the centralized electric utilities' business models.

Distributed forms of energy generation, namely solar PV, are becoming increasingly cost-comparable with centralized electricity generation. As distributed generation is inherently at odds with centralized generation in terms of business models, the utilities have much to lose if distributed generation begins to mount any sort of momentum. While distributed generation still generates less than 1% of total electricity generation, the distributed generation movement is clearly gaining strength.

This, of course, is extremely bad news for centralized electric utility standouts such as Public Service Enterprise (NYSE:PEG), Edison International (NYSE:EIX), and the list goes on. Many of these large utilities have trailing P/E ratios in the 20's, which implies that these companies will retain their current levels of dominance for the foreseeable future. With the threat that distributed generation poses, this long-term view seems too sanguine. Such centralized electric utilities will likely have to undergo massive transformations in order to adapt to changing realities.

Long-Term Viability Of Utilities' Current Business Model

Utilities like Public Service Enterprise have trailing P/E ratios that do not track the realities of the rapidly transforming the energy landscape. While it is only natural to assume that such utilities will remain dominant in the long-term due to their incomparable historical monopoly, such P/E ratios inadequately address the existential risks facing such centralized electric utilities. By factoring in the sizable risks that distributed forms of energy generation pose, such utilities are vastly overvalued.

Distributed energy generation companies are gaining steam both in terms of growth and political support, which is only natural given all the problems associated with the utilities' aging grid infrastructures. Such old grid infrastructures will increasingly be subject to higher levels of maintenance/repair due to factors such as power outages or age, all of which will require trillions of dollars to remedy. On top of this, the grid increasingly represents a national security liability, where terrorist attacks on grids could literally shut down the electricity flow for millions of individuals in worst case scenarios.

With the mounting problems associated with centralized generation, and the increasing viability of distributed generation, the long-term outlook for centralized utilities is gloomy. Centralized electric utility companies clearly should not have such high valuations given the rapid emergence of new forms of electricity generation. While this may not seem obvious given the electric utilities' current overwhelming dominance in the electricity generation sphere, such dominance will likely come to an end much faster than most expect.

Utility Transformation

Distributed forms of generation act as a sort of panacea for the problems plaguing the electric grid system, so its increasing levels of support on both the regulatory and political level are not surprising. Distributed forms of generation add reliability to the grid, reduce peak load demand, and could even make a grid system obsolete in the long-term future. Despite this, distributed forms of generation still have a flaw in that they require cost-effective energy storage. As such, distributed forms of generation are still currently heavily dependent upon centralized electric utilities for their grid infrastructures. Whether or not distributed generation companies want to admit it, the utilities are a vital part of their business models.

Centralized electric utilities can take advantage of this dependence by leveraging their grid infrastructures. While many utilities are arguably going about this in the wrong way by levying excessive grid fees for distributed generation customers(in an attempt to suppress distributed generation growth), utilities have an opportunity to remain relevant for the long-term by acting as grid service providers. Unfortunately for electric utilities, they will likely not be allowed to compete directly in the distributed generation business due to regulation.

Such regulation only makes sense in order to avoid the more-than-likely possibility that such utilities will push out pure play distributed generation companies (through unfair means) in order to kill the distributed generation movement. After all, it makes no business sense for these utilities to embrace a business model that would essentially destroy their existing business models (in which they invested billions of dollars into) just to establish a new business model that may be even less profitable.

As such, the most reasonable course of action for such utilities would be to slowly make a transition to a grid service business model in order to ensure long-term relevancy. Fighting against the distributed generation trend will likely only waste time and resources, which means that adapting to the changing electric generation paradigm may be the best long-term option. In any case, current centralized electric utilities will likely see downside moving forward, as there is a very low probability that such companies will be able to maintain their current levels of profitability in the mid/long-term future.

Here is a simplified timeline of the electricity industry in the United States. Despite the century of dominance, the centralized electricity industry clearly looks to be on the decline.

Source: renewableenergyworld

Industry-Wide Challenges

The centralized electric utility industry is being challenged for the first time in over a century, which like means that the vast majority of such utilities are not prepared for the changes to come. While there will inevitably be some utilities that get ahead of the game, and could even see future upside as a result, the majority of electric utilities likely represent bad investments. Unless fossil fuel lobbyists can successfully shut down the distributed electricity generation movement, which seems highly unlikely given the momentum building for distributed generation, the utilities are in trouble.

Even if doom and gloom scenarios such as the widely talked about "utility death spiral" does not occur, it is extremely unlikely that the electric utilities will continue to enjoy a near complete monopoly over the electric industry. The majority of utility standouts such as Public Service Enterprise are unreasonably valuated, with market capitalizations oftentimes in excess of $20B. Even if such utilities survive the numerous challenges facing them in the next decade or so, such companies still represent inferior investments.

Conclusion

Even many of the largest fossil fuel power companies are starting to realize the immense potential of distributed electric generation, which speaks volumes about this burgeoning industry's prospects. Some of the largest power companies such as Duke Energy (NYSE:DUK) are starting to invest billions in distributed generation infrastructures, despite these companies' attachments to the utility business model. Power companies and utilities alike are starting to recognize the potential of distributed generation, although investors are still lagging behind in this recognitions(evident in the utilities' overly optimistic valuation).

It is likely one of the best times to sell electric utility holdings focused almost exclusively on centralized generation and buy utility/power companies more heavily involved in distributed generation like NextEra Energy (NYSE:EEA) or NRG Energy (NYSE:NRG). By the time distributed generation enters into the high single digits of total electricity generation, much of the upside currently to be had will likely disappear as investors move in on distributed generation. On the other hand, investments in centralized utilities such as Public Service Enterprise, Edison International, etc., should be losing ventures in the long-run.

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.