This article originally appeared Jan. 27, 2014, on Real Money. To read more content like this, + see inside Jim Cramer's multi-million dollar portfolio for FREE -- Click Here NOW.
Some confusing information is circulating about electric and gas utilities. The issue is energy sales and utility profits. Many people believe that a utility becomes more profitable if it sells more energy. Alternatively, some may argue that if a utility's energy sales decline, the utility could be in financial jeopardy. It is not true.
The source of this information appears to be the Edison Electric Institute (EEI). Last year, the institute published "Disruptive Challenges: Financial Implications and Strategic Responses to a Changing Retail Electric Business." Since then, The Wall Street Journal referred to the document and suggested that "Utilities' costs and their return on investment are spread across the kilowatt-hours billed to consumers."
For some, the implication is that if customers change their consumption levels, shareholders could see dramatically different returns. In the regulated utility world, this is not always the case. In particular, in the 19 states where regulators decoupled their electric utilities and the 25 states where gas utilities were decoupled, utility returns have little to do with energy sales.
However, the larger point in Journal's article, "Turning Down U.S. Power's Dimmer Switch," is true. Consumers are demanding more from their distribution utilities while they consume less energy. As utilities invest more assets on a declining consumption base, the unit price of energy must increase.
A good example is the aftermath from a major storm. After Hurricane Sandy, consumers demanded costly upgrades to the utility's infrastructure. After the "derecho" storm, other consumers made similar demands. As a result, utilities such as Northeast Utilities (NU), Consolidated Edison (ED), FirstEnergy (FE), Public Service Enterprise Group (PEG) and Pepco Holdings (POM) were required by state regulators to infuse new capital investments as consumers began to withdraw consumption.
The algebra is simple. As regulated utilities are required to make additional investments, they must spread them over a declining customer base. The result is higher retail costs for consumers.
Shareholders should not be harmed. The state guarantees that utilities will receive a return on equity. Because the cost of capital has declined in recent years, the return dropped accordingly. Nevertheless, the guarantee is there, and shareholders are protected.
However, storms are only part of the picture. Big changes are emerging. Three changes will have consumers demanding more while consuming less.
One is solar power. Utility managers refer to solar power operating on consumers' properties as "distributed energy resources" (DER). Utilities do not care if it is solar, wind or fuel cells. Any energy produced on the property is less energy delivered to the property. Add all the DER assets together, and a lot less power needs to be distributed through the utility's system. As more solar is installed; the utility's unit cost of energy must go up.
Another change is demand response. Again, industry insiders prefer a different term. Demand response is part of demand-side management (DSM), which includes having the consumer invest in energy-efficiency technologies. Add all the DSM assets together, and a lot less power needs to be distributed through the utility's system.
Another change is energy storage. This could be in any form, including customer-owned pump storage or car batteries from Tesla Motors (TSLA). As customers combine distributed energy with energy storage, even less energy is needed from the native utility.
In the end, independently owned microgrids would combine all the technologies. The combined effect would reduce energy consumption even further.
For the foreseeable future, consumers will need the local distribution utility to provide reliable sources of energy. However, as consumers consume less and demand higher levels of reliability, their unit costs must increase.
The mistake is to position this issue as a price on energy. It is really a price for reliability. Utility shareholders want a return on their investments. If they do not get their returns, they will invest elsewhere.
The nation has about 3,000 electric distribution utilities. It also has about 1,200 gas utilities. All are regulated by their respective state governments. These utilities operate under government-guaranteed cost-plus arrangements. This means a return on equity at the top line. It also means repayment of debt.
Unfortunately, this could become a social issue. Those who cannot afford to invest in solar or other distributed energy or DSM will end up paying the most for their energy. In all likelihood, those will be lower- and middle-income customers.
This is a customer issue, not a shareholder issue. Since shareholders own a regulated asset, they are assured a prudent return by state regulators no matter how much energy is, or is not consumed. For those who are concerned about reliability costs, "prudent returns" mean reasonable returns, not sky-high returns.
At the time of publication, Glenn Williams had no position in any of the stocks mentioned.