Changing Dynamics in the Utilities Sector

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.

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