Aligning the Utility Business Model

Feb. 13, 2015
What are utilities thinking about as they struggle with new ways to reach out to customers?

The utility industry business model has not strayed far from the initial industry structure developed over one hundred years ago.

Is this model on target with the needs and objectives of the next century?

Electric reliability, safety, availability and affordability remain the paramount objectives for customers, policymakers and utilities. However, the changing dynamics of our economy, policy and customer alternatives, suggests that our utility business model is no longer as well aligned with an array of new and evolving stakeholder objectives. Energy efficiency, peak shaving, sustainable resources, environmental stewardship, customer choice, grid modernization and new technologies provide a range of new objectives that are not fully aligned with the historic business model.

For example, efficiency and peak shaving are somewhat universal objectives, but they cannibalize utility revenues and growth potential. While many support customer choice, net energy metering programs allows customers that are renewable energy suppliers to have their electric service subsidized by non-supplier customers.

Immediate wholesale change to our industry model is not necessarily the correct approach. There is no easy, one-size solution or one best business model. Regional differences exist and must be considered. However, since electric utilities are regulated at the state level for retail services, we have 50 potential incubators to test and evolve the utility business model.

Today, the utility investor benefits from earnings on capital invested and recovered through an approved rate increase. Within this model, investors are not rewarded for efficiency and reduced investment does not support earnings growth. Many would say this business model does not promote customer interests for lower electricity bills and other socially conscious objectives by aligning interests of all stakeholders.

Why is alignment of interests an important consideration? If a business is going to succeed in developing best tier products and services that customers desire, there must be a financial incentive to the provider business (i.e. the utility) for executing on a best in service strategy. With customer and policymakers seeking an array of new objectives, there must be an alignment of interests with service providers to promote policies that achieve the objectives of customers while providers and their investors have an opportunity to earn a reasonable return on their invested capital.

Aligning the objectives of customers, policymakers and investors requires an assessment of the goals of each. Customers are focused on opportunities to reduce their electric bill and price stability going forward. In addition, due to social evolution and technology advancement, customers are interested in new technologies that will assist them in enhancing their control of electric consumption, environmental friendliness and choice as to the provision of service.

Policymakers generally support energy efficiency, peak demand reduction, renewables, customer choice typically issuing mandates to achieve their objectives. While utilities will support actions that are good for customers and what policymakers support, the utility investor, who management has a fiduciary obligation to represent, is compensated in most jurisdictions by the volume of commodity sold and any policies or mandates that adversely impact on such sales is a potential drain to utility revenues and investment value.

In a low growth economy with capital investment greater than depreciation—which will prevail when today’s costs are compared to historical costs and mandates are promoted to encourage conservation—there will be ongoing pressure on customer rates. The value proposition of utility service will be under ongoing attack by the optics/politics of such cost dynamics.

Policymakers have focused their actions to achieve efficiency and environmental objectives principally by issuing mandates on the utility: regulatory rulings authorizing the utility to a prescribed program offering. I propose business and regulatory models which align interests through an incentive model that encourages all stakeholders to accelerate and capture the desired objectives of all stakeholders. For example, if policy objectives are achieved as to efficiency, customers will use less energy and thus, lower their overall bill. In the long-run, this will reduce utility capital requirements for incremental generating capacity and reduce energy needs and thereby, reduce the rate of utility rate increases. To encourage and incent such action, the utility, besides earning a return on invested capital, would be allowed to earn a pre-determined incentive to promote this activity. If structured properly, this approach could reduce utility revenues while allowing for higher returns earned on invested capital. The higher the adoption of efficiency, the greater the earned incentive for utilities.

We have fifty states that have the opportunity to identify models to align the interests of stakeholders. We can then learn from studying adoption goals, customer feedback and financial market feedback as to which models achieve desired objectives and are preferred by stakeholders, including investors.

Peter Kind, a longtime utility industry banker, is now an advisor on the strategic and financial implications of industry change in the utility and energy sectors.

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