Takeaway: The utilities sector must gear up for the renewable energy revolution and adapt to the changing habits of U.S. consumers.

MARKET WATCH: What’s Happening? The utilities sector has a century of experience as a slow-and-steady dividend machine that generates profits from a regulated return on accumulated capex. But things are changing quickly. Despite falling fossil fuel prices and expiring solar subsidies, ever-more consumers are switching to renewable energy—sometimes even selling the excess back to their power provider.

Our Take: The arrival of price-competitive renewables has changed the game of utility provision forever. In their next act, utilities will no longer be able to count on the return generated from their fossil fuel-burning plants—but must instead find a way to provide value while staying ahead of new (unregulated) competition.

Houston residents are marveling at a prototype of a new energy-efficient home that features everything from a solar panel-lined roof to smart thermostats to energy-saving window blinds.

The kicker? The home was built by a utility company, Reliant Energy (a subsidiary of NRG).

Why would Reliant, a firm that makes money on power, provide a way for consumers to use less of it? (And in Houston, of all places?)

It all has to do with the rapid rise of price-competitive renewable energy, which is changing how utilities do business.

HOW UTILITIES OPERATE

To understand why a shift toward renewables hurts utilities, we must first examine how the sector makes money. Utilities have always adhered to a simple principle: The more you invest, the more you earn.

Due to prohibitively high barriers to entry (power plants are neither cheap nor quick to build), the sector operates as a natural monopoly consisting mainly of regional players. In exchange for their monopoly status, these firms are heavily regulated by state-run public utility commissions (PUCs), which control virtually every part of a utility’s business—from signing off on investments to setting rates of return. This tightly controlled relationship is known as the “regulatory compact.”

A core tenet of this regulatory compact is that PUCs get to set a “total revenue requirement” for each utility, which consists of a “rate base” (the value of a company’s assets) multiplied by the allowed rate of return, plus expenses. In short, utilities are reimbursed only on a cost basis for the services they provide, but are allowed to generate a fixed rate of return on their assets. Thus, more assets mean greater returns. This is a great business. It’s an especially great business in an era—like the last twenty years—when interest rates and earnings yields are declining, since utilities get to enjoy a “regulatory lag” of months or years between their fixed ROR and the declining cost of capital.

It’s little wonder why utilities have been investing at such high rates. Annual capex by U.S. investor-owned utilities has roughly doubled since 2010 alone. Last year, utilities poured $45 billion into their electric transmission and distribution systems (up from $28 billion in 2010), $24 billion into gas pipeline storage and distribution (up from $4 billion in 2010), and $7 billion into renewables (up from nothing in 2010). In New York, utilities have spent $17 billion on new equipment in the past decade.

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The sector’s low-risk, low-reward business model makes these stocks attractive to investors in search of safe assets that pay steady dividends. The average utility has a levered beta of just 0.38, making the sector attractively uncorrelated to the rest of the equity market. Dating back to 2010, the average utility stock has posted a dividend yield of 3.8%—nearly twice the yield of the S&P 500 (2.0%).

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These low-beta stocks are seen as bond alternatives—which is why 10-year Treasury yields and utility P/E ratios enjoy a strong negative correlation. Alternatively, the 10-year yield and the utility earnings yield (E/P) enjoys a strong positive correlation.

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THE FIRST SCARE

For the past century or so, this is how the sector has operated—making more and more investments in the grid, keeping a small slice of the revenue or themselves, and returning the rest to shareholders.

But the narrative changed coming out of the Great Recession, when utility professionals feared that rising energy prices would incentivize consumers to switch to renewable energy. At issue were the forced “buyback” programs by which consumers who generated their own power could sell it back to the utility. (Fully 42 states plus Washington, D.C. had implemented such programs in 2010.)

These buyback programs coincided with the introduction of huge subsidies that convinced consumers it was possible to go green without going broke. Beginning in 2006, the federal solar Investment Tax Credit (ITC) allowed consumers and corporations to deduct 30% of the cost of solar installation from their taxes.

Sure enough, as energy prices spiked and ever-more consumers adopted solar power systems, utilities like Arizona Public Service (owned by PNW) and Denver-based Xcel Energy (XEL) began asking regulators to reduce incentives or impose new charges on consumers who installed solar rooftops. Others lobbied to lower the cash value of these buybacks, arguing (with some justification) that consumers were essentially charging their power companies the retail rate for power generation, despite not bearing any of the fixed costs attached to that rate. These efforts, however, largely stalled thanks to stronger-than-expected bipartisan support for renewables.

Naturally, when fossil fuel prices plummeted in late 2014, utility executives breathed a sigh of relief. No longer would renewable energy hold a comparative advantage over fossil fuels.

THE LATEST SCARE

Or so they thought. In the years since, it has become jarringly evident that the game has changed for utilities—and there is no going back.

In spite of falling energy prices, the shift toward renewables has not only continued—but has accelerated. The Financial Times reports that global renewable capacity rose by 9% YOY in 2016, powered largely by a surge in solar capacity (which shot up 30% YOY). For the second consecutive year, renewable capacity accounted for more than half of all capacity added worldwide.

The EU is on track to meet its goal of generating 20% of its power from renewables by 2020, with 25 of its 28 member countries exceeding their growth targets. China, meanwhile, added 35 gigawatts of solar capacity last year, an amount on par with Germany’s total capacity.

In the United States, the story has been the same. Wind and solar alone accounted for 65% of all capacity added in 2016, the third consecutive year in which fossil fuel growth took a backseat to renewables. U.S. consumers added 1 million solar panels last year, a figure that the Solar Energy Industries Association expects to double by the end of this year. Renewables are doing best in green states like California, where regulators anticipate that 85% of consumers will be getting at least some of their electricity from a source other than an investor-owned utility by 2020.

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DRIVERS

Why are Americans continuing to switch over to renewable energy sources even as fossil fuels are becoming cheaper?

Supply side: Productivity improvements are driving down cost. One explanation is that the cost advantages of renewable energy have not yet disappeared. How is this possible? Quite simply, productivity gains in renewable energy generation are proceeding so rapidly that renewables remain price-competitive no matter how low fossil fuels go.

According to Greentech Capital Advisors partner Jim Long, “In 2010 we financed a 15-megawatt solar plant in southern California that cost $55 million to build…This year we have done another one the same size in the same area that has cost $15 million and will produce at least 40 percent more energy.”

It’s not only getting cheaper to generate renewable energy—but also to store it. Continued advances in energy storage technology have made it ever-easier for consumers to go “off the grid,” much to the dismay of their power provider. (See: “Energy Storage Powers Up.”)

What’s more, these productivity gains have occurred far faster than forecasters expected. In 2010, IEA projections suggested that there would be 180 gigawatts of installed solar capacity worldwide by 2024. Actually, there were nearly 300 gigawatts by 2017. In 2011, the Department of Energy predicted that utility-grade solar power would fall below $1/watt by 2020. Actually, it fell below $1/watt earlier this year.

Surprisingly, even the expiration of the ITC in 2022 is not expected to negatively affect prices. According to the Institute for Energy Economics and Financial Analysis, renewable energy costs are falling so rapidly on their own that, by the early 2020s, even unsubsidized wind and solar will be cheaper than coal and natural gas.

Demand side: Xers don’t like relying on Big Power. Meanwhile, the demand side is being warped by generational change. America’s rising appetite for renewable energy is being fueled by Gen Xers and Millennials—each for different reasons.

For individualistic Xers, renewables promise self-sufficiency. If the grid goes out, a backup generator or solar power could mean the difference between life and death—or at least between comfort and hardship. In the Xer vision, Big Data plus emerging battery and distributed electrical inverter technology will give birth to microgrids (communities that pool their solar and wind generation) and nanogrids (single homes that both generate and store power—in effect, taking themselves “off the grid”). This generation’s prepper, me-against-the-world mentality is the same one that has brought “survivalism” into the mainstream. (See: “I Will Survive.”)

Demand side: Millennials are living sustainably. Millennials care a lot less about survivability (amazingly, they trust the “system”). But they care a lot more about sustainability and urban living. So for them, renewable energy is also a natural match.

Pew Research finds that consumers ages 18 to 29 favor the development of alternative energy sources over the expansion of fossil fuels by 54 percentage points, by far the widest margin of any age group. The mere mention of fossil fuel elicits a negative reaction from young Millennials: According to Ernst & Young, 16- to 18-year-olds have a much less positive perception of natural gas (40% positive) and oil (25%) than older consumers (60% and 35%, respectively).

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Attitudinally, Millennials are interested in living sustainably and leaving a small carbon footprint. Their land-use patterns reinforce this worldview: This generation’s affinity for urban living naturally leads to less dependence on utilities. Author and sustainability expert David Owen writes that, because of the extreme compactness of city life, the average New York household uses less than half of the electricity consumed by the average U.S. household (4,700 kWh compared to more than 11,000 kWh).

WHAT THIS MEANS FOR UTILITIES

Lights out for utilities? Not overnight. Fossil fuels still create around 85% of the world’s power, a share that will not disappear any time soon.

Clearly, however, fossil fuels are no longer a growth driver for utilities. Instead of investing ever-more heavily in fossil fuel-powered plants in order to generate a profit, the sector must find another revenue stream.

Accenture global managing director Tony Masella says that, “Utilities are really beginning to realize that the world has shifted…It’s not something that will happen in five years. It’s happening now.” A recent survey by Utility Dive, a trade publication, found that only 5% of utility professionals say that their business model does not need to evolve.

Best-practice firms are betting that consumer-facing services will be their next cash cow. Accenture data indicate that the average consumer spends only 20 minutes each year interacting with their energy provider. Utilities want to extend and deepen this relationship—even if it means offering services that encourage less power consumption.

Along with Reliant and its Houston smart home, there are several noteworthy examples of utilities pursuing this course of action. Southern California Edison (a subsidiary of EIX) offers a digital home energy advisor tool that provides tailored recommendations for reducing household energy usage. Duke Energy (DUK) and American Electric Power (AEP) are now market testing a new mobile app that offers everything from bill pay to real-time outage updates.

Lawmakers in some states are trying to revamp the utilities sector’s cost structure, allowing firms to earn additional revenue through such services. One example is New York and its “Reforming the Energy Vision” (REV), which (along with the stated goal of modernizing the grid) would enable utilities to earn money on their consumer-facing business lines beyond the mere cost of service. In the future, for example, a utility could earn additional revenue through performance incentives or software-as-a-service offerings. Illinois is reportedly pursuing similar legislation addressing the utility business model.

But investors take note: While this move from electricity provision to “energy-service provision” may garner firms some much-needed favor among consumers and state regulators, there’s no guarantee that the strategy will pay off. Utilities have spent a century in the business of generating and selling power to consumers. They have little to no experience building appealing consumer-facing services in an unregulated marketplace.

Their direct access to consumers’ homes and their knowledge of the power business does give utilities an early advantage. But unless they can use that head start to build a truly meaningful relationship with consumers, they may be marginalized once third-party tech companies with vastly more experience in digital IT begin competing in the space.