by Tom Flaherty and Eric Lowery, Strategy& (formerly Booz and Co.)
Electric utilities have proven themselves an anomaly during the past six years. Since the recession, the electric power sector has experienced anemic load growth, tightening return on equity awards and intrusive policy pronouncements. Yet for the past few years, electric utilities have enjoyed relative financial market prosperity: high capital investment levels, earnings growth and valuation multiples.
Capital investment for the industry approached $100 billion annually during the past two years, based on information provided by members to the Edison Electric Institute. This was fueled largely by transmission growth, grid modernization and environmental compliance. Earnings growth expectations from companies across the sector centered at 5 to 7 percent because of this investment growth. And Bloomberg data indicates price-earnings valuation multiples soared to about 18.5 times by year-end, from a compressed range of 15 to 16 times forward earnings. Even with lower returns on equity, the industry did a better job of earning these returns in recent years. That’s not bad for an industry widely recognized as reaching a major directional inflection point from the convergence of technology advancement, customer progressiveness and nontraditional entrant emergence.
But these heady days easily could be in danger of disappearing. The Environmental Protection Agency’s Clean Power Plan is creating uncertainty and constraining further environmental retrofits and delaying future baseload growth or replacement. Federal Energy Regulatory Commission (FERC) Order 1000 is having a similar effect on transmission investment with longer application and selection processes’ occurring in the regional transmission organizations. State policies on distributed energy resources are eliminating barriers to disintermediation and creating slow streams of revenue erosion. This already is dampening expected earnings growth rates in the forward market guidance of companies.
So where does an electric utility look for growth when the prospects for demand growth are still less than robust? The answer is “no single next big thing.” Rather, future growth will come from electric utilities’ seizing the opportunity disruptive technologies provide to reshape their current business model and unlock multiple new revenue streams. And it will come from continuing to build out the infrastructure needed to optimize the deployment of new technology within the system.
Paths to Growth
Fortunately for the power sector, numerous avenues exist to drive growth in the business while companies analyze and monitor whether demand destruction is permanent or will turn around. For companies that seek to sustain earnings growth rates above 5 percent, decisions first will be needed about their strategic priorities. Companies will need to challenge their current positioning and define three key future choices: where to play, how to play and how to win. These choices form the blueprint for the future and shape the market direction of a company.
First, companies must define where to play in business segments, markets, products and services. Core, adjacent and growth market participation areas are assessed based on attractiveness, capability to compete and potential for profitable success. Next comes assessing how to play in these selected areas, which defines the go-to-market strategies to be adopted by participants that are pursuing their market aspirations (e.g., new products, unbundled pricing, etc.). Finally, attention is placed on the most important dimension of the blueprint: how to win. This element defines the tailored approach to ensure competitive market success (e.g., partnering, pricing, value-added services or channel expansion). With attention to each of these choices, companies then can define and assess further the specific paths available for growth.
When companies start to define in detail their strategic growth options, they will explore them across several dimensions. Each dimension provides a range of choices that are characterized by distance from the core, (i.e., how far along a path a company chooses to participate). These paths include:
à¢—ª Extend the business. In many cases, a principal path for growth is to take the business beyond its current boundaries (i.e., grow it geographically). This has been the case with companies that are pursuing merchant or renewables development in adjacent markets or building transmission outside their current footprints.
à¢—ª Enhance the business.The nature and parameters of the current business are being reforged continually through technology and new entrants. Leveraging this technology to create and offer new and more valuable products and services can reshape the role a company plays in an emergent market.
à¢—ª Expand the business.Companies also can seek to broaden the dimensions of the current business by developing relationships with nontraditional partners. This path is particularly appropriate as companies seek to ally themselves with partners that expand capabilities and channels to market.
à¢—ª De-emphasize the business.Management may determine the best choice is to wind down a business that does not demonstrate an ability to achieve meaningful sustained growth. In these cases, monetization in some form might be the smart path to enable growth by subtraction.
Companies need to make choices among these alternative paths (see Figure 1).
Although no single path likely will enable a company to forge a successful long-term growth strategy, companies should not try to avail themselves of every possible option. Companies need to discern which combination of these available dimensions best positions them to build a distinctive and differentiated model for market success. Defining the right mix of growth paths will enable capital to be invested productively, resources to be smartly deployed and risks to be effectively managed.
Business Model Innovation
Electric companies are at the front end of a potential transformation of the power sector into a 21st-century grid. Although the traditional ubiquitous grid will maintain a high-value role, it will be supplemented by the emergence of multiple subgrids that provide parallel value and enhance the importance and worth of the integrated network. This transformation in grid structure will be characterized by three fundamental shifts in industry structure:
1. Disaggregation of power supply;
2. Emergence of the connected customer; and
3. Innovation in technology deployment.
Each shift provides opportunities for incumbents to create value to their current business and develop new value sources through unique go-to market or business models.
The current power supply and delivery model will not be entirely displaced regardless of the nature of technology deployed. Incumbents still will need to invest in generation, transmission and distribution; however, the balance of future capital expenditures likely will be different as companies move from uniquely large-scale projects to a blend of large and small projects. Each of these more discrete projects will be designed to add value to the overall grid and, more important, to customers in a more targeted and local manner. And future capital, services and knowledge investment will migrate toward these emerging roles for incumbents and be complemented by stand up of new lines of business to match how customer needs are evolving.
The broad range of options where electric utilities can look to grow the core business ranges from asset-intensive areas (e.g., the grid) to services-based areas (e.g., electric vehicles) to knowledge-based areas (e.g., customer energy management) (see Figure 2).
Participating in many of the areas shown in Figure 2 requires capabilities that have not been developed in the past. Some will necessitate managing and deriving insight from big data (e.g., energy management and standby power).
Others will require continuous innovation (e.g., behind-the-meter products and energy efficiency). Finally, certain areas will require managing broader interfaces with third parties (e.g., DER aggregation and electric vehicles). But in all cases, a renewed focus on customer engagement, marketing prowess and new revenue streams to drive top-line growth will be necessary.
As uncertainty continues over the sustainability of top-line revenues and bottom-line earnings, electric companies will seek to backfill the losses and create sustainable growth in areas where early market participation can solidify future revenue streams. Successful companies will recognize that traditional business models will not apply as readily in future markets, at least without modification, nontraditional model development or both. These companies will define new business models directly built for customer-based micro energy markets (i.e., the prosumer) and engage other entrants and customers in nontraditional ways.
In these future markets, imagination, ingenuity and imagination will become the table stakes for sustained growth and the fuel for revenue diversity.
Armed with these capabilities, incumbents need not fear disintermediation; rather, they can embrace a broader role in a more technology-driven, customer-connected energy marketplace.
Tom Flaherty is a senior partner with Strategy& (formerly Booz & Co.).
Eric Lowery is a senior associate with Strategy& (formerly Booz & Co.).