what the utility “death spiral” is

I’ve been hearing and reading a lot lately about a potential electric utility “death spiral.”  So I thought I’d write, in simplified terms, what this is all about (by the way, the Economist magazine has an excellent recent survey of the electricity generating industry worldwide).

utility 101

Governments have generally decided that capital-intensive public service businesses, like provision of water, electric power, natural gas shouldn’t be open to all potential entrants.  Instead, the government chooses a single provider.  In return for being awarded a monopoly in a given service area, the company in question agrees to government regulation of its charges.

For every utility I know of (cable tv being, arguably, an exception), regulation takes the form of limiting the utility to a maximum allowed return on its net investment in plant and equipment.  Net here means after subtracting accumulated depreciation charges.  In most countries, the return is set annually.

setting rates

The rate fixing process boils down to this:

–the government utility regulator specifies an allowed return on plant for a given year, say 5%.  If the utility has net plant and equipment of $40 million, the  total allowed profit is 5% of that, or $2 million.

–the utility submits an estimate of the number of units it will sell in the coming year and what the cost per unit will be.  Let’s say it figures it will provide 20 million units to customers and that it will cost $.20 a unit to do so.  The utility is allowed to add a profit element (i.e., $2 million/20 million units = $.10 a unit) to its costs to arrive at the total per unit charged to customers.  In our case, this is $.30/unit.  [The reality is a little more complex:  bulk customers or industrial users who agree their service can be interrupted in periods of peak usage may get discounts; peak period users may be charged a premium.  That doesn’t make a difference for the “death spiral,” though.]

electricity

Let’s say the service in question is electricity.  Let’s also say the population is stable (there’s a life cycle aspect to utility profits, but that’s another wrinkle we won’t worry about yet).

the spiral begins

Over time, people buy appliances that conserve power.  New construction is better insulated, so air conditioning doesn’t have to run so much.  New light bulbs run cheaper.  Home power monitoring systems optimize and reduce electricity consumption even more.  On top of this, responding to government subsidies, some people put solar panels on their roofs.

Suppose all of that cuts electricity usage in the service area by 20% (very high, but just to make the point), to 16 million yearly units.

The new calculation of the electricity company per unit profit becomes:  $2 million/16 million units = $.125/unit.  The per unit charge becomes $.325, or 8% higher than before.

The 8% increase causes more people cut their power consumption, either by investing in new, less power-hungry devices, finding substitutes (those solar panels no longer look quite so ugly) or simply by heating/cooling the house less.  Let’s say the price response reduces annual demand in the service area to 14 million units.

What happens at the next annual price setting?  The new per unit allowed profit is:  $2 million/ 14 million units = $.143/unit.  So the cost of electricity rises by another 5.5% to $.343.

That causes another round of conservation/substitution   …which drives the per unit charge even higher   …and prompts another round of conservation.

That’s the death spiral.

Is it real?  Maybe in some places in the EU.  In the US it seems to me there’s a tipping point out there someplace that we haven’t yet reached.  I don’t spend time dreaming about my next utility stock purchase, however.

other stuff

If the service area is growing, with new customers arriving every day, the potential problem is a worry for the distant future.  If the service area is shrinking, on the other hand–like if retirees are departing for warmer/cheaper climes–the issue is on the table today.

From an investor point of view, two further non-death spiral complications:

–when the service area matures, the regulator typically sees no further need to maintain a high allowable return on plant to make raising new capital easier, so the return percentage is pared back

–without new capital spending, net plant shrinks as accumulated depreciation …well, accumulates.  This is another minus for mature service areas, since smaller net plant = smaller allowable profit.

Both of these factors mitigate the spiral effects.  Neither makes the utility in question prettier to Wall Street eyes.

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