California’s Big Utility Experiment

If there’s one place in the world that has had an absolutely revolutionary effect on power utilities, it’s the state of California. And we believe the Golden State is about to do it again, with far-reaching investment implications for the sector.

Earlier this month, Governor Jerry Brown signed a law requiring the state to cut carbon emissions at least 40% below 1990s levels by 2030.

And in late September, the governor singed four new bills that would further accelerate the development of behind-the-meter and utility-scale storage technologies.

This follows landmark legislation signed last year that mandates that 50% of the state’s electricity must be generated from renewable resources by 2030.

California’s existing renewable portfolio standard already requires utilities and other electric service providers to produce at least 33% of their energy from renewable sources by the year 2020. The state’s largest utilities are on track to achieve this goal.

But the latest raft of laws has obviously created loftier expectations.

Although Hawaii has set even more aggressive targets, we believe the changes proposed in California could be more transformative, given the state’s tighter timeline, scale of development, and the amount of investment being proposed.

Further, these policies, if successful, would accelerate California utilities’ adoption of cleaner technologies beyond almost any state or country, hasten the rise of electric cars, and fast-track new energy efficiency and storage technologies.

Indeed, California could force a level of technological advancement in a period of years that the industry had previously believed would happen over the next two decades.

And if this were the result, California’s policies and its utilities would be the new model for policymakers and utilities in the rest of the country, thereby redefining the sector and changing how investors value the space.

Of course, we’ve devoted substantial analysis on the so-called existential threat such technological disruption poses to the utilities sector. But we don’t believe that will be the case for California’s three largest investor-owned utilities.

On balance, PG&E Corp. (NYSE: PCG), Edison International (NYSE: EIX) and Sempra Energy (NYSE: SRE), which have a combined market capitalization in excess of $80 billion, have welcomed such initiatives and are pushing forward with meeting the new mandates.

For instance, the president of Edison International’s utility subsidiary, Southern California Edison, recently remarked on the passage of the latest law, and his attitude reflects that of the other utilities toward these legislative changes.

“This landmark legislation demonstrates Gov. Brown’s commitment to a clean energy future, and Southern California Edison is proud to help the state in its efforts to reduce greenhouse gas emissions, improve air quality and provide more renewable energy,” CEO Pedro Pizarro said.

Moreover, what makes California’s efforts different is that it has created an environment where utilities are central to achieving the state’s goals.

At the same time, it should be noted that some of the technological advancements proposed could eventually disrupt the industry nonetheless.

But given the state’s collaborative nature, the question today is not so much about disruption, but more so about whether these three utilities will be able to implement such policies profitably and effectively, particularly as some of these technologies are still in their early stages and cannot at present meet these goals.

These questions take on greater significance for utility investors when one is reminded that this is not the first time that California’s utilities have been asked to participate in an uncertain transformative experiment by policymakers. Last time around, things didn’t work out so well.

Back to the Future

In the mid-1990s, California was one of the first states to deregulate its electricity markets in a purported effort to provide consumers with cheaper power and more choices. As an energy industry analyst at the time, I had a front-row view of the state’s development of its competitive market, as well as the deregulation of other markets around the country.

There was really a feeling at the time, much like now, that we were on the cusp of a new era. Back then, it was all about how electric competition would unleash the development of transformative technologies and markets, much as the deregulation of telecommunications ushered in technological innovations such as cell phones and communications at lower cost.

In California, the three big utilities embraced this new world by changing their names and building competitive energy divisions.

“But by 2000, wholesale electricity prices skyrocketed, California’s electricity system was experiencing energy shortages and blackouts, and various investor-owned utilities were facing bankruptcy,” as one report summarized the outcome.

The state did bail out these utilities, but that may be little consolation to investors viewing California’s latest initiatives, as the bankruptcies at a number of utility subsidiaries weighed on each holding company’s overall earnings and financial position. As a result, many of these companies lagged their peers for years in terms of valuation.

As far as what happened, some placed the blame for this debacle on bad actors, others on the design of energy markets, and others on the lack of regulations.

Today, there are still energy experts who passionately defend the cost benefits of competitive electricity markets, which are in half of the country. Meanwhile, detractors believe that policymakers only succeeded in creating another type of poorly regulated market, which isn’t that much better than original monopoly regulation.

The jury is still out on who’s right, but the fact that many utilities have returned to fully regulated business models should be telling.

The good news is that the success of recent state renewable initiatives, such as in California, means that technological innovation will play a larger role in utilities’ success, rather than a reliance on the design of energy markets–though market designs are still important.

The problem, however, is that it can be exceedingly difficult for investors to evaluate the success of these technological initiatives.

In the second part of this special report, which will be published two weeks hence, we develop various scenarios to determine whether these new technologies will be successful in transforming California’s utilities and possibly the rest of the sector, thereby creating a new investment paradigm.