From defense to offense, utilities game plan for a recession

The recent pandemic- and energy price-driven market slowdown has been a very quick cycle: a rapid downturn followed by a short recovery, and now a potential recession. Meanwhile, inflation pressures and the Federal Reserve’s reaction has supported the recent increase in long-term bond yields, even though the growth in the cycle is slowing. According to S&P Global, amid the recent rise in rates, utilities have materially outperformed the broader stock market in the last 12 months. This indicates that the group's defensive characteristics outweigh rate sensitivity as growth slows and the risk of a recession rises. On top of those macroeconomic issues, several key near-to-mid-term market drivers are presenting competing priorities for utility management teams:

1. Capital expenditure plans for the next few years are expected to be significantly higher than historical levels amid a focus on modernizing grids, interconnecting renewables, replacing natural gas infrastructure, and addressing extreme weather events.
2. Commodity prices are expected to remain high in the near term, putting additional pressure on retail electricity prices. Simultaneously high inflation and supply chain issues will impact affordability and the ability to procure the equipment required to develop new power generation.
3. Near-term revenue protection challenges related to collection moratoria mean that many utilities, based on their respective regulatory environments, are either recovering uncollected revenue broadly across customer rates or creating a balance sheet item to be addressed later.
4. Accelerated corporate decarbonization commitments continue to weigh on local utility load growth and increase interest in companies “greening” the power supply for their operations.
5. Federal legislation, such as the Bipartisan Infrastructure Law (BIL) and the Inflation Reduction Act (IRA), is driving decarbonization investments.
6. Increasing electrification will create opportunities for utilities but will also require significant investment in infrastructure.

In the immediate term, to best position themselves, utilities can develop integrated strategies across three primary themes:

• Buckle Down by deploying short-term cost management strategies, optimizing capital spend and divesting non-core assets to manage overall earnings — a defensive strategy to improve the balance sheet.
• Transform the Business by fundamentally rethinking the purpose of the utility and how it provides value to customers — an aggressive strategy intended to reshape all dimensions of cost, operations and innovation performance, with a digital accent.
• Invest to Grow by taking advantage of the macro environment and identifying undervalued companies or assets to acquire, prioritizing certain regulatory issues, and determining how to best approach prioritization and execution — an offensive strategy for financially strong companies.

Below is a summary of these strategies, along the continuum from defense to offense:

• Divest non-core assets. Many utilities are reviewing the assets on their balance sheet, adjusting their portfolio with the objective of investing more capital/cash in the regulated electric utility business, given the certainty of returns, potential for transmission investments offering higher return on equity (ROE), and higher ROEs relative to gas utility businesses. This has resulted in three main opportunities — asset sales through divestment of smaller/non-core/gas operating companies, sale of minority stakes for high-valued assets (e.g., transmission), and separation of unregulated businesses (renewables/fossil generation).
• Reduce operating expenses. To manage the impact of a severe economic downturn, many industries, including utilities, have deployed rapid and aggressive cost management techniques to influence near-term cash flows. Over the last 20 years, leading utilities have deployed cost management strategies to decrease administrative and general (A&G) costs per customer and adjusted non-generation O&M per customer by approximately a 3.4% and 0.5% CAGR respectively, on a real dollar basis.

Utility management teams have historically considered two main options to reduce costs: reshaping service company costs through investments in technology and digitalization of work (e.g., intelligent automation), particularly in finance, customer and other back-office functions; or enhancing field workforce planning, management and execution by evaluating what and how work is performed — often leveraging data and analytics to drive value by bringing workload volumes, scheduling and resource management into harmony.

• Optimize capital efficiency. For regulated utilities, prudent capital spending provides the basis for earnings growth. Utilities with effective capital project lifecycle management capabilities — addressing project identification, asset investment planning/prioritization, project planning and scheduling, execution, and feedback mechanisms for continuous improvement — are effective at deploying capital for the benefit of all their stakeholders. New federal funding opportunities can be strategically leveraged to drive value and establish (or reinforce) this foundation to invest and grow.
• Rethink business purpose. Changes to the overall operating environment are occurring at a pace hard for utilities to navigate, even without a recession. Fundamental business shifts and adverse circumstances provide an opportunity to re-examine all facets of the enterprise — starting with the purpose of the organization. Priorities often require reassessment and rearticulation — are utilities focused on the traditional trilemma of energy sustainability, security (supply/reliability), and affordability, or should they be emphasizing innovation, transformation, and customer value? These paths do not conflict with each other, but the emphasis for the future is clearly evolving toward utilities elevating the basis of performance to focus on integrating execution and investment (purpose) with direct outcomes to customers (value).
• Digitalize the business. Many companies have been chasing digital transformation as a cause célèbre and to advance the technical acumen of their businesses. But these efforts are often limited to technology adoption rather than digitalization, i.e., leveraging technology to redefine business performance standards and execution processes. A purely digital approach allows utilities to substitute promising new technologies; however, digitalization also enables companies to advance the business through directing technology to solve day-to-day execution friction and “hard-wired” inputs (technology) to outcomes (value) to the business and customer. This embedded value orientation links intentional purpose and consequential outcomes from technology adoption directly to the performance model and rearchitects how customer benefits are delivered.
• Pursue the “performance frontier.” Utilities have been serial cost cutters over the last several decades and have become very adept at it. But just as strategy needs a North Star to guide direction and priorities, cost management requires a similar aspirational target to drive targets and outcomes. While incremental cost reduction methods like activity value analysis, lean principles, zero-based budgeting, and best-in-class standards can yield meaningful results, they still reflect conventional approaches. A more challenging and higher-yield model is to drive the business toward the “performance” or “efficient” frontier depicted below, i.e., the theoretical boundary where optimal cost and service converge and relevant objectives are incorporated — business purpose, utility role, service levels, and value delivery to shareholders and customers – by adopting a different set of lenses to view the business, such as the value of scale, unconventional ownership, digital thinking, and redefined incentives.

Focus on market prices and outcomes

This requires utilities to identify “frontier” levels of execution optimization considering the prioritization of targeted outcomes, revolution in delivery models, and trade-offs between objectives and incentives — thus, resetting the standards of performance and value delivered through execution. Embracing this philosophical mindset enables management’s expectations of the art of the possible to grow from tens of millions for large companies, to unlocking hundreds of millions in fundamental costs, while elevating the bar on service delivery accomplishment levels.

• Expand regulatory strategies. Given the continued increase in utility capital expenditures in recent years and current record inflation levels/commodity prices, many utilities and regulators are working together to develop innovative rate-making mechanisms to enable timely cost recovery. Some recent mechanisms worth exploring by utilities include alternative ratemaking (formula and performance-based rates), demand decoupling, and innovation investment recovery (riders for grid modernization, distributed resources, and energy transition technologies). Utilities also need to determine how to best weave BIL funding (which partially supports new capital investments, often requiring matching funds that utilities will want to rate base) and IRA tax incentive opportunities into their strategies.
• Accelerate ESG-focused investments. A focus on assets that accelerate decarbonization and ESG strategies is driving an uptick in energy transition technology deals. In the recently conducted EY CEO Survey 2022, 90% of CEOs surveyed consider ESG issues in their buying strategies, while 6% admitted having walked away from deals due to ESG-related concerns. While many utilities still do not have explicit short- and long-term blueprints to improve ESG performance, we believe the regulated utility business offers significant upside — principally through use of the IRA tax incentives to invest in a range of low-carbon growth options, from “mature” renewables/storage to less mature carbon capture, hydrogen, and small modular reactor (SMR) technologies. Similarly, utilities can carve out nonregulated new business models focused on growth — including providing energy services for C&I customers, participating in scaled EV infrastructure development, owning renewable assets, introducing new energy systems (hydrogen, SMRs), and building out distribution service platforms. In each of these cases, utilities can partner with OEMs, software developers, and solutions providers as “force extenders” to extend market “reach” and access to expertise, capabilities, funding, and distribution channels.
• Expand the business portfolio. Since the last major recession (2008–10), multiple utility combinations have taken place; merger and acquisition (M&A) activity has significantly reduced the number of investor-owned utilities in the US. However, large utility M&A activity was relatively muted prior to the pandemic, as valuations were quite elevated. Over the last two years, though, multiples for companies with higher commodity exposure or unregulated assets have dropped, while fully regulated companies have maintained their premium valuations. The valuation gap is creating opportunities for companies with strong balance sheets to identify targets. But inorganic growth does not need to come from traditional corporate M&A; plenty of value chain options exist to strengthen the portfolio — e.g., assets, properties, or lines of business that can provide scale or market presence to produce value. Each of these alternatives can help utilities build asset depth, customer presence, revenue sources, and/or market value.

Just as potential effects of the expected recession will create adverse outcomes to utilities, unprecedented opportunities will become available to companies thoughtful about how to optimize the time available before the “official” recession fully affects the economy. Many companies recognize that internal recession responses are far more controllable than externally directed moves, and both types of actions are necessary to lead to an advantaged market positioning when the economy recovers. Consequently, game plans may not reflect a single strategy; rather, they will be built with flexibility in mind so that trigger points are identified to drive action and off-ramps readied should economy, market, and customer impacts and paths be different than initially planned.

Summary

In the looming economic recession, utilities can deploy integrated strategies such as evaluating non-core assets and operating expenses, optimizing capital efficiency, rethinking business purpose, and digitalizing the business.