Executive Summary The U.S. energy landscape is on the cusp of a new era. Fundamental change, driven by regulatory and environmental pressures, technological developments, and demand management issues, has created opportunities for new entrants to break into the market and muddied the waters for the established bastions of energy production and distribution – utilities. Competition between these new rivals – distributed energy players and tangentially-related tech companies and startups – and traditional, vertically-integrated utilities is heating up. They aren’t fighting over resources; their battle is with the customer and competing for share of mind. At the same time, U.S. energy utilities are searching for revenue and growth. Energy efficiency and distributed energy initiatives have led to flattened overall demand and projected usage declines. The industry has turned to mergers and acquisitions (M&A) as its primary strategy to achieve growth, but sustained activity is dependent on deal fundamentals remaining strong and available acquisition prospects. This transitional period for U.S. energy utilities is not unfamiliar – every industry undergoes transformation at one point or another, and the mark of a successful business is the ability to adapt with it. But these particular set of changes have direct parallels to the transformation of another utility landscape: the energy industry following deregulation in the UK. Much like in the U.S. presently, UK energy deregulation brought about sweeping changes that ultimately resulted in heightened levels of competition and challenges to continued growth. British Gas, the monopoly gas supplier in the UK for decades, recognized that it needed to shift its business model and find new sources of revenue growth. Initially, the company diversified by moving into the electricity sector, but competition only increased as large electricity utilities began entering the gas market by cross selling gas to their electricity customers and through M&A. These new multi-utilities threatened to steal not just market share, but brand equity. British Gas needed another way to diversify its revenue streams, set itself apart from its competitors, and re- establish its position as the number one trusted advisor in the energy space. The company focused on growing its home services division, which provided residential customers with maintenance and repair service plans underpinned by boiler replacement, from an insignificant piece of its business to a fully supported division. Not only was the program immensely successful from a financial perspective, it would serve as a competitive differentiator and valuable customer retention tool. As energy utilities executives consider how to manage change in the new era, British Gas and its residential services division offers a proven model for success. 1 About the Author Sir Roy Gardner has extensive corporate experience, first in executive roles in the utility, telecommunications, and defense sectors, and then as a non-executive director for a wide range of companies. In his last executive role, he was Group Chief Executive of Centrica plc from 1997 to 2006, having taken the reins following the privatization of British Gas, and was responsible for growing the UK-centric gas supplier into a major multi-national energy business that more than doubled revenues over the period. Sir Roy was knighted in 2002 for services to the gas and electricity industries. After stepping down from Centrica in 2006, Sir Roy was appointed Chairman of Compass Group plc, the global food services and catering group, where he served until February 2014. He is currently Chairman of EnServe Group Ltd. and of Mainstream Renewable Power Ltd., and a non-executive director of Willis Group Holdings plc and of William Hill plc. In addition, he is a Visiting Fellow of Oxford University, Senior Adviser to Credit Suisse Group, ex-Chairman of the Government's Apprenticeship Ambassadors Network, and Chairman of the Energy Futures Lab at Imperial College. 2 SECTION I. IOUs FACING ENORMOUS CHALLENGES, OPPORTUNITIES For years, U.S. energy utilities operated profitably as vertically-integrated entities with limited outside competition. Now, however, industry insiders and experts agree that the energy utility industry of the future will not look like it does today, and investor-owned utilities (IOUs) will no longer be able to operate in exactly the same way. There may not be consensus on the timing of the dramatic changes in store for the industry, but there is no doubt that big change is coming. Many of the anticipated changes pose significant challenges to current utility financial and operational models. For a hundred years, utility executives have assumed that growth in gross domestic product (GDP) and energy sales were intertwined. But while our GDP has rebounded from the Great Recession, sales have been lagging for seven consecutive years, despite the abundance of new tech gadgets. That century-old dynamic appears to be irrevocably changed.1 Underscoring this trend, the U.S. Energy Information Administration estimates that retail electric sales will grow at an annual rate of 0.8% through 2040,2 under the 1% growth in sales utilities need to keep ahead of growth in expenses.3 A number of Wall Street analysts, including Citigroup, Bank of America, Goldman Sachs, and UBS, recently warned about the “decline of the traditional utility” as new market threats have entered the energy sector.4 Beyond Wall Street, pundits have opined on the urgency of the challenges facing utilities. News headlines like “Why Are Utilities Letting Other People Take All the Value?” and “Dear Utilities, Change or Get Dumped” are indicative of the state of affairs.5 6 Their message is straightforward: if utilities want to survive in the energy industry of the future, they need to understand the transformations that are happening now and lie ahead, evolve their businesses and find opportunities to move forward. Distributed Energy: Biggest Change on the Horizon Distributed generation is often cited as the biggest threat to the traditional vertically integrated IOU model. Many business and residential customers are taking their energy needs into their own hands and generating their own power. A recent article in The Wall Street Journal cites the example of Arizona-based Sherry Pfister, who leased solar panels for her home, cutting her utility bill by a third.7 Unless utilities are able to assist customers in managing energy use and provide other value-added services, customers are increasingly going to shift toward the do it yourself energy model. While U.S. utility customers currently generate only a small fraction of the nation’s energy supply from distributed sources, European countries, where solar and other distributed sources comprise a much higher percentage of electricity generated, serve as a bellwether for the future. Peter Terium, CEO of RWE, a traditional centralized distribution electricity utility in Germany and the parent company of npower, one of the “Big Six” energy providers in the UK (discussed later in this paper), acknowledged the inevitability of this shift: “We have to adjust to the fact that, in the longer term, earning capacity in conventional electricity generation will be markedly below what we've seen in recent years,” Terium said, adding that this put strains on RWE's business model.8 The development of renewable energy sources is not just being pushed by distributed energy players like solar and wind businesses; state governments are also advocating for renewable energy in the form of Renewable Portfolio Standards. These standards, mandated in 29 states and the District of Columbia, require utilities to generate a certain percentage of their power from renewable sources, essentially creating competition to the traditional electricity model.9 The states are also demanding utilities undertake energy efficiency initiatives and reduce carbon emissions. And with the announcement of new regulations from the federal government’s Environmental Protection Agency (EPA) in June 2014, these restrictions will be more stringent than ever. The Clean Power Plan gives 3 guidelines on a state-by-state basis to further reduce carbon pollution by 30 percent from 2005 levels as a nation.10 While there are clear environmental benefits to promoting energy efficiency and carbon reduction, these programs are not always integrated with energy utility business models, and ratemaking has not evolved with the regulatory environment.11 Instead, utilities have felt cornered by the new regulations: with the traditional utility price model predicated on the idea that the more energy consumers use, the more the utility profits. To address this, some utilities have chosen to decouple profits from sales to accommodate these changes, leading in some cases to higher rates for customers. Competition from New Market Entrants New market entrants are another major challenge promising to disrupt the energy IOU industry.12 There are a number of new entrants making inroads into the sector, from the assumed to the unexpected, including those focused on generating electricity from renewable sources such as wind, solar and biomass, as well as energy management technologies that allow consumers and businesses to reduce their energy consumption, even tech giants like Google, which acquired Nest Labs in January 2014. With its acquisition of Nest, Google also acquired its signature product, the Nest Learning Thermostat, the world’s first “smart thermometer”