Why Utilities have Avoided Disruption Thus Far – Financial Metrics

This is part 3 of a series on disruption of electric utilities.

Disruption of Electric Utilities
1.  Background on Utilities
2.  Why Utilities have Avoided Disruption Thus Far – Reliability
3.  Why Utilities have Avoided Disruption Thus Far – Financial Metrics
4.  Community Choice Aggregation is a Red Herring Disruptor
5.  Distributed Solar is the Real Threat - Trends
6.  Distributed Solar is the Real Threat - The Difficult Position of Utilities
7.  A Survival Strategy for Utilities

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Across industries, low-end disruptions are among the most common forms of disruptive innovation.  A low-end disruption occurs when a new entrant targets the lowest margin customers of an incumbent company.  Examples include steel minimills, which first produced low-margin rebar rather than high margin sheet steel, or Toyota USA, which started with the low-margin Toyopet and Corona models before moving up market to make Lexus vehicles.  Low-end disruptions occur because incumbent companies do not mind losing their lowest margin customers, and thus do not waste their resources fighting new entrants.  Unfortunately for incumbents, a rational pursuit of short-term profit maximization, can lead to a longer term disruption as new market entrants are able to gain a foothold in the market and move to higher margin products over time.

Utilities have been resistant to low-end disruption because they are unique among industries in the way they measure profitability.  Since the utility regulatory structure was established, utilities have been able to collect revenue according to a revenue requirement formula.  The revenue requirement is the total amount that the utility is allowed to collect from customers and, with demand forecasts, is used by regulators to set retail rates for consumers:

Utility revenue requirement = opex + (rate base * rate of return)

Opex is equal any operations and maintenance costs the utility faces as well as fuel costs if the utility owns generation assets.  A utility’s rate base is equal to its capital expenditures minus depreciation.  The utility’s rate of return is an agreed upon figure which is negotiated with state public utilities commissions for distribution assets, and the federal government for transmission assets.

The unique part about the utility profit formula is that there are no low-margin customers.  It is more expensive to build utility assets to serve customers in rural areas compared to those in dense urban areas, but all utility assets contribute to the rate base.  The costs associated with the more expensive customers are simply redistributed and collected in the rates of all customers.  Under this unique profit formula, a utility will respond aggressively when a new entrant targets any utility customer.