Managing Director & Senior Partner
At one time, following the standard playbook paid off for power and utility players. That’s why companies have increased their exposure to regulated businesses in recent years. By doing so, they benefited from safer, more stable returns. But the playbook’s rules keep changing and so does the field of play. Disruptive forces from new technologies and market transitions are growing by the day, and utilities need to respond or risk falling behind.
Understanding how the TSR leaders have achieved success provides insight into the shareholder value creation drivers of the future. Companies that followed the standard utility playbook—by increasing the rate base, exiting riskier business areas, and keeping costs in check—delivered TSR in the middle of the pack over our five-year study period from mid-2013 through mid-2018. To be in the vanguard, companies had to demonstrate that they could adapt to change by placing big bets on adjacent noncommodity businesses and embracing emerging technologies. This ability will be essential as the industry continues to transform in radically new ways.
In BCG’s overall 2018 Value Creators study, the global power and utility industry delivered median TSR of 10.9% from 2013 through 2017, placing it in the bottom quartile of those rankings. For this study focusing on power and utility companies, we selected a sample of North American players so that we could better understand the drivers of TSR in a common regulatory environment and identify actions that companies need to take to maximize their TSR performance in the future. (See the sidebar “Companies in Our Sample.”) We also extended the time horizon through June 30, 2018, in order to provide a more timely analysis. TSR for the 32 companies we analyzed averaged 13% from the end of June 2013 through the end of June 2018.
Our sample of 32 North American power and utility companies (4 of which were Canadian) includes two broad categories: unregulated businesses and regulated businesses.
The seven unregulated players are hybrid companies that are engaged in more than one activity across the energy chain and whose generation business is primarily in competitive energy markets. These companies deliver between one-fifth and five times the electricity they generate via their networks, and the regulated portion of their generation portfolios constitutes less than 60% of their total portfolio.
The 25 regulated businesses comprise networks and integrated companies. The six network companies deliver more than five times the amount of electricity they generate. Several also own gas transmission and distribution (T&D) assets. The remaining group consists of integrated players. They deliver between one-fifth and five times the electricity they generate via their networks, and more than 60% of their generation portfolios are regulated. Several of these companies also have gas T&D networks as well as midstream assets.
Power and utility companies display less share price variation than companies in other industries because their return on equity is largely set by the regulator and is therefore more stable than in other industries. Many investors value the fact that utilities are defensive, noncyclical or less-cyclical stocks. But while the overall performance of North American power and utility companies was modest compared with that of other sectors—almost all of which produced leaders with TSRs of 40% or above—a closer look reveals notable variations. Fourth-quartile TSR performers produced an average annual TSR of just 4% over our study period. By comparison, top-quartile performers delivered an average TSR of 18%.
The new imperative to adapt rather than rely on well-worn strategies was reflected in individual TSR drivers. (See the sidebar “The Components of TSR.”) Debt reduction and generous dividend contributions were key components of TSR among first-quartile companies. But so too was multiple expansion as investors rewarded TSR leaders with higher valuations in anticipation of future growth. For the sector’s laggards, sales growth was the main driver of TSR, while multiple expansion and cash flow contributions had little impact.
Total shareholder return is measured as the return from a stock investment, assuming all dividends are reinvested in the stock. TSR is the product of multiple factors. (See the exhibit below.) Our model uses a combination of revenue growth and margin change to assess changes in fundamental value. The model then factors in the change in a company’s valuation multiple to determine the impact of investor expectations. Together, these two factors determine the change in a company’s market capitalization and the capital gain (or loss) for investors. Finally, the model tracks the distribution of free cash flow to investors and debt holders in the form of dividends, share repurchases, and repayments of debt to determine the contribution of free-cash-flow payouts to a company’s TSR.
The leaders and the laggards shared some common characteristics. These traits united companies regardless of whether they were network businesses, integrated utilities, or hybrid players. Front-runners and midtier companies both followed the industry playbook, but leaders excelled at responding to market disruptions. TSR stragglers failed to deliver new projects, displayed operational weaknesses, or missed market opportunities.
Several macroeconomic tailwinds eased the financial pressures on North American power and utility companies over the past five years. Historically low interest rates and the impact of low wholesale gas prices on the utilities’ generation costs allowed them to invest without causing large hikes in total energy bills.
Given this favorable environment, many utilities stuck with a familiar strategy centered on their core business: increasing capital expenditure to boost their rate base and maximize regulated revenues, keeping a lid on operating costs to contain bill growth, and improving their record on outages to meet the regulator’s reliability expectations.
Switching out of competitive power-generating businesses, which sell their output in unregulated markets, and into regulated assets was another important page in the utility playbook. Conventional generation has come under pressure as demand for power in the developed world has plateaued, while an abundance of inexpensive natural gas has challenged the economics of nuclear and coal-fired generation. The rise of energy efficiency measures, distributed generation, and utility-scale renewables and storage solutions has contributed to the changing market dynamic. In response, companies have increased their exposure to regulated assets through acquisitions, divestments, and asymmetrical investments in the rate base.
By taking these measures, companies delivered TSRs of 8% to 14%. Following the industry playbook effectively and optimizing their core business—as several midtier players did—only got companies so far, however. This approach was a necessary step, although it was not sufficient to make companies TSR leaders. Utilities that were looking to produce strong TSRs for their shareholders and to differentiate themselves from their peers had to deploy other strategic moves as well.
One reason was that tending to the core business, unsurprisingly, was not a unique strategy. Companies generally kept the increases in their operating expenses in line with their revenue growth. Similarly, nearly all of the utilities successfully upped their rate base over the period. While TSR leaders increased the rate base by 9% per year on average, the laggards as well as the players in the middle of the pack also boosted the base at a healthy rate, with both of these groups averaging 7.5%.
Other parts of the playbook produced greater variability. Some companies were better than their competitors at improving network reliability—reducing the duration and the frequency of power outages, for example. But while this may have bolstered their standing with regulators, it did not translate into higher shareholder returns. (See Exhibit 1.) And while hybrid and integrated players shifted their portfolios into regulated power and utility assets, this move did not lead to higher TSR.
The secret to TSR success lay in how companies reacted to market disruptions and opportunities.
Benefiting from Gas Pipeline Spending. Integrated utilities NiSource (the top TSR performer in our study with an average annual TSR of 25%) and CMS Energy as well as network company Atmos Energy generated a greater share of their revenues over the period—nearly one-third on average versus one-tenth for TSR laggards—from gas distribution, a growth market. These companies were willing and able to deploy capital for investments. As a result, they benefited from a rapid and substantial ramp-up in infrastructure spending to replace aging cast-iron gas pipes following the 2010 pipeline explosion in San Bruno, California; the incident led to favorable regulatory settlements for gas utilities that invested in their networks. (See Exhibit 2.)
Expanding into Adjacencies. Placing significant bets on adjacent businesses was another route to TSR leadership. Some utility companies secured their position near the top of the pack by aggressively expanding in utility-scale wind- and solar-power generation, disposing of fossil fuel assets, and investing in renewable-energy storage. TSR leaders DTE Energy and Ameren moved into activities outside their core business, adding power transmission and gas storage, transportation, and marketing to their portfolios.
In all these cases, players made large enough investments that the new business areas added meaningfully to earnings. Indeed, companies with businesses in competitive noncommodity adjacent areas that contributed at least 10% to earnings generally had a higher TSR (as much as 5% higher depending on the period) than those with little or no earnings contribution from these areas. (Competitive noncommodity adjacent areas are adjacent businesses unrelated to commodity-fueled merchant power generation, such as competitive transmission and natural gas pipelines.)
For utilities that miscued their expansion into adjacencies, however, shareholders were often unsympathetic. Companies that came late to the party, overpaying for acquisitions in new business areas as a result, saw their share prices slide, ranking in the bottom half of our sample.
Failing to execute properly and not responding to market trends were the main reasons that some companies were TSR laggards. And unlike others in our sample group, these companies’ earnings margins shrank and their debt increased over the period. There were three main areas where these companies disappointed.
Public-Safety Shortcomings. Companies that handled public-safety incidents poorly, raising concerns that equipment maintenance or other operational failings were partly to blame, typically produced weak TSR. Regulatory interventions and investor uncertainty about the extent of the utility companies’ liability exacerbated share price declines.
Project Overruns. Poor project execution inhibited TSR performance for some companies. In a few instances, big cost overruns and delays led to project cancellations or suspensions, executive resignations, and investigations. The lesson is clear: keeping large-scale capital-intensive projects on time and on budget is essential if utilities hope to create value for shareholders. Failure to deliver on projects can be extremely costly and can leave companies at the bottom of the TSR rankings. Three of the eight performers in the fourth quartile of our sample, including the bottom-ranked company, either were hit by project overruns or had exposure to a utility that was affected.
Missed Market Trends. Reluctance to switch out of legacy businesses was another sure-fire way to deliver poor value creation. One company that delivered fourth-quartile TSR was hurt by its strategic commitment to continue with uneconomical nuclear and coal generation rather than move to regulated assets. For utilities, such overreliance on legacy operations can mean being left behind in an evolving marketplace.
The future will demand changes from all players, whether it’s a shift in strategic direction or an acceleration of current initiatives. High-performing companies have shown that they can take the steps required to adapt to evolving market dynamics. But none of them can afford to rest on their laurels if they want to be in the vanguard of future shareholder value creation.
Power and utility companies will need to find new ways to increase their core generating and network businesses in the face of mounting cost and regulatory pressures. But they will also have to prepare for growing disruption from the rise of distributed generation, digitization, and changing load profiles by expanding into adjacent markets and redefining their role in the energy landscape.
North American utilities are facing a cocktail of pressures: weak growth in demand for grid power, the need to replace aging assets, and the impact of rising interest rates on their borrowing costs. By expanding their rate base, utility companies can increase revenues and meet their financial commitments. Many utilities have guided their shareholders toward projected average annual earnings growth of 6% from 2017 through 2022. This will require that utility companies make significant investments in their rate base so that they can boost regulated revenues to meet these targets. Because of the outlook for modest load growth and regulators’ determination to ensure that energy bills don’t rise above inflation, however, the growth in regulated revenues is unlikely to be sufficient for companies to meet their earnings targets. We estimate that the revenue gap could be as much as $41 billion by 2022. (See Exhibit 3.)
Confronted with such revenue shortfalls, companies have a few options. One is to increase earnings by further reducing their operating and maintenance costs through lean operations, outsourcing, more efficient use of capital, and reorganizing their portfolios to create efficiencies. Strategic M&A is another source of cost savings: Wisconsin Energy’s 2015 merger with Integrys Energy produced $130 million in synergies by combining administrative, planning, and procurement functions, thus creating headroom for rate base growth without big hikes in customer bills. Investing in advanced analytics technologies to reduce costs is a third option.
Utilities will still need to work harder at boosting their rate base by persuading the regulator to approve spending on initiatives that benefit users and the wider community in new ways, such as making the power grid more resilient or increasing electric-vehicle usage (which could lower households’ overall energy bills—given that EVs are becoming less expensive to operate than traditional vehicles—and reduce their carbon footprint). By pursuing these forward-looking investments, utilities will be able to make a strong case to the regulator for above-inflation returns.
As the energy landscape evolves, new areas are growing in importance. Distributed generation and energy storage technologies are allowing individuals to disconnect from the grid, generate power for themselves, and sell the surplus back to their local utility. (See “The Power Grid of the Future,” BCG article, July 2018.) The proliferation of data from energy systems is driving the growth of smart meters and other Internet of Things devices. Digitization also promises to transform grid operations, with sensors enabling real-time network monitoring while predictive maintenance reduces outages and cuts repair bills.
In tandem with these transitions, utilities’ relationship with their customers and the agencies that govern them is changing irreversibly. Consumers expect a more personalized experience, 24-7 access to bill information from their digital devices, greater choice about how their energy is generated, and more control over energy usage through smart-home energy management systems.
Regulators are responding to market transitions with alternative models and fresh demands. In New York, the regulator requires utilities to produce one-third of their energy from renewable sources and penalizes companies that don’t. Meeting the growing thirst for clean energy is only one example. Utilities are also being asked to do more with their aging infrastructure by delivering new standards of resilience, reliability, safety, and customer choice.
Meanwhile, regulators are altering the ways in which they reward companies. They are shifting from cost-plus compensation to models that give utilities an incentive to improve their performance and offer new products and services. Through innovative cost recovery mechanisms, New York’s regulator offers incentives to utilities that facilitate grid connections to renewable-energy sources and curb customer usage through demand management initiatives.
These nascent developments will accelerate over the coming years. Some disruptions will pose a threat to incumbent utilities, but others will offer opportunities to create shareholder value for companies that can adapt. Indeed, a handful of utilities are already investing in electric-vehicle-charging infrastructure. Further out, companies may partner with local governments on smart-city solutions, which use advanced 5G sensors to manage traffic congestion and alert drivers when parking spaces become available, for example.
We expect utilities to adopt different business models for the future, with varying degrees of participation. These models will focus on three areas: grid assets, platform services, and retail and behind-the-meter offerings. (See Exhibit 4.)
Utilities will face both opportunities and challenges in the future. As companies advance their strategies, they need to consider the following steps.
Be Proactive in Shaping Regulatory Decision Making
Future TSR leaders will help drive the regulatory debate about rate base expansions and key policy decisions. They will engage early with industry, environmental groups, and nonprofit organizations and will partner with other utilities to build support for the investment proposals they submit to the regulator. They will ensure that company plans remain in step with changing regulatory structures and will work proactively with the regulator on pilots that support their business case.
Segment Potential Business Opportunities
Forward-thinking companies can’t rely on a one-size-fits-all philosophy for investment. They need to use different strategies depending on how a new area fits within their existing business and capabilities. Some adjacencies, such as utility-scale wind and solar-power generation or electric-vehicle-charging infrastructure, will merit substantial investment with the aim of achieving a significant uplift in earnings.
Early-stage opportunities that are still being tested—such as many smart-city applications—will require a toe-in-the-water approach that relies on low-investment pilots. Nascent technologies that have yet to display their full impact on energy markets, such as blockchain, will need to be actively monitored in case they become major disruptors. Companies will also need to be alert to shifts in their traditional business areas that will result from changing spending priorities, as happened in the gas market following the San Bruno explosion.
Maximize the Potential of Digital
By investing in big data technologies, companies can generate savings and manage their core businesses better using advanced data-driven analytics. These technologies can help companies identify new revenue sources and invest their capital more efficiently, find ways to reduce spending on operations, and enhance workforce productivity. (See “How Utilities Can Boost Workforce Productivity with Digital,” BCG article, March 2018.) They can also lead to improvements in network reliability, customer satisfaction, and safety. And they can drive reductions in customers’ bills and support utilities’ investment cases with regulators.
In our study of one US utility, we found that the company generated savings of $1.3 billion from an initial investment of $500 million. It developed more than 60 use cases for advanced analytics solutions across the business, including in the areas of grid assets, smart energy services, advanced metering, customer-facing activities, and support functions.
Foster a Culture of Change
To be in the TSR vanguard, companies need to be agile and responsive to change. They need to understand how new technologies and market shifts will affect the industry, create strategies for transforming their business so that it’s ready to compete in this evolving world, and set out a detailed approach for getting there. This roadmap will involve defining the necessary resources and assembling a leadership team that can drive change as well as acquiring the capabilities and skill sets to fill any gaps. Companies will also need to create an internal culture of innovation that is customer-focused, open, nimble, and capable of failing fast.
Utilities face a particular cultural challenge: planting the seeds of innovation while preserving the legacy values of safety and reliability. Companies that can do both and create a two-speed culture are well on their way to being TSR leaders.
The power and utility TSR leaders of the future will be companies that access new value pools where they have a competitive advantage. They will place big enough bets on these new business lines to reap the rewards in higher earnings. They won’t lose sight of their core business, but they will also strike the right balance between legacy and innovation. The transition is, without doubt, a difficult one. But by taking action now, companies can emerge as leading value creators in the years ahead.
The full list of companies that BCG tracked for this report is as follows.