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By Matthew Coffina, CFA and Travis Miller | 03-19-2014 02:00 PM

Are These Stocks Bound for a Death Spiral?

Though currently a small percentage of the sector, distributed generation is a threat that could erode utilities firms' moats over the long term.

Matt Coffina: For Morningstar StockInvestor, I'm Matt Coffina. I'm joined today by Travis Miller, who is the director of our utilities team, and we're going to talk about the threat of distributed generation to utilities.

Travis, thanks for joining me.

Travis Miller: Hi, how are you doing?

Coffina: What is distributed generation?

Miller: Distributed generation, very simply, is when a smaller user, like a hospital, another industrial firm, or even an individual user, starts creating their own electricity, and the primary threat here is from solar generation. Very simply, a customer puts a solar panel on their roof and they start generating electricity from that and in many cases, they can generate and produce 20%, 30%, 40% of their daily electricity use from that.

Coffina: There is a fear that distributed generation could lead to a so-called death spiral for utilities. We may already be witnessing this with a few European utilities. Can you explain how a death spiral would occur?

Miller: We think about, again, this example where a residential customer puts a solar panel on his or her roof and all of a sudden they only need 60%, 70% of the electricity from the centralized grid system than they were previously using. When you reduce that usage element, the utility that operates a centralized grid realizes lower returns on all that investment that they've already put into the grid; essentially the grid is utilized less often.

When you have fewer customers or lower usage supporting a gigantic centralized grid, it lowers the returns that utilities get on that investment, and that can go from power plants to very large coal, nuclear, gas power plants, all the way down to the meters at individual houses and businesses that the utility has installed.

Coffina: What can utilities do to prevent the death spiral scenario?

Miller: The key here is regulation, and the key is to make sure that regulators understand the importance of the centralized grid network and the threat from distributed generation. If regulators can balance this mix between customers that are still on the grid and get 100% of their power from the grid and those customers who have gone with some other type of generation source at the local level and are using less generation and less electricity or natural gas in some cases, mostly electricity. If the regulators can balance that, then the utilities should be made whole.

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