Are These Stocks Bound for a Death Spiral?

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.

<TRANSCRIPT>

Coffina: Distributed generation is still a very nascent trend at this point, representing less than 1% of overall electricity generation, but assuming that it does start to take off, which utilities would you say are most potentially exposed?

Miller: The key right now are those utilities and areas where there is very good solar efficiency. You think about the Southwest, you think about California, and you think about Florida, some other areas, Texas, where you have very good solar resources that allow customers to put solar panels, whether that's residential or commercial/industrial, and serve a significant amount of their electricity demand through those highly efficient solar panels.

We see utilities in those states, those regions with the centralized grid networks that they have to support, pay for, service debt, service equityholders. They're the ones most at risk if you see a significant amount of distributed generation.

Coffina: Any particular stocks you'd call out either as relatively favorably positioned or relatively at risk?

Miller: Anybody with a significant source of earnings from unregulated centralized networks. Here we think about baseload, very large merchant or wholesale generators. Think about an Exelon, think about a Dynegy, think about a FirstEnergy, some of these utilities that own very large power plants, their power isn't necessarily needed anymore if we have a surge in distributed generation.

On the flip side, there are also regulated utilities that own the transmission wires, the distribution wires, some of that big centralized wire pipe network that will be hurt from lower usage in their centralized network. Again, we think about regions where you have favorable solar dynamics and we think about areas where you have less favorable regulations. So Pinnacle West is one of those that we've identified where you have a relatively poor regulatory environment and you have the potential for a large distributed generation penetration.

Coffina: Thanks for joining me, Travis.

Miller: Thank you.

Coffina: In conclusion, distributed generation is still a nascent trend, but it is a long-term risk that utility investors should have on their radar. Companies with large unregulated merchant generation could be most at risk or companies in the South, Southwest, Southeast, with relatively favorable solar dynamics and relatively unfavorable regulation would be potentially at risk.

For Morningstar StockInvestor, I'm Matt Coffina.

	StockInvestor Newsletter
	Want specific core stock ideas from Morningstar? Subscribe to Morningstar StockInvestor, where Matt Coffina uses our robust data, research and analysis to find the best wide-moat stocks to own.	One-Year Digital Subscription 12 Issues | $125 Premium Members: $115 Easy Checkout