As business fundamentals shift dramatically, how do utilities expand their value proposition?Identifying opportunities and risks across the evolving P&U value chain

Table of contents

Introduction 1

1. Market outlook 2

2. P&U value chain: issues and business opportunities 3

2.1 “Gassier” business models 4

2.2 Electric transmission 6

2.3 Utility-scale renewables 7

2.4 Other emerging options 8

3. Strategic considerations framework 10

Summary 12

Notes and sources 12

The US electric power sector continues to face internal and external drivers that challenge the traditional operating model for incumbent companies. The baseload, centralized and single directional grid design is quickly transitioning to a more intermittent, distributed and interactive model enhanced by two-way flows of electricity and data. The economically dispatchable generation mix is shifting from high carbon, coal-dominated supply to a low or no carbon mix where natural gas, distributed and renewable sources are ascendant. Customers are emerging as the center of the new utility business landscape, and are evolving from rate payers to “prosumers” who can self-generate for their own energy needs as well as distributing energy to other customers directly or through the grid. These and other emerging drivers are raising questions for stakeholders across the entire power and utilities (P&U) value chain, including generators, transmission operators, distributors, retailers and other service providers.

Traditionally, regulated utilities have offered predictable capital investment-based growth that translates into a low-risk business model – attracting investors through modest growth and consistent dividends. However, given the ongoing flat energy demand resulting from a weak economic recovery for energy-intensive businesses, improvements in energy efficiency and an increased adoption of distributed energy resources, the traditional investments that have typically associated with expansion and redundancy are coming under greater regulatory scrutiny. While regulators across the country recognize the need for utilities to invest continually in grid maintenance, modernization, resiliency and security, the appetite for rate increases for these focus areas is finite and in competition with other more customer-driven goals. The balance struck between these competing interests, in a rate-constrained world, will be made on a jurisdictional basis.

Another possible model, the diversified or hybrid business model, at its best spreads the risk of long-term earnings stagnancy by broadening the utilities portfolio to multiple businesses. With any portfolio, while the goal is diversification, there is no guarantee that it will be successful or enough to offset losses in other areas. If lower corporate taxes are realized as discussed by the Trump Administration, diversified utilities1 with unregulated businesses will likely be the beneficiaries of improved earnings and cash flows. However, the merchant generation segment for these companies is facing severe headwinds from low natural gas and power prices and

new environmental regulations. Several companies have vacated the generation business line through asset sales or shutdown of capacity, while others are still evaluating the expected cash flows from these generation assets.

Recently, several new focus areas have emerged for electric utilities across the P&U value chain, which have the potential to provide revenue growth opportunities, including:

• Investments in the gas value chain — driven by safety upgrades and supported by low gas prices and state and federal regulations, gas utilities have continued to accelerate the pace of investment in their assets. An additional attraction is that the upstream, midstream and transmission segments provide attractive returns. There are plentiful shale gas reserves as well as regional “gas deserts” in New England and elsewhere.

• Investments in utility-scale renewables — renewables economics have also been steadily improving, driven by technical improvements in solar and major economies of scale in wind power. Regulators are beginning to realize the advantages of utility-owned assets and are making adjustments accordingly.

• Investment in merchant transmission — transmission capex in the next three to five years remains significantly above the past cycles, Order 1000 from the Federal Energy Regulatory Commission (FERC) starting to drive awards to nonincumbent players in many key regions (California Independent System Operator (CAISO), PJM Interconnections and the Midcontinent Independent System Operator (MISO)).

• Investments in emerging options — although a small focus at this point, many emerging business opportunities, such as energy management, electric vehicle infrastructure, distributed energy resources and energy storage, have the potential to contribute significant earnings for these companies.

In this paper, we explore the outlook for several attractive business opportunities that have real potential to enhance the traditional utility value proposition – including gas-based businesses, merchant transmission assets, regulated renewable projects and other competitive businesses. We also provide a detailed framework that will inform strategic decision-making on these businesses prospects, focusing on project planning and investment parameters.

Introduction

[ 1 ]

US utilities continue to experience foundational changes in their operating environment that create both challenges and opportunities for companies in this sector. In particular, the sub-group of diversified utilities face the tough task of optimizing their business models and achieving the right exposure to regulated, unregulated and merchant businesses. Some key current market drivers include:

• Evolving energy policies under the Trump Administration, e.g., tax reforms and environmental regulations and the interplay with state objectives

• Increasing interest rates and the negative correlation with valuations of high dividend-yielding utilities

• Low natural gas or power price environment and weak fundamentals of merchant generation

• Rising specific infrastructure requirements, e.g., electric and gas infrastructure replacement or modernization, electric transmission and gas pipelines

• Continued retirements of coal and nuclear generation capacity

• Dramatic growth in distributed energy resources, e.g., rooftop solar and microgrids

• Rising threats to critical infrastructure and data privacy due to digital convergence

• Enhanced customer expectation and commercial savvy

Source: SNL Energy; EIA; EY analysis.Note: P/E multiples are estimated using last 12 months earnings (LTM) of considered companies, including investor-owned electric utilities in the US (purely regulated and diversified utilities).

[1] Market outlook

The ongoing weakness in power prices across the US, primarily driven by low natural gas prices, substantial build-out of renewables and stagnant demand fundamentals, is significantly weighing on the earnings for conventional power producers. For example, in 2017, there have been several instances of negative power prices in CAISO – driven by hydro and other renewables in the region. Currently, there is no consensus on the future of the generation business in the diversified or hybrid business model. While some large companies have recently exited, or have announced plans to exit, the generation sector, many other companies are still operating generation assets – anticipating a rebound in the energy or capacity markets.

However, current policy considerations by the Trump Administration may have positive implications for these companies, including:

• Potential lower tax rates, which are better suited for diversified utilities versus pure play regulated utility business models, where companies have an obligation to refund any savings to customers – only earning their authorized return on equity (ROE).

• The recent executive order2 calls on the US Environmental Protection Agency (EPA) to reverse the Clean Power Plan, lift restrictions on new fossil fuel power plants and end a moratorium on federal coal leasing.

• Lower regulatory oversight and new infrastructure spending proposals could create growth opportunities.

US 10-year treasury yield vs. electric utilities price/earnings (P/E) multiple (%, 2008–present)

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‘08

10y US T-Note Yield (left)

0.00 0.0x

1.00 5.0x

2.0015.0x (X

)

(%)

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5.00 30.0x

P/E (right)

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US spot natural gas prices (US$/MMBtu, 2008–present)

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0

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(US$

/MM

Btu)

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Current forward prices remain near US$3.0 by 2020

[ 2 ]

The traditional value chain for the US P&U sector is rapidly evolving, largely driven by changing supply and demand fundamentals, rising customer expectations and changing regulatory requirements at the federal and state level. The major trends shaping the industry value chain are not isolated to one area, and will have a lasting effect moving forward.

Demand • Stagnant electricity demand, largely due to technology advancements and focus on energy efficiency• Changing customer needs and behavior, e.g., energy management and analytics• Rise in penetration of distributed energy resources (DERs)

Supply • Rapid growth in renewable capacity, mostly because of policy support and improving economics• Changing energy mix, driven by low natural gas prices• Retirement of coal and nuclear capacity, due to regulatory and economic challenges

Regulatory environment • Rising focus on grid modernization, security and resiliency• Declining allowed returns for transmission (FERC formula rates) and distribution assets• Increasing competition in the transmission segment

P&U value chain and investment opportunitiesBecause of this, and within the current environment, utility management teams will need to make increasingly complex decisions to identify and participate in the evolving business opportunities, which should help drive future growth and deliver on investor expectations.

[2] P&U value chain: issues and business opportunities G

asEl

ectr

ic

Utility-scale renewables

Distributed generation (community and individual scale)

Electric vehicles

Merchant transmission

Distributed energy resources

Behind the meterRetailDistribution

Storage Software and analytics

Energy storage

Rising demand (gas-based electric

generation)

Higher usage (gas vehicles, heating fuel

and distributed generation)

MidstreamUpstream

Evolving value chain

Opportunities

Downstream

Energy management and services

TransmissionGeneration

[ 3 ]

In the present environment of weak electric sales and low power prices, finding low-risk growth is a hot topic for electric utilities. With no significant upside to electric sales or power prices in sight, the natural gas value chain provides an attractive investment alternative for large P&U companies.

Multiple P&U companies are already pursuing these gas-based business options through acquisitions, joint ventures and organic investments across the natural gas value chain. The gas utilities subsector is relatively fragmented, with smaller market caps of companies versus their electric and diversified utility peers. With increasing demand and improving regulations for gas pipeline investments, acquisitions of these smaller companies are gaining interest.

Natural gas value chain opportunities As change continues to unfold, the natural gas value chain provides multiple avenues for investment and earnings growth for P&U companies. With disruption and collaboration being relevant in all industries, P&U companies need to react actively and correctly to key opportunities, including:

• Upstream investments. Investing in gas reserves not only drives rate-base growth for utilities, but also hedges exposure to price movements and potential gas shortages in below-normal cold weather seasons. However, these utilities will need to work with their regulators to allow recovery of capital investments.

• Midstream infrastructure. Large P&U companies can leverage their low cost of capital, strong relationships with regulators and deep understanding of their customer usage to make strategic investments in long-distance pipelines. In recent years, multiple diversified utilities have announced interest in investing in large gas pipeline projects ranging from 1-2Bcf/day capacity in east and southeast regions. Some companies have even gone the M&A route to add these assets to their portfolios.

• Improving pipeline reliability and safety. The gas utility industry is deeply focused on improving the safety and reliability of its transmission and distribution network, especially following major accidents in San Bruno, CA (in 2010) and Manhattan, NY (in 2014). According to the American Gas Association (AGA), gas utilities spend more than US$22b annually to help enhance the safety of natural gas distribution and transmission systems. Most states have implemented automatic rate adjustments to encourage accelerated replacement programs, allowing timely recovery of capex in these initiatives by utilities.

[2.1] “Gassier” business models

• Retail sales expansion. Currently, 39 states have adopted or are considering some form of gas expansion initiatives through regulatory requirements or utility-driven programs. Many utilities also have the opportunity to expand customer base by converting existing heating oil or propane customers to natural gas. For example, of the total households in the US using some form of heating fuel, only half use natural gas currently, despite it being the lowest cost option. According to the AGA, households that use natural gas for heating, cooking and clothes drying save an average of US$874 per year compared with homes using electricity for those applications.

• Natural Gas vehicle (NGV) fueling. Many gas utilities are building fueling infrastructure to serve their own vehicles as well as offering public access. There are typically two models of operations: • (1) Regulated tariff model: in many states, utilities have

received approvals from their regulators to establish special NGV tariffs that allow regulated utilities to rate-base and recover their fueling infrastructure capital costs.

• (2) Non-regulated model: a few states have allowed regulated utilities to use grant and leasing programs outside the rate- based structure to build fueling stations.

• Higher usage in electricity generation. Currently, the Henry Hub natural gas price is approximately US$3.0/MMBtu. At these levels, we can expect continued growth in natural gas consumption for electricity generation. Also, driven by increasing grid resilience and integrity issues, microgrids and distributed generation (DG) technologies are gaining momentum. Natural gas-based combined heat and power (CHP) plants are the most commonly deployed microgrid generation units in the US.

[ 4 ]

Growth opportunities for gas utilities

Earnings driver Situation analysis Growth business Declining business

Supp

ly

Regulatory supports9

Service unbundling8

Aging pipelines and lack of key capacity

7

Distributed generation6

LNG exports5

New construction4

Heavier industrial reliance on natural gas

3

Conversions from fuel oil and propane

2

Gas supplies up and prices down1

Regu

latio

n

• Shale gas is >50% of US gas production in 2015

• Prices are down 60% from 2008

• Gas-fueled electrical generation• Chemicals and fertilizers• LNG exports• Natural gas vehicles

• Coal and oil powered generation• Coal fired power plants• Coal mining and related surface

transportation

• Fuel oil home heating• Propane delivery where natural

gas distribution exists

• Heavy electrical sales only• Small and mid-sized

gas and oil companies

• Home and business renovations using fuel oil or propane

• US businesses and facilities reliant upon cheap natural gas: petro chemicals, gas-fired generators, large industrials

• Traditional large electric plant to end user model

• Oil refineries• Petrochemical• Coal fired power plants

• Traditional bundling of commodity, transport and delivery

• LDC selling commodity direct to end users

• Requiring equity to finance improvement projects

• Natural gas appliances (heating, clothes dryer, range) backup generators

• Organic growth opportunities

• Maintaining and expanding industrial customer base

• Petrochemical and fertilizer companies esp. valuable

• Distribution line expansion • Incentive programs to builders

using high-efficiency natural gas systems for heating and cooking

• LNG terminal construction• LNG exporters

• Microgrids• CHP units• NG turbines, fuel cells

• Accelerated interstate and intrastate pipeline replacement programs

• Distribution line replacement and upgrades

• Natural gas marketing• Web-based customer tools• Rebate and incentive programs

• Revenue growth through rate mechanisms for capex spend

• Adding gas reserves to rate base

• Natural gas is heating fuel of choice for residential and commercial applications

• Nearly half of industrial customers are served by natural gas gas local distribution companies (LDC)

• Continued strength in the US construction industry

• First new LNG export facility came online in 2016

• Four new facilities expected to be online by 2021

• Natural gas-fed fuel cells and CHP units are increasingly economically viable

• About 30% of US pipelines were installed prior to 1970

• Need to improve gas and power transmission integration

• 50% of US states participate in customer choice programs

• Increasingly, regulators support timely returns through rate adjustment mechanisms

Dem

and

[ 5 ]

[2.2] Electric transmission

The focus of P&U companies has recently increased on transmission investments, primarily to improve electricity reliability, replace aging power lines, meet public policy requirements and incorporate the rising penetration of renewables (utility-scale and distributed energy resources). The majority of the electric transmission lines and transformers in the US are more than 25 years old3 and were not designed to meet many new demands, such as greater adoption of renewable and other low or no inertial generation sources, growing numbers of DG resources and the need for greater resilience.

Investor-owned electric companies are planning to invest approximately US$84b in transmission construction between 2016 and 20194 – dramatically higher than the past averages. However, the FERC continues to lower the allowed returns for transmission operators, given declining cost of capital for these companies. For example, in September 2016, the FERC lowered the base rate of return on equity previously approved for most transmission-owning members in MISO from 12.38% to 10.32%.

Merchant transmission Issued in 2011, the FERC’s Order 1000 established new requirements with respect to the planning of power lines and the allocation of the cost of those lines both within and between regions. The purpose of the order was to increase regional transmission development by eliminating long-standing monopolies and create competition and incentives for innovative, cost-effective projects.

Order 1000 eliminated the right of first refusal, implying that no utility, RTO, ISO or other entity solely “owns” the right to construct and operate transmission facilities. Any qualified entity, private or public, can bid on construction and/or services. Order 1000 also provided for regional cost allocation of regional transmission projects that allocates development costs according to the level of anticipated benefit.

As incumbents, utilities no longer have the monopoly on transmission projects, and operators from other regions have opportunities to come in and bid against regional entities, after establishing their qualifications and stability. To date, there have been no projects built and operated under Order 1000, but there have been multiple projects awarded under Order 1000 in California, PJM and MISO. For example, MISO selected a partnership led by a nonincumbent developer to build, own and operate the Duff-Coleman 345-kV line in southern Indiana and western Kentucky, the first transmission project selected through a competitive process in compliance with FERC Order 1000 in the region.

According to a 2016 FERC staff report, “Nonincumbent proposals accounted for 48% of all competitive transmission project proposals submitted in CAISO’s and PJM regional planning processes from 2013 to 2015 (excluding the 2015 Regional Transmission

Source: EEI; EY analysis.Note: Transmission spending includes CapX by investment of investor-owned electric utilities and stand-alone transmission companies.

Expansion Plan 2 window in PJM). In CAISO, nonincumbent proposals accounted for the majority of proposals in all three years; in PJM, nonincumbents submitted more proposals than incumbents in 2013 and 2015, but not in 2014, when PJM received the majority of proposals from incumbents.”

As the rules and regulations continue to change, opportunities will continue to surface, and companies looking to capture opportunities will find untraditional and outside-the-box approaches to capitalize on investments and opportunities. Some of the key emerging trends in the merchant transmission space include:

• Nonincumbents are continuing to win project bids:• Multiple recent examples in PJM and CAISO• Previously in non-FERC regions, ERCOT selected

nonincumbents for multiple Competitive Renewable Energy Zone (CREZ) projects, and Ontario ISO selected a nonincumbent to build the East-West Tie Line

• Multiple nonincumbent business models are emerging:• Incumbent-owned subsidiaries entering into JVs • Independent and semi-independent companies • Project-specific partnerships with incumbents • Public-private partnerships • Independent transmission projects

• Utilities are continuing to set up competitive transmission companies

With the growing diversity in transmission business models, expect to see innovative financing models also emerge. For example, real estate investment trust (REIT) mechanisms were only recently recognized as being applicable to certain transmission projects and may provide benefits to developers and operators that exceed traditional rate recovery approaches to transmission expansion.

Annual transmission spending by US companies (2010–2019)

$10.2

2010

A

2011

A

2012

A

2013

A

2014

A

2015

A

2016

E

2017

E

2018

E

2019

E

$11.9

$14.8$16.9

$19.5 $20.1$21.5

$22.5$21.0

$18.5

[ 6 ]

[2.3] Utility-scale renewables

The US has a fast-growing renewable energy industry, with deployments across the subsectors. According to Energy Information Administration (EIA) data, the share of renewables in the US generation mix in terms of installed capacity will reach about 28% by 2025 — with wind and solar photovoltaic (PV) driving the growth. P&U companies will continue to play a key role in development of these assets through direct ownerships, joint ventures or by buying output through power purchase agreements (PPAs). Primary drivers of growth include capitalizing on declining costs, especially for solar; utilizing available tax credits; fulfilling renewable portfolio standard (RPS) expansions; replacing retiring coal and nuclear capacity; and increasing customer demand for green products.

For more details on utility-scale solar generation outlook in the US, read our recent thought leadership report titled What’s the right path to illuminating your solar investment?

Source: SNL Energy; EIA; EY analysis.

Regulatory status of solar and wind capacity owned by US investor-owned utilities

Regulated

Merchant

14%

86%

Utility-scale renewable projects present an interesting challenge for regulated utilities. These utilities need to address two concerning questions: should they make direct capital expenditures, with consequent additions to the rate base, or should they procure power through third-party developers via PPAs? When contemplating both they need to keep in mind the key benefits under the utility-owned model, including the following:

• The utility-owned project is expected to have a relatively lower levelized cost of energy (LCOE), given the lower cost of capital for utilities, driving lower bills for customers. According to a large cap utility in Northeast US, utility ownership for solar translates to a 30% reduction in customer bills and 20% reduction for wind when compared with a private developer ownership, given the access to low cost of capital by the utility. Also, utilities can ease any interconnection or transmission issues and costs with the project.

• The utility-owned model retains the full asset value for local customers and provides for the depreciated asset’s low-cost generation, and the renewable credits stay within the state for the entire life of the asset. This is not always the case with PPAs after the offtake contract expires.

• Any O&M cost improvements achieved in the future due to asset management improvements would be passed on to customers under the utility-owned model. Under the PPA approach, these benefits would go to the asset owner.

• Any higher-than-expected earnings through tax credits, energy and capacity market value would benefit customers, given the reduction in revenue requirements for utilities.

Installed solar and wind capacity as a % of total US capacity

0.00

2015

Wind Solar Wind and solar as a % of total US capacity (right)

2016

2017

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2020

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0.00%

50.00 5.0%

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(GW

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250.00 25.0%

[ 7 ]

[2.4] Other emerging options

New and emerging technologies are not only providing utilities with the tools to modernize their infrastructure, but also can drive earnings growth for these companies. On the supply side, DG and storage are considered a threat to the traditional utility model. However, by embracing these technologies, and incorporating them in their business models, utilities can somewhat manage these threats. On the demand side, new sources such as electric vehicles (EVs) will also create the need for new infrastructure that could benefit utilities.

Name Description

Energy-as-a-Service

With evolving technologies such as wind and solar power, battery storage and microgrids emerging quickly, large consumers are looking for best solutions for their energy needs. Other technologies deployed for managing energy usage include: control systems, energy management and SMART devices. Energy-efficiency solutions can be potentially implemented cost-effectively in every region, versus solar and storage solutions, which are financially attractive in limited states.

Market: according to the EIA, sales to commercial and industrial (C&I) customers is expected to be approximately 2.4b MWh in 2020, up 4% from 2016 levels. A significant percentage of these companies may not accurately understand their energy spending, and are looking for opportunities to save. Many utilities are already focusing on providing energy consultancy services to consumers, largely focusing on C&I customers, as they look for integrated solutions in this increasingly competitive market place. Note: a recent industry survey5 indicates that many utilities offer energy management consulting to C&I customers, and do not focus on small business customers to manage their energy usage.

Strategy: many key utilities have gone the M&A route to procure these consultancy capabilities by acquiring engineering and consulting companies.

Electric vehicle (EV) infrastructure

The US continues to be one of the market leaders for electric vehicles, primarily driven by policy support, lowered vehicle costs and reduced consumer barriers.

Market: according to the EIA, full zero-emission vehicles (ZEVs) and transitional ZEVs will make up 6% of national light-duty vehicle sales and about 2% of the total light-duty vehicle stock by 2025. With the increased stock, light-duty vehicles are projected to account for about half a percent of national electricity demand by 2025. While California leads the country in electric vehicle adoption, the trend is expected to grow in more states. For example, nine other states (Connecticut, Maine, Massachusetts, Rhode Island, Vermont, New Jersey, New York, Maryland and Oregon) have adopted California’s ZEV program. These plug-in vehicles will potentially create new demand for both electricity and infrastructure for utilities.

Strategy: many key utilities are currently positioning themselves to own and pilot EV infrastructure, given its long-term growth potential. However, P&U companies will need to work with their regulators to figure out a rate-base structure that is cost-effective for the long-term benefit of ratepayers.

[ 8 ]

Name Description

DG DG continues to have strong adoption in the US, especially solar PV capacity, primarily due to favorable policies and rapid reduction in installation costs. States with favorable regulatory structures have achieved highest penetrations: for example, California, Vermont, New Jersey and Massachusetts. Other sources include technologies such as CHP or cogeneration systems, microgrids, wind turbines, micro turbines and backup generators.

Market: according to the Solar Energy Industries Association (SEIA), there are more than one million solar installations in the US, with the residential PV capacity installations growing by 19% in 2016 (year-over-year). However, the capacity is concentrated in a few states, with the top five markets accounting for nearly 70% of national installations. The nonresidential PV market as a segment grew at its fastest pace in 2016 over the last five years, with capacity installed up approximately 49% (year-over-year ).

Strategy: increasing amounts of DG sources at the customer side represent both challenges and opportunities for grid operators. Given the impact of rapid growth on utility demand and earnings, utilities in multiple states are seeking changes to local net energy metering (NEM) constructs in order to mitigate their financial exposure to DG growth. Utilities have many advantages of owning DG over non-utility competitors, such as existing customers, regulated recovery of investments, deep knowledge of their service territories and low cost of capital. Because of this, most states are still deciding on if they should allow utilities to own these assets. However, new upcoming regulations in many key states recognize the role of utilities, especially in the scenario of deploying distributed capacity with energy storage, maintaining grid reliability, focusing on underserved customer segments and demonstrating new technologies. Multiple utilities are forming programs and partnerships to participate in DG, e.g., a group of six utilities and three solar companies filed a proposal recently in New York to continue full retail NEM till 2020, but they would be partly paid by developers.

Energy storage

The growing availability of relatively low-cost, efficient battery storage systems is driving more utilities to expand their planning and procurement processes to understand the economics of the technology.

Market: according to the Energy Storage Association, in terms of megawatt-hours, the US market grew 284% in 2016 alone. The demand for energy storage as a means of integrating wind and solar generation into the grid is increasing sharply in the US. Policy support continues to build up for the technology, both at the state level and the federal level. For example, in November 2016, the FERC issued a notice of proposed rulemaking that would require RTOs and ISOs to remove barriers for energy storage to participate in competitive wholesale electric markets.

Strategy: utilities are playing the storage market through multiple channels, including M&A, partnerships and innovative business models. Many companies are establishing partnerships with battery and PV vendors for new customer acquisitions. Also, allowing customers to participate in pilot programs provides a less capital-intensive approach.

[ 9 ]

[3] Strategic considerations framework

Developing a new business in the P&U space involves a deep and thorough understanding of the local regulatory environment and collaborations with many stakeholders including customers, owners and developers, landowners, regulatory authorities and financing parties. The key due diligence activities and considerations include:

Bridging the gap between current and future business models

Key industry drivers High-level analysis

[ 10 ]

Stagnant electric demand

Traditional business model

New business prospects (e.g., gas distribution, midstream and emerging options)

Changing customer behavior

DG growth

Changing energy mix (coal retirements)

Regulation changes

Low authorized ROEs

Understanding the impact of the industry drivers on future earning

Estimating the level of risk appetite for the company before venturing into new business

Understanding local regulatory policies and support

Retail: establishing customer profile, regional demand and C&I customer interest

Generation: site identification with characteristics driving economic feasibility; transmission access

Establishing preferred route to expand business:• M&A• Strategic partnerships• Organic growth

Opportunities and considerations Risks

Gas distribution • Higher near-term growth on average versus electric• Accelerated capital recovery mechanisms• Structural industry trends supportive of long-term

growth • Fewer long-term business risks• Authorized ROEs for gas utilities averaged near 9.5%

in 2016 across the US

• Higher current valuations versus historic levels • Lower allowed returns versus electric operations • Higher scrutiny of operational safety by regulators • Volatility in natural gas prices

Gas midstream assets

• Provides a natural hedge against transportation bottlenecks for natural gas as a fuel source for electricity generation and natural gas for heating applications

• Provides advantages of bringing and growing supplies of natural gas to existing and new geographic markets

• Volatility in gas prices and demand • Construction risks

Merchant transmission

• Requires aligning dedicated resources, formalizing business development plans, developing regional transmission solutions, undertaking partnering discussion and influencing policy and regulatory debates

• Project selection risk • Higher-than-expected capex• Interest rate risk • Issues with the past awarded project creates

uncertainty

Utility-scale renewables

• Includes understanding of local regulations, local market conditions, project economic profile, ownership options and available internal capabilities

• Lower tax credits • Change in environmental regulations • Delays in regional approvals such as construction

permits, zoning approvals and water use • Higher interest rates • Construction and O&M risks

Others • Regulated versus competitive ownership structure • Understanding of the market size, potential customers• Tax impact, benefits • Improvement in technologies and evolution of new

technologies

• Regulatory uncertainty • Unproven market size• Additional internal capabilities required

Key considerations for diversifying across the P&U value chain

[ 11 ]

AuthorsDana G. HansonEY Americas Advisory — Power & Utilities Sector LeaderDirect: +1 704 491 0894 Email: dana.hanson@ey.com Office: Charlotte, North Carolina

Jaideep MalikEY Americas Advisory — Power & Utilities ConsultantDirect: +1 404 817 5291 Email: jaideep.malik1@ey.com Office: Atlanta, Georgia

[4] Summary

In the US P&U industry, emerging challenges and opportunities are fundamentally changing the way business is conducted for the electric utilities. Consumers are lowering their net consumption, as well as demanding more and better services from utilities. Also, new technologies are transforming traditional relationships, roles and responsibilities for utilities, regulators and customers. These congruent factors are forcing utilities to look at new business and earnings opportunities.

There are many examples of utilities that have diversified beyond their core businesses. The industry is experiencing a convergence between traditional gas and electric business models. Many electric utilities have recently acquired gas utilities. Additionally, some of these same electric utilities have invested in midstream and upstream gas infrastructure. Conversely, many gas utilities are currently investing in electric generation, through renewables. Since utility-scale renewable projects became feasible in the US, many utilities have integrated these assets into their portfolios – through their non-regulated subsidiaries. However, there is a movement by utilities to include these assets in their regulated rate base structure, as regulators begin to understand the advantages of utility-owned models. Some utilities have also diversified into the merchant transmission business in their own jurisdictions or by engaging in building transmission in other incumbent utilities service areas.

Business diversification should be a top agenda for more utility management teams, given the rapid transformation of the traditional utility business. While there have been examples of diversification efforts by many utilities in the US, their success is not always guaranteed. Hence, a thorough understanding of consideration or risks and business suitability is key to moving forward.

[ 12 ]

Notes and sources1 Diversified utilities: these companies operate a diverse portfolio of businesses, including regulated and

unregulated components. Regulated businesses include traditional electric T&D and gas distribution. Unregulated businesses might include merchant power, international businesses and non-utility ventures such as mining or construction as part of their portfolio.

2 Presidential executive order on promoting energy independence and economic growth, March 2017.

3 According to Department of Energy paper “The Power of Information: Redefining U.S. Energy Infrastructure with a Modern Smart Grid”.

4 According to Edison Electric Institute report “Transmission Project: At A Glance, December 2016”.

5 Survey conducted by Chartwell Research.

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About EY’s Global Power & Utilities SectorIn a world of uncertainty, changing regulatory frameworks and environmental challenges, utility companies need to maintain a secure and reliable supply, while anticipating change and reacting to it quickly. EY’s Global Power & Utilities Sector brings together a worldwide team of professionals to help you succeed — a team with deep technical experience in providing assurance, tax, transaction and advisory services. The team works to anticipate market trends, identify their implications and develop points of view on relevant sector issues. Ultimately, this team enables us to help you meet your goals and compete more effectively.

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This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice.

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Other sources1. US Department of Energy (DOE)

2. US Energy Information Administration (EIA)

3. National Renewable Energy Laboratory (NREL)

4. Solar Electric Power Association (SEPA)

5. Company disclosures

6. SNL Energy (S&P Global)

7. EY analysis