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Investors in utilities should be considering the impact of alternate energy sources on utilities. One of the best way to measure the impact is by looking at the decisions of the Public Utility Commissions and how they respond to alternate energy sources. We look at California market as one example where the Public Utility Commission decisions should discourage utility investments. When electricity rates go up in a region, consumers in that region are quick to blame the local utilities and cast them as villains. This phenomenon is particularly acute when it comes to Investor Owned Utilities. While the IOUs profit motive gets most of the blame, in many regions of the US, utilities operate under some very specific mandates from local Public Utility Commissions. This dynamic did not matter much to utility investors in the past since utilities were in a monopolistic situation and customers did not have much of a choice when it comes to energy sources. However, times are changing and in this era of distributed energy, utility investors should factor in the mindset of the relevant PUCs in determining which utility investments are vulnerable. The concern about utility future is especially acute in states where solar penetration is increasing rapidly. In these states, a local PUC’s response to solar and wind technologies is one very good way to assess whether a utility can do well in its regulatory landscape. In this context, we look at the regulatory landscape in California – a state with the highest solar penetration in the US outside of Hawaii. California Public Utilities Commission, or CPUC, after much contentious dialogue, announced a much awaited new rate design a few weeks back. While not completely unexpected, the rate decision is reflective of ongoing poor rate setting history in California and has severe long term implications for California’s three major Investor Owned Utilities Pacific Gas & Electric (NYSE: PCG ), Southern California Edison [owned by Edison International] (NYSE: EIX ) , San Diego Gas & Electric [owned by Sempra Energy] (NYSE: SRE ) While the decision itself is a long complex document with many nuances, the highlights of the ruling are as follows: – A minimum bill of $10 as opposed to a fixed bill requested by the utilities – Two tiered rate structure with a 25% cost difference between the tiers – A new super user rate for heavy electric users – A relatively accelerated path to TOU rate structures – 4 year glide path to new tiered rate structures Almost all of these decisions, except for the TOU rate structures, while directionally positive compared to the prior rate structures, fall woefully short of what is required to align California electric rates with the market forces. In evaluating the decision, it is instructive to understand the parameters that the PUC set for itself for this rate design. The so-called rate design principles, RDP, adopted by the Commission are as follows: 1. Low-income and medical baseline customers should have access to enough electricity to ensure basic needs (such as health and comfort) are met at an affordable cost; 2. Rates should be based on marginal cost; 3. Rates should be based on cost-causation principles; 4. Rates should encourage conservation and energy efficiency; 5. Rates should encourage reduction of both coincident and non-coincident peak demand; 6. Rates should be stable and understandable and provide customer choice; 7. Rates should generally avoid cross-subsidies, unless the cross-subsidies appropriately support explicit state policy goals; 8. Incentives should be explicit and transparent; 9. Rates should encourage economically efficient decision-making; 10. Transitions to new rate structures should emphasize customer education and outreach that enhances customer understanding and acceptance of new rates, and minimizes and appropriately considers the bill impacts associated with such transitions. What is most ironic about these rate design principles is that many of these goals are in conflict with each other and there is not a single criteria that mentions the goal as delivering low cost long term electricity to consumers. Understandably, a look at the pricing difference between California IOUs and municipal utilities (image below from energy.ca.gov) indicates that CPUC has largely been a failure in delivering low prices to California consumers. (click to enlarge) The root of the problem related to CPUC’s incoherent principles and an over reliance on cost based metrics, instead of market based metrics, in setting utility directives. This poor process has led to historical over investment in assets to justify a higher return to the IOU shareholders. This worked reasonably well for all involved (except customers) as long as there was no competition to the utilities. However, solar energy, and to a lesser degree, wind energy, are dramatically changing the market place dynamics. With many alternate sources of distributed generation accessible to customers, utilities are no longer the energy generating monopolies they used to be. The CPUC, unfortunately, continues to see consumers as subjects that pay the rates they set without considering that the electric generation landscape has changed and the consumer today has choices. CPUC rate structures hide many different subsidies in the form of volumetric rate structures. These subsidies will be problematic to utilities because they are not applied evenly across all the energy sources and will be increasingly coming at the expense of utilities. By being oblivious or nearly completely ignoring market forces, the CPUC is on the course to making utilities a lot less relevant for a big part of its customer base. Given the exponential growth in solar, this subsidy structure will start exacting an increasingly heavier toll on these utilities. The problem, especially in California, is likely to get worse if the PUC continues with its net metering policies and layers in subsidies for battery technologies on top of the already expensive other subsidies. Unless Pacific Gas & Electric, Southern California Edison, and San Diego Gas & Electric can meaningfully alter this regulatory landscape, their future in California will be threatened. Investors will do well to stay away from these and other utilities that operate in an archaic framework that does not properly recognize the threat of solar to the utility business models. We see Pacific Gas & Electric as one of the highest risk utilities. Our view on PCG: Avoid