There are some things we do in our everyday lives that we barely think twice about, such as flipping a light switch or turning on the stove. Behind those simple acts, though, is a multibillion-dollar industry that provides just about every home with electricity through a complex distribution network. We rarely give deep thought to these utilities, except when we receive the monthly bill or when something goes wrong.
There is a simple beauty to the utility space. Heavy regulation provides many companies in the industry with massive competitive advantages, or what Warren Buffet likes to call economic moats. It's no wonder, then, that Buffett has several billions of dollars of his fortune tied up in utilities. Let's look at utilities so you have a better idea of how the industry works and what its drivers are before investing in this space.
What are utilities?
Transmission lines, the backbone of the utility industry Photo Source: U.S. National archives via commons.wikimedia.org.)
A utility, by definition, is an organization that maintains or provides a basic service such as electricity, water, natural gas, and wastewater. Since these are considered a public service and not necessarily a product, a single company can have a monopoly over a particular region without being subject to antitrust laws. In exchange, the government regulates the payments for these services. For example, a regulated utility's rates will be negotiated with a local regulator to ensure the amount is enough to cover the operation and maintenance of its facilities and infrastructure, along with a certain rate of return. Recent years, though, have seen the emergence of deregulated utilities. These independent power providers are allowed to sell to either a regulated utility or directly to a customer using the grid, establishing competition in order to drive down costs and eventually the amount paid by consumers.
A majority of the utility providers in which you can invest are regulated electricity providers. However, a small set of water and natural gas utilities, as well as independent power providers, are traded on U.S. exchanges.
How big are utilities?
Several utility companies are owned as co-ops or by municipalities, so putting an exact figure on all utility providers is difficult. However, investor-owned utilities in the United States have a market capitalization close to $700 billion and pull in annual revenue of roughly $500 billion. Some of the largest utility providers are worth tens of billions of dollars and have operations covering large swaths of the country.
Hydroelectric dams provide a stable source of power for the grid. Phtoto credit: Hi540 via commons.wikimedia.org.
How do utilities work?
The premise of a utility is simple: sell customers basic services such as water and electricity. The challenge is getting those services to the customer. These companies must spend billions of dollars to build and maintain both the means to source those offerings -- in the case of electric utilities, power-generation stations -- as well as the transportation network to deliver it to their customers.
For electric utilities, there are also special considerations. The technology to store electric power cheaply and effectively doesn't really exist yet, so electric utilities must supply just enough power to meet demand at that instant. This means there are two main categories of power generation: base-load power and peak power capacity. Base-load power is the amount of electricity that we pretty much use 24/7, while peak power loads are associated with times when energy use is greatest -- such as when everyone arrives home from work. Peak power is expensive to produce because it needs to be able to start up and shut down quickly, so utilities must manage the energy delivered to the system to minimize the amount of peak-power generation while providing sufficient power to the grid.
What drives utilities?
As long as we don't all have generators in our homes or natural gas wells in our backyard, we rely on utilities to get these basic staples. However, the dynamic of this industry has changed in recent years. Since some states have deregulated their utilities, the de-facto monopolies that many of these companies had no longer exist. Companies that own the transmission infrastructure are still heavily regulated, so those that generate more of their revenue from transmission fees are going to be more stable and less subject to competition.
One major hurdle for electric utilities in coming years involves how to deal with aging U.S. power generation facilities that rely on coal. New carbon emission rules that will be enforced will make it challenging for existing coal power plants to continue operating and for new coal-fired plants to be built. Also, the increased use of alternative energy generation such as solar and wind will pose a challenge because they are intermittent power generation sources. Without major advancements in power storage, it will be difficult for utilities to ensure an adequate load to the grid.
For investors, this industry can vary from a low-risk dividend payer like a regulated utility to higher-risk independent power providers and power traders.
