What Utility Executives Should Be Thinking About in 2020: Preparing for the Future by Examining Prior Disruptions Inside and Outside the Electric Utility Industry
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- Jan 29, 2020 10:09 pm GMT
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Co-authored with Karen Weigert, VP of Business Strategy & Regional Operations - Slipstream Group
While seeing the future is always challenging, we make it even more difficult if we do not understand key events in the past. When considering the potential for disruption in the electric utility industry, historic events can inform us. The upshot of the retrospective analysis may be surprising. Utilities have already survived large acute shocks to the industry; their ability to survive chronic, slow-and-steady changes going forward is less clear.
So what should utility executives and policy makers look at in 2020? The past 60 years of financial history, both inside and outside the industry.
Disruptive Shocks in the Electric Utility Industry
Talk of the impending disruption of electric utilities has been at the forefront of industry discussion for more than a decade. In common discourse, the term “disruption” is rarely defined, and we must recognize that there are different types. Frequently we assume implicitly that disruption is driven by technological advances, referred to by Clayton Christensen as “innovative disruption.” That sort of disruption follows a standard pattern, which he documented in considerable detail. Nevertheless, as Christensen noted, to assume that all disruption is of the technological type is to mischaracterize, and misunderstand the implications of, some of the biggest disruptive events.
In the 1970s the electric utility industry was brought to its knees by the combination of two oil embargoes (1973 and 1979), an unprecedented run-up in long-term interest rates, and a series of problems relating to nuclear plant construction, none of which had anything to do with technological innovations by competitors. The most singularly disruptive of these was a political event, the 1973 embargo which quadrupled the price of oil in only a matter of months.
Unlike today where less than 1% of electricity is generated using oil, in 1973 16% of U.S. electric generation was oil fired (U.S. Energy Information Administration). East Coast utilities were especially dependent on oil as a generation fuel. The impact of increased prices caused by the embargo manifested quite quickly across the utility industry. With input prices soaring, and with regulatory processes not designed to absorb severe shocks, Consolidated Edison of New York soon ran out of cash. It eliminated its dividend, sending investors rushing to the exits, temporarily destroying massive amounts of investor wealth. See Figure 1. From the time of the embargo in October 1973 to the announcement of the dividend elimination in April 1974, Con Ed’s real stock price declined by 73%.
While lightning strikes are traumatic, many people survive them. This is an apt analogy when considering the impact of and response to the 1973 embargo. By necessity, acute disruptions must be addressed in a timely fashion. Within a matter of a few years following the 1973 embargo, the electric utility industry dramatically reduced the amount of oil-fired generation in its mix, thereby limiting the exposure to oil price strikes. When the second oil embargo occurred in 1979, there was still an impact, but it was less severe. Although oil prices have continued to be volatile since that time, regulated electric utilities today have almost no exposure to those price changes.
For approximately 60 years, when viewed in isolation, Con Ed’s stock price provided no real capital gain for investors, as Figure 1 shows. That, though, is not particularly troubling because the value from utility stocks is driven primarily by dividends. Following the embargo, Con Ed was able to quickly restore its dividend and that's what mattered. Over the 1960 to 2018 period, if Con Ed shareholders had reinvested their dividends, they would have earned an average real annual return of 6.8%. Beating inflation by 7 percentage points per year is similar to the long-run total return generated by the broad market. Con Ed survived the lightning strike.
Slow-and-Steady, Fatal Disruption of Eastman Kodak
The disruption of Eastman Kodak had a more chronic nature. Over a period of several decades two primary disruptive forces drove the company from its position as one of only 30 stocks in the prestigious Dow Jones Industrial Index into bankruptcy. Dealing with that sort of disruption turns out to be much more difficult to address, in large part because incumbents do not initially recognize it as a threat, nor do they see the economic damage being done before it's far too late. And even if they do see the threat, many executives find it impossible to make changes that downplay the products and services that had created value for the firm for many years in the past. Note that before and after the oil embargo, Con Ed was still an electric utility. For Kodak to have survived, it would have had to become a different company, which is much more difficult to achieve.
Kodak was first attacked by conventional competition from firms such as Fuji Photo in the 1970s to the 1990s, and then by digital technology from 1990 to its ultimate demise in 2012. See Figure 2. This type of disruption is not a lightning bolt; it is a steamroller. Individuals can survive a lightning strike, but if they do not get out of the way, no one survives being overrun by a steamroller. The latter moves slowly, but with devastating cumulative effect over the long run.
We can see that in real terms Eastman Kodak stock reached its peak in 1973, about 40 years before it filed for bankruptcy. In addition to the slow decades-long decline, there was also a cataclysmic event in Kodak’s history—the 2007 introduction of a high-quality camera in the smart phone, which eliminated the need not only for film-based cameras, but also for stand-alone digital cameras. In the early 2000s Kodak had switched from film-based photography to making digital cameras, but this was far too late and became irrelevant once the smart phone cameras were capable of producing high-quality photos. Notice that by the time the smart phone camera arrived, though, Kodak had already lost an amazing 96% of its real economic value.
Kodak had an opportunity decades earlier to have made a strategic shift. In 1989 Kodak was to choose a new chief executive. Kim Whitmore, a chemical engineer who had worked for Kodak for 30 years, advocated for a continuation of the film-based strategy; Phil Samper, who at the time served as Vice-Chair of Kodak's Board of Directors, argued that film was a dying product and that the future was inevitably going to be digital. To its credit, Kodak was considering a fundamental change in strategy at an opportune time. Yet, true to form with slow-and-steady disruptive innovation, the incumbent simply cannot pull the trigger if it involves moving away from the product or service that had been the mainstay of the corporation in the past. Whitmore was hired. Samper left Kodak to form Sun Microsystems. Whitmore would be fired three years later.
This decision was not as easy as it seems in retrospect. In 1989, Kodak was still making substantial amounts of money from photographic film sales. To put this in perspective, this would be akin to a utility CEO candidate today suggesting that the firm chart a course that moves away from monopoly grid-based service toward a highly-distributed electric utility industry. No matter how clearly executives and boards see the future, due to financial and emotional commitments to the incumbent product or service, they do not, or perhaps cannot, get out of the way of the slow-moving, but devastatingly disruptive steamroller.
How, though, decade after decade could Kodak executives have been so blind to the economic consequences of their decisions? Executives typically spend little time looking at the past. And those that attempt to look backward in earnest often get an incorrect signal because they look at their companies’ stock prices in nominal, that is, not inflation-adjusted, form. See Kodak’s highly-misleading nominal stock price history in Figure 3.
While Kodak was struggling considerably in an economic sense, using nominal prices suggested that from 1972 to the turn of the century it was holding its own. The real stock price data (Figure 2) shows that it had actually lost 90% of its economic value. Converting stock prices to real levels takes a little work, but provides the relevant information. Examining nominal prices can provide an illusion of comfort to executives when the real prices are signaling that the company is destroying economic value. This may be why Kodak did not feel the need to make a strategic shift in 1989.
To see how easily one can be misled in this regard, consider that in real terms the Dow Jones Utility Index today trades at a level lower than it reached in the mid-1960s. See Figure 4. As was the case for Con Ed, in real terms the value proposition for the typical utility came only in the form of dividend payments, with essentially no capital appreciation. So while in nominal terms it appears that utility stock prices have produced value gains for investors, over the long run in real terms they have simply been treading water. How many people in the electric utility industry today know that?
Lessons for Electric Utilities
Preparing for unexpected shocks, such as an oil embargo, is nearly impossible. But history shows that utilities and their regulators have adapted to this sort of shock.
It is disruptive innovation that should attract the attention of utility executives and policy makers. It follows a familiar pattern. Incumbents focus on their core customers, trying to satisfy that group. That leaves a set of marginal or fringe customers who are not happy with the incumbents' products or services.
The disruptors’ products and services typically have an unexpected characteristic—from most customers' perspectives, they are inferior to those offered by the incumbents. The disruptors come in under the incumbents' radar, establishing footholds by serving those dissatisfied customers with lower-quality products. But, and this is the key aspect, through slow-and-steady innovation, the disruptors improve their products. They begin to capture additional customers, offering products or services that are then as good, and eventually better than, those offered by the incumbent. Sometimes decades after their initial entry into the incumbents’ markets, in a cumulative sense the disruptors have severely damaged the incumbents. Disruption does not have to be fatal to cause economic consequences. It took four decades to achieve, but per-capita consumption of bottled water now exceeds that of soda, a result that has taken a considerable toll on Coca Cola’s real stock price.
This pattern repeats itself over and over in tragic form. Executives of incumbents at first do not see the steamrollers coming. Eventually they do, but they remain committed to their core products. The steamrollers move closer. By the time they decide to change, as in Kodak’s 2004 strategic shift to digital technology, the disruptors have already stolen many of the incumbents' customers and destroyed substantial amounts of their economic value. Time after time, disruptive steamrollers have crushed incumbents through their slow, but unrelenting movement. Eastman Kodak was one of those casualties
Our ultimate suggestions for 2020 for utility executives and policy makers concerned about disruption in the industry is that they review two useful publications:
- Christensen, C., Raynor, M., & McDonald, R. December 2015. What is disruptive innovation? Harvard Business Review.
- McGrath, R. 2019. Seeing around corners: How to spot inflection points in business before they happen. Houghton Mifflin.
The first addresses in more detail the items we discuss above. The second provides insightful ways to look forward. Investing time reading these publications, which make several counterintuitive but critically important points, is critical for those hoping to adapt to the slow-moving, but powerful aspects of disruptive innovation, the real long-term threat to the electric utility industry.