The New Normal


Our economic future depends on adaptability.

Fortnightly Magazine - September 2009

For the past several months, analysts and pundits have been using the term “the new normal” to describe post-recession economic conditions. The phrase describes a variety of changes, from stock-market returns to personal savings rates, but it boils down to this: After the recession, the economy will go through a soft recovery, and it won’t return to pre-recession levels of financial and market activity in the mid-term future.

The idea is centered primarily on trends in banking and finance—which makes sense, since that’s where the meltdown began—but of course the whole economy depends on the strength of our financial institutions. Nobody is exempted from the new normal. “The forces of consolidation and shrinkage will spread beyond banks, impacting a host of non-bank financial institutions,” writes Mohamed El-Erian, CEO of PIMCO, in the firm’s May 2009 outlook titled A New Normal.

El-Erian’s scenario also predicts that governments around the world will continue their trend toward intervention in markets. “Burden sharing will feature more prominently,” he writes, forecasting a “heavier hand of government in economic life.”

Of course, not everyone agrees with this outlook. However, in the utility industry we see plenty of evidence to support it. Power and gas sales are diminishing rapidly for many utilities and much of the industrial demand destruction seems permanent (see “The Fortnightly 40”). Also, interventionist government policies are shepherding utility investments, most notably toward green-energy and smart-grid technologies.

This industry always has been influenced by “the heavy hand of government;” there’s a reason we’re called “regulated utilities.” But recent trends are fundamentally changing how electricity and natural gas are provided to customers. Government policies, market forces and technology trends seem to be reshaping every- thing from resource-planning assumptions to customer-service practices.

Whether these changes portend a structural rebuild or an incremental shift in the utility business model, they’re challenging executives and regulators to re-examine the industry’s financial and regulatory foundation—and to adapt it to the realities of a new normal.

Rational Prudence

In terms of macroeconomics, the new normal suggests previous economic growth was an illusion, a bubble inflated to irrationally exuberant levels by a debt-financed shopping spree. And now that the bubble has burst—via the housing market collapse, the subprime mortgage crisis and the Wall Street meltdown—life will be a whole lot less buoyant. “Exuberance and excess, spawned by cheap credit, are making way for prudence and pragmatism,” write Rutgers University scholars James W. Hughes and Joseph J. Seneca in a February 2009 report.

Whether this prediction is correct or not, an honest assessment must recognize certain overhanging realities—namely the country’s yawning trade deficit (including energy imports) and its inflationary fiscal and monetary policies (see earlier Frontlines columns, “Security vs. States’ Rights,” July 2009, and “A Time to Lead,” October 2008). Even if housing and banking should spring back to improbable pre-recession levels, America’s growing deficits will bleed our GDP, constraining stock-market prices, real-estate values, employment rates and median incomes. Indeed, in El-Erian’s new normal, he tacitly attributes this phase of consolidation and de-risking to investors’ recognition that America’s financial future might be less solid than it once appeared to be.

Now, before anybody jumps of the ledge, consider that El-Erian might be wrong. Some very good economists disagree with him. They argue that recessions come and recessions go. Each one seems terminal when we’re in the middle of it (see “No New Normal: JPMorgan Sees V-Shaped Recovery in U.S.,”, Aug. 14, 2009). And even if El-Erian is right, he isn’t saying we’re walking into a tar pit, but an extended briar patch. As long as America retains its efficient free-market economy, with a healthy democracy and a free populace, we’ll adapt to whatever changes occur.

Centralizing Decentralization

Although trends in energy consumption, financial markets and government policies clearly affect utilities, the industry’s performance actually seems somewhat detached from broader economic trends. Regulated utilities in most states still operate under a cost-of-service business model that tends to insulate the industry. So while utilities and regulators might hear more complaints when costs begin rising, utility returns will remain strong as long as the regulatory compact remains in effect.

Thus a valid question arises about this “new normal” idea; is it merely a short-term distraction, driven by shifting economic and political currents? Or is it a long-term reality that might change the U.S. utility business model?

The answer depends on a series of industry-specific developments involving green policies, technology trends, fuel prices and consumer behavior.

First, the green movement shows no signs of reversing course, having progressed steadily for at least 40 years, since President Nixon signed the Clean Air Act in 1970 and created the EPA. Even when the political pendulum swings back from its current leftward course, green-policy mandates will continue—albeit perhaps with greater flexibility.

Second, renewable energy and battery technologies have advanced dramatically in recent years, portending logarithmic market growth in the next decade (see “Sunrise”)—especially for PV plants and electric vehicles. At the same time, the utility industry is embracing smart-grid technologies. Even in the most traditionally-regulated, vertically-integrated markets, utilities such as Southern Company are installing smart meters and automating distribution systems.

Third, fuel-price trends remain notoriously difficult to forecast. If gas and oil become scarcer, sooner than expected (see “Betting on Shale”), then sheer economic necessity could transform alternative energy into mainstream energy, and ratepayers into savvy and engaged consumers. But even if fuel prices remain relatively stable, analysts across the spectrum expect electric rates will rise substantially during the next several years—even without factoring in the prospective costs of GHG regulation. Cost pressures might slow the transition toward more expensive green energy, but at the same time they will place a premium on improving system efficiency and giving customers greater control over the way they use utility services—especially if El-Erian’s new normal proves correct.

The final piece of the puzzle, customer behavior, also remains somewhat difficult to predict—but that’s changing. Regulators and transmission-system operators are closing the loop between smart meters and wholesale energy resources, turning customer demand into a tradable commodity. Experiences so far in the PJM market suggest demand resources represent a fertile area for growth. And the smarter the grid gets, the more dispatchable and reliable demand resources will become (see “Wholesale Market Realities”). Eventually, if advanced metering continues on its current trajectory, ratepayers will become smarter consumers of electricity with minimal effort on their parts. Rising costs will provide all the incentive they need to accept new metering technologies, and green-policy programs might provide a final push.

Toward these ends, many companies across the country are seeking changes in their rate structures to ensure their shareholders’ incentives align with today’s policy priorities and tomorrow’s technology possibilities. In this way, the industry’s operating model is evolving toward something less centralized, more transactive and more cost-efficient than it otherwise might be.

Whether or not El-Erian’s new normal becomes a reality for the U.S. economy, the utility industry is facing fundamental changes. The ability to adapt to those changes—and to turn them into opportunities—will differentiate winners from losers in the industry’s new normal.