We all know that banking is a confidence game. As long as depositors believe that the bank has enough money in its vaults (or other access to ready cash) to pay them, they leave their money in the bank. But as soon as enough depositors disbelieve and demand their funds back, they discover that the bank does not have the cash in hand to pay them all out. That causes a run on the bank, and the bank either folds (with depositors unpaid) or the government steps in.
Understand that the problem does not stem from fraud but rather from a peculiarity of banking’s business model. The bank lends out money on terms that do not require the borrower to repay the loan until months or years after it is made. But the depositors who (to a great extent) provide the money for the loans can demand their money back at any time, creating a mismatch. The bank, in a sense, borrows short-term funds from depositors to make very long-term loans like home mortgages. Despite its obviously precarious financial nature, p the model works until depositors lose confidence and they don’t want to wait until loans are paid off. They want their cash now. The money in the federal deposit insurance fund could never pay off all depositors, but it doesn’t have to as long as depositors believe that it will rescue them.
Now the electricity business, at least in the United States, also depends on confidence in two ways. Start with its financing model, devised long ago by Samuel Insull and his contemporaries. In its original form, it resembled a gigantic Ponzi scheme and still does to some extent. The electric industry does not generate enough cash from operations to pay for new and replacement plant. It must sell debt and common stock every year in order to raise the extra money. It does not have enough cash left over to pay dividends to existing investors so it raises money to pay them by selling shares of stock to new investors. What does that sound like? A Ponzi scheme? Then there is the debt. The industry does not set aside funds to retire its debt during the life of the bonds. When the bond comes due, corporate treasurers assume that new investors will willingly step up and buy new bonds to refinance their maturing debt. Somewhat resembling troubled banks, if, at any point, utility investors lose confidence in the industry, it will very quickly have difficulty continuing its financing processes: borrowing, paying off maturing debt and paying dividends to shareholders.
Like banks, utilities also have a mismatch between long-term assets and short-term obligations. Utilities make long-term investments (lives of 20-40 years) to serve customers who pay bills on a monthly basis, with no obligation to continue paying for the life of the assets purchased to serve them. That mismatch meant little in the past because the consumers had little choice but to buy from the electric company (or do without the creature comforts afforded by electricity). Now, technology and pro-competitive laws open the doors for consumers to abandon their legacy utilities in two ways: they no longer have to purchase the electricity itself from the utility, and they can also refuse to pay a high monthly fee for connection to the grid if their solar/battery system, for example, proves adequate. Too theoretical to take seriously? Well, so were electric vehicles and rooftop solar connected to a storage battery a decade ago. That uncertainty about ultimate customer behavior translates into greater risk for investors, and that will mean a higher cost of capital for utilities.
Finally, consider that consumers purchasing new electrical vehicles and appliances (whose sales have risen faster than expected) need to have confidence that the electricity industry will provide the electricity whenever and wherever required. So far, they don’t seem fazed by the increasing level of service interruptions (blame them on one-off events such as forest fires or storms). But consider that the owner of that electric vehicle might need it most when the power lines go down. When there are more electric vehicles and even more weather-related power outages, then what? On the other side of the transaction, electric companies need confidence that consumers will buy electric vehicles and appliances before they install all the additional equipment. Hope springs eternal, but is it realistic to commit resources without some assurances that the consumers will show up, stick around, not move out of the service area, or worse install solar plus batteries and “cut the cord” entirely? Maybe the government has to provide that assurance. Sort of like the assurance it provides the banking industry. Better than nothing and cheaper than failure.
By Leonard S. Hyman and William I. Tilles
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