Saturday, January 24, 2009

Electron Peddlers: Rethinking Core Capabilities of the Electric Utility Industry

Decisions related to investments in the general energy industry are complicated by the large capital requirements, volatile operating expenses, varying time-scales, uncertain technologies, uncertain (or absent) values for externalities, and a web of non-aligned decision-makers. As we discussed on Thursday, it’s no surprise, then, that the electric utility industry is going through a process of deciding exactly what business they want to be in.

This is not a new discussion and many different revenue models have been explored. Thomas Edison’s original 1882 power plant on Pearl Street in New York was built not to sell electrons, but rather sell the service of light, and thus benefit from the ever-improving technologies that convert electrons to lumens (i.e. light). Over the past two decades, electric utilities (which often have a monopoly to sell electricity within a given service territory) and the regulatory bodies (typically state public utility commissions) that govern these potentially dangerous monopolies have explored various “decoupling” models where the revenues (or profit) of the utility are not simply “coupled” to either the amount of electricity they produce or power plants they build. After all, as Edison astutely noticed, nobody really wants electrons or power plants, but rather the services that they enable.

Organizations like The Regulatory Assistance Project have done a great job in teaching various decoupling “tools” and regulatory structures to both utility companies and their regulating bodies. Only six states currently have decoupled electric utilities, but presentations like this by Wayne Shirley help spread the benefits of these more aligned structures. Progressive utilities such as PG&E (CA) and Duke Energy (NC) have embraced this change (see appendix here). PG&E will receive a regulated return of 9% or of 12% on all capital spent on saving energy if they achieve 85%-100% or >100% (respectively) of the targeted energy savings goal set by their regulatory body (the CPUC). They receive zero return on these funds if they meet less than 85% of this savings target. Duke has proposed their “Save-a-Watt” incentive mechanism that allows them to recover 90% of the customer’s avoided costs (levelized over the life of the investments) on money they spend on saving energy.

These business models have not been limited to regulated utility industry. A $3.6 billion industry exists in the US where firms install energy-efficient equipment for customer at no cost (See Chuck Goldman’s regular over view of the ESCO industry). A “performance contract” allows these firms to recoup their capital plus profit over time based on the savings generated. During the late 90’s, I worked at Enron Energy Services where we invested over $250 million dollars in energy-efficiency projects because their levelized costs (as well as the associated option value based on volatile commodity prices) was less than the Enron’s forward commodity curves that showed the “market value” buying energy. To my knowledge, this was the first time the supply-side and the demand-side were valued as economic substitutes based on real-time markets.

But let’s return to this post’s opening statement. The primary concept expressed is clearly that our energy future is rooted with uncertainty. In a highly uncertain environment, one may best achieve robustness (i.e. an ability to survive frequent perturbations) by focusing on core capabilities rather than a clearly defined business model. Metaphorically, the craftsman may not know what type of house is required nor how he’ll be paid, but proficiency in hammering, sawing, bricklaying, and painting will serve him well. Therefore, I therefore pose the question, “What core capabilities will best position an existing electric utility for the future?”

Traditionally, a utility may have stated their mission as “bringing safe, reliable, and low-cost electricity to our customers.” These mission statements have evolved to include broader ideas around environmental externalities, trade-offs, economic development, and even quality of life. To fulfill such ambitious missions amidst the uncertainty of our energy future, the electric utility must excel at four primary capabilities. Electric utilities must be experts at:

Energy Conversion: Traditionally a utility may have included “energy generation”. I broaden this capability to an expertise in all energy conversion. This more abstract expertise includes understating the broad portfolio of energy decisions and knowing when and how to substitute a demand-side solution for a supply-side solution. From a supply and demand perspective, improving the energy conversion of lighting equipment from 50 lumens/watt to 100 lumens/watt should be given equal (arguably more) attention than improving the conversion efficiency (or heat rate) of a natural gas generator.

Energy Delivery: The logistics of delivering energy (be it natural gas, liquid fuels, or power) is a substantial task. In addition to the traditional delivery model, the broader energy delivery capabilities of the future include distributed generation and demand response as well. Sometimes the lowest-cost solution to delivering power behind an overloaded substation would be to add distributed generation such as solar photovoltaics. Energy delivery will include securing and delivering intermittent wind power to customers at distance load centers or may include remotely dimming lights, shutting off pool pumps, and raising set-points on air conditioners to match supply resources and demand loads over a “smart grid”. Energy delivery also means an ability to deliver energy efficiency. During California’s energy crisis of 2000, they leveraged their existing infrastructure for delivering energy efficiency to allow them to reduce their peak load even further.

Risk Management: Originally, risk management focused on safety and reliability. These aspects hold true today without doubt. However, electric utilities are managing a portfolio of highly uncertain solutions over long time periods. The price paths of oil and natural gas over the last six months are proof of this challenge. Risk management should broaden to include the value of externalities (e.g. carbon). Finance theory must quantify the impact of correlated risks (i.e. covariance) in a portfolio of energy systems as well as the true option values of perpetual rights to turn-off loads or use stored power from plug-in hybrids to “firm-up” intermittent wind. Of course, in an environment post 9/11 and post Katrina, systems with concentrated points of failure will simply appear silly.

Stakeholder Service: Since traditional utilities were regulated monopolies, their primary “customers” were not the real customers (i.e. end-users), but rather their regulators. Going forward, utilities will need to be increasingly responsive to customer needs and understand the needs of a diverse and growing set of stakeholders who include state/federal regulators, environmentalists, technologists, suppliers, R&D groups, and employees.

Over the next decades, the electric utility industry will undergo substantial change matched only, perhaps, by that when Westinghouse’s AC model beat out Edison’s DC model in the late 1800’s during the “War of Currents”. Regulators will likely experiment with various business models and the costs of generating CO2 will likely change the traditional competitive landscape. However, if utilities can excel at the four capabilities discussed above, they will be well positioned to provide a fundamental enabler to our safety, prosperity, and society.


Rational Energy

1 comment:

David Wogan said...

Have you followed any of the news on the stimulus package making it's way around the Capitol? It's been proposed that $2 trillion dollars (!!) are required to update our electrical grid.