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The new normal: Financial, structural challenges for electric utilities

Jim Heidell

Intelligent Utility

7 July 2014

The electric utility business model is facing new challenges from rapidly advancing technology and innovation, which is disrupting the historical electric utility service model.  These technology threats include distributed generation (DG), storage technologies, micro grids, and internet based energy management products and services.  Non-utility entities are actively seeking entry into serving customer electric needs by carving out services traditionally supplied by the monopoly utility.

From the electric utility’s perspective there have generally been three broad categories of response: 1) this is not a significant threat compared to other more immediate challenges, 2) this is a threat that needs to be managed and contained, and 3) this is an opportunity for providing new services.  At one end of the spectrum there are organizations such as Moody’s that state that the threat is overstated and at the other end NRG and Duke are examples of organizations identifying these innovations as creating a “new world order” for electric utilities.  In reality, the threat varies by region between the doom-and-gloom outlook of the impending destruction of the historical regulated utility model, and a threat that is so distant it is not worth dealing with today, influenced by fuel prices, existing capacity costs, and public policy. 

The technological changes in the power sector have the potential to be as disruptive as cellular has been to the regulated wired world of the plain old telephone services (POTS).  While any significant disruption to the monopoly wires model may be years away, the regulatory process and changes to corporate culture tend to move slowly.  It is necessary to develop a transition strategy now, even though the future is uncertain.

There are three broad challenges to managing this transition.  

  1. Electric utilities have previously been down the path of adapting their business models to pursue new opportunities with disappointing, and sometimes disastrous financial results as a result of not having the organizational capabilities and experience necessary to succeed in highly competitive markets.  (One of the more extreme examples is the bankruptcy of Montana Power in 2003 after investments in fiberoptics.) 
  2. Utilities have dealt with the issue of stranded assets in the process of divesting of their power generation businesses.  As recovery of investments is not a guarantee, utilities need to ensure that new, and sometimes significant, regulated infrastructure investments are aligned with the long-term drivers of customer value.  Investments need to anticipate changing requirements driven by customer distributed generation investments and services provided by non-utilities.
  3. Utility rate structures, especially for residential customers, have not changed significantly in the last two decades. Despite the implementation of smart meters and some smart grid capabilities, customers continue to be charged based on the amount of energy they consume rather than for the connectivity or reliability support they receive and costs they impose on the electric grid.    

There are a number of precedents for utilities seeking to expand their business model to behind the customer’s meter.  Key issues include whether the expansion is structured as part of the regulated or unregulated business. Given the interest of technology and information companies in moving into this space, there is likely to be significant resistance to utilities desiring to enter this space as a regulated business and using the resources of the regulated monopoly to compete. This will inevitably be a lengthy discussion as the public policy merits of a monopoly versus competitive business model.  The traditional justification for a monopoly is based upon economic efficiency.

Where competition can benefit customers, the regulators may be willing to lower the monopoly barriers such as exclusive franchises and defining what services make a provider a regulated public utility.  Alternatively, utilities can expand into distributed generation and micro-grids as an unregulated business.  However, this is contrary to the recent swing of the pendulum as utilities have tended to focus more on their regulated businesses. (For example, Ameren and Dominion selling their unregulated wholesale generation businesses.)

Many utilities are in a cycle of increased capital investment.  This investment is focused on replacing aging infrastructure, integrating new renewable central generation resources, smart grid investments, and smart metering.  According to EEI annual T&D investment is expected to be on the order of $35 billion per year over the next few years.  This investment reflects a continued trend of increased investment in utility infrastructure.  Significant changes in demands on the power grid as a result of distributed generation and micro-grids could potentially diminish the value of these investments.  In turn this can lead to a regulatory inquiry of whether all the investment continues to be used and useful and be recovered in rates.  Therefore, it is important to both carefully evaluate new investments in light of current needs and a potentially changing grid.  Obtaining the regulator’s buy-in,   reduces the chances, but does not guarantee that there will not be future disallowances.

Current debates surrounding net metering have highlighted a number of long-term issues surrounding rate design.  Traditional structures were designed to either simply recover costs on a volumetric rate, or to encourage energy conservation with inclining block rates.  However, these rate structures can potentially encourage uneconomic bypass or cross subsidization for customers seeking alternatives to traditional utility service.  Therefore, it is important to redesign rates so that customers are both appropriately charged for the services that they are utilizing and to also receive appropriate price signals.  Customers within the same traditional class of service that use different utility services are not necessarily similarly situated and it would not be discriminatory to have different rates depending on the services taken from the utility.  

It is clear traditional wires utility services are facing a number of challenges. The degree and timing with regards to how these challenges manifest themselves has both a regional and utility dimension.  However, realignment of utility strategy and customer rates is complex and time consuming.  If utilities wait too long to start the internal change process as well as the associated discussions with stakeholders and regulators then technology change and market economics may overtake the current business model with potentially devastating impacts to both investors and customers seeking traditional utility services.

Jim Heidell is a utilities expert at PA Consulting Group 


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