[BETA] Fortnightly

Virtual DisCos? Utilities might be stepping out,

but outsourcers could be cutting in.Wholesale competition and the prospect of competitive retailing are leading many electric utilities to turn their distribution activities into discrete business units. But the emergence of the "DisCo" as a distinct entity may only mark the first step in a more radical disaggregation.

Why the distribution business may see radical change isn't immediately apparent. Electric utilities staking out positions in the emerging electricity commodity markets will be tempted to view their DisCos as a source of dependable cash flow and, perhaps, as durable brand franchises that will continue to retain significant local market shares in the event of retail competition. In contrast to generation and retailing, distribution looks safe and staid. It remains a natural monopoly (it will rarely make sense to duplicate pipe or wire), and will likely continue subject to local regulation. Functions (such as marketing) that are critical to survival under retail competition are migrating to other parts of the utility.

Nevertheless, electricity distribution, along with gas distribution, remains a mammoth industry. With the wholesale commodity value of kilowatt-hours and therms removed, the distribution industry in the United States still generates revenues of about $50 billion in electricity, and $25 billion in natural gas. Most of these revenues, arguably, represent the value added from energy distribution (em and compensation for a wide-ranging and complex set of activities. In the electric utility industry, distribution represents only one-third of the assets, but half of the employees and an even larger share of the collection of

technologies and skills involved in creating and delivering kilowatt-hours.

Yet energy distribution remains both highly fragmented and vertically integrated in ways that leave open possibilities for changes as dramatic as those taking place on the commodity side. There are over 200 electric and gas utilities in the United States with over 100,000 customers each; none has a market share in fuel sales of more than 4 percent. Still, these companies maintain internally virtually all of the functions and capabilities required to procure, transport, meter, bill, collect payment, and initiate and terminate energy service.

A number of forces will lead the vertically integrated DisCo industry to restructure, most likely along more horizontal and functionally disaggregated lines:

s Unbundling. As in the State of New Hampshire's pilot to test retail competition, markets that embrace customer choice of supply are likely to develop pricing structures that involve unbundled distribution charges, either on a fixed or per-kilowatt-hour basis. These markets will allow the emerging wires businesses to claim identifiable revenue and profit streams that are independent of the generation or retailing operations (em the first step toward developing distinctive business strategies.

s Performance-based Ratemaking (PBR). Price caps or other forms of PBR will allow distribution utility shareholders to benefit from improvements in operations & maintenance (O&M) efficiency, by allowing them to achieve higher rates of return than those allowed traditionally, and by coaxing them to seek more optimal mixes of O&M expenses and fixed-asset investments.

s Technological Change. The decoupling of distribution asset investments from guaranteed returns will