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Carbon Wargames

U.S. utilities gain strategic insights by playing out a carbon-constraint scenario.

Fortnightly Magazine - December 2007

this magnitude—affecting different sections of the country with vastly different levels of severity, in the service of a generic social benefit of global scope—would pose enormous challenges for public policy, extending well beyond the purview of traditional regulatory institutions. In contrast to the generally accommodating posture adopted by regulators in this game, the regulatory attitude created in real life by this level of rate increase almost certainly would be skeptical and severe. The unfavorable pressure on shareholder returns already indicated by the game would be exacerbated.

• A steeper supply curve: Apart from the obvious overall price increase, costs increased sharply at relatively low levels of demand. “Mid-merit” generation shrank, and the supply curve became almost binary—either base or peak. Under such circumstances in the real world, significant price volatility would emerge at even moderate demand levels—significantly increasing the opportunities for traders and the risks to spot buyers. Moreover, the value of load-shifting initiatives would diminish, as most reductions in the highest peak demand would have only modest impact on marginal cost.

• The role of demand: Initially, DSM programs represented an important compliance strategy, used extensively by each company serving retail loads. Over time, however, demand levels were affected less by these interventionist initiatives than by the straightforward economics of high prices. Under the game’s long-term price-elasticity assumptions (on average, a 10 percent decline in power consumption for a doubling of power price), by 2030 the impact of power price on demand was roughly four times the impact of DSM initiatives. While utility DSM investments typically are compensated through regulatory processes, price-driven falloff in demand typically is not. How regulators, legislators, and the industry will accommodate the potentially serious impact on utility revenue—particularly under circumstances when ratepayer tolerance for compensatory rate increases will already be strained—will be a dominant issue in any carbon-constrained future.

• Alternative energy: The market forces operative in this game brought the portion of renewables in the industry’s overall generation portfolio to 18 percent, without recourse to explicit renewable portfolio standards (RPS). With growing deployment, scale-based cost efficiencies made renewable technologies increasingly attractive. The potential of such technologies for distributed rather than concentrated application, combined with the rate pressures noted above, could fundamentally reshape today’s utility model—plunging it into an active intermediation role among myriad suppliers as well as myriad users of power.

Endgame: Strategic Questions

Typically, games of this kind aren’t one-shot efforts. Instead, by varying the fundamental assumptions, introducing different “game events,” observing the strategic patterns that emerge and adjusting individual strategies accordingly, players gain a progressively richer picture of the strategic landscape ahead. That picture informs the modeling, the options analysis, and the scenario hypotheses that frame robust strategic analysis and foresight.

The results of this single game nonetheless tend to validate the hesitations of today’s utilities. Uncertainty regarding carbon regulation makes it difficult to place big generation bets today. Allowing sound tactical incrementalism to narrow a company’s strategic vision, however, would be a mistake. While the game justifies current caution, it also conjures a future of fundamental changes. Industry leaders who hope to