If you were a utility executive today would you consider building a new nuclear power plant?
What if the United States decided to implement the emission reductions called for in the Kyoto Protocol without adopting it?
How might your business be affected by another 9/11-scale terrorist attack on a U.S. target?
What would be the impact of growing reliability problems in key U.S. power markets?
Some utility executives are asking themselves just such questions. Energy is a volatile and highly uncertain business. The list of factors that impact the North American power and gas markets is long and growing: glutted power generation, growing gas demand and rising prices, war and terrorism, increasing dependence on imports, potential (inevitable?) regulation of hydrocarbons, regulatory uncertainty regarding market organization, and the impact of new technology.
Scenario analysis is one technique used by some of the largest energy companies in the world today to effectively map strategies—and to manage the uncertainty associated with a decision about whether to build a new nuclear power plant.
In an effort to provide an independent, forward-looking perspective on markets, risks, and strategy, Global Energy Decisions developed Electric Power Horizons to provide robust alternative future energy market scenarios that challenge our clients’ existing perspectives on the future and test strategies against alternative business landscapes.
Today every energy company is rethinking and retooling its corporate strategy. The question is whether they adequately are stress-testing their strategy options and factoring uncertainty into the decision process (see Figure 1).
Past strategic mistakes can be traced to a failure to fully understand the key uncertainties and pre-determined elements that form the business environment. A key pre-condition to achieving sustainable competitive advantage is for a firm’s strategy to be consistent with its business environment.
Scenarios provide powerful tools to evaluate alternative strategies against possible energy futures. Thus, they offer a strategic compass in turbulent markets.
As risk-management tools for thinking critically and systematically about the future, scenarios can offer powerful insights to help clients manage their business across every stage of the energy business cycle.
Developed in the late 1960s, scenario planning is a proven risk-management tool that forces managers to think critically and systematically about the uncertainty of the future.
Scenario planning works by iteratively building plausible alternative views of the future based on critical economic, regulatory, and technological driving forces. By challenging participants’ mental maps, the process checks over-optimism, provides strategic insights, engenders a common language, and leads to better decision-making.
Global Energy Decisions worked with a broad cross section of clients to identify four distinct themes that could have the greatest impact on the energy business environment over the next 20 years. The themes are:
• Terrorism & Turmoil: Terrorism impact on petroleum and natural-gas supply imports, and on economic growth;
• Green World: Broader application of environmental controls, including CO2 taxes;
• Return to Reliability: Reliability standards adopted; and
• Nuclear Resurgence: Less dependence on fossil fuel generation.
These themes became the foundation for four alternative scenarios of the energy future, with main elements specified in outline and matrix form (see Table 1). The interplay among these elements and forces, and how they play out over time, is provided in the scenario storylines, which also include timelines. Each of the scenarios passed the three essential tests for robust and insightful scenarios, by:
• Capturing the critical uncer- tainties;
• Telling a credible, internally consistent, and complete story; and
• Provoking and stretching personal perspectives on the future marketplace.
Table 1 provides a high-level overview of the key themes in all four scenarios. The themes—fuels, energy pricing, economy/energy demand, market structure, and environment—represent the key drivers, which define and differentiate each scenario.
The four Electric Power Horizons scenarios provide a robust format for evaluating alternative corporate strategies given different business landscapes. Figure 2 is Global Energy’s high-level overview of how six generic business strategies are likely to perform across the scenarios.
Wholesale power prices are lowest in the Return to Reliability scenario due to higher reserve margins (less volatility), lower gas prices, and greater reliance on low-cost coal. In the Green World scenario, wholesale prices soar as CO2 taxes are introduced and the North American coal fleet is fully retired by 2026. In contrast, power prices in the Terrorism & Turmoil and Nuclear Resurgence scenarios fall somewhere between Return to Reliability and Green World.
In all the scenarios, natural-gas prices play a critical role in price formation and fall from their early period highs. Despite the record gas demand in the Nuclear Resurgence scenario, new sources of LNG play a critical role in keeping gas and power prices manageable. In Terrorism & Turmoil, global and domestic terrorist attacks on petroleum and gas facilities cause near-term commodity scarcity and price volatility. Prices also are relatively high in the Nuclear Resurgence scenario initially and provide the catalyst needed by LNG project developers (and regulators) to begin building more gasification capacity. Green World experiences the highest prices driven by strong natural-gas demand coupled with few new sources of LNG due to inadequate gasification facilities.
• Regional Utility. Regional utilities are likely to weather all four scenarios given their regulated earnings profiles. A possible upside in Terrorism & Turmoil is that the focus of the business moves to security and reliability regionally and away from broad national restructuring. The significant fuel switching and energy savings challenges presented in Green World suggests this business environment may prove the most difficult for regional utilities and marketers.
• Diversified Energy Co. This business strategy is likely to see the greatest upside in Green World given that growth opportunities more likely will present themselves in this renewable market-expanding environment with lower regulatory risks. As the economy contracts and slows, and restructuring comes to a halt in Terrorism & Turmoil and Return to Reliability, this business environment suggests less upside for diversified energy companies’ unregulated services.
• Integrated Oil/Gas. Integrated oil/gas strategy will face its greatest challenge and greatest business risk in Terrorism & Turmoil as gas and oil supplies from outside the North American continent become constrained. The Nuclear Resurgence business environment with healthy economic growth should be attractive for this strategy and possibly offer a good foundation for further downstream investment into power.
• Energy Merchant Co. Energy merchants will be hard hit in Terrorism & Turmoil. By contrast, energy merchants could thrive in a Return to Reliability environment, and gas merchants should have a significant opportunity to gain as coal comes under increasing environmental pressure in Green World.
• Renewable Energy. The business conditions in Green World and Nuclear Resurgence, while turbulent, play to renewables energy’s advantage as carbon-burning fuels are taxed. A renewable energy focused strategy will face new growth opportunities in Terrorism & Turmoil as natural gas becomes constrained and reliance on coal grows. Reliability business environment is likely to provide the greatest challenge as renewables will have to compete head-to-head with coal and natural gas.
• Technology Focused. Like renewables, because they start from a small base and are likely to be in a position to take advantage of favorable cost differentials in the future, technology focused strategies can be expected to be increasingly successful across all four scenarios. Terrorism & Turmoil will be a difficult environment, but technology companies focused particularly on clean coal are likely to see growth.
The powerful predetermined elements that exist across scenarios indicate common drivers and elements in all future business environments (see Figure 4). The key overlaps in the energy value chain that may offer strategic sweet spots—businesses with a high likelihood of seeing growth in the future—are identified below.
Natural Gas. A key defining feature of all scenarios is that demand for natural gas requires all potential sources to be explored, including frontier and LNG. Thus, significant investment likely will be required along the natural-gas value chain, including energy trading and risk management capabilities in Nuclear Resurgence and Green World, the expected high gas consumption scenarios.
Renewable Energy. Wind and solar energy are expected to grow across scenarios as economic, regulatory, technological, and societal pressures drive demand for these power sources. The higher-energy price scenarios—Nuclear Resurgence and Green World—are expected to be particularly attractive environments for renewable energy.
Pollution Control and Emission Markets. Existing environmental regulations continue to be enforced in all four scenarios and are tightened in two scenarios. Present efforts to regulate SO2 , NOX , and Hg continue, while Green World and Nuclear Resurgence scenarios move a step further to tighten CO2 emissions. These trends represent significant challenges for the industry and growth opportunities for pollution control companies.
Nuclear Units. Demand for environmental quality, rising natural gas prices over the last 10 years of the time period, and the solid operational record of the country’s nuclear fleet indicate that the value of these assets is likely to grow in each scenario. A CO2 tax in Green World and Nuclear Resurgence would be particularly advantageous to the existing and second-generation fleet of nuclear power plants.
Energy Saving, Metering, and Pricing Technology. Economic, technology, and regulatory drivers are expected to push energy intensity further along its downward trend in all four scenarios. Demand for energy-saving technologies, including metering and real-time pricing, will be especially significant in the two high-price scenarios where consumers pay a premium to cut power usage and save bills.
Fear of terrorist attacks, federal-state regulatory tension, and regulation and enforcement of environmental quality, and reliability are fundamental drivers in the four scenarios:
• Terrorism & Turmoil: Security Concerns;
• Green World: Environmental Regulation and Transition Away From Carbon;
• Return to Reliability: Reliability Concerns; and
• Nuclear Resurgence: Environmental Quality and Federal Legislation.
Regulatory challenges represent significant regulatory risk across all scenarios, and that risk is likely to grow in any plausible future business environment. As a result, regulatory expertise at both the federal and state level will continue to be a key core competency required for competitive advantage.
Scenario analysis provides the opportunity to play “what if” and test considerations across alternative views. Combining the qualitative power of scenario analysis with the quantitative capabilities of market and risk analytics software solutions can provide CEOs with a consistent, transparent, and independent decision support solution to assess strategy options across the enterprise and across alternative views of the energy future. Simulating the impact on market fundamentals and portfolio performance takes scenario planning to the next level and makes it suitable to guide business decisions and transactions.