A TRANSFORMING EVENT
Retail sales of gas and electricity run about $300 billion a year. The deregulation of energy production, wholesale logistics, and bulk consumption has brought competition to about 40 to 45 percent of the value chain from wellhead and busbar to the retail meter. Thus, 15 years of fitful deregulation has brought competition to less than half the final price paid by middle-market and residential gas and electric consumers. Moreover, gas and electric final markets are extraordinarily balkanized; each is circumscribed by the geographic boundaries and regulatory confines of thousands of franchised and municipal firms engaged in distribution.
Retail deregulation will compress industry margins from existing lines of business (while creating enormous new business opportunities), transform energy selling into a cyberspace retailing enterprise, and eventually cause the gas and electric industries to converge (see figure on p. 22). Convergent evolution promises significant business consequences for the production, merchant, local logistics, and network (that is, gas and electricity long-haul transportation, balancing, and system control activities) segments of the emerging and essentially integrated U.S. gas/electric industry. For the next 10 to 15 years, this convergence will affect consumers, investors, executives, regulators, legislators, and of course, business and government advisors/counselors. Neither private strategy nor public policy can succeed if it ignores or denies the rules of this new energy game.
COMPETITION AND COLLABORATION
Industries converge at the level of the consumer and then at the level of collaboration. First, different industries seek to maximize their share of the consumer's spending to satisfy a set of cognate needs or buy a class of related services (such as financial products or information, entertainment, and communications). At the level of the consumer, converging industries compete until they erase market boundaries.
At the second level the converging industries become collaborators or mutual customers. For example, investment banks and commercial banks, while increasingly battling for corporate finance clients, are also each other's good customers. Similarly, the telephone, television, and computer industries buy large amounts of goods and services from each other. As inter-industry trading increases, the industries begin to overlap. The boundaries of their delivery systems begin to blur, paving the way for an eventual reordering and integration.
Energy markets exist because consumers seek to gratify their wants and needs for heat, light, and motive force (including propulsive force) in the most satisfactory way. Currently, energy consumers meet their needs rather awkwardly by purchasing combinations of final fuels and appliances. A particular fuel and appliance combination, such as a gas furnace or electric heat pump, leads to a given price/performance result. In a free market, consumers will gravitate toward the best price/performance combination, as long as they have choice and information, and are courted by merchants eager for their business. Today, of course, consumer decisions are severely circumscribed by an energy delivery system in which gas and electric retail distribution operate as compartmentalized monopolies. But as monopoly eventually vanishes, choices and the ability to exercise choice will proliferate and empower all consumers. Then, gas and gas-using technologies and electricity and electrotechnologies will strive vigorously against each other for the prize: customer loyalty and consumer dollars.
Inter-industry trade between the gas and electricity industries will grow substantially during the next 10 years. A minor aspect of this increased collaboration will involve greater use of electrotechnology and electronic equipment by the gas industry as it seeks to boost its own productivity. The major part will come from refining molecules into electrons via the impressive advances just ahead in gas turbine plants. These facilities will appear in various guises (em merchant, dedicated, industrial onsite, and (nonpipeline quality) gas field onsite plants, ranging from 20 MW (niche) to 200 MW (commodity) (em will dominate new generating capacity late in this decade and well into the next.
The new gas-fired generating units (basically jet engines), especially the merchant plants, will produce electricity at dramatically lower costs than either utility peaking turbines or industrial gas cogeneration facilities could manage even three years ago. By the end of the 1990s, the gas-fired generators coming on line will be profitable at a benchmark wholesale electricity market price of 3.5 cents per kilowatt-hour (›/Kwh), FOB the high-voltage transmission network. A confluence of factors will make this possible: 1) a compressed construction cycle of 14 to 16 months compared with the current 22 to 30 months; 2) continued rapid advance in the heat rates of gas turbines; 3) manufacturing process improvements; 4) standardized engineering and construction practices; and 5) reduced O&M costs as automated operations dramatically reduce the need for labor. By 2005, the competitive benchmark price may fall below 3›/Kwh.
Four great economies will emerge during the period of convergent evolution. Those able to capture these economies will invent both the structure of the new gas/electric industry and sources of profit for their firms.
s Economy of competence (intellectual capital): The most powerful in the merchant end of the industry, since the mass-marketing of gas, electricity, and efficiency services in an unregulated environment are substantially similar endeavors. It will lead to lateral integration of the merchant segment.
s Economy of logistics: The most influential in the local, regulated transportation of molecules and electrons. Local transportation is essentially a step-down function from high volume, high pressure, or high voltage to retail levels, combined with safety and maintenance skills and the ability to process energy routing transactions. As a result, the existing distribution structure will first be legally and financially separated from the rest of the delivery system and then reconstituted and consolidated under new ownership and regulatory regimes.
s Economy of network operations: Most apparent in running large-wire or large-pipe businesses, both of which are evolving into true network systems with many nodes and enormous connectivity. Again, this economy will dismantle and then reassemble big wire and big pipe companies.
s Economy of production: The most compelling in the large-scale production of gas and electricity. With the capitalized cost of gas as fuel amounting to about 4 to 5 times the capitalized cost of a modern combined-cycle gas turbine facility, forward integration into generation by owners of gas reserves (or backward integration into gas reserves by owners of substantial gas-fired generation capacity and much cash) will bring considerable competitive and operating benefits.
Competition and collaboration among the gas and electric industries provide the impetus for convergent evolution, which changes the industry structure. However, convergent evolution of functions does not by itself determine who wins and loses, which firms end up owning which assets, and who makes money where in the industry. That essential business aspect will be determined by which companies are either clever or lucky or diligent (or all) enough to internalize the various economies. It will prove quite unlikely for any company to internalize even two of the economies, since each requires a different corporate culture, balance sheet, executive emphasis, and corporate priority. It is almost impossible that any firm will successfully internalize all four economies, though many will squander fortunes and bruise executive egos trying to.
CYBERSPACE AND THE NEW ENERGY MERCHANTS
Just as the combination of Intel, Compaq, Apple, Microsoft, and Novell invented computing democracy and overthrew IBM's seemingly impregnable rate base, so too will electric and gas supply aggregators/wholesalers and unregulated electric and gas retail merchants combine to replace the production and sales rate base of utilities. The new retail merchants will leverage their intellectual capital to unleash cyberspace marketing on the energy industry. For historical reasons, a paucity of marketing imagination has long characterized both the electricity and natural gas industries. This gap creates a powerful opportunity. All successful unregulated energy retailers will be Net (that is, Internet) merchants by the end of the decade, using the vast potential of cyberspace to create entirely new and highly appealing ways to satisfy energy consumers. These Net merchants will actually market five broad categories of energy service to middle market and residential customers: electrons at the meter, gas molecules at the meter, energy information services, energy efficiency, and consumer financing for energy efficiency. The second generation of Net merchants (within 10 years) will transcend electrons and molecules (energy goods) to begin directly selling heat, light, and motive force (energy performance) to retail energy consumers.
The Net merchants will succeed by vaulting over the three great barriers to retail sales entry, as perceived by utilities: retail billing, collection, and customer service systems; efficient mass aggregation of meters; and access to every consumer in the service area. This remarkable new breed of energy retailer will staple their dreams of consumer service and proliferating energy products to five reinforcing technological trends: (i) remote digital measurement systems; (ii) the geometrically increasing connectivity of Internet; (iii) hypertext software; (iv) exponentially decreasing costs of bandwidth (over 5 million miles of fiber-optic trunk lines have already been installed, and these are massively underused); and (v) interactive audio/video via the television or telecomputer, incorporating speech recognition codes and information navigators.
The future of billing, collections, and customer service in every retailing industry is mass customization. No existing utility billing system seems capable of being modified to meet this need. Interestingly, most utilities are not adept at retail marketing and meter aggregation because they have never had to do it. Utilities did not go forth and laboriously build a book of business. Captive energy users were delivered by the thousands or millions to each utility through the device of the franchised service area. Consumer marketing is, thus, hardly a core competence of the typical utility. Finally, most utilities, despite their access to every consumer in their service area, barely know the individual needs, circumstances, and desires of the consumer (em much less design tailored services.
The future of energy retailing, however, is customizing and delivering services for each consumer by endlessly combining and recombining the product features most valued by that consumer into a unique energy package.
A utility culture dedicated to the proposition that money is made by obtaining the highest possible allowable rate of return on the largest possible rate base will find it very difficult to adopt a retailing culture that makes its money by pleasing the customer. Each customer has a different sense of what is valuable because each consumer is unique. Value is created by meeting felt or unarticulated needs and solving problems. Value is created by delivering benefits at the meter, the mailbox, and the video screen (em not just by producing electrons at the busbar or making the gas pipelines roar.
Before the decade is out, many consumers could have the ability to exploit directly all the advantages of cyberspace marketing and turn proliferating choice into expanding benefits for themselves. These consumers will be as diverse as the purchasing manager for a multilocation assembly company, the president of a winery, the administrator of a school district or hospital, the general manager of a chain of hotels, the owner of a bakery, and eventually, the homeowner. Each will be empowered by cyberspace retailing to summon all the information needed to analyze and select energy products and services; scroll through and peruse electronic catalogs; screen and query Net merchants; solicit, compare, and accept offers; negotiate directly on the screen; record an order for a service or package of services; choose the invoicing format, pricing structure, and payment method; instruct that charges be made to a desired credit or debit card (perhaps an affinity group card from a telecommunications, consumer retailing, or personal financial services company); and enter his or her speech recognition password into the automated and interactive customer service system of the preferred Net merchant.
DELIVERY SYSTEMS AND VANISHING CAPITAL
Once the structural change is complete, a truly integrated gas/electric energy delivery system will emerge around 2010. There will be few purely gas or purely electric companies, except, perhaps, at the local regulated distribution (small wire, small pipe) level. Instead, we will see gas/electric producers; gas/electric network companies (owners of big pipe and big wire) to move molecules and electrons long distances; gas/electric wholesalers and traders to buy and sell and trade bulk molecules and electrons; and unregulated gas/electric retailers to deliver energy price/performance benefits to all consumers, including homeowners, transporting energy to the final meter via regulated little pipe and little wire logistical firms.
Regulators and legislators will gradually (suddenly, in some states) adjust to the will of the competitive market. The production and sale of energy will be almost completely free of price and sales controls. High-voltage transmission will likely witness joint federal and state jurisdiction, with the Federal Energy Regulatory Commission taking the lead role. Either voluntarily or forcibly, local regulated gas and electric entities will give up their sales tariffs (em soon in high energy price areas, and later in lower priced areas.
Regulated electricity distribution (little wires) will separate from regulated electricity transmission (big wires) as various states deregulate electricity. This separation will bring a phased consolidation of regulated electricity distribution and regulated gas distribution companies. The pace will stay leisurely until most of the large consuming states have embraced utility deregulation and Wall Street discovers a way to pay for the premium over book that mergers entail. Regulated transmission companies will exchange stock to create multistate and multiregion entities to better serve natural transmission markets. Moreover, a few mergers (or quasi-mergers through alliances) of regional electricity transmission and gas pipeline companies may occur. The business of transporting molecules and electrons long distances is likely to evolve into an "intelligent network" business where the truly innovative companies will perform feats of regional or continental logistical magic, accepting energy at one node of a transportation system and making it appear as a package of energy and services at another.
To accommodate the growing sophistication of inter-financial market gas/electric futures, swaps and options instruments, and strategies, one or more of these enormous intelligent network companies (or alliances) may find it lucrative to accept molecules and redeliver electrons, and vice versa. This would, in essence, combine a physical logistical service with a financial molecule/
electron crack spread service, enabling producers of gas and electricity to participate directly in the hundreds of thousands of interregional and inter-energy market arbitrage opportunities that always exist in vast, fairly fragmented, and rapidly moving markets. Such a service could, in theory, enable a gas producer in West Texas to contract with an electricity wholesaler or even a retailer in Northern California to directly sell electrons in a composite one- to two-year location/ energy swap transaction, receiving a netback price for the gas. The netback could come from an electricity hub or network nodal pricing point in either state.
As a corollary to these pipe and wire combinations, deregulation functions, and increased efficiency, scores of billions of dollars will be squeezed out of the shrinking energy rate base. A portion will simply be extinguished; other losses will come at the expense of stock and bondholders of uncompetitive asset-based companies; the rest will be repatriated to their holding companies and nonregulated affiliates. In almost equal amounts, surplus liberated capital will seek North American and foreign outlets. Nonregulated U.S., Canadian, and eventually, Mexican gas and electricity producers, among others, will find great receptivity for their many proposals to absorb the North American component of this mobile capital. This new flow of capital, could, in fact, hasten the integration of the gas and electric industries.
PRODUCERS (em NICHE, MERCHANT, AND GEMCO
Large gas producers (more than 250 million cubic feet per day (MMcfd) of deliveries) face two dominant strategic issues. First, they cannot rely on rising commodity prices to improve the generally disappointing return on capital they have realized in the past 10 years, because competition may keep real prices at the wellhead flat or falling (from the 1994 annual level) for many years. Second, they cannot afford to be excluded from the convergence of gas and electric supply.
Most large-volume gas producers have not made a return on total U.S. E&P capital that averaged 11 to 12 percent per annum over the 10-year period between 1984 to 1994 (since the modern gas market arose). Very large-volume (more than 500 MMcfd of deliveries) producers are unlikely to have averaged even a 10-percent return over the same period. There is little prospect that the large producers as a whole can do better over the next 10 years unless they change their strategy from commodity gas production to gas-electric "manufacturing" (GEM) and gradually become gas-electric manufacturing companies (GEMCOs). Merchant gas-fired generating plants could produce an average return on capital in the low teens, after tax, over the foreseeable investment horizon. Niche plants could produce a return in the middle or even high teens, depending on location. Niche generation is not for large producers but merchant generation is. Integrating forward into merchant generation and wholesale power marketing can boost the mar- ginal return on capital for large producers, including the majors, appreciably. Niche generation can also be desirable for medium-sized producers (at least 75 MMcfd in production).
The economic imperative for medium-sized independents or subsidiaries of diversified energy companies and financial houses to integrate into niche generation, and for large producers to integrate forward into merchant and dedicated power generation (through both grass-roots construction and the acquisition of generating assets from the rate bases of utilities), will drive the gradual development of combined gas and electric supply companies or GEMCOs. In time, GEMCOs will broaden their fuel mix and asset base by acquiring other fossil energy (oil, coal) generating assets from rate bases, or by acquiring independent power (IPP) and cogeneration companies or unregulated utility affiliates now in the IPP/cogeneration business. Reverse transactions are also likely with spun off fossil energy generating companies of electric utilities integrating backward by buying a large IPP or the regional E&P division of a major. GEMCOs, anchored by gas reserves and gas turbines, may well have North American assets of $10 to $25 billion each when the integrated gas/electric supply industry finally evolves.
FOOD FOR THOUGHT
Since this article began as a thought experiment, it should close with questions, not answers:
s Influence. Which companies or regulators will embrace convergence; which will oppose it? Which side can wield enough power to get its way?
s Finance. What will convergence mean for balance sheets, credit quality, and equity formation at energy companies? And how will it affect the pace at which assets are transferred from rate base functions to market activities? What happens to nuclear plants?
s Efficiency. Will companies capture sufficient economies to win big through lateral integration of the merchant, logistics, and network businesses, and vertical integration of the energy production function?
s Survival. What irreducible natural monopolies will endure in the energy delivery system from wellhead (or mine mouth) to busbar to final meter? Who will regulate these residual monopolies?
s Institutions. Will the force of technological change and the rise of intellectual capital sweep aside regulatory, organizational, and industry structures?
s Grassroots. Will consumers, especially large energy users, be content with gradual change, or will information about choices empower them to compel rapid and substantial change in the energy delivery and regulatory system?
The future cannot be predicted. No single path is ordained or inevitable. The future can, however, be invented (em by those who who would shape the world in their own image through will, money, and imagination. t
Vinod K. Dar is chairman of both Jefferson Gas Systems, Inc., a private co-investment company, and its electric services subsidiary, Jefferson Electric Inc. He also serves as senior advisor to RCG/Hagler Bailly, Inc., an international energy and environmental consulting firm.
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