The advent of a competitive electric utility industry will fundamentally change the role of fuels in the industry. The fact that fuel is the dominant variable cost in power generation will reverse the relationship between the fuels and power production functions in many companies. Only plants that are competitive will operate; only operating plants will produce revenues. Economic survival will require a generating company (or that part of an integrated company responsible for generation) to: 1) compete successfully on variable cost for both offsystem sales and native load, and 2) ensure that fixed costs are profitable at the average price of electricity. Companies that position themselves for this shift will prosper; companies that do not will have these changes imposed on them by the market and will risk their continued viability.
Traditionally, the fuel adjustment clause and utility franchise laws were thought sufficient to limit a company's fuel risks and opportunities. Although subject to prudence review, rising fuel costs could usually be passed on to captive customers. Savings were similarly passed on to customers. Fuel has been even less of a concern over the last decade because fuel costs have been the only declining component of operating costs (see Figure 1).
A competitive business environment that allows customers to take power from the lowest-price offeror is quite different (em neither fuel cost recovery nor customer retention are guaranteed. Moreover, success is determined by the relative fuel costs of competitors, not the absolute fuel cost that a regulated firm is charged with minimizing. A company can satisfy regulators by lowering fuel costs and still lose to its competition. The financial impact of even a small fuel-cost advantage over a competitor is highly leveraged; saving a potential customer a few thousand dollars can result in a power sale many times that amount. These realizations are spreading. Customers, not regulators, are seen as the constraint on fuel costs. Aside from their growing irrelevance, a movement toward eliminating fuel adjust-ment clauses is gathering steam before state commissions. All of this argues that fuel costs will no longer be a neutral factor in utility performance. Fuel management will greatly hurt or help a company's bottom line.
In a competitive environment, customers are sensitive to the cost of fuel when the utility's fuel costs can affect either the amount of power purchased or the price paid. The degree of customer sensitivity to fuel costs depends on three factors:
The share of fuel costs in the rate charged. Rate designs and cost responsibilities, and hence the relationship of prices to fuel costs, vary for different customers under regulation. These will continue to vary under competition. Since fuel is a variable cost, the price of power to virtually all customers covers those costs. The prices customers pay differ more, however, as to the amount of fixed costs they cover. Fuel costs represent a larger share of rates charged to those customers less responsible for a utility's fixed costs (em typically bulk-power and larger industrial or institutional customers.
Customer supply choices. Customers with other options for meeting their electricity and energy needs are more likely to react to higher fuel (or other) costs
recovered in the rates they pay by reducing electricity usage or switching to their other supply options. The mobility of many larger customers will increase with growing competition.
Customer electricity price sensitivity. Electricity is a large part of the cost of doing business for certain customers (em such as wholesale customers or large electricity-intensive industries. These customers will be the most sensitive to fuel costs. Customers that consume large amounts of power and are in price-sensitive commodity businesses themselves will be especially sensitive to electric prices.
Overall, customers that are the most highly fuel sensitive are also exhibit the greatest propensity for being lost to a competitor (see Figure 2 on p. 30). In recent years, as wholesale power markets have grown, industrial customers have begun to demand open access and rate concessions. Utility attention, not surprisingly, has been focused on these customers (em customers that are clearly the most fuel sensitive. But this is only part of the story. Fixed (capital and O&M) costs must be covered for a company to be profitable. Some customers must pay more (em typically much more (em than variable costs. Regardless of cost-cutting measures, a company must maintain a core of committed customers that are willing and able to pay the
remaining fixed costs. Unfortunately for many utilities, competition may soon extend to these customers as well. They too may have other options. Fixed costs and the executives responsible for them will continue to play a key role, but fuels will take the lead.
The crucial issue is the balance between variable and fixed costs. It does little good to minimize fuel cost if doing so creates capital or operating and maintenance (O&M) costs that cannot be recovered. Similarly, it does little good to minimize O&M costs or improve efficiency or reliability if fuel costs are driven so high that the power output becomes noncompetitive. In addition, customer needs vary and the services offered (em and the mix of fuel and nonfuel components in those services (em must still be matched to those needs. Fuel and power production managers (em as well as others throughout the company (em must work together to reach a balance that ensures both competitiveness and profitability over the long term.
Managing Fuel Costs
Utility fuel departments already work hard to minimize fuel costs. (In some utilities, they work with the power production department to minimize generation costs, which is a more relevant goal.) But, ultimately, the fuel department's efforts are constrained by the physical and operational infrastructure of the company's power plants. Plant fuel flexibility, location, access to fuel sources (rail lines, navigable rivers, pipelines), emission limits, and prior contractual relationships all place limits on what the fuel department can do.
In many high-fuel-cost companies, plants will not be dispatched if their fuel costs are higher than competitors (em certainly not for offsystem sales, and in many cases, not for native-load sales. Increasingly, the distribution/retail operations of integrated companies will be empowered (em or forced (em to view dispatch of the company's own plants as part of a broader make or buy decision.
The only long-run choice open to many companies will be to restructure their plant mix or operations in such a way that fuel costs become competitive. Yet the incremental fixed costs of doing so must remain low enough that the utility still makes money.
Restructuring generation resources to meet fuel objectives and constraints is exactly the opposite of the way that fuels have traditionally been managed. In many companies the fuel function reported to the production department, and fuels were viewed as just one more commodity to keep the plants running. While this perspective has broadened, many companies still consider power production their core skill. Unfortunately, by itself, this skill provides little enduring competitive edge: Power plant operating skills are common; considerable excess capacity exists in many regions; and new plants can now be built by a broad range of potential competitors. Coordinating power production and fuels with power marketing and environmental activities, however, is the lifeblood of an effective corporate strategy.
Many companies can produce a greater impact on variable costs through innovative fuel management than by changing power plant operational practices. Heat rates and availabilities can only be improved a few percent at most plants. Furthermore, the technologies and practices that allow such improvements are usually available in the marketplace and can be replicated by competitors. Fuel management options, by contrast, are often much more diverse. Creative fuel strategies can have unique and continuing impacts on variable costs beyond just a few percentage points. Competitive fuel prices don't just happen.
Companies will structure their strategies to improve fuel management in a variety of ways:
Explicitly linking power market transactions to fuel market transactions. Fuel market activities will be designed to meet the needs of specific power contracts. Relationships with producers and carriers will be structured to ensure that fuel prices support competitive power pricing. Utilities will develop innovative fuel contracts and establish relationships with fuel suppliers and carriers other than the traditional arm's-length relationships.
Acquiring and disposing of generation resources. Fuel considerations have long been key to technology choice and environmental compliance. Now they will take on added significance as utilities shuffle their generation mix. Plants that are poorly sited or structured to produce low fuel costs will be dropped; plants with favorable fuel-supply characteristics will be added. Evolving distributed generation concepts will also present significant fuel-supply challenges.
Increasing reliance on outside production capacity or energy. This strategy may include purchases (or leases) from neighboring utilities as well as independent power producers (IPPs), and perhaps even moving utility-owned plants outside the corporate structure (sale/leaseback). By adjusting contract terms, such shifts in reliance may convert generation assets from a fixed cost to assets with different degrees of cost variability. This option will increase operational and financial flexibility and reduce dependence on specific fuel suppliers.
Restructuring fixed costs. While variable costs may determine which companies are competitive in currently price-sensitive markets, coverage of total costs determines profitability. Companies will be seeking creative ways to minimize fixed costs; much of this burden will fall to power production managers. Frequent tradeoffs will take place between variable (fuel) and fixed (capital plus O&M) costs. Determining the proper cost structure and how to implement it will require coordination between fuels and other departments such as power production, power sales, accounting, and finance. In some cases, a restructuring will ensure the profitable operation of the restructured entity, based on its potential fuel-supply portfolios. The regulatory treatment of "stranded in-vestments" and "stranded liabilities" and the reactions of
the financial markets to such restructuring will complicate matters.
Developing creative joint operating agreements and alliances. Many potentially fruitful cooperative options exist among: (a) power producers; (b) power producers, fuel suppliers, and carriers; (c) power producers and their customers, and (d) other combinations limited only by the creativity of the parties. Merger is perhaps the most extreme form of cooperative alliance.
Fuels expertise means more than just buying the lowest cost fuel; it means understanding the fuel markets to give the utility an enduring competitive edge in both the fuel and power markets. Power production skills will remain important, but in a new way. Greater two-way interaction will take place between fuels and power production. This interaction will include system planning, dispatch, and bulk-power sales. t
Jeffrey Price is president of Resource Dynamics Corp. in Vienna, VA. This article derives from discussions with a broad cross-section of U.S. electric utility fuel managers contacted during the course of an Electric Power Research Institute study on fuels management and corporate performance.
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