Many of the obstacles and strategic issues that utilities face today are all too familiar. This time they must be solved with a different business model.
Judith Warrick is senior advisor at Morgan Stanley. Contact her at Judith.Warrick@morganstanley.com.
In the 1970s, the industry struggled under the burden of a huge capital expenditure program to improve reliability that came on top of spending needed just to keep up with customer demand. Inflation reared its ugly head. Interest rates began to rise. Fuel prices doubled, then doubled again. And the icing on the cake: new environmental laws that mandated costly new equipment. Sound familiar?
All those costs for environmental spending, coupled with higher reliability and increased demand, led to higher customer rates. No longer did new investment mean lower prices and happy stakeholders.
At first, it didn't matter. Regulators were supportive. They understood. They wanted adequate supply and higher reliability and cleaner air. They knew costs were out of control.
So they approved the price increases and supported the plans for new capacity-and the capital expenditure programs necessary to fund them. They supported environmental spending and new plant to meet greater customer demand, understanding that geopolitical factors caused rising fuel prices-even as they happily passed along those increases, too.
But finally it all began to take its toll. The price increases began to pinch, consumers complained, and politicians listened. Gubernatorial races turned on promises to stop rising utility rates and "restructure" those utility commissions that simply rubber-stamped outrageous requests.
Unfortunately, that's just when those price increases were needed most- to cover higher interest costs on debt and dividends necessary to convince investors to risk their hard-earned money on companies with such dire prospects.
We all know history never repeats itself. But sometimes it comes uncomfortably close.
The future I see looks frighteningly like an old rerun. The same prospects are on the horizon. And the first stirrings of unrest are already apparent.
Analysts are focusing on capital expenditures. The first revisions of cost projections have been announced. Free cash flow after dividends is turning negative. And when that happens, investors get grumpy-then demand higher returns.
Ironically, they'll need higher returns just when regulators will be searching for creative ways to justify reneging on their promises to support the capital budgets. Remember the last time that happened? Remember the fun of prudence reviews? That won't happen this time, but something equally unpleasant will—because one of the easiest ways to cut back rate requests is to lower returns on equity.
You'd Think We'd Learn
We overbuild, run short, then overbuild again. You'd think we'd learn, because when the forecasts aren't accurate, when overcapacity plagues the industry, companies fail.
Can we get the forecasts right? Probably not. But we can plan for forecasts that will be wrong. They always are. And they will be until the system is redesigned to let prices clear the market.
That has nothing to do with deregulation. It is simply getting accurate price signals to your customers and then letting them choose how much and when they want to consume.
Until people and equipment have the information necessary to choose to use energy based on the actual cost to produce it, we have to make the best of the system we have.
So we must structure systems and operations to minimize the problems inherent in forecast error. And that means recognizing the fallacies in the assumptions that underlie them.
Let me put it in stark terms. Should a management bet the company on its ability to estimate future customer demand? We all hope not. Remember those forecasts in 2000 about how much power the United States was going to need over the next decades, and how we couldn't begin to build enough? Now look at the glut we're still trying to work off! Some regions will have overcapacity into the next decade.
What about gas price forecasts?
Or oil? Know anyone who's gotten that right? Not me. And by the way, I continue to be a contrarian here. Current natural gas prices and consensus forecasts for supply and demand remind me of the power markets from 1999 into 2001.
Will we need all the plants now on the drawing boards? Will gas prices ever see $5.00 again? And are you willing to bet your company on the answers, and then double down? The stakes are high, because you're banking that:
- Customers won't revolt at the prices needed to recover your investment;
- Politicians won't change the rules of the game yet again;
- Regulators will keep their promises; and
- Investors won't decide there are easier and less risky ways to make a buck.
A New Business Model
Before depression sets in, let me say I believe this industry has a great opportunity to do things differently, to see things differently, and to choose a business model that doesn't crash if your crystal ball develops a crack. One that doesn't depend on the grace and good humor of your regulators or on the forbearance of your investors. One that doesn't make you hide from people at cocktail parties, fearful they might ask where you work.
What could the business model look like? One that could overcome all the costs required by forces outside your control: rising environmental costs, renewable standards, and green mandates, mounting labor and pension costs, higher fuel prices, rising interest rates and inflation? Fuel and interest rates are two of the biggest costs on the income statement.
Lower Prices When Costs Are Rising?
How do you lower prices when most of your costs are going up-before investments in expensive new plant that require price increases? We can learn from history.
In the 1960s, economies of scale in generation sent prices spiraling down for a decade. In the 1990s, heat rates dropped from 10,000 Btu/kWh to 6,500 Btu/kWh. When the economics changed, so did merit order, dispatch and industry structure.
In the 1990s, the energy industry accomplished heat-rate reductions through technology, as 3-D seismic technology changed the cost structure of finding gas and oil. That's now happening with LNG, as technology lowers shipping costs.
But such innovation needs to happen throughout the utility world. Utilities need to focus on technology that lowers prices, but why should they take risks when there's no reward?
Transmission and the Power to Transform
Today, any technological transformation in the industry is likely to start with transmission. Why? Computers control electricity flows 24/7, but the electricity grid can't direct the electrons flowing across its network. The difference is silicon. Computers use electronic switches; the transmission grid uses mechanical switches. And silicon makes all the difference.
An electronic switch operates at the speed of electricity. Add silicon to the grid and throughput can be increased.
We don't need to site and build new lines. We can use the lines we already have more efficiently-and with higher reliability and stability. When electricity flows are controllable, the system can operate closer to design limits, and that transforms the economics not just of transmission, but of generation as well.
Imagine the impact of increasing power flows on existing lines by 50 to 300 percent. What would it do to capacity utilization of generating plant? To fuel prices? To gas demand?
A Smart Grid Is … Well, Smart
That's the start. And from there, it only gets better. Creating an intelligent network enables a system that is self-healing. That means the most efficient use of plant, equipment, and resources. That improves energy reliability and stability. That enables new products and services.
A smart grid enables appliances like air conditioners and refrigerators to cycle themselves on and off, depending on the owners' preferences for comfort and price. Think what that could do to peak-demand requirements and the value of expensive and inefficient generation. Think about air-conditioners and refrigerators beginning to network, creating complex systems that adapt to changing weather and price conditions.
Think about what that means for pricing. Some estimates show that a 2.5 percent reduction in peak demand could reduce the costs of serving that peak by 25 percent.
And eliminating frivolous or time-insensitive peak load not only frees up generation but has a huge effect on transmission system capacity.
Then there's broadband over powerline (BPL) technology, which can start with load control and peak demand and then morph into a whole new line of products and services-ones with higher profit margins and happier customers.
All of this makes me wonder about the future of central station power generation.
Distributed Generation for the Digital Economy
Distributed generation (DG) is the future. It has to be. DG can provide support to the transmission system, so the costs of DG shouldn't be compared with central-station plant but evaluated based on how they change reactive power needs, voltage, and stability on the transmission lines.
DG also is the future in a digital economy. Central station power plants cannot supply the reliability and power quality needed for a digital society. Most customer interruptions are not due to failures in central-station plant. They're in the transmission and distribution (T&D), and mostly the D side of the house. So siting plant closer to (or actually at) the load source will increase power quality and reliability.
Imagine what would happen to your load forecasts if the majority of your customer growth is siphoned off by DG installed for stability and reliability, not cost.
Another rather clever reason: Digital power is DC. We generate power at DC, convert it to AC, and then convert it back to DC. That is not efficient. And because all those converters weigh a lot, take up space, and consume unnecessary energy, someday that will change. Someday a small DG unit may sit in the basement and a dedicated circuit in all new housing will service digital equipment.
Smart and Reliable
So if the future is distributed generation, why not get there as fast as possible? Why even consider building 30-year assets that require years to license and build when forecasts just 10 years out are a roll of the dice?
And think of the value for gas companies in a distributed generation future. One where small units distributed throughout the system are networked in to a smart and reliable grid. A network of units (think of them as agents) that "learn" and "adapt," that design the most efficient system, the most efficient network, the most efficient combination of supply and demand and price possible without any input from us mere mortals.
Sound a bit crazy? Perhaps. But I believe it is the future—"smart matter" in John Seeley Brown's words, or matter that can remember and learn, matter that can distinguish where high quality power is needed, where and when energy has a high value, where and when interruptions might be tolerated or even disregarded.
Today's electric power system is not flexible, scalable, or economical. It is a command-and-control system. Yet the most powerful systems in the world are just the opposite. The more powerful, the more complex a system, the more it can neither be understood nor operated and controlled by a central point of intelligence.
The electric system could be designed and operated just like the Internet. It could be controlled by algorithms, not by human system operators. Sound futuristic? Sound crazy? Sound expensive? If so, consider what such a system might prevent: siting and building a new 1,000-MW plant; $10 gas prices; constructing an LNG terminal; and costly, erroneous forecasts.
Get the prices right, and the rest shall follow.
Prices to Customers, Shareholders, and Employees
John Maynard Keynes wrote, "Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally." We need to prove that wrong. This industry does not have the luxury of doing things conventionally.
Customers need lower prices. Shareholders need to be rewarded for the risks they take. Your utility employees are the only ones who can make that happen. Technology can help them.