2008 CEO Forum: Conservation Compact


Utilities test new models to encourage investments in efficiency and conservation.

Fortnightly Magazine - June 2008

Efficiency is the topic of the moment. Across the country, utilities face increasing pressure to prioritize investments in conservation and load-management programs. But every utility has a different set of resource options and investment strategies, and every state approaches efficiency-related investments in a different way.

Amid this jumble of policy and business factors, one technical fact seems clear: Demand reduction is the low-hanging fruit, and every utility will be expected to harvest that fruit as thoroughly as possible—in part to demonstrate that other investments truly are necessary and prudent, and also to address customers’ concerns about rising utility bills.

“Properly managed energy efficiency and conservation efforts reduce the need to finance and build resources,” says J. LaMont Keen, CEO of IDACORP and Idaho Power. “That drives down capital needs and operating costs, and improves customer satisfaction.”

In this year’s CEO Forum feature, Fortnightly interviewed leaders at several companies with dramatically different approaches to financing efficiency and conservation investments. Their wide variety of perspectives exemplifies the many business models being used by U.S. investor-owned utility companies—and the multiple paths leading toward a more efficient electricity future.

Green Mountain Model

When Green Mountain Power CEO Christopher Dutton announced his successor last December, he said Mary Powell was “fearless as she embraces change and new thinking.”

That’s a good thing, because senior v.p. and COO Powell will take the reins to one of the newest-thinking utilities in the country. The company’s power supply is almost carbon free, and it expects to satisfy all future demand growth with renewables or conservation. Plus GMP finances and earns a return on conservation investments through the state’s “Efficiency Utility,” and its returns are decoupled from its sales revenues.

Fortnightly: Most of your power comes from contracts with Hydro Quebec and Entergy’s Vermont Yankee nuclear plant that will expire in the next few years. How will you replace those supplies?

Dutton: We’re engaged in discussions with Entergy and Hydro Quebec. In fact we’re exploring the potential to increase purchases from Hydro Quebec. But there’s some uncertainty about relicensing Vermont Yankee. We certainly hope the plant is relicensed, and we can get an economically attractive agreement. The plant has been a remarkably reliable and efficient generator of electricity over its 36 years of operations, but we’ve had concerns about too much dependence on a single generating unit.

We’d like to continue and enhance the carbon-free characteristics of our supply, and the degree to which we can do that and achieve diversification represents one of the challenges we have going forward.

Powell: Vermont has become a leader in the country because of our Efficiency Utility. We’ve bent the load-growth curve through efficiency. That’s no small feat. Now, how do we develop a renewable strategy for Vermont that meets our baseload requirements?

Right now the strictest definition of renewable wouldn’t include existing large-scale hydro, yet it is an important resource for our portfolio.

Fortnightly: How do investments in conservation and efficiency affect GMP’s business? Do Vermont policies provide adequate incentives?

Dutton: We in Vermont have made a remarkable commitment to efficiency, and we’ve done it in a somewhat different way than elsewhere in the country. Seven or eight years ago our legislature enacted statutes that authorized the creation of a free-standing entity called the Efficiency Utility, which operates under the auspices and supervision of the Public Service Board. That entity takes revenues generated by a surcharge on all electricity bills in Vermont, and then invests those monies in efficiency programs in homes and businesses in the state. We’re responsible for serving the load that remains after the Efficiency Utility does its work.

The other thing that has developed is that we are the only utility in the state with a decoupling arrangement in place. By and large we are indifferent to how many kilowatt hours we sell. We have an alternative regulation plan in place that among other things provides for a pass-through of power-supply costs and an adjustment for revenue volatility. As long as we can control our other costs, we have the opportunity to earn the appropriate return on equity. It has worked brilliantly. It has allowed us to focus on what we need to do, and to look at our power supply portfolio in a completely objective way, so we make the right choices on behalf of our customers.

Fortnightly: Do the decoupling and efficiency policies actually provide an incentive to invest in conservation, or do they just make you neutral to it?

Dutton: In part we just collect the revenues and the Efficiency Utility makes the investments. But one of the features of our acquisition last year by Gaz Métro was to help fund an additional $10 million of efficiency investments in Vermont [beyond the revenues raised from the efficiency surcharge]. We contracted with the Efficiency Utility to provide that service. Under the order approved by the PSB, we earn a return on the investment we make. We earn 10.25 percent, which we think is reasonably attractive.

Fortnightly: Some consumer advocates say decoupling shifts risks and costs to customers. How does your mechanism protect customers and ensure they’re getting the best deal?

Powell: It’s not about us getting off the hook in our responsibility to deliver the best possible portfolio strategy for our customers. There’s no worry in that regard, because the way it was structured, we have more reporting and review by regulators now than we did before decoupling, and we have a more transparent relationship. The cost pass-through can be somewhat quicker, but in the first year we actually brought our customers lower rates through alternative regulation adjustments. The rigor around how we structure it ensures we’re not just fat and sloppy about how we procure contracts and think about things.

Fortnightly: How does your decoupled structure affect the way you look at T&D investments, particularly things like smart metering?

Powell: I don’t see any more or less incentive to make investments. What drives us is whether it’s the right thing for our consumers and business, and if it is then we will work with regulators to move in that direction.

Dutton: The ability to have two-way communications with customers through the meter is a very attractive proposition and we’re very interested in it, consistent with the idea that we grow our business by investing in hard assets associated with delivering electricity. Included in that delivery proposition is using technology to help our customers save money. I think there’s some potential upside there for our customers that will have the effect of reducing their bills and making their lives better.

Fortnightly: Do you think the utility business proposition is changing in America, given the combined pressures of resource constraints, environmental concerns and evolving technology? If so, how does the regulatory compact need to change?

Dutton: It is changing, but I’d submit that’s nothing new. Really, since the late 1960s, when we stopped being a declining-cost business, we’ve been under pressure as we operate within the regulatory compact.

There’s no doubt that the carbon question, on a nationwide basis, will present us with some real challenges. Shifting away from a coal-fired base in electric generation is a major shift, and it’s going to require the efforts of nearly everyone. But we can’t just simply say we’re not going to do it because costs are going to go up. Society as a whole will benefit from that shift. We have to demonstrate the value in making the shift, and work with our political and regulatory leaders to enable investments in alternatives, so if costs go up there’s broad-based support.

Powell: There are good and valid reasons for utilities to have staying power and avoid getting caught up in the latest fad. But about four years ago I started seeing a tremendous shift in this industry, particularly on the issue of climate change and the role of utilities. It has gone from very traditional, with staunch support for coal, to now almost completely the opposite. CEOs are tripping on themselves to be leaders in the transformation, in terms of how the industry needs to meet the demands of society.

The fundamental fact is electric utility investors can profit from that, but unlike other parts of the energy sector, those profits are capped. Consumers should take great comfort from that. If the utility does well and earns close to our allowed rate of return, it’s a good thing for customers because it lowers the cost of our capital. It’s a good thing if we have good ratings and perform well, and run as efficiently and innovatively as possible. The focus, for regulators, should be on determining whether the investments are necessary, prudent and efficient.

Nuclear Progress

When Progress Energy CEO Robert McGehee died suddenly during a trip overseas last October, he left the company in the midst of a gauntlet of changes, challenges and projects—including plans to add four new nuclear reactors at sites in Florida and South Carolina.

Fortunately McGehee’s management philosophy included a careful focus on succession planning. Bill Johnson, formerly president and COO, was able to pick up where McGehee left off—even if he could never really prepare for such a transition.

Fortnightly: You took the reins of Progress Energy under tragic circumstances. What have been your biggest challenges since then, and what are your biggest opportunities?

Johnson: We lost a great friend and great leader in Bob McGehee. It was a shock for the entire company and frankly we’re not over it yet. It happened at a difficult time, a time of rising costs in the industry, and the climate-change debate. But I can’t say enough about how the people at Progress Energy have stepped up to the challenge. I’m really pleased with that. We’ve continued to do our strategic planning and thinking.

We see our basic job as securing the energy future for our customers. But the expectations are changing, and we see our challenge as doing that in an affordable and secure way. That’s our biggest opportunity as well.

Fortnightly: Progress Energy’s customer base is growing. What’s your resource planning strategy? How do various energy sources fit into these plans?

Johnson: We’re pursuing a balanced approach that includes a strong emphasis on energy efficiency, investments in renewable energy and state-of-the-art power plants. We have a mix of generation resources that includes nuclear, coal, natural gas, oil and hydroelectric power. We’ll continue to leverage all these fuel sources in meeting growing needs, and we’ll incorporate cost-effective renewable energy into the mix as well.

Fortnightly: What do you mean by “state-of-the-art” power plants?

Johnson: In general we mean when we’re in a position to build new plants, we’ll apply state-of-the-art, advanced technology that’s available at the time, the most efficient and environmentally sound technology. At the moment that essentially means new nuclear or natural gas.

In our state, building new coal is really not an option, and there isn’t advanced state-of-the-art technology in coal at the moment. For the near term, we’re investing in incremental intermediate and peaking generation fueled primarily by natural gas. Our longer-term need includes base load generation, and we’re taking steps to ensure that nuclear remains viable and available. We’re also investing more than $2.5 billion in emission retrofits on our existing coal-fired fleet, and we’re looking at options for repowering some older fossil-fueled units.

Fortnightly: You mentioned renewables. Few utilities see it as a primary resource, but instead as a sort of green cover. What about Progress Energy? Will renewables be only the icing, or is it a real part of the cake?

Johnson: It’s a little too soon to give a definitive answer on the ultimate role of renewables. We have a requirement in North Carolina to have 12.5 percent of our energy be renewables and efficiency by 2021. We intend to meet that legislative standard.

We recently went into the market to see what’s available in the Carolinas and Florida, and in our first solicitation in the Carolinas we got a little more than 700 MW. A lot of that is intermittent, with the exception of some biomass, and some of the biomass projects are counting the same fuel source. So you can see there isn’t 700 MW of dependable capacity in that solicitation.

We’re looking hard at what’s available and what we can do on our own. Going forward, renewables must be a part of the cake. But if it’s a layer cake, renewables are toward the top. They’re still pretty expensive compared to conventional power sources. In North Carolina, we’re seeing proposals that are more than five times the cost of generating electricity using nuclear or coal.

Fortnightly: Are you talking about five times the cost of new nuclear or coal, or existing nuclear or coal?

Johnson: I’m talking about new plant production costs. Some of the proposals are about 10 times higher than our average system production cost, which is 5 cents. Some of the renewables would be closer to 50 cents. That doesn’t mean we shouldn’t do them, but at those per-unit costs, we need to make sure we’re doing it as effectively as possible and integrate into the delivery chain as best we can.

Fortnightly: How would you characterize Progress Energy’s recent order for reactor vessels for new nuclear power plants? Is this purely a “just-in-case” move to get into the manufacturing queue, or does it signal a strategic commitment to develop new nuclear capacity?

Johnson: We’re strongly committed to nuclear energy, along with energy efficiency and renewable energy. We haven’t yet made a decision to build new nuclear plants, but given the growth in both our Carolinas and Florida markets, it’s clear that new baseload generation will be needed in the future. New nuclear plants take a long time to build, so we’re taking these necessary early steps to ensure that nuclear power remains a viable alternative for meeting our customers’ needs, and to ensure certain long-lead materials are available should we elect to move forward.

Fortnightly: Your recent filings in Florida disclosed that the overall cost of the two-unit nuclear plant proposed for Levy County would be $17 billion. That’s about three times your initial estimate of $5 billion to $7 billion. How are Florida regulators reacting to that price tag?

Johnson: The commission can’t talk to us about this while the case is pending. We expect a decision in July. But when we made the filing and the number went public, the governor was very positive and said this was the right thing for Florida, and we should proceed on the nuclear path.

Florida made a public policy commitment on nuclear about a year and a half ago. It makes it a better proposition for everyone, gives us pre-construction cost recovery in advance of commercial operation, and allows us to recover our financing cost on an annual basis. It’s incumbent on us to make our case, and we’re in the process of doing that. We expect a positive decision from the Florida commission.

Fortnightly: How do investments in conservation and efficiency factor into Progress Energy’s strategy and value proposition?

Johnson: Conservation of resources and energy efficiency are essential components of our balanced solution to meeting growing energy needs. With climate change becoming a driver in state and national energy policy, we’re seeing a shift from the traditional least-cost utility model to one that balances energy needs with environmental concerns. As such, renewable technologies and energy efficiency have become a significant part of Progress Energy’s overall strategy.

We favor a shared-savings model with customers. Our idea of how this would work is we’d recover our program cost, net revenue lost and a 50/50 sharing of benefits with customers. That’s a good model because it’s transparent—here’s the cost and here’s the benefit. And this shared-savings model provides Progress Energy and its customers with appropriate incentives for maximizing the benefits of reduced peak electricity demand.

Fortnightly: Some states are decoupling retail energy rates from utility revenues—including a pilot for gas utilities in North Carolina. Assuming this trend continues, do you see this as a useful regulatory change?

Johnson: I’ve been following the developments in other states. In our states, we’re in the early days of thinking about efficiency and renewables incentives and changes in the regulatory compact. Our view is for some period of time we should do this methodically, and introduce changes as we understand things better.

I’m not sure decoupling is a trend but it’s increasing as a concept. In our states we need to follow a more traditional regulatory path until we understand how customers, regulators and utilities respond and perform under that system, and how they respond to the changes we’re already making.

Fortnightly: Given increasingly intense resource scarcity and environmental constraints, how does the business proposition change for vertically integrated utilities whose profits are based on capacity and throughput? If I’m a Progress Energy investor, what changes should I expect to see in the way the company earns a return over the next decade?

Johnson: This is an excellent question. The first part of the answer is that our obligation remains the same, to make sure we have adequate supply tomorrow, as well as 10 or 20 years from now.

We’ve always pursued the least-cost model and built least-cost infrastructure, and you earn a return on your infrastructure. As we go to a least-environmental impact model, that’s already changing the regulatory thinking, when incenting companies to invest in efficiency and renewables. That’s happening and there will be changes. We’re just at the front end of it now.

It will require innovative thinking and a partnership among utilities, lawmakers, regulators and customers. But at end of the day, we have the same objectives: quality standards, reliable service, and the most affordable price possible.

How we achieve that mission is the challenge as well as the opportunity.

Carbon-Light In Idaho

With reservoir levels falling and power demands growing, utilities in the West are facing difficult choices. Idaho Power is taking an integrated approach that relies heavily on shoring up its existing resources, procuring as much renewable and climate-friendly conventional power as possible, and slowing demand growth in an expanding economy.

IDACORP President and CEO J. LaMont Keen sees revenue decoupling as critical to that approach.

Fortnightly: How would you characterize Idaho Power’s outlook on power resource adequacy for the mid-term future?

Keen: We’ve established four cornerstones for how we’ll meet customer needs over the next 20 years. The first cornerstone is to preserve the base. Our existing supply curve has a negative slope. We have a concentration of hydropower, which is declining with depletion of river flows and hydro relicensing requirements. Also, river-flow requirements are reducing cooling capacity for thermal facilities. So we try to smooth the decline of the supply curve as much as possible.

Second, we go after cost-effective energy efficiency, and third, we take a hard look at renewables. These parts of the generation profile are somewhat intermittent, and they need to be partnered with other resources that have a more dependable profile. So we see a need for more conventional resources. That’s the fourth cornerstone.

Fortnightly: Have Idaho and Oregon policies provided adequate incentives to prioritize investments in conservation and efficiency?

Keen: In both Oregon and Idaho we have strong regulatory support for our energy-efficiency initiatives. With Idaho’s Marsha Smith serving as president of NARUC and co-chairing the National Action Plan for Energy Efficiency, we believe we have a commission that is positioned to be exceptionally supportive.

Properly managed energy efficiency and conservation efforts are good for both the customer and the shareholder. They reduce the need to finance and build resources, and that drives down capital needs and operating costs. They also improve customer satisfaction, which we witnessed recently with a 30 percent increase in our customers’ positive perception of our energy efficiency efforts.

Fortnightly: What’s your perspective on revenue decoupling?

Keen: Working with our regulators and the Natural Resources Defense Council, we positioned our company as a leader in the decoupling effort. Energy efficiency and conservation are critical parts of the resource mix, so any disincentive to pursue them should be removed.

In Idaho, our pilot decoupling mechanism applies only to residential and small commercial customer classes. We chose these two sectors because their rates have the largest percentage of fixed-cost recovery.

Decoupling is one of three legs on the energy-efficiency regulatory stool. It removes the disincentive to the utility. The second leg is prompt recovery of energy-efficiency expenditures, achieved through a tariff rider on customer bills. The third is providing incentives for successful program implementation, which we are piloting through the Energy Star Homes Northwest program.

All three are in place in Idaho and we have a positive and useful regulatory approach.

When you look at this uncertain world, as we make these big capital investments, going to a carbon-light economy, anything that takes pressure off the capital budget is a big plus for the shareholder. We’ve been out in the capital markets raising both debt and equity, and it takes some pressure off what we have to raise each year to fund other things.

Fortnightly: Some critics of decoupling argue it shifts risks and costs to ratepayers. How does Idaho Power’s mechanism protect ratepayers and make sure they get the best deal?

Keen: I don’t view an investment in energy efficiency any different than an investment in a new power plant. Efficiency investments might increase rates for non-participating customers, but their rates would have gone up in the alternate scenario as well.

That’s how we view it and the Idaho commission does too. We have a team made of our employees, Idaho commissioners, environmental groups and other state groups that provide oversight to our energy-efficiency programs. It’s done in a collective way, and provides assurance we are doing the right things first, and doing projects that make economic sense for our customers compared to the alternatives.

Fortnightly: How does the trend toward a smart grid and advanced metering figure into IDACORP’s business strategy?

Keen: We view smart-grid applications and advanced metering technologies as value enhancements for our T&D systems. The hype is well out in front of the applications, but we think it’s moved far enough now to do most of what we’d like it to do—enhance reliability and resource management and contribute to quality customer service. So we’re implementing AMI this year. It will give us the ability to send price signals to customers. That has become increasingly important. If we can find ways to get people to pay more for electricity during times when it costs the most to produce it, people will change their behavior voluntarily. It’s certainly more practical to do that today than it was before, because the technology has caught up.

And automated meter reading, of course, will produce manpower savings. We’re planning on a three-year implementation, with planning and bids this year, and implementation in 2009 through 2011.

Fortnightly: What’s your perspective on mandatory greenhouse-gas regulation?

Keen: GHG regulation now seems certain to happen. If applied appropriately, either a carbon tax or a carbon cap-and-trade mechanism could work. Whatever the form it takes, it’s important that regulatory efforts be applied economy wide. The electric utility industry is probably the easiest to regulate, but if carbon regulation is to succeed, no single sector should be unfairly burdened. More importantly, time frames should also be consistent with development of the carbon capture and sequestration technologies needed to comply. The key is getting adequate research dollars collected and applied toward developing the necessary technologies.

In a cap-and-trade program, how allowances would be apportioned is the million-dollar question, raising serious issues of effectiveness and fairness no matter how the apportionment is done. Whatever method takes place, it is appropriate that companies gain some recognition for the wisdom of earlier decisions to invest in, and develop, emission-free forms of generation. I don’t believe it’s appropriate for the allocation method to come out in a way that’s biased against companies with a smaller carbon footprint today. Some of the concepts I’ve heard discussed might do that.

It’s possible for the industry to come together and strike a balance, but the devil truly is in the details.

Fortnightly: Do you think the utility business proposition is changing? If so, how does the regulatory compact need to change?

Keen: The business proposition has changed already, and the regulatory compact needs to be strengthened and renewed in order for needed infrastructure to be sited, built and financed.

The last time our industry faced an infrastructure expansion challenge similar in scope to the one facing us now, utilities enjoyed much higher credit ratings than they do today. Absent strong regulatory support, this doesn’t position the industry well to make the major investments required. The uncertainty surrounding an industry transformation from carbon-based to carbon-light only exacerbates the problem of financing major capital projects.

Policy makers and regulators need to recognize the infrastructure requirements and support electric utilities in their efforts to size and build needed facilities, or they may not get built.

Pepco’s Blueprint

Among U.S. electric utility companies with their revenues decoupled from sales volume, Pepco Holdings is one of the largest outside of California. And if the Washington, D.C., Public Service Commission accepts the company’s amended proposal, nearly two-thirds of the company’s distribution revenues will be decoupled from volume.

As it did for other decoupled utilities, this structural change effectively has transformed PHI’s business proposition, from one focused on demand growth and throughput capacity, to one focused on efficiency and conservation.

For investors in any other industry, this would represent a fundamental shift—and probably a big movement in stock price. But according to PHI CEO Dennis Wraase, the company’s stockholders barely have noticed.

Fortnightly: Lawmakers have decoupled profits from energy sales in many of PHI’s service territories—Maryland being the most recent example. How does this affect the company’s business strategy, outlook and investment plans?

Wraase: Efficiency and conservation are now the major thrust of PHI. We have on file in each of our states something we call the blueprint for the future. It involves a significant number of different components, but the major ones are energy efficiency, peak load reduction and the implementation of AMI and the smart grid. A major component of that is decoupling.

We anticipate we’ll have about 60 percent of our distribution revenue decoupled. It completely eliminates any disincentive to conservation and efficiency investments.

We’ve received permission in Maryland for our Delmarva and Pepco service territories, and have worked since last June under a decoupled structure. In Washington, D.C., there are a couple of legal hurdles to get over. I think they are solvable.

Maryland seems to be ahead of the other jurisdictions. We have a CFL rebate program. We’ve given out certificates for more than 600,000 CFLs. And we received approval recently to implement a demand-reduction program where we will install either programmable thermostats or an outside remote switch, where we’re allowed to cycle residential air conditioning.

To be perfectly honest, I’ve been somewhat disappointed with how little attention investors seem to be giving it. Speaking with analysts, they want to know if you’re able to earn on the dollars or recover the dollars. Those are all parts of our blueprint. For all practical purposes, our investors treat these investments like we’re building a new distribution line. As long as we’re being treated fairly, investors are somewhat indifferent.

It clearly provides us with a growth opportunity we wouldn’t have otherwise, and decoupling eliminates the disincentive to invest in conservation.

Fortnightly: How does the smart grid figure into PHI’s business strategy?

Wraase: It’s a critical component. We’re investing heavily in the smart grid, and a key component is smart metering, which we believe is critical. There are a lot of efficiencies and improvements we can get on our distribution system just from having an intelligent grid, and those efficiencies can translate into lower costs for customers, in addition to better service—in terms of knowing when customers are out and managing outages.

Critical peak pricing is an important component of that. We’ve had some very limited experience with it, but that sort of disappeared with deregulation. We have an experiment now in D.C. We’re trying different kinds of critical peak pricing techniques on 1,400 customers, to test which type will have the best result.

If we’re going to have any real impact on the future energy needs of this country, we need to solve the peak problem, and that will have a dramatic overall impact on customers’ bills. It won’t happen without critical peak pricing.

Fortnightly: Do you think the utility business proposition is changing in America, given the combined pressures of resource constraints, environmental concerns and evolving technology? If so, how does the regulatory compact need to change?

Wraase: Everyone in this industry would say we’ve always been customer focused. But we’ve never developed our equivalent of call waiting, as occurred in the telephone industry. I believe we’re going to become more customer focused. Customers need to be in charge of their energy use, and we need to give them the tools to make their own decisions.

We can offer them tools like different pricing structures, and things like electric transportation. We can provide off-peak pricing to plug in your hybrid, and the ability to sell back energy from your hybrid during peak periods at a premium price. That’s the major change I see coming. Technology will allow us to do that.

As a T&D company, there’s very little I can do about the price of coal, oil and gas. Those costs will be reflected in rates. Likewise if there’s a carbon tax, that will increase rates. The place where I can benefit my customers is in helping them consume less so they can minimize their bills. That’s the future role for utilities.

Decoupling goes with that. But it doesn’t necessarily require a change in the regulatory construct. Nothing in the compact would restrict us from doing what we’re doing. We can still file rate cases as before, it’s just a matter of how you recover your money. But there’s protection added for the customer with regard to cost.

I’d like to see commissions take a broader perspective on this. It’s not just about a short-term rate increase, because there are huge long-term benefits. If you’re putting in smart meters, yes, there’s a modest rate increase. But if you couple that with critical-peak pricing and other tools, customers can benefit because their overall energy bill will come down. That’s part of our blueprint filing. The end game is the total cost to customers, and that cost comes down even though we have a modest rate increase.

Competition, Texas Style

While other states were rolling back their retail restructuring policies, Texas removed the last vestiges of its old regulatory structure. The results so far suggest the state’s approach has brought spirited competition and innovation among market players.

As CEO of one of the biggest incumbent players, Reliant Energy’s Mark Jacobs has high hopes for competition in Texas. If it works as he expects, the entire country could be speaking with a Texas accent within a decade or so.

Fortnightly: In releasing your financial report for 2007, you stated that “we shifted from a repositioning strategy to a distinctive, value creation strategy which capitalizes on our strong foundation.” What does that mean?

Jacobs: The key element is trying to rebuild the business model around the customer. That may sound fairly simple, and in virtually every other industry that is how the business is built—around delivering value to customers. But it’s not the case in the power industry. The customer has been the long forgotten party in this industry, and there’s a significant opportunity to reshape our business around customers.

Imagine if you went to the grocery store and nothing had a price on it. Then you went to check out and they wouldn’t tell you the price. Then you went home and used what you bought, and 45 days later there’s a bill in the mailbox for that shopping trip.

That’s how we sell our product in this industry. In my view that’s an incredibly poor way to sell your product. I can’t think of another product or service that I buy in such a poor manner, and I can’t come up with a good reason why people should buy power that way.

We’re out to change the way people buy and value and use electricity.

There are four key elements to making this work. Number 1 is transparency, and what that means is enabling customers to know how much they’re using when they use it, not after the fact. Number 2 is disaggregation. That’s a fancy term for being able to break down for the consumer all the various uses of electricity, in an itemized bill. How much is the cooling or heating component costing? How much are you spending for lighting or major appliances?

The third element is control, making it easy for consumers to make clear and conscious decisions, such as being able to decide up front, for example, if you want your home at 72 degrees in July it will cost you $100, and at 74 degrees it will cost you $85. You can pick as a consumer how much you want to exchange for how much comfort you get. Consumers should have a choice, how much they want to spend for the value they get.

Fourth is time-of-use pricing. In general, we sell our product at a blended rate across all hours of the year. It’s like a hotel on the beach that charges the same room rate every night of the year. Everyone wants to come in the prime season and nobody comes in the off season.

We see significant opportunities to move peak load into off-peak periods and reduce overall load through smart energy concepts. The benefit is a happier customer who can make a clearer purchasing decisions, and we have a big benefit back upstream in the generation business.

Fortnightly: How does that benefit the generation business?

Jacobs: For system reliability we look to have 15 percent or greater reserve margin—15 percent higher than the peak demand. The power industry is unique in describing supply and demand in that manner. In virtually every other capital intensive industry one would find the supply-demand balance by finding the capacity utilization rate, and you’d find those rates in the 75 to 90 percent range. The power industry operated last year at a 44 percent capacity factor—dramatically below any other capital-intensive industry.

The big difference with power is we can’t store the product, so we’ll see lower overall capacity utilization rates. But if we compare to other industries where you can’t store the product—such as airlines and hotel rooms—those industries operate in the 75-percent capacity utilization range.

Is this just because we’ve had people who aren’t great managers? No, to the contrary we’ve had very good management. It gets back to the industry’s incentive structure.

Here’s the secret of the regulated-return model.

The amount of money you make is your allowed rate of return multiplied by the assets in your rate base, right? Now consider the capacity utilization factor. The lower your capacity utilization factor the more money you make. If you can have two plants to serve a given load, you make more money than if you have one.

So of course we’ve sold the product to consumers the way we’ve sold it! If we don’t tell them how much they’re using, they’ll use more. And if we don’t charge differential rates, they’ll use more in peak time periods and we’ll have to build more equipment.

In a competitive environment, the higher your capacity utilization rate, the higher your returns. We have a structure in the regulated rate-of-return model, ironically, that has created an incentive to be inefficient.

Through smart energy we can alter the load profile. If we can move from a 44- to 54-percent capacity factor—not even close to airlines or hotels—we could defer another 10 years of growth without building another power plant.

Fortnightly: What does that imply for the regulatory construct?

Jacobs: Here’s the beauty of competitive markets. We’ll get additional customers because when we help them save money, we’ve provided something valuable to them.

If we were a rate-regulated utility with a fixed number of customers, and we had to earn a certain amount of money to get our regulated rate of return on rate base, it doesn’t work to help our customers save money. We have only a certain amount of customers.

Fortnightly: What about revenue decoupling?

Jacobs: Decoupling fixes the inherent disincentive in the model, but how effective do you think conservation will be if the person that must decide to use less isn’t getting the benefit? My view is decoupling will bring very little progress, at best.

Think about it. The utility will help the customer use less, but will charge more per unit so investors can be kept whole. Some are even brazen enough to say they not only want to be kept whole, they want to earn a return on the assets they don’t build.

How much sense does that make from a customer standpoint—loading up the customer’s bill with all these charges, because we have a model in place that has the wrong incentives from a public policy standpoint? Wouldn’t it be far easier to change the model to make sure you have the right incentives?

Again, the beauty of the competitive market is we don’t need an additional incentive. If we can help the customer spend less, we will get more customers. The competitive market, at the end of the day, can deliver an energy efficiency solution that a regulated rate-of-return model cannot.

Fortnightly: It’s been a year since the Texas price-to-beat structure was removed. How has that affected competition in the state?

Jacobs: In my view, today we’re still in the early stages of seeing the benefits of a competitive market. Most of the competition is still price-based as opposed to value-based. When we deregulated telecom in 1984, most of the early competition was price based. All the technology we have in the palms of our hands today was unthinkable 20 years ago when we deregulated. It didn’t happen right out of the chute.

We’re going through a similar process in power. Now as a customer you can pick a variable-rate plan, a fixed-rate plan, different tenors in terms of your contract for power supply, and more degrees of freedom. But mainly the products are differentiated around price. The next evolution in the market will move beyond differential pricing and into value added services.

Today in the retail business in Texas we sell a commodity. What we’re working toward is providing people with a value-added service that helps them buy that commodity. It sounds similar but it’s very different. Electricity purchases in Texas are a big line item, so helping people be thoughtful about that and understand what they are buying, when they buy it, will be valuable.

Fortnightly: Arguably retail deregulation didn’t work in most states the first time around because meters weren’t up to the task of delivering added value. Is the meter the key?

Jacobs: The smart meter is kind of like computer hardware. By itself it doesn’t do anything. We and other companies are providing the software to take advantage of the hardware. We’re providing solutions that will give customers valuable benefits—such as disaggregated rates and time-of-use rates.

The smart meter is the enabling technology. It will allow the power of competition to take over.

Fortnightly: Most of the country has essentially rejected retail competition in electricity markets. What are the odds of that changing any time soon?

Jacobs: It’s true Reliant is something of a lone voice on this topic today. In our industry, the vast majority of players don’t want competition because it will be bad for them. But consumers are voters, who elect politicians and appoint regulators. Ultimately what’s best for the consumer will prevail.

The benefits I’m talking about have to be proven in Texas. We’re aggressive in delivering our smart energy product, and proving our customers will use less electricity and be happier with the product than they were before.

I don’t expect the industry will change very quickly. We will have a lengthy debate, but time will prove competition is a superior model and can deliver an energy efficiency solution better than can a regulated model.