Disruptive Business Models

Disruptive Business Models

August 01, 2013 | By Todd Alexander in New York

Fuel cells, rooftop solar, small CHP projects, microgrids and other forms of distributed generation threaten to undermine the traditional US utility model. How do distributed generation and regulated utilities co-exist? Is it fair to have the full burden of cost recovery for utility assets fall on a shrinking pool of ratepayers who have not moved to generate their own electricity? Do utilities that have divested generating capacity and are merely wires companies care? Is the most sensible utility response to move into distributed generation themselves and, if so, how? Three utility executives talked about these issues at the 24th annual Chadbourne global energy and finance conference in June.   

The panelists are Bert Valdman, senior vice president of strategic planning for Edison International, James Lambright, senior vice president of corporate development for Sempra Energy, and Rye Barcott, special advisor to the chairman and CEO of Duke Energy. The moderator is Todd Alexander with Chadbourne in New York.

MR. ALEXANDER: The Edison Electric Institute released a report that says regulated utilities are facing a serious long-term threat from distributed generation and other demand-side energy programs. The traditional utility model relied on central station power production.  Customers are moving off the grid and are no longer sharing the fixed costs. That creates upward pressure on rates and may lead eventually to downgrades in utility credit ratings and a downward spiral. How much of this is hyperbole and how much is reality?

MR. LAMBRIGHT: This is a real topic of conversation inside the utilities. There are numerous new, potentially-disruptive technologies that are at different stages of commercialization and availability to customers. The biggest one that gets discussed is distributed generation.

California utilities get their returns on infrastructure, not the electricity. The electricity is largely purchased from independent generators and passed through at cost to ratepayers. California utilities have a tiered residential rate structure that allows customers who buy low quantities of electricity to pay roughly half of what higher-consumption customers pay. The cost of rooftop solar has been falling. Utility rates have been increasing. Over the last few years, we have seen rapid growth in rooftop solar installations. However, we have not seen many customers go completely off the grid.

One topic of debate is what those customers should pay since they are still connected to the grid and still rely on the utility for certain services, including standby power.

MR. ALEXANDER: Rye Barcott, rooftop solar has not taken hold in North Carolina in the same way it has in California. Does Duke view rooftop solar as a threat? 

MR. BARCOTT: We believe that distributed generation is both a potential threat and an opportunity for Duke. We continue to debate what makes the most sense as an entry point. The options range from least aggressive, where we limit ourselves to advocating for rate changes, to most aggressive, where we enter directly into the business, perhaps through the unregulated affiliate.

MR. ALEXANDER: Bert Valdman, the EEI paper talks about whether the utility business is going the way of the telephone and airline businesses where there was heavy regulation, but the regulation did not keep up with the times. Is there a need for a major overhaul in how utility rates are set?   

MR. VALDMAN: We are not the first industry to face the existential question of what the future looks like and how to serve customers better. If you look at other industries that have successfully navigated through uncertainty, you find common features.

They have strengthened the core business by providing excellent service while cutting costs and they have adapted to change, particularly as it relates to what customers want. Our core business is delivery of electricity, and our customers increasingly want a product that gives them energy independence and advances sustainability. There is a clear priority to decarbonize. We need to take a thoughtful approach, adapt our business models, and invest in new businesses that achieve these outcomes. We can enable the business models that show promise and support management teams that have talent. We have to accept that these new activities might compete with our existing business and, while it might create some tension within our organizations, it is a healthy tension.

Rethinking Utility Rates

MR. ALEXANDER: Jim Lambright, will this lead inevitably to an overhaul of the ratemaking process?

MR. LAMBRIGHT: A bill is already working its way through the California legislature to return ratemaking authority to the California Public Utilities Commission as opposed to leaving it in the state legislature where it has been since the energy crisis more than a decade ago. An open and frank conversation about ratemaking is on the way and is long overdue.

If you look at the proliferation of new technologies, there is a strong case for revamping the rate structure.  We need to send the right price signals to customers and ensure that customers pay for the services they receive from the utility.   

One way to do that could be by unbundling the components in today's tariffs. You would have a rate structure that breaks down services and products into fixed costs and policy-driven subsidies that everyone connected to the grid should bear and energy charges for the variable amount of electricity consumed. There could be a time-of-use feature so that people driving electric vehicles would have incentives to recharge during off-peak hours. These issues are starting to work their way through the political process.

MR. VALDMAN: We should ask ourselves what a perfect rate structure should do. It would provide price signals to customers so they make informed decisions about how to make better use of energy. It would allocate costs equitably across different customer rate classes. It would balance the interests of utilities and emerging competitive businesses and support investment. The current rate structure does not serve any stakeholder well.

MR. ALEXANDER: If you start charging people for specific things, those with means will opt out. The bigger customers will drop off the grid and may be comfortable not paying a standby charge. That will leave those without means or other options having to pay more for electricity. 

MR. BARCOTT: Utilities may not be able to carry the day with arguments solely about fairness. I do not think it is enough just to adjust rates. A company like ours needs 4% to 6% earnings growth every year. One way to do that as the utility industry evolves is to own the distributed generating assets and be in the rooftop solar business. That is where the creative energy, teamed with rate adjustments, needs to occur.  

Regulated companies have a hard time adjusting to change. They have very different cultures than the distributed generators who are making inroads into our service territories. One of the things we have struggled with at Duke is the overall process of how disruptive investment proposals can find support as they move through the corporation. A risk review process for regulated investments and utility-scale projects does not work with disruptive ventures.  Disruptive ventures are best evaluated separately with different metrics, time horizons and other strategic considerations. 

MR. ALEXANDER: So the utilities are still building central power stations when the future may be distributed generation.

MR. BARCOTT: Room must be made within large utilities for a traditional business model focused on operational excellence and a disruptive business model to co-exist. There are precedents in other industries. Smart utilities will ask hard questions about how to own disruptive ventures and keep them independent long enough from the parent company so that they can seed, grow and compete. 

Potential Disruptions 

MR. ALEXANDER: Jim Lambright, the rating agencies do not seem worried about the potential for disruption.  Is there is a risk that will change?   

MR. LAMBRIGHT: The conversation has begun. The risk in not facing these issues head on now is that while these disruptive business models may command a very small market share today, markets can shift quickly. This is especially true of technologies whose cost and effectiveness keep changing every day. More and more customers may be attracted to new technologies. The earlier a business anticipates that and makes the right adjustments, the better. In a regulated business, that means you have to start the conversation with your regulators as early as possible, because it is not likely to be a quick conversation. It will take years, not months.

MR. VALDMAN: It is dangerous to think about utilities as if they are all the same.  You have 50 states and the District of Columbia each with its own regulations. But there are common themes that bring the industry together, regardless of regulatory jurisdiction: safety, reliability and affordability.

Within the transmission and distribution business, there are many applications for new technologies to balance the system and make it more resilient and reliable. Instead of putting in a new substation, is there a storage technology that could achieve the same outcome? Part of the challenge is how to adapt the traditional way of thinking about system planning so that new technologies can be properly evaluated and deployed. A number of us are thinking about installing storage on our distribution systems. There is a lot of opportunity.

MR. ALEXANDER: What does potential disruption to the traditional utility model mean for the independent generators and bankers in the room? They do not view utilities as particularly nimble. Almost all of the utilities with which they deal are investment grade. If utilities have to adjust to change and only 80% of them are successful, that will have a profound effect on the broader market.   

MR. VALDMAN: No one is suggesting that utilities will be but sub-investment grade in the future. Utilities have a good infrastructure business when managed well. There is room under the same roof for a number of different business models with different risk profiles that can be capitalized differently. It then becomes a matter of effective portfolio management. Other industries have done this and can serve as models. It will be a dynamic process. The investor community will reward management teams who manage their portfolio and risk profiles well.

MR. BARCOTT: One question facing utilities is whether this is the right time to act. Take the rooftop solar business, for example. There is a natural bias in a regulated company against taking risk. Employees are often incentivized to defense the status quo, not attack it.  In such a culture, it is no surprise that employees are more comfortable giving hard looks at deals and passing on them rather than placing calculated bets.  In this day and age, utilities need both attackers and defenders.

Moreover, what's the point of being a large company if you cannot make some smart, small strategic bets, and realize that some of them will not pan out? If you really want to understand something, you have to be in it.   

MR. VALDMAN: I agree. Moreover, for a lot of these emerging business models, there is a lot that utilities can do to help. That should be our role, whether it is providing capital, an opportunity to test these technologies on our system or an understanding of how the regulatory process works. There are all things that we as an industry can undertake to advance new technologies in areas where all interests are aligned. The worst outcome is to sit back and do nothing.

MR. BARCOTT: The market is changing. Distributed generation is gaining ground. My own view is utilities need to adapt by owning distributed generating assets themselves. 

MR. VALDMAN: I entered the energy business more than 25 years ago in oil and gas. On my first day, someone told me something I never forgot: never bet against the engineers. Today, engineers are hard at work in labs creating and perfecting a whole range of new technologies that will transform our industry. We need to pay attention.

MR. LAMBRIGHT: We are in the middle of a shift from a one-way flow of electrons to a two-way flow. Not only do you have rooftop solar, you also have more data through smart meters and smart grids. Customers now have more tools to monitor usage. Given this, there are a lot of products and services that can be offered by utilities and third parties alike. The customer is in the driver's seat and will shape ultimately how the industry realigns itself.