Is the Power Industry Business Model at a Tipping Point?

Is the Power Industry Business Model at a Tipping Point?

February 14, 2014

The Edison Electric Institute released a report last year warning that regulated utilities are facing a serious long-term threat from distributed generation and demand-side management programs. The traditional utility model relied on central station power plants. Customers are moving to generate their own electricity and are no longer sharing fully in the fixed costs of the grid. The report warned that this could put upward pressure on rates and could even affect utility credit ratings in the longer term. A panel talked about where the power industry is headed at the Infocast projects & money conference in New Orleans in January. The following is an edited transcript.

The panelists are Robert Hutchinson, managing director of the Rocky Mountain Institute, Jeffrey Goltz, former chairman and current commissioner of the Washington Utilities and Transportation Commission, Brian Daly, managing director of Babson Capital Management, an investment fund management group that manages more than $188 billion in assets, Drew Murphy, senior managing director of Macquarie Infrastructure and Real Assets and, before that, head of strategy and M&A for giant independent power producer NRG and president of the Northeast region for NRG, Jan Smutny-Jones, head of the California Independent Energy Producers Association, and John Shelk, president of the national Electric Power Supply Association. The moderator is Keith Martin with Chadbourne in Washington.

MR. MARTIN: There is no industry today whose business model is immune to disruptive technologies. The power industry is no different. Jeffrey Goltz, are we on the verge of a major upheaval in the electric power industry?

Major Shift?

MR. GOLTZ: It is geographic specific. Utilities in Arizona, Hawaii and California are being affected by a large build out of distributed solar. In the state of Washington, we do not have as much distributed generation, but we have the same pressure on utilities in the long run because of the increased emphasis on energy efficiency, which has made for relatively flat load growth in the Pacific Northwest.

MR. DALY: I think we are on the verge of a major shift.

MR. MURPHY: The biggest source of pressure on the utility business model is low demand growth. We forecast low and, in some cases, negative demand growth both in customer count and volume. That said, in states where distributed solar has taken off, it is an important part of the business model. It is just not the biggest pressure point across the entire US at the moment.

MR. HUTCHINSON: There is a very significant shift going on, but we are not near a tipping point where the business model collapses to be replaced by something else. It has regional flavors. The phrase “demand destruction” is absolutely real. Even places in the South like Louisiana have now officially endorsed efficiency programs for the first time.

MR. MARTIN: Are the regulated utilities most seriously affected or is the biggest effect on the independent power companies who are competing directly with newer sources of supply like rooftop solar?

MR. DALY: The distributed solar industry is taking advantage of current rate structures and tax credits. One wonders how long that will last. My first job at Long Island Lighting in the 1980s was to design rate structures to defeat small cogeneration units. There was a great piece out last week on why Mexico is a tremendous opportunity for solar even though there are no subsidies. The second rate tier in Mexico is 22¢ a kilowatt hour. It is pretty easy to compete against that. I think what we will see is a change in the rate structures to disincentivize net metering and large-scale deployment of commercial and residential solar.

MR. GOLTZ: There is a lot of pressure in a number of states. There will be a big push in that direction. That is not the only way to address the issue of load loss due to an increased number of net-metering customers, but it is one of the ways that public utility commissions will have to consider.

MR. MARTIN: Drew Murphy, you sat on the inside council of a very large and successful independent power company. Do you see this pressure on the business model we have been discussing as a greater concern to the independent power producers or the regulated utilities?

MR. MURPHY: Both are affected. The independent power producers have a different concern. I am not sure the pressure on them is any greater.

Independent power producers are looking forward and are trying to move into distributed generation because they realize it is another source of generating capacity that they can own or in which they can invest.

The issues on the regulated side are what will happen with rate structures and additional fees for access.

The bigger threat for the competitive power generators like NRG and others is the price of natural gas and the ability to find a place to make money from building new generation. Distributed generation is not a big threat because independents are trying to participate in that whole boom as distributed generators.

MR. MARTIN: Do you see energy efficiency companies as a major threat to the power sector?

MR. HUTCHINSON: We believe so. The efficiency movement is not aimed solely at reducing the overall amount of electricity used, but it is also starting to focus on the times of day when electricity is most valuable. We are starting to see more de-peaking type of activities. Our building design practice is seeing people using latent thermo-characteristics of buildings to design control systems that can shift peaks to different time periods. At the end of the day, this is about economics. It isn’t just a matter of counting kilowatt hours.

MR. MARTIN: You said once that the trouble the efficiency guys have is that it is hard to make a good ad that sells making do with less. How do you see the efficiency companies getting past this?

MR. HUTCHINSON: Efficiency gets mischaracterized. You can talk efficiency all you want, but let’s be clear: we are talking about waste. The message is that there is a cheaper way to consume electricity. We spend a lot of time with Fortune 1000 companies. The scaling of major programs around efficiency is coming back again. I have been working lately with Walmart on its program, and it is just scary how many things even Walmart has not done. We are going to see some serious demand destruction in utility systems where larger-scale or more sophisticated commercial and industrial customers are a big part of the load.

Building codes are changing rapidly. Seven states adopted higher-grade building codes recently. There are now nine cities with very clear labeling laws on commercial buildings. One city has started to move to residential. We are starting to see information come in on the side of efficiency, so maybe you cannot effectively market the whole concept, but you can market pieces of it and those are starting to be visible.

Empire Strikes Back?

MR. MARTIN: To what extent will the utilities strike back by taking over energy efficiency, rooftop solar and other forms of distributed generation? They have access to cheaper capital than the rooftop solar and energy efficiency companies.

MR. DALY: The utilities have ratepayers, not customers, and I think there is a very big difference. Independents handle customer care a lot better. A regulated utility might buy a rooftop solar company, but the lower cost to capital is not going to move the needle for them.

MR. GOLTZ: I hear utilities say that there is a lot of pressure to become more like energy services companies as opposed just to providers of electrons. Electric companies, as mandated by state law, are in the energy conservation business. If a utility is providing electrons and also insulating your roof, maybe it can put solar panels on the roof as well. The utility could be like a general contractor. It is a daunting task for a homeowner to figure out how to manage his or her energy consumption. There might be a market for utilities who can serve as a one-stop shop for electrons, conservation assistance and rooftop solar.

MR. DALY: PURPA was about getting the utilities out of the business of building and owning large power plants. We did not do a particularly good job of that. Utilities are not going to give the customers a low cost experience of installing rooftop solar.

MR. GOLTZ: We will see a variety of responses from the utilities over the next five to 10 years. Some are more involved in the customer service area than others and see themselves as having some of those core skills. They need to be the party that ensures the entire system works. That is what good regulated utilities that provide transmission and distribution service do. We are talking about trying to get the management to see itself as essentially going on the other side of the meter to make sure it all ties together.

MR. HUTCHINSON: Look at the Nest thermostat. Yes, it is neat, but I really don’t care about it. I would rather it just worked. I don’t want to come home and have a little icon pop up that says “rebooting.” I am afraid that is what we will end up with if we let the technology companies be the guys who own the thermostats in our houses. We will end up with a situation where none of the pieces fits together. It is okay for the TV. It is even tolerable for my cell phone, but it is not okay if turning on the lights trips the thermostat. There is a real role for the local utility to play.

There is a need for a more concrete set of standards on multiple levels at the distribution edge. That is one of the barriers to experimentation with business models. Progress is being held up today by such issues as how to measure efficiency gains, what are the real costs and what costs are avoided. PG&E, which probably has one of the better measurement systems, has a factor of five between its average and highest marginal cost of putting in new capacity to serve particular locations.

MR. MARTIN: Arizona Public Service wanted to charge customers who generate their own electricity using solar panels $50 to $100 a month as a backup charge for the right to draw electricity at any time from the grid. It also wanted to credit customers who send excess electricity back to the grid through net metering at the wholesale power rate and not the retail rate. APS argues that all users of the grid should help pay for the grid. Does APS have a point?

MR. GOLTZ: It has a point about the need for some sort of mechanism to recover the cost of the grid. There is a debate about the right level of backup charge and how best to structure it. Minnesota is offering utilities an alternative to the net metering system. The Minnesota Public Utility Commission has been charged with assigning a value to solar through a very complex formula. A customer installing rooftop solar would still buy its electricity from the grid, and then be paid for the value of the energy it produces. Calculating the value of the solar energy is hard. It may be that it is larger than people think. There are environmental benefits and reliability issues to factor into the equation.

MR. MARTIN: Is there a counter argument that solar customers should not have to pay any backup charge?

MR. MURPHY: The argument is that a customer should only have to pay for the grid to the extent he uses it.

A small backup charge is easier to swallow, but the day is coming where it will be too large to ignore. This debate will continue, and there is going to have to be a balance. Neither side will get everything it wants. We will need to recognize that the grid has to be sized to accommodate customers who may want power on a backup basis, but these customers are on average only sometime users of the grid, and that too must be taken into account in determining the proper amount of fee to charge. Someone who uses the grid infrequently because he is generating his own electricity should not have to pay a huge charge for what is essentially insurance.

MR. GOLTZ: A downside of the Arizona battle is the bad blood it is creating. One thing we are doing in Washington state is to open a docket and try to approach the issue in a more collaborative way without coming to a solution right away.

I am on the advisory committee of the Critical Consumer Issues Forum that is a group of utility representatives, ratepayer advocates and regulators. It is designed to bring these groups together and reach consensus on a number of principles. In the last year, we spent a lot of time worrying about distributed generation, and we were able to reach a consensus about some general principles. It is better to have the luxury of time to approach this in a methodical manner than trying to address it through litigation and adjudicated proceedings.

MR. MARTIN: Has any fresh thinking come out of these discussions or are we left with just the two variables that Arizona Public Service put in play — a monthly backup charge and the price paid for net-metered electricity? Are there other ways to tackle the issues?

MR. GOLTZ: There are many different things that you could do with rate structures. The “value of solar” rate pioneered in Austin is one. There are a number of other rate structures. There are also the moves towards different utility business models or portfolios of business models within a utility framework.

MR. MARTIN: Will the utilities make their own situations worse by charging a high backup fee? Won’t the largest customers withdraw from the grid entirely to avoid the charge?

MR. GOLTZ: I can’t imagine that we will move back to a world of micro grids. We are better off in this together. Electricity is becoming a more valuable commodity than it ever has been. When electricity first came into general use in the early part of the last century, it was used for light, manufacturing and heat. Now it is essential to our communications network. Without electricity, we cannot communicate with each other. It is replacing the post office and, with more electric vehicles, it may become essential to the transportation system.

MR. MURPHY: While some large consumers are trying to take control of some of their energy supply, I expect that almost everyone will want to remain connected to the grid as insurance. We count on reliable electricity more than ever. It is woven into the fabric of all of our businesses and lives.

Opportunities?

MR. MARTIN: If there are pressures on the power industry business model, perhaps it is a pivot point and an opportunity for profit. Where do you see the opportunities in this shifting business environment?

MR. DALY: The most capital is going to be deployed in large-scale generation, transmission and distribution, and that trend will continue. For all of the energy and buzz around distributed generation, it is a few percentage points of the entire business.

As an energy efficiency engineer, I once had a wonderful conversation trying to convince a commercial customer to sign up for a demand-side management program. I explained how he could reduce his energy bill by 75% if he would just turn off three days during the summer, and he looked at me and explained how much money he made processing credit card receivables and he would never shut off.

MR. MURPHY: We certainly look at and want to do more in the renewables space. We would love even to get into some of the distributed technologies on a portfolio basis, but the real money will continue to go into the transmission and distribution systems and utility generation. I don’t see that changing in the medium term.

MR. MARTIN: So, Brian Daly believes this is an epic battle, but he would still put his money in the old business model. Drew Murphy, you agree with Brian that the big money will still go into utility-scale facilities, but you are also prepared to bet on the disruptive technologies?

MR. MURPHY: There is opportunity there. The bigger money is, as Brian said, in the bigger old-style projects like transmission, distribution and utility generation, but we have to be looking at both.

MR. HUTCHINSON: My money is on distributed, not because I don’t think there are good deals in the utility-scale market, but I would argue that the market is changing quickly. Distributed consists of small pieces, but our ability to create portfolios is changing terrifically if we can break some of these barriers. If I want to be in an exciting growth business, that place is on the distributed side.

MR. MARTIN: Let’s bring our two trade association heads into the discussion. John Shelk, the law plays a big role in how the power industry is structured. You do not have to look very far back to see how changes in law created the independent power industry. Law decides the structure of the regulated utility business. Is the surge in distributed generation likely to be more disruptive for your members, the independent power companies, than for the regulated utilities? Do the distributed generation companies threaten to meet the entire growth in electricity demand? Seventy-two percent of it was met by solar in October.

MR. SHELK: The short answer is no. Many of our members are also engaged in the distributed business.

It is useful to differentiate between demand for electricity in the aggregate and demand from the grid. The impact of distributed generation is greater on the distribution utilities because it affects load growth and the need for additional investments in equipment that add to rate base. We have seen a number of reports from Wall Street analysts saying that there will be very little load growth. They are expecting flat demand for on-grid power. To the extent that there is growth, it will be largely met by renewables because of the RPS standards.

MR. MARTIN: Jan Smutny-Jones, you told me when we were preparing for this panel that the California Public Utilities Commission staff has said there is about a $1 billion shift in the burden of paying for utility plant and equipment from customers who install rooftop solar to those who don’t. How do you see the battle between the rooftop solar companies and the regulated utilities unfolding in California?

MR. SMUTNY-JONES: This is an area where there is going to be a lot of fighting over the next year or so. There was a staff report that came out last October that had that number in it. The commission is looking at the retail electricity rate structure and the way that net metering has worked in California. I expect this to be hotly litigated.

MR. MARTIN: The state legislature enacted a bill, AB 327, last fall that addressed the issues, but did not settle them. Which side came out ahead?

MR. SMUTNY-JONES: It was a draw that will be played out next before the California Public Utilities Commission. After the California energy crisis in 2001, the legislature concocted a fairly complex rate system in which the top two tiers of utility customers were paying about 54% higher rates than less heavy users of the grid. This has created a ready market for the solar rooftop companies. AB 327 was originally intended to undo that rate structure and put it back in the hands of the CPUC to figure out how to set rates. However, as all politics work, on the way to that conclusion, the rooftop solar guys showed up and were able to persuade the legislature to lift a cap on the amount of net metering that the three investor-owned utilities are required to permit. As I said, the argument now moves to the CPUC.

I live in the Sacramento Municipal Utility District, SMUD, which is a very progressive utility and does a lot of renewables, energy efficiency and demand response. It is adjusting its rate structure and phasing in a demand charge. The base charge for anyone connected to the grid is $20 a month and then there will be time-of-use rates on top of that. You may see something similar coming out of our commission. I can’t predict what the number will be, but I think the idea that the utilities need to recover something for maintaining the infrastructure is not absurd. The question is what is the appropriate demand charge.

MR. MARTIN: California is predicting that by March 2020, 13,000 megawatts of electricity will drop off the grid at sundown each day. How large is the total capacity in California?

MR. SMUTNY-JONES: On a peak day, it is about 60,000 megawatts. You have this surge of solar, and as the sun goes down and the peak demand goes up, about 13,000 megawatts of capacity falls off the system. We see this as an opportunity, but the challenge is that a large portion of the existing gas fleet is combined cycle gas turbines that operate well but at a midrange. They are not designed to be peakers. The state is trying to figure out how to retool to meet this challenge.

Changing Laws

MR. MARTIN: John Shelk, one of the things we have been talking about is energy efficiency. It is potentially as big a threat to load growth as distributed solar. Is the federal government about to give energy efficiency a bigger push?

MR. SHELK: Yes. The Department of Energy has authority to do such things as impose appliance efficiency standards, and it has been moving aggressively in this area. The government itself is a large buyer of electricity, and there have been initiatives through the General Services Administration and the Pentagon. Legislation on the matter will be difficult, if not impossible, to put through the current Congress. This Congress can’t agree on the day of the week, but last year, the Senate did start to take up the legislation introduced by Senators Rob Portman (R-Ohio) and Jeanne Shaheen (D-New Hampshire) that would have made a stronger push for both government and private sector energy efficiency measures.

MR. SMUTNY-JONES: I have lived and prospered in a world of demand destruction for the last two decades. In California, load growth has basically been at 1% to 1.5% a year for the last 30 years. That is basically one large power plant per year. Despite that, California has built about 16,000 megawatts of gas-fired power plants since 2000. In the last 14 years, we have had a fairly substantial change due to retirements. I don’t see a hugely negative impact on the independent power industry in the long term.

MR. MARTIN: Utilities in California invest $1 billion every year in energy efficiency efforts. They pay their customers to make energy efficiency improvements, and they put the payments into rate base and earn a profit on the payments. How quickly are the payments recovered or backed out of rate base?

MR. SMUTNY-JONES: It is fairly quick, but I don’t know the period.

MR. MARTIN: John Shelk, one of the more significant legal changes in the offing is that the federal bank regulators are considering whether to bar banks from owning physical assets and also trading commodities like electricity. The banks account for a large share of the wholesale power market in places like Texas. The Senate Banking Committee recently held a hearing on this. What are the bank regulators doing in this area? Are banks likely to be told they can no longer trade commodities? What is your trade association’s position?

MR. SHELK: We will hear the head of enforcement at the Federal Energy Regulatory Commission and representatives from the Securities and Exchange Commission and the Federal Reserve Board talk about the recent enforcement cases involving banks at a Senate hearing later this morning. The Senate Banking Committee hearing was originally scheduled last fall. The Federal Reserve posted an advance notice of proposed rulemaking yesterday. It did not decide the issue, but rather asked for public comment by March 15 on what it ought to do. Banks were allowed a decade ago to start trading commodities. The bank regulators are having second thoughts.

We wrote the regulators in September to urge them not to bar banks from trading in electricity. We need creditworthy counterparties and their liquidity to hedge electricity prices.

The Fed will be under pressure to do something by the end of the year.

MR. MARTIN: Are there other changes in law under discussion in Washington or at the state level that could have a major effect on the power industry business model?

MR. SMUTNY-JONES: The principal driver in California is the climate change policy of the state. California wants to reduce greenhouse gas emissions to 1990 levels by 2020 and to 80% of the 1990 levels by 2050. The path to 2020 is pretty well understood. No one has a clue on how we get to an 80% level by 2050.

The utilities, in response to a growing interest by our state legislature on clean energy procurements, are countering with something called a greenhouse gas standard. The details are a little unclear. We are going to have some interesting public policy discussions.

MR. SHELK: I don’t see Congress passing any new statutes like the Public Utility Regulatory Policies Act of 1978 that created the independent power industry. The Environmental Protection Agency will move forward on greenhouse gas regulations for new and existing power plants that will have a big impact. The Federal Energy Regulatory Commission has opened dockets about how to encourage needed capacity additions in places like the Northeast. We and others have filed comments arguing that this issue of flat demand about which we have been talking this morning is one of a list of a half dozen new realities that fundamentally change the landscape from what it was when FERC approved the initial regional transmission organization market design. We will have a new FERC chairman and a new commissioner at some point. FERC will end up at the center of a lot of activity this coming year.

Next Job

MR. MARTIN: My last question is for each of you on this panel. If you were to leave your current job and start a company that is in some aspect of the power business, where would you go?

MR. MURPHY: Not a rooftop solar company. I would want to join a company that focuses on how to put together and finance portfolios of distributed generation projects: somebody who can crack the code of how to bring down the cost of capital for distributed generation much like the Canadian pension funds do by pooling long-term money. There is a huge opportunity there.

MR. HUTCHINSON: Drew took my answer. I would go where the spreads are. There is a huge potential gain to be had by reducing the average cost of capital for distributed generation to 6%.

MR. GOLTZ: Transmission and distribution efficiency such as smart grids.

MR. DALY: Having had some time to think about this the last few years, I would focus on LNG distribution for over-the-road trucks and then do biomass on remote tropical islands.

MR. SMUTNY-JONES: First, if we are retiring all these coal-fired power plants, we have to come up with something to replace them, so I see opportunity in gas-fired generation. Second, I think the real big niche market is integration. The more solar we put on, the less value it has because it all comes on in the middle of the day. What you do in the middle of the night becomes very important. Third, the Mary Kay Cosmetics franchisees are having a big meeting here in New Orleans at the same time we are all sitting in this casino. I am starting to believe the best opportunities are in cosmetics.