By Curt Underwood and Gerry Yurkevicz
This article appeared in Public Utilities Fortnightly in the July 2018 edition.
Over the past twelve months, U.S. utilities have had to deal with widespread damage to the electric grid as hurricanes wiped out service to millions in several states and Puerto Rico. Intense Nor’easters toppled power lines in the mid-Atlantic and New England. Ice storms ravaged the upper Midwest. Wildfires devastated parts of California.
Utilities also have been the target of cyber warfare by Russian hackers attacking the power grid. Simultaneously, three long-term trends – the 3-D’s of decarbonization, decentralization, and digitalization – continue to play out, challenging the industry and transforming its economic model.
Meanwhile, power companies have a business to run. Customers, regulators, and government officials expect adequate supply, reliable and secure operations, environmental sustainability through efficiency and renewable power, and affordable electricity. Shareholders expect profits. Those are a lot of mandates to fulfill in a regulated environment amid disruption and crises.
New DNA
Tumultuous times are providing opportunities for rate-base growth and new services. Regulated utilities need to challenge and change their DNA and culture to succeed in this evolving landscape.
Adaptation and acceptance of new revenue models is a key part of this shift. Some utilities are exploring what would be revolutionary new models serving as platform-provider or operating on a fee-for-service basis. These new business formulas would seek earnings that are distinct or additive to returns on rate base, but may also involve lengthy proceedings to obtain the desired regulatory outcomes.
However, utilities cannot afford to wait until the revolution succeeds. Instead, they need to also pursue creative evolutionary solutions that extend existing regulatory models to other assets or parts of the value chain, strategies aimed at producing near-term, bottom-line results. (See Exhibit 1.)
Utilities cannot afford to wait until the revolution succeeds
Challenges ahead
Incorporating these new approaches today will help utilities tackle the industry’s biggest challenges: modernizing the grid, promoting efficient grid use, and building a healthy ecosystem of universal-scale and distributed energy resources. All of this should be accomplished while still delivering more value to customers and shareholders in the short run.
For instance, one priority should be to use smart-city initiatives to develop new approaches to create shareholder value. These include various public-private partnerships that leverage the efficiencies from, among other things, smart meters and smart grid infrastructure to provide services to other utilities and municipalities.
While there has been considerable interest related to such initiatives from individual utilities and the Edison Electric Institute, most proposals to capture additional shareholder value focus solely on targeted initiatives, such as those related to more efficient and advanced streetlight technology. So far, many of the campaigns seem aimed at improving brand equity for utilities rather than affecting real financial gains for shareholders.
Smart-city initiatives
However, to create shareholder value from smart-city initiatives, electric utilities should take a page from their gas utility cousins’ playbooks. Many local gas distribution companies in the United States have gas storage programs that allow the regulated utility to hedge and trade gas and share the profits among customers and shareholders.
Regulators permit shareholders to retain some of the profits – distinct and additive to the return on equity (ROE) from the rate base – to compensate for the utility’s necessary expertise and potential risk from these activities. Customers, at the same time, benefit from more efficient operations that keep rates down.
Extending this regulatory model to smart-city initiatives might enable customers and cities to partake in the savings from sharing the smart meter and grid communications infrastructure. And it should also allow part of the benefit to be passed along to shareholders.
Sharing profits
Sharing the smart meter and communications infrastructure, including a fee or profit divided between customers and shareholders, is a more economic option on a societal level. It provides an overall lower cost than funding a separate communications infrastructure to support municipal services or other utilities.
Another example of extending a regulatory model from one part of the value chain to another is associated with the charging of electric vehicles. Studies performed by our firm and the National Renewable Energy Laboratory highlight the probability that allowing people to
charge electric vehicles whenever they want – typically plugging in cars as they arrive home from work – will lead to substantial strain on the grid and necessitate substantial investment in transformer and network capacity.
Some of that added operational cost and capital expense may be avoided if the utility attempts to coordinate the charging. While time-of-use pricing can influence customer decisions on when to use power, it doesn’t necessarily guarantee they will choose wisely.
Two-tier pricing
A more direct and perhaps more effective approach might be instituting a two-tier pricing structure that imposes higher rates for customers who do not let the utility coordinate or manage their vehicle charging. The strategy should elicit more adoption by consumers and thus require less new investment.
Elsewhere in the value chain, some utilities already charge an additional opt-out monthly fee when customers refuse to install a smart meter. Why not extend this two-tier pricing model to those who refuse to allow the utility to manage their charging schedule? Extending this metering model to vehicle charging allows the utility to better reflect its cost to serve customers and target investment for higher value needs.
A last example of extending the regulatory model is associated with expanding the services provided by regulated utilities. Economies of scale matter in the utility industry and are becoming more important.
To create shareholder value from smart-city initiatives, electric utilities should take a page from their gas utility cousins’ playbooks
Investment needed
The 3-D transformation of the electric sector is requiring significant capital outlays in grid hardware, distribution network planning and analysis tools, and distribution management and customer systems. It will also require investment in a highly skilled workforce of data scientists and analysts, and planners capable of analyzing two-way power flows.
This pressure to invest to upgrade capabilities will hit smaller utilities the hardest. It could potentially lead to a shakeout among smaller utilities and disruption for the more than twenty-five percent of Americans who get their power from municipal and cooperative utilities, in most cases small entities.
There are three hundred and fifty utilities with twenty-five thousand to three hundred thousand customers. Some of these small entities may present acquisition opportunities for investor-owned utilities (IOUs).
Pairing up
To stay independent, some small utilities will consider outsourcing distribution network operations and distribution system planning activities to a third party. In this search for a partner, regulated utilities may in fact have a competitive advantage, especially for those smaller utilities sitting within or adjacent to an IOU’s service territory.
It’s an opportunity for IOUs to leverage capabilities and expertise and mitigate some of the potential cost increases for customers of these smaller entities. But that strategy won’t work unless shareholders are compensated for the effort and risk of providing that service.
Analogous to smart cities, extending the gas storage and trading regulatory model to provide distribution network operations services could be a win-win for customers of both the smaller utility and IOU, and for the IOU’s shareholders.
The current transformation of the power industry provides utilities with opportunities for growth and new services. In addition to exploring new rate models not directly linked to capital investment and ROE, utilities should examine solutions that extend existing regulatory models to other assets or parts of the value chain. A complementary evolutionary strategy may yield near-term bottom line results while the longer-term journey to revolutionize the regulatory model is underway.
This article originally appeared in Public Utilities Fortnightly
Oliver Wyman Ideas App
