Utilities Can Overcome the "Death Spiral"

The future electricity grid requires a whole new social compact between utilities, regulators and the public in order for it to remain relevant.
Published: Fri 21 Feb 2014

Utilities continue to hold on to 100-year old business models-invest in equipment, turn the customers’ meters, and earn a steady profit. But, for the first time utilities’ profits are being undermined by a changing energy sector.

But, as the industry faces an unfamiliar and uncertain future, traditional business models must be done away with. This will affect the way they plan, conduct business and serve their customers.

A number of innovative energy service suppliers have increased significantly and is disrupting the traditional relationship between the utility, regulators, and customers. Because customers are gaining access to technology that can save and generate electricity, utilities need to adopt innovative business strategies in order to stay ahead of the competition which wasn’t there before.

A kind of “death spiral” or “vicious cycle” has been created- As customers leave the utility service and provide their own power, the departing customers’ share of utility costs fall on fewer customers. This raises utility rates causing more customers to leave the grid. To avoid this, utilities need to devise new business models, taking into consideration the changing environment, technology and the customer. The new electric power industry will have to be designed with three objectives in mind- creating a decentralized control paradigm, equipping the system for low-carbon supplies, and establishing a business model that promotes increased efficiency.

Maintaining relevance

The Deloitte Center for Energy Solutions points out, “The time is ripe for significant transformation because the potential for dramatic disruption to the existing electricity operating model is coming not from one direction, but from many -- demand, technology, regulation, new products, and new competitors.”

While some utilities choose to avoid the changes by undermining distributed technologies in order to keep customer dollars flowing to utilities, we believe this approach is doomed to fail as it is not in the public’s interest. Instead, the utility should embrace the opportunities offered by distributed generation and energy efficiency technologies. Why? Because it is not going away anytime soon, if ever.

There are a number of ways that the utility can remain relevant. It is up to the utility and policy makers to determine what will work best in that particular environment. The utility can be limited to a role as a “wires company,” maintaining the part of the grid that is a physical monopoly -- the wires and poles -- while competitive providers supply the rest. At the other extreme is the “energy services utility,” which owns and operates all the necessary systems to deliver energy services to consumers. Between these two, a “smart integrator” or “orchestrator” role involves utilities partnering with innovative firms to coordinate and integrate energy and related products and services without utilities necessarily delivering all of them.

Policy rules the roost

The power sector is heavily affected by policy. Utilities cannot establish new business models without the right policies in place. Whether in regulated, vertically integrated monopoly and monopsony (single buyer in a market) settings, or in competitive ecosystems, policy sets the rules. Policymakers must define societal outcomes, determine the legal and market structures under which companies operate, develop and implement the proper market and regulatory incentives, and follow up to make sure that policies are being achieved.

Policymakers and power companies should experiment with different responses to changes in the power sector. By doing this, they can create a range of new business models that work, as well as a diversity of regulatory structures that support them.

Regulatory Models

It is up to the utility and policy makers to create regulatory models which aim to encourage change within the utility, as well as support public interest.

Ron Lehr and Bentham Paulos of America’s Power Plan suggest three regulatory models for the utility:

  • The UK’s new “RIIO model” (regulation for incentives, innovation, and outcomes) is based on broad-scale performance-based incentives with revenue caps. Utilities file business models to achieve the above-mentioned goals. New utility business models, recently filed with the regulator, show how utilities will accomplish a range of public policy outcomes, provide customers value for money and measure performance to support incentives. The RIIO model aims to pay utilities to deliver what society wants going forward, while U. S. regulation tends to focus more on whether society paid the correct amount for what it got in the past.

  • The so-called “Iowa model” describes a series of settlements entered into by parties and approved by regulators that led to electricity prices in Iowa that did not change for seventeen years. This is despite wind power rising to 25% of the generation mix, fluctuating fuel costs, and growing customer loads. The Iowa model proves that stakeholders can negotiate for and settle on a regulatory bargain that works for them to keep rates stable. It also supports shared earnings and utility profits in a less adversarial process. The largest Iowa utility, MidAmerican Energy, has announced plans to get to 39% by 2017. The approach also encourages the movement towards clean energy.

  • The “grand bargain” model combines elements of the RIIO and Iowa models. Most commissions are trapped in solving particular regulatory issues without any opportunity to look across all the issues and work toward comprehensive and coordinated outcomes. This can result in confusing and contradictory outcomes. In a “grand bargain” model, a commission would encourage utilities and stakeholders, including commission staff, to negotiate a comprehensive settlement to a range of desired outcomes.

The common thread for all three of these models is that they clearly define the goals and the parameters, encourage utilities to new and improved levels of performance, and grant the companies the flexibility to achieve them.

All three require unprecedented new levels of communication and cooperation, based on the fact that utility and regulatory “business as usual” will not be sufficient to reach solutions for the new challenges that the industry is faced with.

Companies and regulators need to experiment and find agreement, outside the traditional adversarial venues of utility regulation. They need to be given the flexibility to try new products or programs in the market place.

Further Reading:

Deloitte University Press-Beyond the math:Preparing for disruption and innovation in the US electric power industry

Edison Electric Institute-Disruptive Challenges:Financial Implications and Strategic Responses to a Changing Retail Electric Business [pdf]