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Relentless And Disruptive Innovation Will Shortly Affect US Electric Utilities

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The Edison Electric Institute recently released a report entitled Disruptive Challenges: Financial Implications and Strategic Responses to a Changing Retail Electric Business. The report highlights some of the trends likely to affect U.S. electric utilities in the near future:

“Recent technological and economic changes are expected to challenge and transform the electric utility industry. These changes (or “disruptive challenges”) arise due to a convergence of factors, including: falling costs of distributed generation and other distributed energy resources (DER); an enhanced focus on development of new DER technologies; increasing customer, regulatory, and political interest in demand side management technologies (DSM); government programs to incentivize selected technologies; the declining price of natural gas; slowing economic growth trends; and rising electricity prices in certain areas of the country. Taken together, these factors are potential “game changers” to the U.S. electric utility industry, and are likely to dramatically impact customers, employees, investors, and the availability of capital to fund future investment.  The timing of such transformative changes is unclear, but with the potential for technological innovation (e.g., solar photovoltaic or PV) becoming economically viable due to this confluence of forces, the industry and its stakeholders must proactively assess the impacts and alternatives available to address disruptive challenges in a timely manner.”

The piece asserts that the financial industry is not yet aware of this disruptive potential, and notes that of the major actors in other industries which underwent regulatory restructuring (airlines and telephone companies) few of them still exist today.  It further suggests that with the advent of demand response, distributed generation – such as behind-the-meter solar, storage, electric vehicles, and increased end use efficiencies, revenues may fall and new tariff structures may become necessary.  If tariffs for capacity or kilowatt-hours are raised to compensate for declining volumes, the effect may be to drive customers from the grid (especially if storage becomes cost-effective).

The report notes that the industry would benefit from “proactive assessment and planning to address disruptive challenges” and highlights some interesting statistics that reflect the dynamic of disruption.  Among them:

1)    PV panels have fallen in price from $3.80 per watt to .86 per watt in just four years, from 2008 to mid-2012.

2)    PV solar is now grid-competitive in 16% of the US retail market (higher on-peak time-of-use rates reinforce that dynamic).

It also notes a projection from Bloomberg that PV solar will grow by 22% annually through 2020, with 4.5 gigawatt-hours (4,500 megawatt-hours) coming from on-site solar.  This would equal 10% of existing generating capacity in some key markets.  With the corresponding decline in revenues, this could also lead to a 20% increase in rates for ratepayers burdened with continuing to support the utility infrastructure.  If prices of solar fall still further - and they will - estimates are that the addressable market can increase by 500%.  Rates go higher, more people leave the grid, forcing the rates higher.  That sounds like a potential long-term death spiral.

The Edison report is interesting, because it looks at existing technologies.  But it is only a limited snapshot of what is really going on out there beyond the borders of the utility kingdom, where the horde of innovators continue to develop more technologies and where the nature of innovation itself is changing.

To get a sense of how innovation is morphing, it is instructive to read the recently published Harvard Business Review (HBR) article on the topic.  The established model of innovation from Clayton Christensen was that new competitors emerged and challenged industries with cheap substitutes.  As these were adopted by customers at scale, new entrants could swim upstream, develop higher quality products, and drive out the more established players.

To some extent, that has changed.  The HBR article suggests that in today’s world, the disruptive innovators often don’t even come from the same industry.  They can develop products to enter the market quickly.  Large numbers of customers can switch in extremely short timeframes - resulting in what they call “Big Bang” disruption.

Much of this disruption lives in the information ecosystem, with pervasive computing and mobile phones.  The early innovators - eBays, the Amazons, the IOSs and Androids - rule the platform kingdom (for now) while the next generation of innovators works to build their apps to fit this new and evolving world.

The HBR piece warns “Big bang disrupters may not even see you as the competition.  They don’t share your approach to solving customer needs.  And they’re not sizing up your product line and figuring out ways to offer slightly better price or performance with hopes of gaining a short-term advantage.  Usually, they’re just tossing something shiny in the direction of your customers hoping to attract them…”

If your competition is not gunning for you, but simply creating something new to see how it goes, how will you compete?

What Does That Mean for U.S. Utilities?

This paradigm may happen more slowly in the electric utilities world than in cyberspace.  To date, it doesn’t look as if all that much physical change has really happened.  But we are in the early days, and poised on the precipice.  The innovative forces that have driven change in other industries are hard at work in the electric energy industry as well, and they are coming at it from all angles.  The Edison Electric report captures the financial implications of this change, but it really doesn’t come close to describing the seething stew of innovation that is out there right now.

To take just one example, this month, the UtraLight Future Energy Event was held at MIT, sponsored by Shell, and hosted by the MIT Clean Energy Prize.  During this event, eight (pre-selected) would-be start-ups had nine minutes each to pitch a start-up concept, answer questions from a panel of VC types, and receive advice.  Their technologies included: printable high-efficiency photo-voltaics, zinc-ion pseudo capacitors, fuel cells, software for electric and thermal monitoring, grid-scale storage based on enormous weights and gravity, a glass technology that would concentrate the sun’s rays to the pane's edge for energy conversion by a solar panel, and a small-scale containerized nuclear reactor.

This is only one of a number of forums run by UltraLight to identify new and promising technologies. What will happen to the utility world if any of these or other nascent technologies develop as quickly as solar has in the past decade?  We may well be watching the beginnings of a new – and very complicated – electric ecosystem evolving.  With the continued and rapid march of technology, it’s probably only a matter of time.  (An insightful view on this comes from a former colleague, Doug Short, on his blog at Exxas Consulting: http://exasconsulting.com/blog/is-your-head-still-in-the-sand-big-bang-disruption-in-the-electric-industry/)

The Incumbent Electric Utilities Need to Pay More Attention; Tweaking the Existing Business Model Is Probably Insufficient

In some overseas markets with high tariffs, the Edison Electric/HBR Big Bang scenario is already here.  In Germany, where installed solar power on residential rooftops is much cheaper than in the United States, farmers and private individuals own more than 50% of the solar generation.  CEO Peter Terium of RWE – one of Europe’s largest utilities – stated in 2012 “Our core markets are changing remarkably fast.”  With 32 gigawatts of solar – 40% of that on residential rooftops – consumers are now both producers and consumers “prosumers.”  In addition, Terium stated "Almost no other industry is currently undergoing such dynamic change as the energy sector…The success of this transformation of the energy industry will be decided at the local level." RWE is already living the Edison Electric report scenario.  With the advent of solar, as well as increasing end-use efficiencies, the utility now forecasts declining electric sales from now to 2035, with mid-afternoon peak demand falling almost 20% from just over 24,000 MW to 19,000 MW.

Australia is looking at similarly rapid and significant changes, having gone from 20,000 solar rooftops in 2008 to over 1,000,000 as of March this year.  Australian utilities are struggling to cope with this change, and looking to find new ways to remain relevant to customers.

NRG's CEO David Crane is one of the few utility CEO's in the US who appears to fully appreciate - and publicly articulate - the potential for this coming dynamic.  At recent Wall Street Journal ECO:nomics conference, he indicated that solar power and natural gas are coming on strong, and that some customers may soon decide they do not need the electric utility. “If you have gas into your house and say you want to be as green as possible, maybe you’re anti-fracking or something and you have solar panels on your roof, you don’t need to be connected to the grid at all.”  He predicted that within a short timeframe, we may see technologies that allow for conversion of gas into electricity at the residential level.  If this were to occur, one could expect a significant impact on the value of existing generation companies - especially the ones with large generation fleets (such as Duke - at 57,700 MW of capacity; NRG, at 46,500 MW; Southern at 43,500; and AEP, at 38,000).  It would not occur overnight, but the long-term impact would be inexorably downward as sales volumes would begin to decline.  Similarly, the value of electric distribution utilities would be affected.

Possible Future Roles

This dynamic change is not only unavoidable, it is accelerating.  The utilities need to heed the advice of the Edison report and prepare for a new and disruptive future, starting with some scenario planning.  A good place to start is the way Shell Oil’s team has done it for years, as highlighted in Peter Schwarz’s “The Art of the Long View.”  That process involves outlining a broad range of potential scenarios and then working backwards to the present, identifying events and milestones that suggest you are moving more quickly towards one scenario rather than another.  Of course, within each scenario, you have to have your general strategies mapped out in advance.  This is not easy in any company. It takes resources and commitment.

It’s even harder in a regulated world where all utility expenditures must be approved by the regulators.  But it is necessary.  Utilities should be thinking about how to take advantage of their assets – their revenues and balance sheets - and provide energy services to the customer in new ways – for example, whether they should be the providers of PV and storage solutions.  Should they be leasing efficient end-use technologies to customers?  Such approaches merit consideration.  Germany’s RWE thinks this approach has merit, and has taken steps to develop such an offering.

Utilities should also be considering the increasing flows of information, as this internet-of-things continues to develop and machines increasingly talk to machines.  They should be thinking about how to position themselves at the center of the energy information network, supplying the pricing and real-time usage information to the customer and his or her machines.

The full realization of “Smart grid” – that interaction of markets, technologies, and customers - will not and cannot happen without some centralized entity efficiently providing near-instantaneous pricing and usage information.  Utilities are a logical choice to assume this role since they have the meter data, and large IT systems.  They would need to become more information centric, but they could morph into this and charge a tariff for making the information available.  If they don’t assume this role, somebody else will eventually fill the space.  There is too much long-term value there to customers and vendors for it to be ignored.  And provision of this service could become a stable revenue generator in the years to come.

The Edison report makes it abundantly clear that the game has already changed.  Somebody took the old ball and replaced it with a new one.  The HBR article suggests that innovators may change the game itself, and without bothering to tell anybody.  These looming challenges are no longer avoidable and they may be closer at hand than people think. U.S. utilities are probably about to see what other disrupted markets are already grappling with – declining sales volumes, a need for new revenue streams, and a strategic imperative to stay relevant to the customer.

The problem, admittedly, is that the answers are far from clear.  More problematic however, is that - locked in the regulated utility paradigm of the past 100 years - most utilities do not even appear to be asking the right question  That will need to change very soon.