Tuesday, February 16, 2016

Disruption - Part Two - Electric and Gas Utilities

I started a trend of posting on disruption with the taxicab industry being walloped by Uber. While disruption is everywhere in the press, the question is - when is disruption truly real and where is it a distraction? Let's move on to the electric and gas utility industry.

The electric and gas utility industry is the "exact opposite" of the classic "disruption" thesis... although disruption and revolution have been promised many times over the years, they have failed to materialize. Let's look at the characteristics of this industry and find the salient facts that either "enable" or "defeat" disruption.

I worked in the electric and gas utility industry throughout all of the 90's. I traveled to over 100 public, private and municipally owned utilities (there aren't that many left today because there have been many mergers in the industry space). Since then I have followed them through business publications and public sources of information.

The electric utility industry has 4 main components:
1. Generation - the generation of power through nuclear fuel, coal, natural gas, hydro or solar / renewable
2. Transmission - moving power via high voltage lines from where it is generated (remote) to the cities where people live
3. Distribution - the local city with overhead and underground wires and substations and physical trucks
4. Customer Service - who you call and how they dispatch crews and respond to incidents

The electric utility industry also is characterized by "real time" surges and the fact that power can't be stored (yet) on a large scale; thus peaks occur on the hottest days or the coldest days and power is needed exactly at that moment at your particular location. These peaks can results in demand far higher than during a "typical" day.

The natural gas utility industry is conceptually similar to the electric energy industry with two main differences. Generation isn't handled by them (exploration companies find natural gas and get it to their system through their own processes and methods) and natural gas is much less "peak sensitive" and can be stored near the point of demand and injected into the system.

Broadly speaking, there have been many attempts to "de-regulate" the electric and gas utility markets over the last THREE decades. Let's start with natural gas.

A solid history of natural gas regulation through 2013 can be found here. Key elements:
1. Natural gas utilities have long been recognized as a "local monopoly" with virtually all cities having a single supplier for distribution and customer service and with utilities receiving a guaranteed but regulated profit
2. The price of natural gas used to be regulated which limited exploration to the point where the US government stopped allowing new customer hookups in the 1970's because they believed we were "running out" of natural gas; after price controls were lifted, exploration companies found vast new stores of natural gas and brought them to market under the profit motive
3. Pipelines (transmission) were opened up to customers for bidding in FERC Order 636 in 1992 which reduced bottlenecks and allowed for transport of natural gas to end users who were not utility customers (such as large commercial enterprises). This allowed them to seek and source their own gas without having to build their own transmission network
4. The current regulatory environment allows customers to source gas from other than the local utility; you may have seen ads for this. They are still using the utility's transmission (if they own it), distribution and customer service functions and paying a fee - but you can lock in a different provider of natural gas and lock in a different rate / unit with different terms if you want to do so

Today, gas utilities have benefitted immensely from the plummeting costs of natural gas which is due to all the innovations of fracking that also caused the price of oil to plummet from over $100 / barrel to under $30 / barrel. These innovations came from outside the regulated energy industry, since exploration has been effectively de-regulated since the 1970's, enabling vast new supplies to enter the market. Roughly half the costs to an end consumer is the gas transmission / distribution / customer service component and half is the cost of natural gas itself. Thus there have been large savings to end customers of natural gas over the last few years.

While there has been vast innovation in exploration, there has been limited innovation in the other elements of the gas utility space, which is typical of a regulated entity with little to no competition. There are some huge difficulties coming for the industry, however - their distribution networks are old and have been allowed to deteriorate in many areas and giant investments in pipes and systems will be needed over the next decade. In Chicago, for instance, the cost of upgrading the old systems have ballooned from $2B to over $8B and rising and are years behind schedule. Note that in the current regulated utility model customers bear the costs of these upgrades through rising bills and charges, unless regulators decide to disallow the charges.

The electricity industry was always larger in size and scope than the gas industry because the utilities themselves (mostly) built and were responsible for their own generation plants, which can cost billions of dollars. The electric utilities were also responsible for transmission, distribution and customer service. This article summarizes the history of electric utility regulation. Some highlights:
1. Electric utilities were hit hard with inflation and high costs of new generation (primarily nuclear plants) in the 1970's and 1980's and since then investment in "traditional" baseline generation such as nuclear, hydro, and coal plants have been muted. We are essentially leveraging generation assets that are 40+ years old or greater (with the exception of natural gas)
2. Electric utilities are regarded as local monopolies with guaranteed returns and profits on their transmission, distribution and customer networks; in many places generation has been partially de-regulated and prices can fluctuate significantly with demand
3. While there has been some investment in distribution and transmission, these investments are very difficult to make due to prohibitive local costs and regulations and a lack of financial incentives in many cases for transmission. There are exceptions on a state level but it is generally the case that we are leveraging past investments
4. At the local level there is some customer "choice" but it is on the provider of generation and this is often more "financial" than "real" - the network still is interconnected and requires real time monitoring and supply for peaks
5. Some states and municipalities are increasing the use of "green" power which is almost always far more costly, particularly on peak, than standard base-load resources. To the extent that this becomes the norm, electricity rates will rise to end users

On the electric utility side, their failures of de-regulation have been more prominent, including the spectacular meltdown in California with the collapse of their ill-fated spot regulatory system amid gaming from Enron. It even has its own wikipedia page you can read here. I have written many articles on the failed "nuclear renaissance" and our nation's failed energy policy and you can read a good summary here. In general, our overall failed electric energy plans have been (mostly) bailed out by the plummeting cost of natural gas, which led to a new and (relatively) efficient baseload model. Note that this benefit has been earned by the private sector outside of our regulatory or government research model; private sector investors did the research and built the infrastructure that "changed the world" by unlocking US resources at a reasonable cost. Our model of incenting land owners through mineral rights, meaning that they receive profits for oil and gas under their lands, means that this private sector model received encouragement not discouragement that it would have received elsewhere (such as in Europe, where these rights mainly belong to the state).

What can we learn about "disruption" and the "barriers to disruption" from the perspective of a review of the electric and gas utility industry? Here are some thoughts:
1. The main response by regulated entities to competition was to buy up adjacent companies, remove back office staff and facilities, and become "bigger oligarchs". Rather than invest in market-changing disruptions, the key was to become larger and use financial engineering in an attempt to increase profits. Both the electric and gas utility markets have undergone massive consolidation over the last 3 decades
2. Another way to increase profits is to decrease investment; the US is basically living off investments made decades ago in generation, transmission and distribution networks and some day these bills will come due, or there will be a (continuing) fall in reliability which is just another symptom of disinvestment
3. Regulatory capture and regulatory meddling (renewables, etc...) may have mutated over the years but there is little or no semblance of a free market especially at the transmission, distribution or customer service end, and as a result there is little innovation and disruption
4. The largest POTENTIAL source of disruption would be competition between natural gas and electricity, or between new entrants (such as backup home systems with the potential to switch between gas and electricity). Sadly, this has been muted, because typically regulated industries care more about their regulators' opinions than the market and lack entrepreneurial skills and even if they were successful the profits would likely be capped by the regulator

It can be safely concluded that our electric and gas industries have walled themselves off against disruption through regulatory barriers and any claims of disruption from new entrants clamoring for investment opportunities should be treated with more than a grain of salt. Thankfully our unregulated exploration business has effectively "bailed out" our failures on the regulatory side with the plummeting costs of natural gas (in fact mainly a by-product of our relatively unregulated oil industry). While someone may point to "Nest" (and Google likely has a valuation bigger than the combined market caps of gas and electric utilities in the USA) this is a marginal not game changing technology since it still utilizes the regulated "pipes and wires" from start to finish, although it can help on the customer service side if integrated in the longer term (and is absolutely a welcome player).

Cross posted at Chicago Boyz

1 comment:

Anonymous said...

I have worked in the electric utility business for over 35 years. If I may point out an important, maybe critical, reason for points 2 and 3 in the paragraphs on electric deregulation: at the distribution level, it is not physically practical to have multiple service providers. Adding two or three more sets of overhead distribution lines, in addition to being extremely costly, would be terribly unsightly and probably dangerous, and buried cable costs at least 10 times more per unit of distance as overhead lines and is therefore cost prohibitive. Economists, even many free-market advocates, used to say that gas, electric, and water distribution is a "natural" monopoly.
Of course, there are alternatives such as owning a generator, or having a well, or using bulk propane tanks. In terms of safety and quality of life neither propane nor backyard generators are desirable in urban and suburban spaces, and water wells have limits in densely built-up areas also. The capital costs of the distribution infrastructure are such that unless assured of a reasonable return, investors won't finance new investment. I'm not sure what type of disruptive technology would be viable in the near future, although it is the beauty of free enterprise if there is a new technology, someone will bring it to market. We can only hope the regulators and lawmakers stay out of the way when the game-changing technology is ready for prime time.