SOURCE: US EIA
There is a profound process of change underway in the regulated utility business. It is brought about by a combination of good forces of healthy competition, low natural gas prices, the growing sense of environmental awareness and a hard to describe but easy to feel sense of vulnerability by customers. The shape of this power shift is also being driven by Federal and State regulatory agendas wrapped around environmental policy objectives. There is broad public support for a clean energy economy. But the devil is in the details and we do not yet know whether these good intentions will turn into good policy results.
The investor owned utility business model and its companion the regulatory compact have been in place for nearly a century. They arose from the chaos and monopolistic behavior of the age of Sam Insull. Insull was Thomas Edison’s secretary. While Edison was a great inventor he found running the day to day operation of his light business a bigger challenge. Edison sent Insull to fix the problem and get the business back to scalable growth. Insull succeeded beyond Edison’s wildest dreams. His M&A skills turned an essential business into an interlocking sets of trusts that gave rise to the trust busters of the progressive era. So profound was Insull’s impact that he came derisively to be called the ‘father of the US Securities and Exchange Commission’ created to regulate monopolistic behavior and its corrosive impacts on the stock market.
What does that have to do with the current threat to the utility business model?
Technology now just as it did a hundred years ago has a way of disrupting the equilibrium of markets. The regulated utility business model we have today worked by balancing the interests of shareholders eager for a fair return on their invested capital in exchange for regulatory assurance that just and reasonable rates fairly allocated costs and revenue requirements across customer classes. This balancing of interests required utilities to accept an obligation to serve all customers and to provide reliable service. When issues arose between the parties a quasi-judicial regulatory hearings process settled the matter based upon a evidential burden of proof showing that the actions were just and reasonable.
But this post is not about the electric power industry past or its regulation today but rather its future. There are big shifts in market fundamentals, transformational changes in technology bringing regulatory implications for the electric power industry. These changes have profound implications for renewable wind and solar resources, the fuel mix, embedded cost, reliability and reserve margins and whether the changing market structure can support reliability.
- Power Shift Phase 1: Three Mile Island Nuclear Accident Changed Everything. The big shift began with environmental concerns arising over the Three Mile Island nuclear accident. So profound were worries over nuclear power plant safety that the nuclear industry never recovered enough public confidence to support building the next generation of nuclear power plants.
- Power Shift Phase 2: The Arab Oil Embargo and Looming LNG Imports. The Arab oil embargo shocked Americans about our energy security and vulnerability. Calls for more energy efficiency and conservation resulted in demands for wind and solar energy tax credits and renewable portfolio standards to mandate utility purchases of renewables. in the face of high natural gas prices and a widely held belief that the US would be forced to import natural gas as LNG just as it was oil, Congress action passed the Industrial and Fuel use Act of 1978 and the Natural Gas Policy Act of 1978 of natural gas as a power generation fuel..
- Power Shift Phase 3: Inflationary Rate Spikes Lead to Wholesale Competition. The big shift at work today began when rising inflation eroded the economics of new power plant construction especially nuclear power. Until then each new power plant built reduced the average cost of service and thus rates. That virtuous circle turned vicious when inflation and regulatory delays caused power plant construction costs to sky rocket. Public reactions to rate spikes and regulator reactions to power plant construction cost increases resulted in changes in industry structure to encourage more competition. A good summary of energy policy legislation can be found here in a Penn State table. The National Energy Policy Act of 1992 broke up the vertical energy company into unregulated wholesale generation to introduce competition, energy delivery remained rate regulated wires and pipes business while transmission and the ISO formation process was designed to remove barriers to access to new competitive supply, improve cost allocation and retail energy competition in some markets. But before that pressure to introduce competitive market mechanisms lead to pressure to relax the Fuel Use Act and NGPA limits on natural gas through the Natural Gas Wellhead Reform Act of 1989 relaxed wellhead gas price controls.
- Power Shift Phase 4: Regulation is Driving Toward a Distributed Energy Future. Fast forward to today and the big shift for the electric power industry is in its fourth wave driven by the regulatory imperative to achieve renewable portfolio standard (RPS) targets at the state level and the Federal regulatory push to reduce greenhouse gas emissions. The big shift reflects the implications for market equilibrium of what must be built (renewable energy), what can no longer pragmatically be built (new coal fired generation) and what’s left. What’s left is essentially demand response and efficiency to optimize the performance of a portfolio or a regional market and, when new capacity is required for grid reliability it more likely than not will be gas fired generation if the economics for new power plant construction make such units profitable.
So where has this power shift taken us?
The states have played a useful role as laboratories for market experiments in energy and environmental policy as we search for a modern update in the hundred year old regulatory compact. Markets are often messy and the boom and bust cycle teaches lessons:
- Enron and the California Energy Crisis. Wholesale energy competition after the EPAct of 1992 resulted in very bad policy and financial outcomes from trading manipulation and rolling blackouts. The unfettered trading schemes such as ‘get shorty’ cut short the life of competitive trading in energy contracts, caused the financial collapse of Enron and other firms trying to game the system, and lead to even more regulation to clean up the mess.
- The Repeal of the Fuel Use Act and the Growth of Natural Gas Supply. In the buildup of demand for power generation the regulators changed their mind. The Fuel Use Act and the Natural; Gas Policy Act effectively imposed a regulatory regime demanding that utility build coal fired power plants and not build natural gas power plants. By 1987, that policy imperative had been reversed in the Industrial Power Plan and Fuel Use Act Repeal Act of 1987. Natural gas was back in vogue and when combined with the National Energy Policy Act of 1992 and the energy efficiency and alternative fuels provisions of the Energy Policy Act of 2005 the race to remodel the power generation portfolio mix was in full swing.
- Dot.com Bubble, Smart Grid and Digging Out of the Financial Crisis. By now you know the growth of natural gas domestic supply came about because of the growth in demand for natural gas for power generation in the buildup of the dot.com boom, in the M&A rationalizing of the shift to a competitive wholesale market for power generation as utilities unloaded power plants, recovered stranded costs and got their balance sheet aligned with the regulatory obligations.
- Combined Heat and Power as Precursor to Distributed Energy. In the aftermath of the 2008 financial crisis more industrial and institutional customers focused on energy price competition, reducing their energy costs through cogeneration and efficiency, and improving their energy security through more sophisticated combined heat and power projects that included wind and solar projects and demand response opportunities to leverage efficiency and load shifting potential. Net metering laws, smart meters and time of use rates encouraged these CHP activities.
The distributed energy future is unfolding before our eyes creating disruptive innovation tensions that bring both opportunity and risk. What should we watch for?
Here’s my list of factors shaping our secure, competitive distributed energy future:
- The US Shale Oil & Gas Revolution is a complete reversal of fortune for the US. It is turning both the oil and natural gas sectors on their head. The US is expected to begin exporting natural gas as LNG by 2017. The growth in supply of light crude oil is causing congestion in the pipeline system, backups at the refineries and a 6,000% increase in rail transport of oil. While the first flush of the most economic shale oil supplies are expected to peak by 2020, the long tail of production and the expected supply growth from subsequent waves of E&P from additional plays is turning the US and all of North America into a global energy superpower.
- Abundant low priced natural gas is a global manufacturing magnet. How long they stay low and how powerful those low prices are as a magnet for new manufacturing and industrial demand from offshore production returning to the US. US exports of LNG far from hurting supply or raising prices creates more interest in capturing flare gas and extracting gas from more widely distributed plays.
- Pent Up Demand Frustrated by Slow Economic Growth. The current growth rates are frustrating the pent up demand looking for a place to invest, grow and prosper. I don’t expect much to change until we get through the next presidential election cycle, but we might get a better clue to the direction if the 2014 elections produce a change in control of the Senate and perception of as stronger public demand for a growth agenda. If the election results give the markets a more optimistic sense of a future growth agenda we should see it in a pickup in fuel demand for power generation which historically tracks GDP growth.
- Doubling Down for Growth. The seeds of the next boom are often planted in the bust of the last business cycle. We have seen that in the initiate by entrepreneurs washed overboard in the financial crisis turning to start-ups to take back control of their lives. We saw it in the ingenuity of the hydraulic fracking pioneers unable to compete with the super majors in the deep water Gulf of Mexico so they went to work in the shale plays onshore and started a revolution. We see it in the lust of China and other nations for access to US technology, expertise and skills.
America and its markets, workers, technology and rule of law are still the envy of the world. We just need to get our politicians out of the way so the regulations and politically motivated changes in law and policy don’t snuff out that optimistic, ‘can do’ American spirit.
 Cohen, Bernard L., University of Pittsburgh, Plenum Press, 1990, Chapter 9, The Nuclear Option What Went Wrong? http://www.phyast.pitt.edu/~blc/book/chapter9.html