Electricity prices are going up, so why are people saying that the business model for electricity utilities are under threat? Simply put, increasing prices are not always a good sign for a business.
The question is “are they putting up their prices because their sales volume is going down?” or alternatively “will their sales drop if they put up prices?”
It seems that, for the Australian electricity market as well as many international markets, the answer to both questions is “yes.”
As discussed in the first part of this article, electricity demand has been going down since 2009 in the Australian market. This is almost certainly a consequence of increasing electricity prices and recent policies such as the Small Scale Renewable Energy Scheme (SRES) and state based feed-in tariffs that provided strong incentives to install solar panels.
These incentives were strongest between 2009 and 2012 but have almost all been wound back significantly in the meantime. During that time period, solar capacity nonetheless went from almost zero to nearly 3000 megawatts, or 10 per cent of Australian peak energy demand.
The decline in energy delivered through the grid has been causing some consternation in energy industry circles. A serious concern has emerged about a “death spiral” where declining demand would lead to price increases as utilities try to recover the same revenues from smaller volumes. The resulting price increases then could lead to consumers being more frugal with their energy use leading to a further decline in energy volumes or even causing some customers to disconnect entirely from the grid, yet again leading to further price increases, and so on.
This dynamic is typical of industries where capital costs make up the vast bulk of the total cost. A similar phenomenon occurred in the telecommunication industry with the advent of mobile phones. As people started using their mobiles instead of landlines, revenues from fixed line calls started to decline. This led to telecom companies increasing their monthly fixed line charges (rather than per call charges) – a process which is still playing out as consumers are now increasingly choosing to have no land line at all, or at least only broadband over the copper wires (Naked DSL).
At this point in the transformation of the telecommunication industry, these companies are no longer just operating and charging for copper wires used for phone calls. They are selling services more and charging for use of hardware less.
It is fairly clear that a similar phenomenon is beginning to affect the electricity utility. In Australia, New Zealand and the UK, the technological transformation poses a particular challenge because of the vertical disaggregation that occurred, making it difficult for companies to invest in the most efficient technologies and reap profit benefits across the supply chain when they only own for example, power stations, while other entities own distribution or transmission networks.This is known as the issue of “Split Incentives” or “Split Benefits.”
In the US and Europe, this disaggregation was not as extreme. Companies there can own generation, distribution and retail to customers, thereby allowing them to benefit from deploying more efficient technologies such as solar panels, batteries, or ultimately investing in smart grids that deliver significant peak demand reduction.
The class of utilities that will find the coming transition most difficult are the monopoly-regulated distribution network businesses. They are totally dependent on a regulated revenue stream that is designed to cover the cost of their fixed assets and they are not structured to deal directly with customers. Moreover, their shareholders have invested on this basis and do not expect them to become involved in volatile wholesale or retail market activities.
They may ultimately not have any choice but to embrace the new technological reality, however. Their low risk investment always assumed a technologically static market place, a situation that no longer exists. New technologies such as smart meters, solar photovoltaic panels, batteries and smart-grid based load management technologies installed at consumers’ residences or places of business will now be competing directly with the distribution utility’s provision of energy, and even capacity services.
In this new technological landscape, the lowest risk strategy is to enter the competitive market for deployment of these technologies and leverage this into the provision of new retail product and services.
This means the distinction between a distributor and an electricity retailer (think SP AusNet versus Origin Energy) will become increasingly blurred. As a result, we will be seeing a sort of re-aggregation of the electricity supply chain along vertical lines. Electricity retailers already own power stations (or vice versa) in most parts of the world, and bringing distribution assets into the portfolio makes good business sense.
At some stage, transmission may also be brought into the fold, although these companies may survive longer as stand-alone businesses since their revenue streams partially stem from enabling the operation of the wholesale generation market. However, as the balance shifts from centralised to distributed generation sources, transmission network operators will also experience the same revenue decline and will need to adapt.
In the end, these new utilities will look a lot like the old state-owned vertically integrated monopolies but with a kind of Swiss-cheese structure where the generation, transmission, distribution, and retail components of the business will not fit perfectly. Furthermore, the regulatory frameworks will probably need to change, or even be partially dismantled.
The ability for the consumer to choose their physical infrastructure, such as solar plus battery versus grid, will mean that the grid is no longer a natural monopoly, and therefore does not need to be regulated. At this point, regulation will actually be a barrier to the most efficient outcomes and therefore to cheaper services! Thus a new era of energy services will eventually arise where the consumer is king.