A national push to curb greenhouse gas emissions and promote clean energy technologies is creating an unusual business challenge for electric utilities.
Success means selling less of their product.
"What other business do you see in the U.S. economy where you expect a company that has a good business model to spend and to invest a lot of money to use less of their product?" said Larry Makovich, vice president at IHS Cambridge Energy Research Associates Inc., an energy consulting firm.
And that's not all. Policy proposals being promoted by congressional Democrats are also pushing utilities to use renewable sources of electricity and thus downsize the companies' traditional assets. Instead of focusing on 1,000-megawatt power plants, utilities must consider -- among other things -- how to encourage property owners to install rooftop solar panels, incorporate electric vehicles onto the grid or turn down water heaters.
The recession has provided a peek at the financial future that utilities face. With electricity demand drastically reduced, revenues for most power companies were down in the last six months. Plus, the Brattle Group released an economic forecast report last year showing the industry facing up to $2 trillion in investment needs by 2030.
What does the future hold for utility companies, most of which are conservative and traditional? It is adapt or fail, said Amory Lovins, co-founder and chairman of the Rocky Mountain Institute, a longtime champion of energy efficiency and conservation. The new energy paradigm, he said, is "turning the utility inside out."
"Practically every assumption they grew up with is turning on its head," Lovins said. "I think smart, big utilities will do fine, but dumb, big utilities will do badly. They won't even be around. This sector faces the most numerous, diverse and severe changes I know."
David Owens, executive vice president of business operations at the Edison Electric Institute (EEI), the policy arm of investor-owned utilities, said utilities are ready to embrace change, but the path forward is not clear yet.
"The utility will not be a passive entity as it is today," Owens said. "Folks believe a utility exists to sell kilowatt-hours; that is not going to be the model of the future. The model of the future is 'Let me look at how I can improve efficiency, how I can reduce greenhouse gas emissions.' That is what the utility is going to be focused on."
But there are no business models yet for how utilities can make that happen, Owens said, even though several companies are already experimenting with new ways to make money. For example, some utilities are testing ownership of distributed generation and giving customers more options in how they manage their electricity.
"I would say we are in a period of potential transformation," Owens said. "But it is an opportunity for the energy industry."
A 1930s business model
For about 75 years, there has been one major business model for utilities.
The companies have moved power from large central generating stations to homes and businesses. In return, the state regulators approved rates allowing utilities to recover "prudently" incurred costs. If electricity demand was expected to rise, the companies built more supply.
The costs of building the power-supply infrastructure were divided among expected customers through a rate structure, and the price of electricity was set.
So if a utility's customer base expanded or customers used more electricity then expected, it was to the benefit of a company's bottom line. But if customers used less electricity than expected, utilities failed to recover their capital costs, let alone secure money for profits or to invest in future projects.
Opening the industry to market competition has changed the ownership of electricity generation and transmission. But the distribution and retail side -- which affects customers -- has not changed much.
"Historically, the industry looks back. It was easier to repair, rebuild and replace than it was to take a chance on new technology because of the way utilities are compensated," said Mark Gabriel, senior vice president and principal for RW Beck, a technically based business consultant. "We are ... encumbered by an industry model that has not yet recognized the pace of change."
But that era is about to end.
"Everything will be changed by, driven by climate change," Owens said.
Electric utilities account for 40 percent of the nation's emissions of carbon dioxide, the principal greenhouse gas. To reduce CO2, Democratic climate change bills would cap utility emissions, forcing companies to produce less electricity and change to cleaner fuels.
Lawmakers, utility CEOs and many experts agree that ramping up the nation's energy efficiency is the fastest and cheapest way to cut emissions.
Congress is weighing proposals to toughen energy codes for building and appliance efficiency. And the Energy Department has already provided loans and grants to improve the efficiency of the grid itself through digital technology, known as the "smart grid."
Climate change, technology and the new push for efficiency are transforming utilities' strategy from the "generation end" to the "customer end," the Rocky Mountain Institute's Lovins explained.
"That is a wrenching cultural change," he said.
To some extent, reducing electricity demand can save utilities money, as they are spared the expense of building new power plants. But that incentive can only go so far.
"It's clear that they ought to be able to choose between supply-and-demand side investments at least neutrally," Lovins said. "They shouldn't be biased toward supply-side investment."
The new utility business model, he said, should follow this rule: "Whatever is least cost to the customer should be most profitable for the utility, so the utility's choices emulate the proper outcome."
Fourteen states are experimenting with rate structures to encourage efficiency.
California, for one, has "decoupled" utilities' revenues from the amount of electricity they sell -- meeting revenue requirements based on customer growth, productivity, weather and inflation and providing additional incentives or penalties to meet efficiency targets.
Meanwhile, Kentucky, Ohio and other states provide "lost revenue" mechanisms for utilities using a formula based on marginal rates, variable costs and estimated kilowatt savings. There are also several pilot programs that allow utilities to "true up" revenue depending on whether original cost estimates were accurate.
But mechanisms that forecast efficiency targets and then penalize or reward a utility based on them are poor models, as efficiency is difficult to validate and measure, CERA's Makovich said.
"In order to compensate people whether they have achieved the goal or not, everyone has to agree what power use would have been but for these actions," Makovich said. "What if a recession happens and demand is down -- under these programs, are you going to reward a company because demand is lower because you haven't anticipated the depth and length of recession? Or technology, for instance, something like the plug-in electric vehicle creates more demand; will they be penalized for it?"
He added, "The key going forward is to give power companies the incentive to do the efficiency investments that people didn't do because they didn't get the right price signal."
Makovich points to Duke Energy Corp.'s "Save-A-Watt" effort in Ohio as an effective program that could be copied in regulated markets. Duke is able to build into its rates a part of what it would have invested if it had built additional supply instead of investing in efficiency. Regulators in North Carolina and South Carolina are reviewing the program, as well.
But Frank Graves, a principal in the utility and finance teams at the Brattle Group, said current efficiency efforts won't deliver the type of results that federal energy and climate proposals demand.
"At some point they are going to say, 'This isn't going to make sense,'" Graves said. "We are pricing increasingly what looks like a fantasy. ... The mechanisms are set up to reduce, say, maybe 100 to 200 megwatts and some demand response that works fine. No one is going to freak out at that level. But 2,000 megawatts of load growth, then it starts to be more of a fistfight."
And electricity customers and politicians are likely to be unhappy when they realize that reducing power use does not necessarily mean electricity costs are going to fall, said Bob Grant, vice president of operational excellence at KEMA, an energy policy and technical consulting company.
"This was the dirty little secret in the 1970s," Grant said. "You can do conservation, but we are going to charge you more for it because there is still a certain amount of investment that has to be paid for by somebody. That plant investment has to be covered."
A big difference this time: Utilities have technology on their side, Grant said.
"The saving grace ... is your products are going to be more efficient, but there will be more conveniences around you," he said. "People will pay for that ... if they can use those kind of devices more efficiently and make their life better."
Helping consumers make better choices about their energy use through "smart grid" and other technologies could provide new opportunities for utilities -- maybe even make up for revenue losses, some experts say.
"I have run into some CEOs that think this is fantastic and want to move into the value-added end of services," Brattle Group's Graves said. "Others think of themselves in a passive way, more of a platform for services, and want to let the services play out on top of them."
Lovins, the energy efficiency advocate, said smarter utilities are already figuring out how to sell customers what they want before someone else does. "Utilities ... know their customers, are technically skilled and have huge cash flows," he said. "These assets can be redeployed in different ways at better costs, lower risks."
Many see this also as an opportunity to bring real competition to concentrated markets.
Beyond efficiency and energy management, utilities and independent parties are also starting to compete in distributed generation and demand response -- which are alternatives to the large central power plant.
While there is debate about how much of future energy supplies will be made up of small power sources -- typically, those of less than 100 megawatts capacity and usually of just 10 or 15 megawatts -- most experts say distributed generation will have a strong presence in the nation's future fuel supply makeup.
In most cases of distributed generation, a property owner buys the generation equipment himself and then consumes the electricity, selling any extra power back to the grid or offsetting any grid electricity he consumes. But buying and maintaining power equipment is prohibitively expensive for many homeowners and companies.
So utilities see an opportunity to generate electricity and meet renewable electricity standards -- possibly even getting emission-offset credits -- by renting rooftop spaces, installing their own equipment and owning the electricity that is generated. Southern California Edison and Pacific Gas & Electric Co. are each undertaking projects worth several million that involve the ownership of rooftop solar panels, and Duke also has a pilot program in North Carolina (Greenwire, Oct. 7, 2008).
Until now, third parties have usually stepped in to alleviate the expense and maintenance issues by leasing the equipment to the owner or even renting the space for their own equipment and repaying through rent or providing some discounted electricity. The companies sell the rest of the electricity back to the grid.
Third parties are also dominant in the supply of demand response, or electricity provided to the grid by contracted parties using less of it at certain times, usually peak periods. The supply source has great potential. A study released this summer by federal energy regulators shows demand response could free up and "provide" 188 gigawatts -- 20 percent -- of the nation's power supply at peak times. And the supply source has made remarkable progress in markets on the East Coast, including ISO New England and PJM Interconnection.
A third party provides the necessary energy management system and a payment to the volunteers -- usually large buildings or commercial users -- for lowering their demand, while it aggregates the energy savings and sells that "supply" on the market against traditional supply from traditional coal, gas and other generation.
In the past, utilities have outsourced demand-response programs to third-party companies like EnerNOC Inc. and Comverge Inc., but recently, utilities have been bringing those services back in-house.
"Utilities ultimately should be able to play in these end-use added-value functions," Graves said. "I do think they have better economic opportunities than other parties. If third parties are asked to do it, my impression is that they turn back to the utilities and say, 'We need to know a bunch of stuff in order to get it done,'" he said.
Ultimately, third parties also cannot provide the reliability of utilities, said Gabriel of RW Beck. Unlike many consumer choice products -- cell phones or cars, for example -- whose loss can be merely annoying, the loss of electricity can be devastating.
"We want to be off the grid, unhook from the grid, but what if there is an emergency?" Gabriel said.
KEMA's Grant said utilities should be compensated for the high level of reliability they supply. "Technology developments will put in a certain level of self sufficiency, but there is going to be a capacity charge convenience just in case that mechanical device fails," Grant said.
"At the end of the day, I can go back to the grid if I need power. For that privilege, we should pay a charge."
Recession buys time
The recession has provided utilities with an opportunity to consider their next moves as capacity margins have eased and construction costs have gone down.
But, Graves cautioned, "That bigger problem hasn't gone away. It just has been pushed out a couple of years."
The financial squeeze and rapid technology changes are also pushing utilities to partner with other companies, EEI's Owens said.
Companies that lack renewable energy expertise are looking to work with those that have it. Utilities are working with other utilities, third parties or financial industry partners to pay for new power plants or other infrastructure. And utilities are also turning to long-term contracts with independent renewable energy companies rather than owning and financing the new power sources themselves.
Said Owens, "You are not going to have the traditional, vanilla utility."