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The $250 billion U.S. electric power industry is in the midst of historic transformation. The industry structure of the past — vertically integrated utilities operating in protected geographic markets — will soon go the way of the gas lamp. Participants in the future electric power marketplace will have more diverse corporate structures and product offerings. Some will operate in narrow niches, and others, across state and even national geographic boundaries. All will focus on specific areas of competence and, as a result, may be forced to invest in a narrow range of assets and earn a return for their investors in a broad range of ways.
In this article, we outline a new structure for the U.S. electric utility industry. We discuss the factors that will likely lead the industry to fragment into a wide range of service providers in an expanded business. These disparate segments will be linked to serve customers through three emerging types of “value networks” rather than through integrated providers. The first value network will be based on regulated boundaries. The second will be based on linkages created by “virtual” utilities — firms that supply energy services but no longer own all the assets necessary to supply these services. The third will be based on customer-initiated linkages. As a result of these three new networks, customers themselves will be able to assemble more easily a panoply of power services that best suit their unique needs.
Our purpose here is to paint a vision of the emerging future. Such predictions are always risky; nevertheless, articulating a vision helps shape the debate and therefore, indirectly, the evolution of the industry. Our vision is based on analogies drawn from other regulated and unregulated industries that have undergone similar dramatic changes. In addition, we extrapolate from current electricity industry initiatives that provide a glimpse into the future.1
First, we summarize the factors that are forcing a restructuring of the electric power business. Second, we make five projections about the industry’s future based on similar experiences in other industries. Third, we describe how the industry will evolve into six discrete business segments, from power generation to energy services. To dominate each segment, utilities will need different core capabilities and will have to learn or import them from industries where competition, powerful customers, and choice have prevailed for years. The market leaders in each business segment may well come from outside the traditional boundaries of the U.S. electricity industry. Fourth, we describe the three value network models. Finally, we discuss the challenges that today’s vertically integrated utility will face in the future.
Three Forces Driving Change
An examination of the forces affecting the electric power business suggests that a competitive market will emerge and trigger a radical restructuring.2 Three major forces – regulatory and political, market, and technological – will ultimately lead to a disaggregated industry with great opportunities for those who can organize the overall value chain for consumers.
Regulatory and Political Forces
The regulatory and political forces in the electric utility industry are part of a broad wave of deregulation that has swept across the United States since the 1970s. During the Carter administration, it became apparent that the regulatory framework that had served so well since the Great Depression was no longer viable and needed to be overhauled to ensure the nation’s future competitiveness. In industry after industry, from airlines and trucking to banking and telecommunications, people increasingly rely on the invisible hand of the market rather than the visible hand of government. In each case, old industry structures have fallen by the wayside, and new ones have emerged.3
In the U.S. electric utility industry, the 1970s marked the breakdown of a consensus among regulators, utilities, consumers, and the public that had existed since the turn of the century. The foundation of this consensus was a long period of national prosperity, cheap energy, and ever-rising energy demand; however, it began to crumble in 1973 with the first oil shock. Energy prices shot up, becoming a significant item on the bills of consumers and businesses. Utilities, saddled with higher costs (partly due to uneconomical nuclear power plants), increased their rates considerably. Dealing with public outcry, regulators in many states were forced to hold down rates, which, in turn, led utilities to halt projects adding generation capacity. Regulators countered again with the passage of the Public Utility Regulatory Policies Act of 1978 (PURPA) to attract alternative suppliers to the market.4 By the 1980s, a whole new independent power-producing (IPP) sector had been formed.
IPPs have used primarily cogeneration5 technologies to provide cheaper power to their customers. In the 1980s, IPPs built most of the new power capacity, creating competition in the wholesale market. From 1980 to 1992, the percentage of total U.S. electricity generated by nonutility sources rose from 2.9 percent to 9.9 percent.6 As a result of the cheaper power, customers and legislators have pushed for greater competition within the wholesale market with the 1992 Energy Policy Act, which mandates access to the transmission grid for wholesale wheeling (“wheeling” is the transmission of electricity by an entity that does not own or directly use the power it is transmitting). State regulators were to decide whether they wanted to extend this policy to retail wheeling.
The breakdown of consensus has led to a plurality of regulatory directions. California, Connecticut, Illinois, Massachusetts, Michigan, Minnesota, and Rhode Island have moved aggressively to enhance competition. Maryland, Texas, and Virginia have resisted. Confronted with this plurality, many utilities are trying to influence regulators in their states to preserve the status quo, although these efforts seem equivalent to plugging a breach in a dam with a finger. As Vietor commented: “Regulation can depart only so far from economic or technological realities before becoming unworkable. . . . Regulation needs to work with market forces and technological progress, rather than against them.”7
The existing regulatory framework in the U.S. electric utility industry is increasingly at odds with market and technological forces. While the pressure for change may vary from state to state depending on existing electricity rates and the political ideology of local regulators, one thing is certain: restructuring may occur at a different pace in each state, but it will be faster and more dramatic than most utility executives expect.
The market forces for change are coming from both consumers and producers. Even though most states do not yet permit retail wheeling, consumers increasingly have found ingenious ways to avoid regulatory barriers. Navarro documents how some clever customers have breached regulatory barriers.8 The community of Falls Church, Virginia, which recently decided to seek an alternative to the perceived high electricity rates of Virginia Power, purchased a set of meters and applied to the Federal Energy Regulatory Commission (FERC) to be considered a distribution company that could buy wholesale power from any other supplier, thereby forcing Virginia Power to provide transmission access. Although Virginia Power has appealed this petition, the case shows a rising trend as consumers try to use strategies such as bringing utilities under municipal supervision to procure the cheapest power prices.
This example is not an isolated instance. Consumers are experiencing growing pressure to cut their power bills. Since the 1970s, real household incomes in the United States have been flat or declining. With less disposable income, residential consumers are no longer willing to pay high prices to their local utilities if they can get cheaper power elsewhere. Cambridge Energy Research Associates found numerous instances in which residential customers were paying electricity charges 50 percent higher than those their neighbors were paying in a geographically contiguous area.9 Such disparities are untenable, and, as the Falls Church example shows, consumers will not let regulatory barriers restrict their economic interests.
Industrial consumers have been even more aggressive than their residential counterparts. Since energy costs are approximately 5 percent of most manufacturers’ total operating costs (and as much as 30 percent in such energy-intensive industries as aluminum processing and steel making), manufacturers have significant incentives to reduce their energy bills. Raytheon is a multibillion-dollar company and one of the largest employers in Massachusetts. Like many U.S. manufacturers since the 1970s, Raytheon has been losing market share to lower-cost domestic and international competitors. It has threatened to move much of its manufacturing out of state unless Boston Edison grants it markedly lower rates. Companies in many other industries have adopted similar tactics, including switching to lower-cost suppliers by municipalizing.10
Power producers themselves are unleashing equally strong competitive forces. For example, Sithe Energies in New York is an IPP that aggressively moved into Niagara Mohawk’s territory and signed contracts with two major industrial customers.11 The recent spate of mergers and acquisitions in the utility industry, including hostile bids, clearly shows the increasingly predatory behavior of power producers. With producers facing limited growth and declining earnings prospects, we can expect such competitive behavior. Indeed, to attract capital and satisfy shareholder demands, utilities may have to abandon their friendly competitive restraints. Electric utilities should prepare for brutal competition, similar to that in the airline, trucking, and telecommunications industries.
The experiences of other industries also suggest the powerful, disruptive effects of technological change. Research has shown that radical technological innovations such as radial tires, mini-steel mills, personal computers, digital switching, automatic teller machines, and wide-body aircraft can transform industry structure and destroy the competitive advantage of entrenched leaders.12 The electric utility industry is confronting the possibility of such technological discontinuities in every segment of its value chain.
The largest technological force for change has been the end of economies of scale in generation technology. From 1949 to 1965, the cost of an incremental kilowatt of generating plant capacity fell 37 percent as the size of the generators increased.13 In addition, as the power industry approached the thermodynamic limit of the Rankine steam cycle,14 the coal-pound equivalent to produce a kilowatt-hour declined 23 percent.15 Since then, however, newer generation technologies such as combined-cycle and cogeneration plants have been producing power at efficiency levels of 50 percent to 60 percent with advanced technology targeting an efficiency level of 70 percent or better by 2005. This compares to a conventional power plant efficiency level of 30 percent to 40 percent.16 Another new force in generation has been the advent of cheap, renewable energy sources like wind and solar.17
In the transmission segment of the value chain, there have been major improvements in power control technologies. Some companies are experimenting with DC transmission that does not need transformers, which, if successful, will double the capacity of the current transmission grid and may reverse the battle between AC and DC transmission won by Westinghouse over Edison at the turn of the century.18
In distribution, information technology (IT) is emerging as a powerful force. New technologies – including high-speed power-line networks, automated real-time meters and other “gateway to the home” devices, and the ubiquitous Internet – have made it possible for the marketer and seller of electricity and related services to be distinct from the provider of electrons (or kilowatt-hours).19 This fundamental shift in the utilities’ relationship to their customers means utilities may lose all direct contact with customers and be relegated to the commodity end of the business. Retail stock brokerage firms have experienced this disintermediation, first with the rise of discount brokers and now with the advent of on-line trading, such as Charles Schwab’s e.trade. New, on-line intermediaries in automobiles, real estate, employment, media, banking, and other industries are proliferating on the Internet, threatening to separate traditional producers from their end customers.20
The disruptive potential of these three forces cannot be reversed. Executives in the electric utility industry must understand how these forces will affect the cost of their product, the purchase and delivery of value-added services, and their relationship with customers.
Five Projections about the Future
The experiences of other industries confronting the confluence of the three forces – regulatory and political, market, and technological – indicate that, in general, industry boundaries were expanded, barriers to entry were lowered or eliminated, markets were increasingly segmented, new distribution channels were created, prices were reduced, pricing mechanisms were more complex and diverse, and new products and services proliferated.21
In this section, we build on the experiences of the airline, natural gas, telephone, and banking industries, indicating some direction for the future economics of the U.S. electric utility industry. We do not suggest that our numbers are exact; they are, rather, estimates of the magnitude of changes that the electricity industry must confront.
It is widely held that the restructuring under way in the U.S. electric utility industry will cause the unbundling of electricity prices. Competition and consolidation could result in a 40 percent decrease in the average wholesale price of electricity, from around 5 cents per kilowatt-hour to 3 cents. The typical industry benchmark for the wholesale price of electricity in a competitive market is 3.5 cents.22 An estimate of 3 cents, however, is more realistic, based on surveys of more than eighty utility executives.23
This price might be lower than conventional industry forecasts because the electric utility industry is much like the airline industry: there is significant overcapacity, and the marginal price of the product is close to zero. Moreover, technological advances that permit smaller generating units to approach the efficiency of larger units mean that new capacity can be added more quickly than in the past and at little cost disadvantage.24
As Telser has argued, in such markets, price competition can be vicious and show little restraint.25 In the U.S. airline industry, average ticket prices have declined steadily since 1978,26 and the industry hasn’t posted operating margins (before interest and taxes) of better than 5.5 percent since deregulation.27 From 1990 to 1995, the airline industry as a whole lost as much money as it had made since its inception in 1914. While such predatory pricing has not yet become rampant in the electric utility industry, there have already been numerous reports of generating entities in the United States and Great Britain that dumped power at below marginal costs. And it is likely that the onset of retail wheeling will only further fuel this price competition.
As in the natural gas industry, the ratio of long-term to short-term contracts for electricity will decline rapidly. Long-term contracts for the gas industry declined from 90 percent to 80 percent in eighteen months after the FERC issued Order 380, and the spot market quickly grew to 2.5 trillion cubic feet on a total market of 18 trillion.28 FERC Order 380 effectively removed a major regulatory hurdle that had prevented many customers from purchasing less expensive spot gas. The order eliminated charges for gas costs from a pipeline’s minimum bill. With the elimination of such charges from their bills, customers were allowed to save money by purchasing inexpensive spot gas and avoiding the generally higher gas costs included in pipeline tariff rates. The pipelines continued to provide their customers with transportation service; however, their share of gas sales fell dramatically. In the first nine months of 1996, the spot market for electricity was approximately $3 billion, up from $500 million in 1995 and only $50 million in 1993.29 This dramatic rise suggests that the spot market for electricity could be as large as 30 percent of the total market, which will open a whole new industry segment in risk management, including electricity futures contracts, exchanges, and power brokering. To serve the California marketplace, two wholesale power exchanges, the COB and the Palo Verde, have emerged.30 Although trading is light and these markets remain illiquid, the development of a robust market for power exchange in California is expected.
New Products and Services
One outgrowth of deregulation is a flurry of new offerings related to the core product. Since the breakup of AT&T in 1984, for example, the telephone industry has fostered many innovations, developing products and services including 1-800 and 1-900 numbers, Intra-LATS WATS options, and voice mail. The industry has also expanded into other related offerings like publishing, cellular phones, and information services. A study of the seven regional Bell operating companies showed that by 1994, ten years after deregulation, more than 30 percent of their revenues came from sources other than local phone service.31
New products and services have already begun to emerge in the electric utility industry. Utilities are testing on-line billing, remote appliance scheduling and control, and energy-usage monitoring. In addition, some utilities are trying to leverage their customer relationships to cross-sell products and services like home-security systems and electrical appliance maintenance contracts. Also under way are pilots to bundle electricity with other utilities such as gas, telephone, and cable. Moreover, by successfully selling “green” (environmentally safe) power during a retail-choice experiment in New Hampshire, some utilities debunked the conventional belief that electricity is an undifferentiable commodity. These innovations will likely multiply as retail competition moves from small, local experiments to mass national markets.
In addition to expanding beyond their core products and services, U.S. utilities – facing the prospect of little domestic growth in total demand for electricity –will have to go abroad. Most of the demand for new power will come from Asia, including China, India, Indonesia, Vietnam, and other rapidly developing countries. The pursuit of global markets is a well-developed strategy in other deregulated industries. AT&T, for instance, pursued this option with its 1988 purchase of a 20 percent stake in Italtel. Since then, MCI, Sprint, and others have also made major overseas investments.
Electric utilities, such as CMS Energy, have built or are participating in the management of power production facilities in developing countries, and others like Southern Co., UtiliCorp, and Central and South West have acquired distribution entities or entered into joint ventures in Britain, Australia, Canada, and New Zealand.32
In the airline and banking industries, the need for information to support the market development (and, thus, the growth of IT to handle the transactions) has increased exponentially. A similar pattern has occurred in the natural gas industry, which has invested heavily in IT during the past fifteen years to improve how gas is tracked, marketed, and accounted for.33
The electric utility industry will probably behave in the same way. In an industry in which power is increasingly sold as a commodity on open markets, the amount of information and computer technology to develop efficient markets will grow exponentially. For example, meters in most U.S. homes are read only once a month. Real-time pricing of residential electricity would require gathering, processing, and distributing this data every minute, which can be done only through sophisticated IT. Ideally, each electron would be a “smart” electron that has information associated with it, such as who generated it, who needs it, and how and when it was used.
In the next five years, assuming data is available on an hourly basis, the information intensity of this industry will likely be at least two orders of magnitude greater than it is now. Certainly, the support of this information flow will require substantial investments in computer and communications technology. Equally, there will be a payoff from these investments because the information and its processing will be priced and sold separately.
While these five directional markers – prices, contracts, new products and services, global scope, and information intensity — are not exhaustive parameters for thinking about the future of the electric utility industry, they do provide concrete indicators on the costs, revenue sources, and necessary investments. Even by themselves, they have profound implications for the industry’s future structure.
Six Fundamental Segments of the Industry
To reduce costs dramatically, to increase revenue from sources other than kilowatt-hours, and to expand globally, utilities will have to focus on the three traditional segments of the energy value chain: (1) generation, (2) transmission, and (3) distribution. In addition, the opportunity to participate in national energy markets and to capture a profitable share of emerging energy services and information-based businesses will expand the value chain to include three new segments: (4) energy services, (5) power markets, and (6) IT products and services. These six segments will define the electric power industry.
Future generation companies, operating in a marketplace characterized by customer choice, eventually will have to sell power for an average of 2.5 cents per kilowatt-hour wholesale, about half the current rate. This will force companies to find ways to dramatically reduce both embedded and operating costs. The generation sector will split in two: those companies that achieve unprecedented cost reductions through scale economies in operations and fuel procurement and those companies that employ radical new generation technologies that dramatically lower per-kilowatt-hour cost.
A half-dozen or so utilities will likely end up as mega-generators, controlling perhaps 80 percent of total generation capacity. The remaining 20 percent will be sourced from many niche generators employing advanced generation technologies. In the current vertically integrated industry structure, the largest producer, Southern Co., has only a 3 percent share of the total U.S. market.
So far, regulators of the electric utility industry have permitted a number of mergers, including Cincinnati Gas & Electric with Public Service of Indiana (now Cinergy). They are evaluating others such as Wisconsin Energy with Northern States Power and Baltimore Gas & Electric with Potomac Electric. Many other deals could gain approval as regulators examine the prospects of cheaper power from eliminating duplicate costs. These mergers, however, are only the first stage in the consolidation of the generation sector. Future deals will become very complex and involve swapping and selling assets or spinning off business units — not just merging two vertically integrated utilities.
The railroad industry also consolidated after deregulation. By 1985, mergers and acquisitions had produced six very large railroads that made up 76 percent of the nation’s rail mileage, 82 percent of total rail revenues, and 85 percent of railroad ton-miles.34 The trend toward consolidation has continued in the 1990s with the merger of Burlington Northern and Santa Fe, Union Pacific’s purchase of Chicago & North Western, and the $3.9 billion merger of Union Pacific and Southern Pacific. Indeed, in most mature industries, production tends to be dominated by as few as three major companies. While this degree of concentration may not occur in the electric power industry, its possibility may sober those who continue to see a fragmented generation sector.35
One perceived impediment to consolidation is the magnitude of the stranded asset problem (estimated to be as large as $300 billion). Because electric utilities are still regulated monopolies, costs approved under state and federal regulations are fully recoverable at a regulated price. Therefore, a utility establishes the value of its assets as the costs remaining on its books and currently recoverable through rates. However, in an open market, current high prices would fall and the costs driving those price premiums would become “stranded” or unrecoverable to the extent that they exceed the market price. In a 1994 study, Studness pointed out that the bulk of the stranded asset problem is due not to the high fixed costs but to the high variable costs of current high-cost producers. Indeed, he noted, if every utility in the country were managed more efficiently so that its variable costs equaled those of the current industry leader, the magnitude of the stranded cost problem would diminish to no more than $30 billion.36
The most efficient operators in the future will, in fact, be able to operate at a variable cost lower than the current best in class.37 Thus cost management and operating efficiency will be the core capabilities of the survivors in generation.
Intelligent Transmission Network
The emergence of full-fledged retail wheeling (through the establishment of a power pool and numerous types of supporting contractual arrangements) will require enormous amounts of data to be captured, processed, and made available to buyers and sellers of power. As transmission traffic becomes more complex, with many buyers and suppliers making hourly deals, unprecedented scheduling and control of the power flow will be required. Thus, full, open access will give rise to the intelligent transmission network – a national “smart” power grid.
The early stages of open transmission access that the FERC is now defining38 are forcing utilities to make their proprietary transmission systems available to others for wholesale bilateral contracts. While many questions are left unanswered, information requirements will clearly be orders of magnitude greater than in the past. Responding to this reality, the FERC opened an investigation inviting parties to comment on regulatory rules governing real-time information networks (RINs) to make transmission availability and costs transparent to prospective buyers.
In California, the Public Utility Commission is exploring an alternative open-access model and considering the creation of two new transmission entities: the independent system operator and the Western Power Exchange. Electricity would be auctioned on the power exchange, where the lowest bid and asked prices would be matched. The independent system operator, which is not controlled by the utilities, would then schedule and dispatch that power to utility distributors. This model, essentially a pool model, will also require vast amounts of information.
Clearly, those who succeed in the transmission business will have strong capabilities in operating the core network and maintaining the grid. These transmission companies may well extend their scope to include gas pipelines and other transmission systems.
Distribution Companies – WireCos
The segment of the value chain between transmission and the end power customer will split into two components. Some companies will specialize in maintaining and enhancing the distribution system to meet consumer needs while providing basic customer service and simple billing. State utility commissions will continue to regulate these “WireCos.” Other companies will evolve to provide new, expanded energy services to end customers. We discuss these companies in the next section.
WireCos will deliver power to all customers within their service territories. They will comprise all functions and processes needed to acquire power and to design, construct, and maintain distribution. These companies, however, may lose direct contact with many customers to intermediaries. They would be left providing access to the intermediaries (much like in transmission) and giving “full” service only to small customers who have either little opportunity to leave (the less attractive customers) or who have simpler needs. Sophisticated intermediaries that provide home and energy management services and power brokering will serve more affluent customers, most commercial accounts, and the large commercial and industrial customers.
The future WireCo will be a very good, low-risk business. It could ensure adequate returns via an enhanced regulatory model that would provide for increased profit potential with various incentive regulation schemes. In all probability, the balance sheet book value of the WireCo assets will be written up through the breakup of the integrated utility. This will serve only to help offset any need to write down the balance sheet book value of stranded investments that the integrated utility may face and increase the WireCo’s revenue level. The regulators will still control the ultimate return on investment in this business.
Of course, the WireCo will serve all customers (including some who have poor payment histories), putting pressure on earnings. Regulators may deal with this issue with an access charge that all users of the distribution system would pay. Or legislation may take care of delinquencies with a statewide tax. In any case, the earnings of these bare-bones distribution companies will be protected in order to preserve universal access.
There could also be consolidation in this segment, because operating costs and logistics will be key. Current municipalities may discover that it makes little sense to own and maintain local wires and that bigger utilities can provide more reliable, effective service. One power distributor is exploring such a partnership and forward integration possibilities with some of its major municipal customers.
Energy Services – EsCos
“Beyond the meter” is a widely used phrase in the literature to describe business opportunities that may provide customers with greater services. They fall into two business segments: the home gateway for home energy services and the energy services company, or “EsCo,” for large customer energy-management consulting. Nearly every utility is experimenting with beyond-the-meter services, banking on a brand name that consumers trust. However, the full-blown home gateway or EsCo does not yet exist.
Some residential customers and small commercial accounts may want (if not need) high-concept energy-management services like on-line customized billing, remote appliance scheduling and control, and appliance energy-usage monitoring. Experiments in providing such services are currently under way in Walnut Creek, California (a joint venture with PG&E, cable operator TeleCommunications Inc., and Microsoft Corp.), and in Laredo, Texas (a pilot run by Central and South West39). Central and South West’s subsidiary, CSW Communications, intends to offer demand-side management services through the network, including automated meter reading, customer messaging, in-home bill estimates, and remote customer billing. It will offer the remaining network capacity to service providers, extending telephony, video, data, and other information services.40
These experiments highlight a critical characteristic of the home gateway: the organizations that have the required assets and competencies are not necessarily utilities. Utilities can supplement their capabilities through partnerships, as they do in the two ventures mentioned above. It is not clear, however, why cable and telephone companies need utilities. In fact, home energy-management services are really a component of a much broader home-services offering (such as information content and entertainment) to which utilities have little to contribute.
Indeed, energy management may potentially be the way cable and telephone companies will pay for their access to the television set-top box. Few utilities will find their “descendants” in this segment. Those who succeed will have to weather fierce competition from the other players. For example, Duke Power is exploiting its “rights of way” by laying extensive networks of fiber-optic cable into new residential subdivisions.
EsCos will specialize in bundling power with related energy-management and consulting services for very large consumers – in effect, moving further up their customers’ energy “value chains.” EsCos not only will procure cheap energy (not just electric power) but will work with their customers to tailor strategies and process improvements to reduce their energy costs. A primary target market segment for an EsCo will be the middle market – office buildings and complexes, institutions, and retail chains – which has many special needs that utilities have heretofore ignored (e.g., lighting services). EsCos will need to provide national account management, high reliability, and customized billing. Companies such as Utilicorp, with the advent of EnergyOne, have already begun to position themselves for such services.
Success in this business requires deep knowledge of the energy needs of customer segments and of an individual customer’s business. It also requires competencies in customer-relationship management and consulting. Here, utilities will struggle to adapt their competencies quickly to demand.
The nationwide power distribution system will give rise to a major commodity trading and purchasing market for electricity. Similar to a stock exchange, a whole industry will emerge for electricity “market makers” – companies engaged in the daily buying and selling of power. In fact, based on the experiences of other commodity markets, the financial transactions generated in the electricity market eventually will dwarf the dollar volume generated by the physical movement of electricity over the transmission network.
These power markets are already forming: utilities, investment houses, and various other companies have positioned themselves as traders and brokers of the hot new commodity — electricity.41 And history suggests that the number of energy brokers will rise quickly. For example, when the trucking industry was deregulated, the number of freight brokers rose from 60 in 1980 to 4,500 in 1985.42 Likewise, independent gas brokers filled the postregulation void in the natural gas industry, where the pipelines of gas carried by others doubled in eighteen months.43 (This occurred prior to the establishment of a forward market for gas.) There is every reason to expect a similar explosion in the electric power market.
If companies want to play in this arena, they must quickly develop risk management skills to deliver hedges, options, and other futures. Of course, this market will be broad to include all forms of energy. Indeed, the possibility of directly or indirectly linking the various markets suggests that the spot market will be larger in volume than is projected. In fact, the BTU – not the kilowatt-hour or barrel of oil – eventually will be the unit of energy measurement by which power is sold in commodity markets. As a result, today’s electric utilities must not think of themselves as being in the electricity business but rather in the broader power supply business.
IT Products and Services
In the future, utilities’ primary products and value-added services will be based on the hardware and software tools they have developed, the associated skills, and the information they have about customers and their behaviors. Everyone, it seems, is selling brokering systems, bulletin board applications, and FERC and power pool accounting software packages. Some utilities are mining their deep experience in meter technologies to create an automated meter, hoping to capitalize on a broader market to drive costs down.
By itself, information on customers will become extremely valuable. Utilities are sitting on a potential gold mine of data. Everything from customer usage information to specific appliance information and usage history is valuable. We believe that electric utilities will be able to sell such appliance data to appliance manufacturers and retailers and provide real-time usage information to the original manufacturers to enable predictive maintenance products.
In addition, the fiber-optic cables that utilities are laying will also provide sources of revenue. Although this seems like an attractive business opportunity on the surface, experience shows that it is dangerous to invest in such infrastructure because standards, technologies, and usage change very quickly, stranding the investment overnight.
In the end, utilities that are focused on acquiring, managing, and using information will find enormous potential business opportunities. For airlines such as American and Delta, reservation systems are more profitable than flying planes.44 Of course, information services will not be the only profitable part of the future utility industry, but this analogy highlights the enormous potential of the segment. In addition to market-making systems, services like transaction processing and billing, consumer-tracking and marketing information systems, and infrastructural services for intelligent buildings, will be important parts of the information services segment of the future electricity industry.
Value Network Alternatives
The electric utility industry traditionally has been structured into vertically integrated monopolies, each directly owning all the components of the value chain (often including the coal mine). Their owners have managed the business to ensure bondlike yields and risk profiles to their shareholders. The asset structure, operating culture, policies, and processes all have been designed without explicitly focusing on customer value. The evolution of the industry will make unprecedented demands on the vertically integrated utility. Few will survive in their current form.
As the existing electricity industry breaks into the aforementioned six business segments (generation, transmission, distribution, energy services, power markets, and IT products and services), creative new entrants will emerge. These businesses will focus on specific niches such as large industrial customers, affluent homeowners, and lucrative segments of the office market. They will differ from the old utilities in two major ways. First, they will focus on selected high-profit, high-growth niches. Second, they will not own all or even most of the assets in the value chain. Rather, they will “cherry pick” and configure only those value-adding activities that are meaningful to a customer segment. In essence, these companies will have created a whole new value chain – one we call the “value network.”45 This competition will dramatically influence the risks and returns of various industry segments.
In a value network, one company exploits the strengths of each value provider and coordinates production and delivery across companies. Value networks have emerged in other industries over the past several years, including athletic shoes (Nike), retail financial services (Charles Schwab and AT&T Universal Card), and personal computers (Dell). Dell, for instance, has avoided the high-cost dealer/distributor system with a 1-800 telemarketing arrangement. It uses sophisticated contract manufacturers like Solectron for PC assembly, and it calls on Roadway Logistics to manage all inbound and outbound logistics worldwide. While Dell appears to be a fully integrated PC company, in fact, it does not own or operate most of the value-creating activities.
The leader in a value network coordinates the activities of other companies in the network, choosing and assembling the capabilities to deliver value to a specific customer segment. By not owning all the assets in the new value chain, the company is a “virtual” organization. The leader, in fact, picks only those value-adding capabilities meaningful to a customer segment. For instance, in the utility industry, the leader of a value network targeting high-income homeowners could aggregate a range of home-energy services without owning all the pieces. The rallying cry for this new “utility” may be: “We can design the model for the specific, value-creating activities in a specific customer segment, but we don’t have to own and operate all of it!”
In any utility value network, the players will use different governance mechanisms such as partnerships, alliances, joint ventures, specialized contracts, and outsourcing arrangements to manage their relationships. Advances in the integration of computing and telecommunications and the emergence of a new information-intensive business infrastructure will greatly speed the development of these new networked business models.
In fact, in the absence of regulation and physical asset constraints, the electric power industry would naturally evolve into customer-specific value networks where the players (producers, brokers, market aggregators) compete independently for a share of total market.46 The physical assets, network economics, and political legacy of the utility industry suggest, however, that with little or no communication and coordination among players, a value network would be uneconomical. Instead, the disaggregated business segments of the emerging electric power industry value chain would be better leveraged if linked and coordinated by new players acting as leaders.
This new value network structure will thus enable a coalition of players to exert greater market power and expand their business scope. The value network leader will connect and coordinate the various players, which each possess highly distinctive, yet complementary, operating and process-based competencies to deliver new levels of customer value. Operating across geographic boundaries, this virtual utility will no longer have to own all the assets necessary to deliver value to end consumers. Instead, it will source specific competencies from within an extended network.
Three value network models will evolve in the electric power industry: regulated, virtual, and customer designed. Initially, regulators at both the state and federal levels will shape the organization of the value network for a specific geography. Over time, however, more virtual utilities and customer-initiated networks will emerge to provide alternative, powerful energy alternatives for all customers.
Regulated Value Network
The current industry structure will rapidly give way to an initial form of value network that is designed primarily by regulators. As the electric utility industry begins the transition to competition, the states will mandate the divestiture of certain operations, create organizing entities to control the scheduling and dispatching of generating stations, control the power flow over the transmission system, and provide distribution and energy services to customers. Additionally, they will craft specific rules to guide the industry in areas like dispatch priority and flow control.
In California, a Memorandum of Understanding, which a number of stakeholders agreed to and submitted to the California Public Utility Commission, seeks to create the foundation for a regulated value network: the independent system operator and the power exchange. Electricity would be auctioned on the power exchange, where the lowest bid and asked prices would be matched. The independent system operator would then schedule and dispatch that power to utility distributors. The power, therefore, would not be under the control of utilities. Other such regulatory designs are under way in many states, such as Wisconsin, New York, and Massachusetts.
Such regulated value networks will not be optimized for any one set of companies or segment of customers. Rather, they will be structured to satisfy the majority of stakeholders. This will be a logical first step in industry restructuring because many complicated political issues – such as stranded costs47 that may be recovered from “competitive transition charges”48 as well as the “obligation to serve”49 – must be dealt with through the transition.
Virtual Value Network
Today’s EsCos are the first example of an emerging virtual value network. Dissatisfied with the one-size-fits-all structure of the regulated value network, many customers will demand that unique linkages of value providers be created to meet their individual needs. This virtual player will aggressively manage its own assets and competencies, emerging as a sophisticated intermediary designed to optimize the value chain to deliver superior value to specific customers.50 No longer defined by the regulatory obligation to serve or constrained by the structure of rate-based economics, these entities will demand dramatic improvements in the performance of the value-providing companies in each market segment.
The virtual utility may extend its reach far beyond the regulation-imposed boundaries of today’s electric power industry. As future gateway companies form alliances and partnerships with transmission, distribution, and information-products providers, the scope of their product offerings could expand to include every external service to the home: electricity, telephone, cable, Internet access, and so on. The virtual utility serving large industrial customers may describe the value offering of its network as a “universal infrastructure support,” offering not just energy and energy services but telecommunications, computing, and facility services for both centralized facilities and large distributed networks of telecommuting employees.
Virtual utilities may, therefore, include power marketers, brokers and aggregators, energy services companies, and some distribution companies. Each will be successful because of its abilities to understand discrete customer needs and then to manage the network of value providers to deliver and meet those needs.
Customer-Designed Value Network
The customers themselves will initiate and manage the final value network that will emerge. The largest energy users will see opportunity in linking their own unique value networks to meet their specific needs. While virtual utilities and EsCos will initially focus on the largest customer segments, technology and direct market access will offer the capability for customers of all sizes to construct their own value networks. Once data sources for pricing and supply information are widely available, intelligent agents over the Internet will provide customers direct access to the purchase and transmission of power. Customers will be able to contract directly for their energy requirements and then source their energy-related products and services from individual suppliers.51
The first and most critical issues that today’s electric utility must face are related to future focus and capabilities. There will be numerous paths to profitability through a value network; every player will not, and should not, become a virtual utility linking the value components to meet customer needs.
Companies will succeed by focusing on individual segments of the value chain. They will have to rescope their operations, however, to compete with other focused service providers or to maximize their return in a performance-based rate-making scheme. The cost structures, risk levels, average returns, and investor profiles for different business segments will vary substantially, with regulated transmission and WireCos remaining closest to traditional utility profiles. Power marketing and information-based segments will be dramatically different, with limited hard assets and pricing based on value rather than cost.
For companies seeking to compete as virtual utilities, nothing short of reinvention will be sufficient. The business structure and management requirements for the virtual utility are polar opposites to the classic characteristics of an integrated utility. The time horizon for responsiveness will shift to product cycles of months and possibly weeks – far from the traditional planning horizons of years and decades.
In this environment, what critical skills does a virtual electric utility need? At minimum, it must be able to:
- Establish and sustain successful partnerships.
- Be creative in structuring products and services.
- Focus beyond the traditional bounds of the electric power marketplace (both geographic and business).
- Manage operations and costs to match unique business opportunities.
- Consider IT the single most important strategic asset.
- Hear and truly understand customer needs.
Utilities in the U.S. electricity industry ultimately will have to choose where to participate in the future structure. The issue, as a result, is not so much whether to choose, but when. Today’s utilities should thoughtfully consider the industry’s direction. The investments they make, the customer relationships they nurture, and the people they recruit and retain should all help them move toward the future.
1. B. Mitchell and P. Spinney, “Public Utilities, Technological Change, and Industry Structure” (Saratoga Springs, New York: Symposium on the Virtual Utility, paper, April 1996).
Mitchell and Spinney highlight the benefits, as well as the limitations, of reasoning by analogy. They show areas in which there are close parallels yet sharp differences between deregulation in the telecommunications industry and the electric utility industry.
2. For detailed accounts of changes in the electric industry regulatory framework, see:
P. Navarro, “Electric Utilities: The Argument for Radical Deregulation,” Harvard Business Review, January–February 1996, pp. 112–125;
L. Hyman, America’s Electric Utilities: Past, Present and Future (Vienna, Virginia: Public Utilities Reports, 1994); and
R. Hirsh, “Consensus, Confrontation, and Control in the American Electric Utility System” (Saratoga Springs, New York: Symposium for the Virtual Utility, paper, April 1996).
3. For an illuminating account of regulatory changes and their consequences in the airline, banking, natural gas, and telecommunications industries, see:
R.H.K. Vietor, Contrived Competition (Cambridge, Massachusetts: Harvard University Press, 1994).
4. Navarro (1996).
5. “Cogeneration” is the coproduction of useful thermal energy (e.g., steam, hot water, or hot gases) and power (e.g., electrical or mechanical) from a single source.
6. Hyman (1994), p. 150.
7. Vietor (1994), p. 328.
8. Navarro (1996).
9. G. Simon, Cambridge Energy Research Associates, “The Lessons from California: Analyzing the Impact of Far-Reaching Utility Deregulation” (Georgetown, Washington, D.C.: CSC Senior Management Interchange on Business Reengineering: An Industry Perspective for Electric/Gas Utilities, presentation, 11 January 1995).
10. Navarro (1996).
12. For numerous examples of such impacts of technological shifts, see:
M. Tushman and P. Anderson, “Technological Discontinuities and Organizational Environments,” Administrative Science Quarterly, volume 31, September 1986, pp. 439–465; and
Mitchell and Spinney (1996).
13. Hyman (1994), p. 116.
14. K.E. Yeager, “Technology Triggering Structural Change,” Electrical Perspectives, volume 18, January–February 1994, p. 27.
15. Hyman (1994), p. 117.
16. R.E. Balzhiser, “Technology — It’s Only Begun to Make a Difference,” The Electricity Journal, volume 9, May 1996, p. 35.
17. T. Hoff and C. Herig, “Integrating Renewable Energy Technologies in the Electric Utility Industry: A Risk Management Approach” (Saratoga Springs, New York: Symposium on the Virtual Utility, paper, April 1996).
18. Hyman (1994); and
G.G. Wattley, “Where Technology Goes, So Goes Restructuring” (Washington, D.C.: The Energy Daily, 20th Annual Energy Daily Conference on “Breaking Up the Electric Utility Industry,” paper, 1–2 December 1994).
19. For a description of how the confluence of various new information technologies can transform consumer processes and alter existing industry structures, see:
R. Buday, N. Nohria, and J. Champy, “The Rise of the Electronic Community,” CSC Index Insights, Spring 1996.
20. For a discussion on the rise of new intermediaries on the Internet, see:
Buday et al. (1996).
21. Vietor (1994), pp. 319–322.
22. C.M. Studness, “Stranded What, Exactly?” Public Utilities Fortnightly, volume 132, 1 December 1994, pp. 40–42.
23. Surveys were conducted at CSC Index utility conferences, February and July 1995.
24. The authors are grateful to one of the reviewers of this article who correctly noted that, strictly speaking, the marginal price is not zero. Only intramarginal units of electricity are generated at close to a zero price, but at the margin, the cost is that of a combustion gas turbine. As this reviewer further noted, prices may fall even in the absence of restructuring due to the ending of a large number of PURPA contracts.
25. T.K. Smith, “Why Air Travel Doesn’t Work,” Fortune, 3 April 1995, p. 46.
26. Ibid., p. 43.
27. P. Ghemawat, “The U.S. Airline Industry in 1995” (Boston, Massachusetts: Harvard Business School, case 9-795-113, revised 7 October 1995).
28. Vietor (1994), p. 146.
29. Simon (1995);
E. O’Grady, “NYMEX: Electricity Contracts ‘Healthy’ as First Year Ends,” Dow Jones Telerate Energy Service, 27 March 1997; and CSC Index analysis.
30. “COB” and “Palo Verde” refer to two separate exchanges for electricity futures and options contracts, established by NYMEX. They were named after their respective delivery locations: one based on delivery at the California-Oregon border (COB) and the other at the Palo Verde switchyard in Arizona. Both sites are major market centers with easy access to the California market.
31. T. Noda, “The Evolution of the Baby Bells” (Boston: Massachusetts: Harvard Business School, working paper, 1996).
32. Forbes, 4 July 1994, p. 66; and
Wall Street Journal, 8 August 1995, p. B5.
33. A.F. Amey, “Complementary Forces: Information Systems Innovation and Competition in the Deregulated North American Gas Transportation Industry, 1970–2000” (Saratoga Springs, New York: Symposium on the Virtual Utility, paper, April 1996).
34. W. Emmons and M. Brand, “Note on Railroad and Trucking Regulation” (Boston, Massachusetts: Harvard Business School, Case 9-793-041, p. 14, revised 3 April 1994).
35. J. Sheth, “Global Competition and the Power of Three,” CSC Index Review, fourth quarter, 1996, pp. 13–16.
36. Studness (1994).
37. Evidence of this can be found in the natural gas industry, where the variable costs of the average gas pipeline today are lower than the lowest variable costs ten years ago. See:
CSC Index internal study, 1996.
38. FERC, through its Notice of Proposed Rulemaking (Docket No. RM95-8-000), the so-called “mega-NOPR.”
39. Newsbytes News Network, File n0704001.8, 3 July 1995.
40. PR Newswire, File p0626175.600, 26 June 1995.
41. Companies like Morgan Stanley, LG&E Energy, and Duke-Louis Dreyfus have obtained power marketer licenses.
42. Emmons and Brand (1994), p. 13.
43. Vietor (1994), p. 146.
44. F.W. McFarlan, D.G. Copeland, and C.L. Marshall, “Canadian Airlines: Reservations about Its Future (A)” (Boston, Massachusetts: Harvard Business School Case 9-195-101, revised 25 October 1995), p. 2; and
American Airlines, Annual Report, 1990.
It is estimated that in 1990, American’s reservation system, SABRE, had pretax profits of $150 million on revenue of $500 million. American Airlines as a whole, after backing out of SABRE, lost nearly $250 million on revenues of $10.5 billion.
45. N. Venkatraman and J. Michaud, research on value networks conducted by CSC Index’s Genesis research program, 1996.
For a more detailed discussion of the new roles in emerging value networks, see:
N. Venkatraman and J. Michaud, “New Roles in the Value Network”(Dallas, Texas: CSC Index Genesis meeting summary, “The Renewed Growth Agenda,” 7–8 February 1996), pp. 8–12.
46. The consumer products industry is a good example. Producers such as Dow-Corning or DuPont provide raw materials to manufacturers like S.C. Johnson, which provide products to retailers such as grocery chains, which in turn provide products to end consumers.
47. The emerging competitive market for electricity envisions that existing utility customers will be able to secure power from alternative suppliers. When this occurs, the utility that originally supplied power to the departing customer may not be in a position to market the power sold to the departing customer to an alternative customer. The utility thus suffers a potential financial loss due to structural changes in the industry, leading to the creation of what have commonly been called “stranded assets.” See:
“The Changing Structure of the Electric Power Industry” (Washington, D.C.: Energy Information Administration, DOE/EIA-0562, December 1996), p. 77, note 170.
48. A competitive transition charge is a non-bypassable fee to collect stranded costs.
49. The obligation of a utility to provide electric service to any customer who seeks that service and is willing to pay the rates set for that service. Traditionally, utilities have assumed the obligation to serve in return for an exclusive monopoly franchise.
50. For a discussion of how a virtual corporation links competencies that it may not own, see:
W. Davidow and M. Malone, The Virtual Corporation: Structuring and Revitalizing the Corporation for the 21st Century (New York: HarperCollins, 1993).
For similar ideas, see also:
N. Nohria and James D. Berkley, “The Virtual Organization,” in C. Heckscher and A. Donellon, eds., The Post-Bureaucratic Organization (Thousand Oaks, California: Sage Publications, 1994); and
H. Chesbrough and D. Teece, “When Is Virtual Virtuous?,” Harvard Business Review, volume 74, January–February 1996, pp. 65–74.
51. Dar also develops and subscribes to this idea. See:
V.K. Dar, “The Electric and Gas Industries Are Converging: What Does It Mean?,” Public Utilities Fortnightly, volume 133, 1 April 1995, pp. 21–26.