The energy sector has been navigating rapid technology innovation, slowing demand, and volatile electricity prices. This blog post explores the disruptive forces impacting electricity utilities, and explores potential risks and opportunities traditional business models should to embrace going forward.
Traditional business models for utilities reflect the centralised system of electricity generation and network design. This centralised system also drove a standard approach to system security and network planning, economic regulation, and underpinned the design of wholesale and retail markets and dispatch engines.
However, this view of electricity utilities as natural monopolies is now coming under increasing scrutiny due to a convergence of several factors across technology, economics, and public policy. Customer impacts are now driving investment trends in the opposite direction (through energy efficiency and distributed generation) and the increasing uptake of solar PV and storage will only exacerbate this trend
Currently, the interests of utilities (preventing stranded assets, maximising electricity sales, preventing increased competition) are in tension with the interests of consumers and the environmental imperative to carbonise the electricity sector.
Further, any solutions designed to meet the transitioning needs of the energy industry will need to be based on the individual regulatory and market contexts in which they emerge. There are also a series of regulatory, institutional, and financial barriers that remain and that inhibit the effective transition of electricity businesses to new ways of operating.
Utilities themselves are also likely to have a predisposition to inertia − what transition theory terms “path dependency” – being locked into a particular pathway that inhibits consideration and adoption of innovative ideas. Traditional utilities have been found to rely on traditional forms of research and development. This is a significant risk across the industry, given the momentum that new, distributed technologies and “big data” is gathering. Nimble information gathering produces a better foundation for strategic decisions and a more diversified flow of ideas for innovation. Utilities of the future will be expected to have their own innovation hubs or partnerships, identify new ideas, and leverage the capabilities of other businesses that can provide products and services complimentary to their traditional offering.
Banking sector acknowledgement
Given the increasing pressure on traditional pricing structures and revenue sources, the financial institutions themselves are recommending utilities to develop “smarter grids” by partnering with solar, battery, and smart meter providers in order to leverage their existing relationship with customers.
A number of banking institutions have already identified the decentralised electricity system as a necessary transition given the financial impact that would result from maintain existing models, and have adjusted credit and stock ratings of involved electricity businesses accordingly. For example, the financial risks created by disruptive technologies such as solar PV and storage systems include declining utility revenues, increasing costs, and lower profitability potential, particularly over the long term. Adding the higher costs to integrate increasing penetrations of distributed generation technologies will inevitably result in lowering profitability and, therefore, credit metrics. Failing to address these financial pressures with a restructure of business models would result in a major impact on equity returns, required investor returns, and credit quality
Stranded asset risk
From an accounting perspective, stranded assets are those that succumb to unanticipated devaluations, early write-downs or are ultimately converted from balance sheet assets to liabilities. In the electricity sector, utility businesses are already witnessing the potential for their assets to become stranded. For example, in Europe, previously highly regarded peaking gas, operating in markets with excess capacity, have quickly become financially unsustainable due to the lower wholesale price of electricity they receive not covering their marginal cost of generation.
Power stations around the world commonly have business cases reliant on high utilisation rates, built on the assumption that energy demand will continue to increase, or that innovations such as rooftop solar PV and battery storage are still nascent technologies years away from impacting their market share. As this article discusses, however, a whole series of factors are disrupting these business cases and underlying assumptions.
Ultimately, if the outlook for these power stations is not expected to improve (e.g. through a resurgence in demand, or a significant change in cost structures), than these assets will need to be prematurely mothballed, or retired ahead of schedule. More often than not, this will involve a significant write-down of capital costs, leaving asset holders with large sunk costs that will never be recovered from the project itself – the stranded asset.
Disruptive forces: lessons from other industries
Originating from an article by Christensen and Bower in 1995, disruptive innovation is defined as:
…an innovation that helps create a new market and value network, and eventually goes on to disrupt an existing market and value network (over a few years or decades), displacing an earlier technology…
The term is now widely used in business and technology literature to expose the vulnerability of existing business models to new innovations in products or services that revolutionise the market. A commonly cited example is Eastman Kodak (Kodak). Once a dominant, highly profitable marketer of photo film and related supplies, Kodak became a redundant observer as the photo business was transformed by digital technology, before finally filing for bankruptcy in 2012.
The electricity industry has largely avoided disruptive threats for over a century due to large customer monopolies and the value derived from economies of scale leading to easy access to relatively low-cost capital. However, given the impact that disruptive challenges such as technological innovation, changes to public policy, and consumer preferences may have on electric utilities in terms of their future investment and access to capital (and resultant impacts on consumers), it will be necessary for electric utilities to keep these historical outcomes for other industries in mind, as the industry continues to shift. Business development plans and medium to long-term strategies must address disruptive threats and be open to replace their own outdated technology with new products.
Potential preventative responses
The electricity industry is very much aware of the increasing pressure to implement actions and prevent a worst-case scenario. Strategic actions circulated previously by industry groups for consideration include:
- Assess depreciation calculations that utilise a recovery life based on the economic useful life of the investment, to consider the potential for disruptive innovations and loss of customers;
- Disconnection charges to be paid by solar PV customers and/or customers going off-grid to recognize the portion of investment deemed stranded as customers depart;
- More stringent capital expenditure evaluation tools to factor in potential investment that may be subject to stranded cost risk, including the potential to recover such investment over a shorter depreciable life; and
- New business models and services that can be provided by utilities in order to prevent continued revenue erosion.
Conclusions and policy implications
The underlying economics for conventional energy markets and systems have already shifted in favour of the decentralised models of clean technology – as afforded by solar PV and storage at the residential level, and larger renewable projects at the community scale. In effect, this has created excessive uncertainty for existing, ‘traditional’ energy market participants, and concerns are already being raised with regards to future industry investment and business decisions for energy companies.
A logical next step would be for utility businesses to embrace these technologies strategically and through a wholesale revision to their existing, traditional business models. Similarly, this suggests that a long-term view is needed by policy-makers to ensure stability and investment certainty can create the appropriate investment environment.If you’ve found this blog helpful and would like other topics covered, please feel free to drop me an email with suggestions and subscribe to get the latest posts straight to your inbox