1 Introduction

A few months before the U.S. Continental Congress approved the Declaration of Independence (July 4, 1776), a little known Scottish philosopher published a book titled An Inquiry into the Nature and Causes of the Wealth of Nations. This now famous book and its author, Adam Smith, described the concepts on which we have built our modern economy. Smith’s statement “consumption is the sole end and purpose of all production” became the root of what we now commonly refer to as “supply and demand” where the science and mysteries of balancing the two drive successful businesses.

For the past century, no industry has embraced and exploited these concepts more than the electric utility industry, building a massive and complex infrastructure for delivering power to homes and businesses around the world. With rapidly increasing demand throughout most of that century, business models were created that assured adequate supply at a reasonable cost to consumers. Over the past decade, as the growth in demand has leveled and in some cases even decreased, utilities have begun to explore new ways of achieving the supply/demand balance.

Electric utilities, as is common for companies that depend on large capital investments, are a mostly fixed cost industry with a modestly rising cost structure for labor, materials, and compliance. Reductions, however, in expected demand and sales growth due to energy efficiency, self-generation, and economic dislocation threatens the core assumption of the historic regulated utility monopoly model. These reductions, while non-uniform, are nonetheless a secular trend in most of the OECD countries and will eventually result in fundamental policy and business model changes for this important infrastructure.

Different jurisdictions have begun to experiment with changes in the traditional business models by passing along certain variable costs directly to consumers; for example, an automatic fuel adjustment as input fuel prices fluctuate. But progress has been inconsistent and too timid to balance long-term goals of security of supply and infrastructure adequacy, environmental compliance, and price competitiveness.

During the expected long transition to achieving this balance, the traditional utility operational model will in the meantime, result in strong pressure on managers to reduce operating costs and on regulators to approve prudent costs over fewer units of sales. This “business as usual” approach will slowly raise prices so that a dilemma emerges:

This chapter will argue that in the long run, utility leaders will make required production and delivery investments only if marginal prices are accurate and if customer decisions to reduce consumption are based on true avoided costs that minimize cost shifting. To achieve this balance, pricing reform is needed now.

The system today encourages energy efficiency and self-generation through a somewhat distorted pricing structure. For example, a solar system supplying 100 percent of the energy for a home or business, served via net metering arrangement, may have a zero cost bill, but still relies on the grid for off-hour energy and capacity. These “zero net energy” homes, as described by Rocky Mountain Institute’s recent report on the subject, create complex value streams and cost shifting [1]. In the example here, all other customers end up paying for this solar customer’s “free” grid support, but may still enjoy the environmental benefits. Likewise, a business using 20 percent less energy than her next-door competitor may nevertheless induce substantially the same delivery costs on the grid. This paradigm is not sustainable from a cost standpoint in the midst of rapid adoption of alternatives to traditional electricity supply of historic volumes.

In response, utilities may delay the onset of the most challenging regulatory decisions around cost allocation by pursuing dramatic cost reductions to maintain cash flows. Or they may find other stop-gap measures, like new product and service revenues, to postpone the time when financial pressures become too high to ignore the need for more fundamental reform. The long-term trends are inevitable, however, and indeed it is desirable now, due to unique economic and political factors, to address this revenue model challenge with regulators.

The timing to address such a shift in the cost recovery model is propitious, in the U.S. market particularly, inasmuch as any changes to consumers’ bills over the next few years can be ameliorated by the historically low cost of natural gas. Utilities that act to resolve this dilemma now will enjoy comparative financial success over the long term as their peer group attempts what will surely be an increasingly challenging environment for structural change in the years to come.

This chapter will address these complex issues by providing an overview of the expected changes in the demand for electricity in sections 2 and 3. Section 4 provides specific examples of how these issues are being addressed by the industry. Section 5 outlines possible industry responses and suggests utilities take advantage of this window of opportunity to address structural pricing changes, since some options will merely postpone the inevitable financial impact of demand growth slowdown. Conclusions are drawn in section 6.

2 Breaking the Addiction to Electricity

Many of us who were born in the 1950s or before remember the day that our mothers began using their first electric washing machine, maybe even the first refrigerator. Soon after came a television, a vacuum cleaner, a toaster, a range/oven, and so on. The marketing of new electric appliances was prolific in newspapers, magazines, radio and television even challenging us to “dream” about all the possible conveniences, as shown in the typical 1950 GE advertisement in Figure 4.1. Often local utilities were complicit with appliance manufacturers, supporting and even leading marketing campaigns. In most cases it wasn’t a hard sell, providing high value to customers in convenience, safety, health, and pleasure. “More time to play” was an often-used phrase promoting the time-saving nature of many of the devices. Implied, of course, but generally ignored or not understood, was how much electricity that was required to operate the device. Hans Rosling does an excellent job portraying this radical lifestyle change brought about by electricity.¹ This lifestyle is one that few of us would relinquish or even slightly modify today. While for many of us in developed countries these changes started more than a half century ago, for much of the world these changes are still yet to take place.

Our workplaces went through a similar transformation with large buildings requiring significant artificial lighting and increased amounts of cooling. Productivity grew rapidly starting with electric typewriters and evolving to massively complex computers and networks, moving information at enormously greater speeds, quantities, and distances. Overall, demand for electricity was growing at a fast pace and utilities were challenged to build more and more power plants and delivery infrastructure to keep pace with the demand.

Figure 4.2 shows the growth in electricity supply from 1950 forward. Federal and state regulations ensured that no matter where, when, and how much electricity consumers wanted, the utility infrastructure would be ready and able to supply it. Utilities built very successful businesses providing this electricity across the United States and in many other countries in the world. Both federal and state regulators worked closely with the industry to ensure reasonable business decisions resulting in electricity consumers could afford, driving our economy forward. When needed, they worked through major and minor disruptions, making adjustments to the successful model to minimize impacts to consumers.

By the early 1970s, this growth in the demand for electricity began to concern some because of the potential for huge environmental impacts as well as the growing need to import energy resources. As discussed by Sioshansi in the introduction to this book, several pioneers took on the challenge of both understanding the fundamentals of electricity use and began to develop ideas that showed how consumers could continue to avail themselves of the services that electricity provided while actually reducing the amount of electricity required for these services.

Figure 4.3 shows the historical and projected growth rates in electricity demand in the United States. While these rates were highest in the 1950s, technology improvements along with market saturation have continued to slow the growth in demand to the point where experts are now predicting less than 1 percent growth in electricity demand for the decades ahead. For example, technology improvements have substantially decreased the amount of electricity used in a typical refrigerator. In 1980, the typical household refrigerator was about 20 cu. ft. and consumed nearly 1300 Kwh/year. Today the typical refrigerator is over 22 cu. ft. and consumes less than 500 Kwh/year; the same or better “service” using less electricity. Nilleson et al further describe the global experiences in these advances.

The real question is whether growth will continue or whether a combination of technology and market forces will reduce existing demand sufficient to offset any new growth. Certainly examples abound, like those described in Australia by Smith. The Energy Information Administration compares the growth in electricity consumption compared to real GDP for the United States from 1980 to 2010 (Figure 4.4). This shows that starting in the mid-1990s, growth in the U.S. economy is becoming less and less dependent on electricity production. Their projections in Figure 4.3 indicate an assumption that a small link between economic growth and electricity still exists, but the projected constant 1 percent growth in electricity demand is likely more based on assumption than fact.

A recent report by the American Council for an Energy Efficient Economy [2] examines the potential for a reduction in electricity consumption between 2010 and 2050. They assume continued strong economic growth of 2.8 percent per year resulting in a tripling of the U.S. GDP over the 40-year period. As a reference case they used the EIA growth projections in electricity consumption on a largely business as usual scenario resulting in an increase of about 25 percent in electricity demand in 2050. They then looked at two scenarios they called Advanced and Phoenix. The Advanced Scenario assumed that current and near commercial technologies available today are deployed throughout the residential, commercial, and industrial sectors. In other words, no technology R&D or breakthroughs are required. The resulting energy efficiency reduces the amount of electricity required by about 25 percent (translating to a 0.8 percent per year real decline in electricity demand).

The Phoenix scenario is a bit more aggressive, assuming, for example, that the average sq. ft. per home in the United States declines slightly between now and 2050. The resulting decrease in electricity demand in 2050 is over 40 percent. The reduction in this scenario is still based on available technologies but assumes faster and deeper penetration. Laitner et al also make similar arguments in their chapter.

Recent advances in smart grid technologies are rapidly becoming a key enabler of energy efficiency by engaging consumers in new and much more effective ways. Laitner presents an elegant analysis of the impact that semiconductor-based technologies have had on the U.S. economy in the last 40 years and projects an even greater impact going forward. He projects, for example, that between 2010 and 2030 that semiconductor-enabled efficiency can reduce electricity consumption by more than 20 percent [3].

While predicting the future is always difficult, the average growth in electricity demand in the United States is most likely to range between a 1 percent per year increase to a 1 percent per year decrease. Of course, this will vary significantly between regions, states, and even cities. Nadel summarizes the variations by state and highlights states where recent policy changes have accelerated the growth in energy efficiency programs and the resulting reduction in electricity demand. While a decade ago, energy efficiency was largely focused in a few states and utilities, programs now are sprinkled around the country. California has always been thought of as the leader in this endeavor, and they certainly can rightly claim the role of pioneer, but as Nadel shows, other states like Vermont, Nevada, Hawaii, Rhode Island, Minnesota, and Iowa are now ahead of California in the percentage of reduction in electricity due to energy efficiency programs. To make the point about the widespread nature of energy efficiency investments, even utilities like Oklahoma Gas and Electric have launched aggressive demand reduction programs that will help them defer the need to build new generation for the next decade or beyond.

3 Self-Generation Becomes the Norm

Driven recently by renewable portfolio standards and generous incentives such as feed-in tariffs and net metering, rooftop solar systems for both residential and commercial applications have dramatically increased in count. This growth in the market for such systems combined with innovative manufacturing and reductions in the price of silicon has continued to push down the cost of solar panels. Figure 4.5 shows both the increase in sales and the decrease in cost, depicting the correlation between the two and indicating the continued potential for further cost reductions. These cost reductions are difficult to forecast, but still highly likely as described in the current Department of Energy “Sunshot” initiative where costs for PV systems are expected to reach grid parity (without subsidy) by the end of this decade [4].

The southwest U.S. is experiencing high growth rates in rooftop solar systems² with San Diego, Phoenix, and Las Vegas leading the way. Some newer housing developments have rooftop PV on every home, resulting in 20 percent or more of the electricity for that neighborhood being supplied by self-generation. While extremely low natural gas prices may slow the growth, it is a trend that will continue especially as solar prices continue to fall.

A 2010 analysis by Arizona Public Service shows (Figure 4.6) that nearly half of the expected growth in electricity demand by 2025 will be met by energy efficiency (EE) and distributed energy (DE) resources. Germany has clearly demonstrated the feasibility of very large percentages of solar power reaching nearly 50 percent of the total electricity generated in a May 2012 two-day period.³

While electricity storage is still too expensive to allow consumers to totally disconnect from the grid in most situations, the cost of storage is projected to come down over the next several years motivating even more self-generation. Current grid-connected systems rely extensively on local distribution grids to supply power when the sun doesn’t shine, at night and during maintenance events. Utilities are beginning to charge consumers additional fees for “leaning” on the grid with their own generation. As these fees become more widespread, they will provide additional incentives for consumers to add storage and permanently disconnect.

This is the key issue: consumers use less grid-generated electricity while exerting increased stress on the grid to keep themselves supplied when they need it. Existing pricing structures result in cost shifting and underfunding of needed operations and investments.

Certain communities, especially where the price of utility-supplied electricity is very high, are focused on maximizing both energy efficiency and self-generation. The Vineyard Energy Project on Martha’s Vineyard is an example where a variety of smart grid projects, energy efficiency, and local renewable energy will help them achieve their long-term goal of operating an independent power grid, fueled by local renewable energy.⁴

With natural gas prices in the United States at historic lows, many commercial and industrial consumers are considering generating their own power using small- and medium-sized high-efficiency turbines. These systems can provide local, reliable, and inexpensive electricity, especially when combined with productively using the waste heat, improving power quality and availability, and displacing utility-generated electricity that must be transported long distances or through congested transmission and distribution lines. Commonly referred to as cogeneration or combined heat and power (CHP), these systems are well understood and very dependable.

A report by the Oak Ridge National Laboratory [5] suggests that with pro-CHP policies, the United States could generate 240GW or 20 percent of its electricity needs from CHP systems by 2030. This equates to three times the current amount of CHP in the United States, but roughly equivalent by percentage to what is already done in Europe. Combined with new microgrid control systems that allow users to optimize the integration of multiple supply options (e.g., solar PV and CHP) with demand management, these self-generation options may become a preferred strategy for many companies. If these new CHP systems were built and operated by local utilities, they could add instead of subtract from revenues, but this would require new business models for most utilities.

As a case study in what is occurring in practice, Portland General Electric is profiled as to their energy sales outlook, their business strategy regarding promoting energy efficiency, and their current revenue model.

4 Industry Implications

While some electricity sales reductions are operationally beneficial if they occur during the coincident peak, most mechanisms for sales growth reductions are not so well integrated into utility capacity planning as to result in much if any avoided cost. Except for utilizing the marginal peaking generation resources, substations have the same equipment, trees still fall across overhead pole lines and cause outages, consumption is measured, and bills are sent. Only reliable and persistent demand response resources have both an immediate and long-term cost avoidance opportunity. These phenomena come from the modern utility industry model, which was conceived and deployed around the three pillars of increasing load growth, declining marginal costs, and cost-of-service price regulation. When one or more of these three pillars erodes, the economic underpinnings of the system become imbalanced. In addition to the sales growth reduction from energy efficiency and self-generation, the other two pillars are under challenge too.

O&M costs have been rising faster than inflation for much of the past decade. Materials have been impacted by global economic growth, and commodity labor prices continue to rise. The Edison Electric Institute reports that O&M expenses for its investor-owned utility members grew an average of 4.6 percent from 2003 to 2011, with some volatility due to M&A accounting and a dip in 2008 due to the recession [9,10]. Generation construction prices have also increased during this time due to high costs of materials, permitting, and labor. Fortunately, in the United States, natural gas prices in summer and Fall of 2012 are between $2–3 MMBtu, which mitigates the total cost of energy in most markets. Many experts believe these low prices will persist for many years to come.

The regulated monopoly behind cost-of-service ratemaking is also beginning to unravel at the seams.

First, in many markets, social spending in the form of low-income service, renewable feed in tariffs, energy efficiency investments, and economic development programs all serve to increase the overall revenue requirement above the basic cost-of-service.

Secondly, rate design is yet another policy decision that can skew the price signal of marginal cost of energy and the associated investment return of energy efficiency or self-generation. For example, in markets like California, significantly differentiated tiered pricing places the prices for the highest tiers at multiples above the lowest tier to encourage such energy efficiency and self-generation options.

Finally, the presence of regulatory compensation or performance incentive schemes that reduce the harm from sales erosion on the investment and operating decisions made by utilities is a factor in the financial stability and investment attractiveness in utility companies.

In the long run, a sustainable energy infrastructure will only emerge from the reassessment and the replacement of these three elements with a coherent system of consumer price structures that reflect the short run and long run marginal price of a unit of electricity.

The need to achieve this sustainable financial structure is apparent. The positive feedback loops of high avoided unit prices, reduced cost of alternatives to utility supply, and supported social policy spending will most likely accelerate these trends toward more energy efficiency and self-generation. In the limit, non-participating consumers will pay more for the basic commodity service or utilities will see diminished financial returns that raise the cost of capital, and thus rates, as investors evaluate the prospects of earnings, cash flow, and risk.

5 Possible Responses

Addressing the cycle in Figure 4.9 can take many forms. The best and most efficient way of addressing this cycle are structural pricing changes that would give the accurate market signals for both capacity and energy, but these may be the most politically difficult due to the elimination of certain intra-class subsidies and the resulting bill impacts.

Less structural in nature and less efficient in result, energy efficiency incentive and sales decoupling mechanisms, currently implemented in various states, can partially offset the financial downside to the utility of lost sales and revenues. Also, aggressive productivity and cost reduction programs can help maintain financial performance by mitigating some of the intra-class pricing increases from any structural price changes. And finally, some utilities are hedging these effects by creating plans for energy services offerings that can yield new revenue streams.

Tailored to local conditions, all these steps should be pursued as a portfolio of responses to the fundamental challenge to the financial integrity of utility providers and to support a long-term investment climate in low-cost and reliable energy service.

6 Conclusions

Energy efficiency and efficient distributed generation are already cost-effective investments for many, and will become increasingly so as technology developments drive cost down and innovative business models overcome other barriers to customer adoption. These favorable economics are often significantly benefited by the existing volumetric biased utility pricing structures, even though a significant amount of fixed cost is collected in these volumetric prices. Combined with variable economic growth across geographies, future sales for most utilities are expected to be flat or negative.

As this trend becomes more visible and utilities adjust their prices to slower growing sales, prices will increase to all customers as remaining and growing fixed costs are spread across fewer sales. This situation, while favorable to efficiency and renewable energy adoption, leaves non-participants with even higher bills and creates an unsustainable situation for the utility business.

Forward-thinking utilities are considering several options and some are taking aggressive action. Some options address the fixed cost recovery problem directly, while the remainder either delay the effect described above or are only partial hedges against the financial effects of decreases in revenue. The most successful utilities will be those that address the long-term structural cost recovery problems head-on with their regulator. Their own long-term viability is at stake.

A bright spot in this dilemma is that natural gas prices are at historic lows in real terms and the resulting negative pressure on prices affords both regulators and utilities alike a short window of opportunity to put into motion structural fixes that address customer equity and ensures reliable infrastructure built on competitive investor returns.

References

1. Rocky Mountain Institute, Net Energy Metering, Zero Energy and the Distributed Energy Resource Future, March 2012.

2. Laitner et al. The Long-term Energy Efficiency Potential: What the Evidence Suggests ACEEE Report number E121 January 2012.

3. Laitner et al. Semiconductor Technologies: The Potential to Revolutionize U.S. Energy Productivity, ACEEE Report number E094 May 2009.

4. Sunshot Vision Study DOE/GO-102012-3037 February 2012.

5. Shipley et al. Combined Heat and Power: Effective Energy Solutions for a Sustainable Future. Oak Ridge National Laboratory report number TM-2008/224; December 2008.

6. Portland General Electric, Investor Presentation, Williams Capital Group March 22, 2012.

7. Interview, Jim Piro, CEO Portland General Electric; April 27, 2012.

8. Interview, Raymond Gifford, Former chair Colorado Public Utilities Commission; May 2, 2012.

9. Edison Electric Institute, Industry Financial Review; 2010.

10. Edison Electric Institute, Industry Financial Review; 2011.

11. Elektrciteit Tarieven, Stedin.net; 2012.

12. Aligning Utility Incentives with Investment in Energy Efficiency, U.S. Environmental Protection Agency, Office and Air and Radiation, Climate Protection Partnerships Division; November 2007.