More questions than answers for the utility industry

reederBy Jake Reeder, MBA/MPP ’15

This article was written in response to a seminar given by Rob Latoff, Director and Senior Partner with McKinsey & Company, in an EDGE Seminar on Sept. 25, 2013 at Duke University’s Fuqua School of Business.

Rob Latoff’s perspective on energy economics in the EDGE Seminar was refreshing in its lack of certainty about the U.S. and global energy sectors. During his talk, Latoff didn’t attempt to, as he put it, “develop the most perfect crystal ball.” That said, several predictions about the direction the energy sector might take over the coming decades emerged naturally from between the lines (or slides), of his talk. Below, I’ve tried to list what I think are the most interesting ones from the utility and electricity space.

1. Technologies will emerge to protect consumers and companies from electricity price volatility. Perhaps the most startling point that Latoff made during his entire talk was about bulk electricity pricing. According to Latoff, electricity prices can rise or fall 10- to 100-fold over the course of a normal day (and he has seen prices vary as much as 1,000-fold within a 24-hour period). It doesn’t take a perfect crystal ball to see that this situation is untenable. As utilities use time-of-use charges and other mechanisms to pass on these costs to their customers, the market will respond by developing products and services to alleviate wild price swings. These might be technology-based (energy storage technologies), service-based (demand management), or end consumer-based (distributed generation and smart devices that, for example, dry clothes at low-demand times). What is clear is that 10- to 100-fold price swings within a developed commodity market cannot remain the norm forever.

2. Technology will allow utility companies to get better and better at following demand. Related to the previous point, Latoff pointed out that electricity’s unique need to be produced and consumed the same instant leads to incredible pressure on utilities. If utilities collectively underestimate demand, brownouts will occur and fundamental infrastructure assets – hospitals, traffic lights, airplane traffic control systems, etc. – will fail. The risks of brownouts pressures utilities to overestimate demand, leading companies to constantly ground out excessive production. As technology progresses, demand prediction systems will constantly improve, reducing unneeded generation and allowing utility companies to become more profitable.

3. Utility companies that fail to explicitly understand their cost structure will go out of business. For electricity generators to stay competitive, they will need to understand their cost structures at the most basic levels. Companies that rely on profit as a decision-making tool and count on squeezing additional capital investments into their rate bases will ultimately go out of business. The seductive simplicity of profit as an operating metric may work in some businesses; however, in electricity generation, managers need to understand that they have to produce whenever the market price rises above their marginal cost of generation. Cost curves and other analytical tools will help utility managers become smarter decision makers.

4. Generation will become less globally fragmented. Nontraditional players may enter the space. Latoff noted that electricity generation is one of the last non-globalized major industries. In direct contrast to other commodities, there are few multinational generation companies, but yet electricity generators thrive on economies of scale. The greater the capital efficiency a generator can achieve, the greater their likelihood success in the market. Accordingly, generation companies that diversify internationally may be able to obtain lower capital costs, reduce local regulatory risk, and be guaranteed that, somewhere in the world, weather and market conditions will allow them to take advantage fly-ups in electricity prices (which, as Latoff pointed out, account for up to two-thirds of generator earnings). I think it likely that these generation fundamentals of the business will ultimately drive consolidation in the sector, and perhaps the entrance of nontraditional companies.

5. Energy is no longer exclusively an OECD topic. It drives development, competitiveness, trade, conflicts, and even wars, and will do so again in the future. According to Latoff, energy is one of the four fundamental inputs to an economy (alongside labor, capital, and raw materials), and without it, no economy can thrive. Unlike in the 20th century, however, conflicts won’t be about access to energy; rather, they’ll be about the consequences of energy production. In a warming world beset by increasingly extreme weather, conflict is almost certain.

Latoff’s theme was that there is massive and interesting churn going on underneath the relatively staid 0.5 percent growth rate in the electricity sector. And, even if only a few of these predictions prove ultimately correct, this theme seems indisputable. Will distributed generation obviate the utility business model or can utilities use better technology to reduce costs and remain relevant? Will utility managers update their outmoded decision-making practices? Will electricity production remain fragmented or go the way of oil and gas? Will the consequences of electricity production drive conflicts in the future, or will international processes be sufficient to smooth the inevitable crises? Latoff’s talk gives us intuition on these questions but not answers. The only thing we know for certain is that for energy, the next few decades will be the most exciting since the days of Tesla and Edison.

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