78/79 The future of energy utilities How utilities can survive the perfect Storm Nick White, Kirsty Ingham, Dr Matthias von Bechtolsheim, Michael Haischer, Dr Robin Francis Introduction Market conditions in the energy utility sector, at least in Europe, are the most challenging in living memory. The centralized, integrated giants, which emerged from waves of central planning and international consolidation, now see their historical business model challenged by several factors. First there was competition. Political initiatives over the last 25 years have led to market liberalization, often introducing private capital into activities previously reserved for the public sector. Regulation in some parts of the sector, coupled with competitive pressures in others, has driven profits down to historically low levels. Structural changes were imposed on businesses to facilitate competition, but the centralized utility model remained largely unscathed. European utilities face a myriad of challenges. Companies in the sector are at a crossroads they need to reengineer business models that worked well for more than 50 years if they want both to survive and to retain their position in the market. In this article the authors discuss the key dimensions for defining the future strategic positioning of utilities, and discuss potential approaches and models. But now, in addition, utilities face a number of factors stagnant demand, aging generation, transmission and distribution assets, high fuel costs relative to electricity prices, and political moves to force investment in (expensive, but subsidized) low carbon-emission generation technologies. These combine with pressure from governments and regulators to keep retail prices low during difficult economic conditions. All of these create a perfect storm of misery for management and shareholders alike. Furthermore, technological change creates additional challenges in areas such as smart meters, smart homes, smart grids, distributed generation, electric vehicles and micro-generation. Relative to some industries, the timescales for innovation to deliver tangible results may seem longer than Picture by E.ON SE
80/81 expected; but the scale of these changes is huge, while expectations (from customers, shareholders and governments) are high. However, challenges can often stimulate innovation. Utilities have the opportunity to use the current crisis to reinvent themselves by innovating in technologies, products, services and business models to fundamentally change the value proposition they offer to customers. While the future of the utility business is impossible to predict, here we present some possible futures along with the business strategies that utilities should adopt to survive in the new paradigm. The industry is at a crossroads For the reasons we ve outlined above, companies operating in the sector are at a crossroads. The business model which has served them and their customers so well in the last 50 years or more seems unlikely to be suitable for the next 10 years, let alone the next half century, at least in liberalized markets. For example, the appeal of the traditional vertically-integrated electricity utility, based on very large-scale centralized generation technologies such as coal, lignite, nuclear and gas-fired plants, seems very low today. Eurelectric reports that the profit pool in conventional generation reduced by 10% between 2011 and 2012, while decentralized generation has increased capacity significantly in the last decade (Eurelectric, Utilities: Powerhouses of innovation, May 2013). The combined market value of E.ON and RWE, two of the largest conventional generators in Europe, has fallen by 76% since 2008. A return to the market conditions of that peak seems very unlikely. The Fukushima accident with all its attendant regulatory consequences, the economic crisis and the difficulties of new nuclear plant (in cost and schedule terms) have all taken their toll on the industry s appetite for investment. It is clear that for the industry, together with governments, to keep the lights on over the next 5-10 years it is necessary to adapt. In order for Europe to remain economically competitive, it is extremely important that it has a stable, fairly-priced supply of power (and heat), that enables it to compete with North America (which is ben- Germany s Energiewende The Energiewende (energy transition) dates back to 2000, when the government decided to foster the renewable energy industry and set out its exit from nuclear power. At that time high feed-in tariffs for wind, solar PV and other renewables were meant to make this market attractive to investors, help mature the technology and build-up a national industry, creating new jobs. Onshore wind and photovoltaic (PV) power mushroomed up to an installed capacity of 65 GW, or a third of the total power generation capacity in Germany. Feed-in tariffs, guaranteed for up to 20 years, were, and still are, very attractive to investors, and have had a significant impact on households, industry and utilities in Germany and neighboring countries. Electricity prices for end-users have risen by 150% for industrial and by 100% for household customers, mainly driven by the renewables' pass through tariff and also by tax increases. While end-user prices skyrocketed, wholesale prices crashed, causing gas and older coal-fired power plants to be idled; year-ahead wholesale power prices have dropped by around 30% in the last twelve months, while coal prices have fallen by around 20% and gas prices have remained fairly stable. Owners have shut down redundant power plants and plan to close more if the earnings situation does not improve. However, flexible gas-fired plants are needed to back-up wind and solar on windless or low sunlight days, otherwise the stability of the grid is threatened. Moreover, the original objective was to reduce carbon emissions, but in fact, due to low carbon emission certificate prices, power generation from lignite has risen, increasing emissions to such a degree that it has outweighed the carbon savings from wind and solar. The Energiewende is now in a critical state, with high costs, lessened security of supply and almost no positive climate impact, leaving all political parties deeply worried, and with no immediate answers on how to organize the future energy market. The new federal government wants to redesign the Energiewende to provide high levels of renewable energy (50% of generation capacity in 2030), limit the cost to an affordable level and assure security of supply. While capacity targets and security of supply are clearly defined, the economic impact is not. This means the burden on industry and households is not set out, nor are the economic benefits (such as job creation) or disadvantages (the impact on domestic industrial competitiveness). Finding a well-balanced magic triangle satisfying all stakeholders (including Germany s neighbors) seems to be nearly impossible. Centralized utilities have seen value destroyed in their traditional areas of strength and face the economic consequences of many policy decisions. Pre-Fukushima, the exit from nuclear power was working to an extended timetable; after the disaster this has been accelerated dramatically. Meanwhile, the smaller, local utilities (Stadtwerke), until recently seen as an anachronism, are once more rising in popularity. On an even smaller scale, village community energy projects, which produce more than half of their energy needs locally, have emerged over the last decade and now number over 130.
82/83 efitting from low prices due to shale gas), the Far East, the BRICs and others. How can companies active in the utility sector reinvent themselves so as to once more create shareholder value? How can they retain the confidence of customers and governments? How can they change their business models, pursue commercial and technical innovation and deliver excellent service to customers as well as superior returns to investors? Potential future models In considering new business models, utilities will need to review the appropriate blend of capital-intensive assets (such as production and transmission) versus asset-light activities (such as energy trading and retailing). It s quite possible that there will be a new round of disintermediation within the industry, with firms moving beyond the traditional vertically-integrated utility model, becoming more specialist and focusing on activities which they can perform well, while partnering and/or making acquisitions to help reach their strategic goals. In looking to the future we see two key dimensions which will define the future strategic positioning of energy utilities: Centralized vs. decentralized generation technologies Will companies retain a focus on large centralized generation assets or transition into a varied mix of decentralized technologies? Asset focus vs. customer focus Will energy utilities continue to focus on upstream generation and distribution of power using traditional assets, or move to a customer-focused business where energy supply is only one of a suite of services provided? The UK is facing major energy challenges. Aging infrastructure, greater reliance on gas imports and tighter controls on emissions, mean that the energy landscape in the UK is changing. Investment is required on a huge scale in order to maintain security of supply and affordability for consumers, while at the same time reacting to environmental targets. These issues have been acknowledged for over a decade, but policy focus has changed over time and difficult decisions were put off time and time again. After much indecision and debate, once the decision finally came from government that nuclear power would indeed be part of the UK s energy future, it became clear that building new plant would only be possible with a major change of the market mechanisms made all the more complex by a political need not to incorporate public subsidy nor breach EU State Aid rules. The UK Government has thus created very complex proposals for Electricity Market Reform. Such large-scale interventionist policy appears to be undoing some of the progress towards liberalization over the previous 20 years. There no longer appears to be faith in the market to deliver the necessary investment. UK utilities evolved to operate within this liberalized market framework, making long-term investment decisions on the economic basis of prevailing market conditions. In a short space of time, the basis for decision-making has changed completely. The complexity of the Electricity Market Reform proposals seem likely to deter some investors, or cause delays while they seek to understand the possible implications and risks involved. Timely implementation and operation will be difficult and costly. The years of uncertainty and continuing lack of clarity on many market reform measures have left the UK with a problem without clarity and consistency investors cannot commit. Too much intervention itself causes uncertainty, leading investors and market players to defer investment decisions. The economic downturn and corresponding drop in energy demand have delayed the crisis point by a few years, but it is fast approaching. Investors in long-life assets need a clear long-term framework within which they can solve the problems of building the right types of capacity in order to provide long term security of supply to consumers, which is the key problem today. Investors need some certainty, while consumers want to avoid paying for assets which cannot provide reliable supplies. Utilities are facing the prospect of lobbying hard to protect their businesses in the short to medium terms, while looking to develop longer term strategies, potentially moving them away from centralized, asset-heavy structures to focus on customers and broader service provision, using smart technologies. There is a pressure to understand where the future value lies in the UK energy market, with much uncertainty still surrounding the future of the market itself.
84/85 Within this framework we see at least four potential approaches: Decentralized 1. Devices Plus: Expand the current offering to include manufacture supply, service and control of devices i.e., taking direct control of smart grid/home elements to give greater power and allowing better value capture. This strategy would likely require the execution of JVs or strategic partnerships with device manufacturers like Bosch, with the energy utility bringing consumer understanding along with knowledge of infrastructure requirements and limitations, and the device manufacturer bringing manufacturing expertise. 2. Price Packaging: Energy as a service move from a commoditized charge per kwh model to a telecoms-like model, with a fee for access (monthly charge) based around tailored packages. These would depend on the needs and demand profile of the customer, such as flexible user, high energy power user, weekend user, etc. This would be coupled potentially with elements of automated demand response and smart devices. 3. Virtual Generator: A mixed model including Virtual Power Plant generation, coupled with the smart grid. Essentially this would embrace rather than fight decentralization and combine diversified generation assets with smart grid/home devices to create automated power communities at district or local levels. 4. Serviced Home: Customer-centric packaged home services provider ambitious sideways expansion into the provision of entertainment, security and monitoring services. Essentially moving into domains traditionally associated with telcos and entertainment companies. This could be combined with a complete exit from the generation business. These choices are shown in schematic form in the following Table: Traditional utility Centralized Asset Virtual Generator Devices Plus Making the change Serviced Home Price Packaging Customer Table 1 Key dimensions defining the future strategic positioning Source: Arthur D. Little analysis Reacting to the changes in the market, energy utilities have already begun to evolve their business models and adapt to the new realities. Across Europe some firms (such as E.ON and Centrica, amongst others) are moving to a position of being customer-centric champions. They see their future as being a trusted supplier of a package of essential services for household customers. In addition to traditional service offerings, such as heat and power, they are offering home security, equipment maintenance contracts and plumbing services, for example. They are reducing the capital-intensity of their business, preferring to invest not in large, inflexible assets, such as power plants, pipes and cables, but rather in assets that add value, such as smart meters and other ways of getting closer to their customers. This already includes, in many cases, the acquisition of small hardware and software producers and service providers, building IP and, to some degree, a new customer base. The data from smart metering should, if managed and analyzed well, allow utilities to understand their customers much better and target products and offers more successfully.
86/87 On the generation side, changes to the decentralized model involve a major shift in philosophy and technology deployment, since in the decentralized world a utility must act as a partner, coordinator and supporter of numerous localized networks of distributed generation, which may or may not be linked to the wider grid. Further, the relationship with the consumer also changes significantly, since the flow of energy becomes two-way with the utility no longer in sole control. The way this will play out is still very much a matter for debate, but small-scale home micro-generation and larger-scale commercial projects are already a reality, and some companies (such as Dong Energy and Vattenfall, amongst others) are already piloting Virtual Power Plant demonstration projects of linked distributed generation devices. Smart grid and smart meter technology will be a major facilitator of this virtual generator model. In order to develop and successfully execute a robust strategy in the new paradigm, energy companies must answer the following questions: What business model and strategy is necessary for the different possible approaches? What is the value creation potential in each approach? What are the key capabilities required in order to be successful in each approach? What is my company s current competitive positioning in each key capability? However, the moves made to date are still relatively minor given the dramatic changes to the energy landscape. As a priority, energy utilities need to be thinking about how they will strategically position themselves in the new reality, and the actions they need to be taking now to make that change a success. What options do I have in order to close the identified capability gaps? How executable are these options? What partnerships or acquisitions do I need to consider? How can I best execute these? What risks does each approach entail? How can I mitigate these risks? We see three essential elements in answering these questions: A clear and well-communicated vision and strategy for future positioning, based on sound analysis of the value creation potential and competitive positioning of the business under different options. A well-defined technology strategy, which underpins the business strategy and also clearly identifies the technology capabilities that a company must master and the actions needed to attain success. Picture by RWE AG A clear roadmap of actions to move the business from where it is today to the desired future state, including investments, divestments, partnerships, R&D priorities, and new products/services.
Getting a better return Prism / 1 / 2013 88/89 Insights for the Executive The utility sector might sometimes be seen as an important but relatively unexciting part of the industrial landscape. It comprises a vast set of highly capital-intensive assets, many of which have an expected lifetime of 30 years or more. Investment decisions made today may not result in assets becoming operational for at least 3 years, and often much longer. But even in times of high economic uncertainly, decisions have to be made and they will cast their shadow over the next half century. And they affect not only shareholders in those companies but also consumers and other stakeholders, such as governments. So it is important to make the correct decisions. In fact, the utility sector is extremely dynamic and requires a high degree of commercial as well as technical innovation. We are in the middle of a technological and information-based revolution, and the new business models which the industry seems likely to choose will be very different from the traditional capital-intensive, supply-driven businesses. Instead, we can expect to see highly customer-responsive, innovative firms, quickly adopting new technologies better to serve their clients. Decentralization will be a key theme, and geographical diversity a key requirement for those firms wanting to capture growth opportunities. Picture by RWE AG Nick White Is a Managing Partner of Arthur D Little s operations in the UK and a member of the Energy & Utility Practice. Kirsty Ingham Is a Principal in Arthur D Little s Energy & Utility Practice, based in London. Dr Matthias von Bechtolsheim Is a Partner of Arthur D. Little in Frankfurt and Head of the Energy & Utilities Practice in Central Europe. Michael Haischer Is a Principal in the Frankfurt office of Arthur D. Little and a member of the Energy & Utilities Practice. Dr Robin Francis Is a Principal in Arthur D Little s Technology & Innovation Management Practice, based in London.