Why Utilities have Avoided Disruption Thus Far – Financial Metrics

This is part 3 of a series on disruption of electric utilities.

Disruption of Electric Utilities
1.  Background on Utilities
2.  Why Utilities have Avoided Disruption Thus Far – Reliability
3.  Why Utilities have Avoided Disruption Thus Far – Financial Metrics
4.  Community Choice Aggregation is a Red Herring Disruptor
5.  Distributed Solar is the Real Threat - Trends
6.  Distributed Solar is the Real Threat - The Difficult Position of Utilities
7.  A Survival Strategy for Utilities

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Across industries, low-end disruptions are among the most common forms of disruptive innovation.  A low-end disruption occurs when a new entrant targets the lowest margin customers of an incumbent company.  Examples include steel minimills, which first produced low-margin rebar rather than high margin sheet steel, or Toyota USA, which started with the low-margin Toyopet and Corona models before moving up market to make Lexus vehicles.  Low-end disruptions occur because incumbent companies do not mind losing their lowest margin customers, and thus do not waste their resources fighting new entrants.  Unfortunately for incumbents, a rational pursuit of short-term profit maximization, can lead to a longer term disruption as new market entrants are able to gain a foothold in the market and move to higher margin products over time.

Utilities have been resistant to low-end disruption because they are unique among industries in the way they measure profitability.  Since the utility regulatory structure was established, utilities have been able to collect revenue according to a revenue requirement formula.  The revenue requirement is the total amount that the utility is allowed to collect from customers and, with demand forecasts, is used by regulators to set retail rates for consumers:

Utility revenue requirement = opex + (rate base * rate of return)

Opex is equal any operations and maintenance costs the utility faces as well as fuel costs if the utility owns generation assets.  A utility’s rate base is equal to its capital expenditures minus depreciation.  The utility’s rate of return is an agreed upon figure which is negotiated with state public utilities commissions for distribution assets, and the federal government for transmission assets.

The unique part about the utility profit formula is that there are no low-margin customers.  It is more expensive to build utility assets to serve customers in rural areas compared to those in dense urban areas, but all utility assets contribute to the rate base.  The costs associated with the more expensive customers are simply redistributed and collected in the rates of all customers.  Under this unique profit formula, a utility will respond aggressively when a new entrant targets any utility customer.

Why Utilities have Avoided Disruption Thus Far – Reliability

This is part 2 of a series on disruption of electric utilities.

Disruption of Electric Utilities

1.  Background on Utilities

2.  Why Utilities have Avoided Disruption Thus Far – Reliability

3.  Why Utilities have Avoided Disruption Thus Far – Financial Metrics

4.  Community Choice Aggregation is a Red Herring Disruptor

5.  Distributed Solar is the Real Threat - Trends

6.  Distributed Solar is the Real Threat - The Difficult Position of Utilities

7.  A Survival Strategy for Utilities

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In the United States, the typical utility consumer experiences loss of power for only 2 hours each year.^[1] That means utilities are reliable 99.98% of the time.  Not bad.

Source: Wikimedia Commons

I mentioned previously that I believe utilities have not been disrupted by innovative new entrants because they do an excellent job serving customers.  They offer electric power, as much and whenever needed.  And with a reliability of 99.98%, they offer a product that is hard to match by other entrants to the electricity market.  There may be certain customers that face more frequent interruptions, such as those in rural areas, but the typical utility customer receives a great service.

Despite the impressive reliability metrics of US utilities, utilities continue to prize reliability above all other measures of performance.  In a 2012 survey of hundreds of utility executives, the top ranked issue facing the industry was reliability.^[2] Furthermore, reliability has been the number 1 or 2 issue in every such annual survey since the surveys began in 2006.^[3] Utilities are not perfect at delivering reliable service, but their employees are oriented to respond to customer outages and have been working against the metric of reliability for over 100 years. Any new market entrant has a difficult task in better addressing this customer need.

 

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[1] The 2 hour per year figure takes some rough estimation because EIA does not publish this information.  I come up with 2 hours by looking at data from a table on page 19 of LaCommare & Eto.  Including LaCommare & Eto’s own survey data, we get a median SAIDI figure of 107 and a median MAIFI of 5.5.  If we assume an average momentary interruption of 2.5 minutes for the numbers in the MAIFI index, we get an average outage time per year per customer of 121 minutes, or 2 hours.   Having said that, the utility surveys listed above are self-reported, and therefore they may not include all events that a utility is unaware of or neglects to count.  In addition, widespread outages from natural disasters are sometimes not included in the data because SAIDI and MAIFI are meant to measure routine events.

[2] Black & Veatch, “2012 Strategic Directions in the U.S. Electric Utility Industry”, p. 9.

[3] Black & Veatch, “2011 Strategic Directions in the U.S. Electric Utility Industry”, p. 9.

Background on Utilities

This is part 1 of a series on disruption of electric utilities.

Disruption of Electric Utilities

1.  Background on Utilities

2.  Why Utilities have Avoided Disruption Thus Far – Reliability

3.  Why Utilities have Avoided Disruption Thus Far – Financial Metrics

4.  Community Choice Aggregation is a Red Herring Disruptor

5.  Distributed Solar is the Real Threat - Trends

6.  Distributed Solar is the Real Threat - The Difficult Position of Utilities

7.  A Survival Strategy for Utilities

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The electric utility industry has long appeared immune from disruption.  Investor owned electric utilities follow the same business model today that they used in 1907.  In that year, Samuel Insull released a policy paper on the electric power industry.^[1] Insull, a protégé of Thomas Edison, conceived the idea of private electric monopolies that would be regulated by the states.  The policy paper caught on as the dominant approach to establish electric utilities.  State regulation created a stable legal and economic framework for utilities as natural monopolies, which enabled the rapid growth of electricity service in America.  Insull went on to become President of Commonwealth Edison, the utility serving Chicago.

A natural question becomes, why have electric utilities been able to resist change?  A common argument is that electric utilities are monopolies protected by the government and therefore highly defensible businesses.  The industry is also highly capital intensive.  However, powerful monopolies in other capital intensive industries, such as Standard Oil, AT&T, and U.S. Steel, have all been disrupted by some combination of competition and anti-trust legislation.  I will argue instead that electric utilities have been more resistant to disruption for two reasons: 

1. Utilities do an excellent job solving real customer needs.
2. Utilities as regulated businesses are evaluated on unusual financial metrics which coincidentally encourage utilities to fight new entrants to a greater extent relative to other business.

In my next post I will examine further the reasons why utilities have successfully avoided disruption.

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[1] Ed Smeloff and Peter Asmus, Reinventing Electric Utilities (Washington, DC: Island Press, 1997), pp. 10-11.

Disruption of Electric Utilities: Introduction

I will be writing a new multi-part series about the disruption of electric utilities.  This topic has received significant attention recently, particularly after the Edison Electric Institute (EEI) published this policy paper on disruption in the electric utility industry.  EEI is the association of United States shareholder-owned electric power companies and lobbies government on behalf of electric utilities.

I’ll start with some background on the industry, discuss some potential disruptive innovations, and finally give my recommendations to the utility industry for how they can successfully innovate on their own and avoid being disrupted.  

These posts are written entirely by me, but they derive from a policy paper written for Professor Clayton Christensen's class, Building and Sustaining Successful Enterprises, at Harvard Business School.  Professor Christensen provided meaningful guidance in the writing of this paper.