This week PG&E cut power to over 800K meters, or roughly between 1.5 -2.5M people. The move was made to prevent a potential repeat of the wildfires PG&E reportedly caused this January.
Unsurprisingly, this prompted a series of tweets of confusion from even the smartest people on my timeline. The population of the most innovative place on earth found shutting off power in 2019 completely insane concept. They aren’t wrong, but there’s more here than meets the eye.
The reaction is one we commonly get when talking about our firm. We usually hear something along the lines of “you mean we aren’t doing this already? or doesn’t all of this already exist?”
When you think about it, that reaction makes total sense. We live in an unparalleled time for innovation and surely we are using that technology to enhance the assets that are essential to our everyday lives. Unfortunately, that’s not the case.
The approach to deploying technology in the energy industry is very different than most of the sectors Silicon Valley has had success disrupting. Instead of innovating with a naivete that ignores the way things are done, energy requires navigating entrenched bureaucracies and the drag of orthodoxy.
Nevertheless, I think it’s important to peel back the layers of this extremely complex industry to understand how we got here and what’s being done to change the status quo.
How does the electricity grid currently work?
At a very, very basic level the energy grid can have 5 major players outside of the end user.
- Grid Operators - also known as ISO’s (Independent System Operators) are responsible for resource planning, reliability, and manage wholesale power markets, the rate the utility or retail energy provider pays for your electricity.
- Power generators - these are the owners and operators of power generation plants that usually come in the form of natural gas, wind farms, solar, nuclear, hydro or coal
- Transmission - transport electricity from generation to substations that power specific regions of a grid
- Utility (distribution)- responsible for getting electricity to the end-user and maintaining the grid within a specific region
- __Retail Energy Provider*__ - firms that purchase power on behalf of a book of customers, in the chart below they’d be between the consumer and utility
There are some nuances to these actors. For instance, regulated markets like California do not have retail energy providers, but municipalities can act in a similar way. If there’s no muni, the utility takes the place of the retail provider.
The last consideration is that some of these groups overlap or are owned by the same holding company. Until recently, New York City was a great example of this. ConEdision was both utility and retail provider (ConEd Solutions) for several customers. Most deregulated markets also have a default provider which in most cases is the actual utility.
What are the goals of a utility?
Contrary to popular belief, utilities have more than one job, though keeping the lights on is an admittedly important one. But we should consider the goals of a utility with slightly more depth since it gives us a sense of the trade-offs utilities and regulators must grapple with in their decision-making process.
- Reliability - is the electricity on when you need it to be? For all intents and purposes that’s 24/7/365.
- Affordability - are customers paying a fair rate for electricity? Ideally, the lowest rate possible.
- Financial stability - can the utility create long-term, stable value for shareholders while not relying on public money for bailouts?
- Resiliency - is the grid stable in the midst of extreme weather, cyber, and physical threats?
- Customer satisfaction - when issues arise are customers taken care of promptly and correctly?
- Sustainability- is the utility building a grid that is environmentally conscious and that can handle the generation resources of the future?
At first glance, it becomes easy to see the inherent conflicts utilities face. If customers want better resiliency, that requires sacrificing some affordability and vice versa.
Utilities are often governed by what is called a “cost of service” regulatory model. They are not permitted to markup the electricity consumed by end-users, though in some deregulated markets like Texas their parent companies may do so through a different entity.
Commonly, utilities’ return on equity is based on deployed infrastructure and typically fixed in the range of 8-11% by regulators. The result of this structure is utilities that are incentivized to primarily spend capital on expenditures which can be depreciated over time.
Unfortunately, most efficiencies are software or systems related, two costs that are not factored into rate cases proposed to regulatory bodies when utilities want to raise revenues. As a result, utilities often won’t take the risk of improving operations or innovating since there’s no guarantee margins will increase.
This is starting to change, utilities are adopting new technology and startups with founders with experience in the sector are coming up with creative solutions to fit within these restrictions.
The Role of Wall Street
Just like every asset class, utilities also have a role to play in the financial sector. Pensions, endowments, mutual funds, etc.. have all enjoyed the stability utilities provide their portfolios.
The best measure of a stock’s volatility as it relates to the overall market is called beta, the lower the beta the less risky a stock.
Utilities as a sector have a beta of 0.27, meaning they are fairly predictable which gives investors an asset they can count on in volatile market cycles. After all, we consume electricity regardless of the economy’s health.
What happens when a power company deviates from a tried and true formula? Look no further than NRG in 2015.
NRG opened 2015 with a stock price of $27.50. The year before they acquired Roof Diagnostics Solar, Goal Zero, and Pure Energy Group, arguably solid acquisitions in the solar sector, and perhaps even visionary given the today’s trends in energy.
Under then CEO David Crane, NRG no longer saw itself as a “conventional” power company. Instead, they tried to position itself to capitalize on what Crane saw as the gradual crumbling of the electric utility monopoly through new technologies and services that empower the American energy consumer.
Yet, the stock plummeted and on December 1, 2015, sat at $9.00. Crane was fired, and the company announced a return to a more traditional approach. The message from Wall St. was clear, we want power companies to look like power companies, not cleantech or technology ones.
(Not So) Obvious Solutions
Bury the Transmission Lines
Probably the number one solution to the PG&E problem I saw proposed by my non-energy follows on Twitter was “why don’t we just bury the lines?”
Believe it or not, this is a common practice for new infrastructure development, but burying existing lines is prohibitively expensive. Some estimates place the total cost in PG&E at $67B with per mile costs ranging from $450K to $4.5M depending on the terrain.
Let’s put that number in perspective. In 2014, PG&E requested $1.2B from regulators to modernize infrastructure, the proposal was met with fierce resistance as it would have raised consumer bills by ~$10/mo. Eventually, the PUC approved a $460M package — startups in the Bay Area routinely raise more.
Earlier in the piece, I mentioned the goals and trade-offs utilities face, this is exhibit A.
The ~$10/mo increase in customer’s bills was too much for regulators to pass and when the small package that was approved increased PG&E’s revenue, the media immediately jumped on their profit gains as customer neglect.
Solar and Battery Storage
Despite costs falling drastically over the last 5 years, solar is still prohibitively expensive to the average consumer and the sales process remains incredibly disjointed, opening up the market for bad actors that significantly markup prices or lock customers into terrible terms.
The average upfront cost for a solar install in California is $12,810 AFTER incentives and rebates. That figure is roughly 1/6 of the total household income in the state.
Depending on the customer’s home, size of solar installs and cost of energy, the payback periods range from 4-10 years. Given that solar panels are still a new technology, I’d ask you which current piece of technology you would want to be locked into for that timeframe.
Imagine financing and still making payments on a Nokia 5110 (the famous navy brick) while your friends have a Blackberry or iPhone they were able to buy with cash.
While an argument can be made for solar, especially for those willing to pay for it upfront. Battery storage still makes little financial sense for anyone.
Residential batteries currently range in cost from $5,000-7,500 on average and their capacity is still quite small. This cost doesn’t include install or necessary additional equipment like breaker panels which can run an additional $10,000.
So, what can we do?
Luckily, there are some solutions to keep all stakeholders in the utility sector satisfied.
Revenue = Incentives + Innovation + Output
The best example of utility reform is currently unfolding in the UK. While Brexit is a complete mess, OFGEM’s (Office of Gas and Electricity Markets) early efforts for utility regulation reform have been quite successful.
In April 2013, the UK’s utilities began to operate under a structure known as RIIO (Revenue = Incentives + Innovation + Output) to evaluate utilities not just on rates, but also on efficiency and long-term planning.
The basic foundations of the structure look like this:
- Utilities are no longer regulated on CAPEX, but instead on “TOTEX” (total expenditures) which encourages utilities to seek out the most efficient solution and in some cases third-party solutions. This solves the problem of utilities only spending on CAPEX due to the regulatory restrictions of revenues based on the deployed infrastructure we discussed above.
- An 8-year baseline rate-plan that is adjusted based on preset targets and cost charges. No surprises for consumers and predictability of revenues for utilities through insulation from events outside of their control.
- An innovation fund created to encourage utilities to take on projects related to innovation and decarbonization.
Despite being only halfway through the first RIIO, OFGEM is already considering updates for what is now known as RIIO-2, Meanwhile, the results of the program thus far are encouraging:
- Rates for customers have stayed about the same or declined in most areas with a few exceptions depending on the utility.
- Customer satisfaction scores have dramatically increased according to third party studies.
- Most utilities have met all of their efficiency goals.
- Financial performance has stayed consistent, utilities in the UK are still in the 9.5% range for return on equity. OFGEM is actually concerned they performed too well.
- The innovation fund has fallen short. Only $80M has been spent on 260 new projects, most of which are still in the pilot phase.
As a result, OFGEM will be focusing on three key components for RIIO-2: continued focus on rate controls, managing uncertainty, and innovation.
It’s likely that the results of RIIO-1 and the subsequent changes for RIIO-2 could determine what the US regulatory landscape looks like in the coming years, especially given that the deregulated markets here took their cues from the UK a few decades ago.
Puerto Rico After Hurricane Maria
Closer to home, Puerto Rico is beginning the process of rebuilding their grid after Hurricane Maria struck the island in 2017.
While it is still early and there are many external factors at play, namely corruption within the government, Puerto Rico presents the first real chance to overhaul a grid from almost zero.
One proposal would have the island divided into 8 mini-grids and further subdivided into microgrids to deliver increased resiliency. Those microgrids would be built by Siemens and other private companies — privatization of development often cuts costs by half.
We’ve also seen the “Build Back Better” plan prepared in conjunction by several groups including the State of New York, Smart Electric Power Alliance, and the National Renewable Energy Laboratory. Highlights from that proposal included:
- $17.6B preliminary budget
- 159 microgrids mostly centered around critical facilities like hospitals, fire stations, and waste water plants
- Category 4 rated poles and wires for anything above ground
- Revamping the fiber optic infrastructure for more resilient communication between assets, control centers, and field workers during times of crisis
It’s unlikely that we’ll see any real utility reform come from Puerto Rico soon, if ever. But the ambitiousness of these proposals show that we can re-think the way we built our power grid in the face of increasing severe weather events.
If you scrolled all the way to the bottom, I don’t blame you, this post is tremendously long. But consider this, I’ve kept it extremely simple. My goal was to inform the common consumer who isn’t looking at this industry every day.
The electricity sector is an extremely complicated one. In a way, it’s not too dissimilar to healthcare: it’s a huge market, regulation plays a large role, technology is changing what’s possible, and the existing business model is broken.
Utilities are currently incentivized to build large, costly infrastructure because it’s the only way regulators allow them to raise revenues while demand for their product is falling due to building efficiency and distributed assets like solar.
Ex. a home uses 1000 kWh x 10 cents = $100 bill; installs solar; 500 kWh x 10 cents =$50 bill. Utilities built the infrastructure and business based on the $100 per customer model.
That model is broken, utilities are now being asked to keep the lights on and maintain resiliency + reliability in the face of rapidly changing market conditions but aren’t encouraged to invest in operational improvements. All while the financial markets demand the same ROE.
As the UK has shown, there are ways to re-think the current structure while keeping everyone happy, but we must be willing to think outside the box and bring all stakeholders to the table.
Puerto Rico and PG&E could be our first chance to do just that, but the odds look long at this point.
If you stuck with me through this entire article, you must be a glutton for punishment, but I hope you learned a lot.
Electricity is the footprint of our daily lives and something we take for granted, but if we are to meet the challenges of tomorrow like extreme weather events, climate change and over population we need to start thinking about new solutions now.