This article originally appeared in Forbes.com.
Margins from electricity generation have declined by about half over the past five years in Europe and North America. Some reasons for this are beyond the control of utility executives: Demand is levelling off in developed markets as consumers and businesses use electricity more efficiently, and the rise of renewable power sources like wind and solar reduces the load on traditional electricity generation from fuels like gas and coal.
But some factors are within executive control, such as determining the right portfolio of power generation assets and keeping those plants running as efficiently as possible by keeping costs down.
The first step towards reviving profitability is to review the company’s broader business goals and deciding whether generating electricity is still vital to them. Some energy companies may decide that it’s time to sell off their power-generating business and focus instead on other aspects of the market –for example, operating with a pure retail model by buying power on the wholesale market and selling to businesses and residential consumers.
For those companies whose strategic ambitions require that they stay in power generation, the next critical step is to look closely at the economics of all of their plants to identify the profitability of each. They can then decide how to make the most from their whole portfolio by taking appropriate actions for each plant. One utility was able to raise margins and, over three years, make its portfolio profitable again by closing one large power plant (saving about 40% of operating costs), putting a stringent cost-reduction program in place (cutting about 25% of operating expenses) and maximizing revenue from the rest of its portfolio (an uplift of 15%). Broadly, there are three things utilities can do to make their power generation operations more profitable.
- Reduce external costs, like fuel and vendors. One energy company reduced fuel supply costs by as much as 6% to 10% by exploring alternative coal suppliers, consolidating purchases among its subsidiaries to gain greater volume discounts, renegotiating contracts and sourcing more directly. It saved another 3% to 5% in expenses by renegotiating contracts with its subcontractors, including maintenance companies.
- Increase revenues. A utility can raise its revenues without raising rates by 15% or more by increasing the flexibility of its assets and offering different types of ancillary services. For example, a utility could develop or extend its capabilities to deliver extra capacity when the grid demands it, in exchange for annual compensation.
- Reorganize to reduce operating costs. As in other businesses, power generators can save significantly by centralizing some of their core business functions like procurement and administration.
Another step that executives can take towards restoring profitability is to look at all the strategic options for their portfolio, including converting plants (for example, from a combined cycle to an open cycle or a cogeneration system) or mothballing or closing them. Because utilities need to consider the technical and regulatory constraints of closing plants, this process requires discussions with regulators to explore how plant closures could affect the region’s energy capacity. In some cases, utilities may want to ask for support for unprofitable plants if they provide reserve capacity to prevent the risk of blackouts.
Executives can then assess the economics of each scenario by applying four best practices:
- Calculate option values based on the asset’s life cycle. Evaluate future costs, revenues and capital expenditures like major maintenance overhauls.
- Determine the return on investment for the entire portfolio rather than for each asset. These calculations must consider the interdependency among plants in a portfolio: Closing one plant, for example, may increase the revenue from other plants —even less efficient plants—that might have to operate more often to meet the area’s energy and reliability requirements.
- Assess sensitivity to the evolution of market prices. Future market prices are a sensitive parameter in decisions about whether to close or mothball a plant. This step involves getting validation from teams throughout a company, especially trading and strategic planning teams.
- Understand restructuring costs for each scenario. In addition to considering the onetime social costs of restructuring, utilities must take an exhaustive assessment of technical costs, including safety decommissioning, fees for terminating supplier contracts and disconnecting from the grid, and, in the case of mothballing, costs for dismantling or restarting a plant.
Utilities should then perform a detailed risk assessment on each of the potential options with a positive economic return, including technical, regulatory, social and legal risks. Armed with these key insights, the senior executive team can design a long-term plan that includes a vision of the future portfolio, a detailed roadmap with milestones and a cross-functional governance structure that clarifies accountability.
Arnaud Leroi is a partner in Bain & Company’s Paris office, where Julien Jaulin is a manager. Jim Wininger is a Bain partner in Atlanta. All three work with Bain’s Global Utilities practice.