Public Util. Fortnightly

Beyond the downturn: today's challenges are transforming the industry

Beyond the downturn: today's challenges are transforming the industry

Beyond urgent business-cycle challenges, powerful forces on the horizon threaten power companies' relationships with their customers, upset rate structures, and expose the industry to potentially disruptive new technologies and competitors.

  • min read


Beyond the downturn: today's challenges are transforming the industry

The credit squeeze, erratic commodity prices, and the deepening recession understandably are top of mind for utility company executives today. But it's important not to lose sight of longer-term structural trends that are reshaping the industry. Beyond urgent business-cycle challenges, powerful changes already on the horizon threaten to transform power companies' relationships with their customers, upset rate structures, and expose the industry to potentially disruptive new technologies and competitors. For corporate leaders who neglect to think about how these forces will affect their companies over the coming decade and beyond, the near-term steps they take to manage through the downturn could leave their companies off-balance when the economy rebounds. For companies that can maneuver nimbly through the curves, periods of economic turbulence create more opportunities than at any other time to move from the middle of the pack into leadership positions.

The immediate pressures certainly are daunting. Among them, volatile fossil-fuel costs over the past year are passing through to customers in the form of destabilizing rate changes. While natural-gas prices have backed off from their summer peaks and may remain subdued throughout the economic slowdown, rising global energy demand from emerging markets virtually ensures that these critical feedstocks will resume their long-term secular increase. Likewise, whipsawing prices for steel, concrete, copper and other basic commodities are upsetting utilities' planning assumptions. Will supplies tighten again and push prices higher or will commodity prices continue their recent steep decline and remain low? And for how long? Gyrating input costs will alter the economics of alternative energy sources. Consumers increasingly will be drawn to distributed-energy generation that promises more stable prices, moving a portion of their demand off the grid to invest in rooftop solar panels or wind-powered generators as a substitute for more costly electricity sourced from central stations. For utility companies, the results will be eroding sales and stranded investments in plants that operate below their cost-effective capacity. Also looming on the horizon, utilities in 24 states face fast-approaching regulatory deadlines to comply with environmental mandates for their renewable portfolios by embracing new green technologies. Over the coming year, the federal government likely will revisit greenhouse gas legislation with consequences that could scramble investment decisions, product offerings, and operating procedures. Meanwhile, an emerging crop of new alternative energy companies likely will be one of the few bright spots to attract investment from cash-rich private equity and venture capital firms, currently sidelined by the economy's credit woes. As capital again starts to flow, well-financed start-ups will begin to reshape the competitive landscape, bringing a dot-com-like buzz to an industry saddled with heavy legacy costs and aging infrastructure. The ratcheting up of environmental pressures and the prospect of federal subsidies for alternative energy technologies will spark development of a new generation of industrial-scale solar and wind electricity-generating assets. Utility companies will feel the heat either to make large commitments to invest in low-carbon-emitting infrastructure or watch new competitors build it instead.

Confronting any one of this litany of challenges will be difficult. But managing the combustible interaction of volatile costs, new competition, and transformative technologies-and their potential impacts on utilities and their customers-will present immense challenges. As electric companies wrestle with these new threats, they increasingly will find themselves battling for market share across a broad front. It is a battle they will have to wage to defend their franchises against new rivals who aim to win over their best customers—cost-conscious, big industrial users, top-rate-paying commercial buyers and conservation-minded residential consumers—with customized products and services.

Crossover Zone

Three actions can help investor-owned utilities build their competitive muscles and emerge stronger from the maelstrom. Utility companies should understand the economics of their businesses-from their customers' point of view. Even as natural gas prices recently have trended downward, their steep increase over the past five years signals a fundamental transformation in utility industry economics. It's a shift that will influence ratepayers' calculations of what they should pay for power-and from whom they will buy it.

Fossil-fuel prices have spiked in the past, of course. But the changing relative costs customers soon may face reveals just how stark a challenge the long run-up in fuel costs will pose. For many power companies, the pass-through cost of natural gas long has been the prime determinant of how much end-users will pay for the electricity they consume. At the current price of around $6.50 per million Btu, on average, consumers are paying some 8 cents/kWh, still well in line with longer-term upward trends.

Utility customers' options will change dramatically if natural gas prices double from recent levels over the coming decade, a reasonable forecast given demand from China, India, and other big emerging-market economies. The price of electricity generated from natural gas could increase from current levels to some 25 cents/kWh from such a steep run-up in fuel costs. Meanwhile, prices for central-station-generated photovoltaic power likely will drop from today's 29 cents/kWh to less than 16 cents/kWh; and prices for solar thermal power could drop from 16 cents/kWh to 10 cents/kWh, making these environmentally-friendly renewables the more cost-effective options. Adding electricity generated from wind, geothermal, and biomass into the mix, the blended cost of installed power-generating capacity from renewable sources in the United States could run between 4 cents and 5 cents/kWh within 10 years. As electricity prices enter this crossover zone, most top-tier industrial, commercial and residential utility customers will migrate to efficient renewables and the companies that offer them. Utilities that aim to hold on to their most profitable customers continually will need to assess their likely energy options, anticipate their needs, and gauge their vulnerability to being picked off by new competitors. Utility companies proactively can market their products and services by grounding their insights in a detailed understanding of the economics customers face. They can begin by segmenting customers to tease out the sensitivity of their most attractive customer groups to rate changes and how that will influence how they buy, what they buy, and from which power suppliers they buy. Zeroing in on those valuable customer segments that are likeliest to defect, they will develop individual profiles based on detailed audits of their power-usage patterns, calculate the rates the customer would pay under alternative scenarios, and come up with price competitive counteroffers that would help boost efficiency while lowering costs. They will apply new demand-side management techniques to reduce or shift load demand during peak generation hours. Through ongoing monitoring of customers' consumption patterns, they will be able to spot opportunities to bundle services, market new green-energy products, or negotiate fixed-price guarantees that better enable customers to budget their energy outlays.
Leaner and Meaner

Boosting efficiency allows companies to elevate their competitive capabilities. Due to pressure to cut costs in the current downturn, prudence and efficiency will be the operational watchwords. Three areas stand out as leading opportunities for utilities to trim down for recessionary times while building a springboard that will accelerate their performance when the economy rebounds.

  • Back-office support services-finance, human resources, legal and other general and administrative (G&A) functions-are inevitably the first and most obvious candidates for deep, sweeping cuts. But many companies wield the ax indiscriminately, chopping G&A costs across the board. A better approach is to weigh effectiveness as well as efficiency. Viewed through that lens, an organization may discover that it makes sense to eliminate some functions entirely and overinvest to consolidate or automate others.
  • A Bain & Company analysis of G&A expenditures at 37 companies revealed that leaders view their back office as a potential performance accelerator that helps them manage their businesses in tough times. Taking simple steps to reduce unnecessary functions led to significant savings. But, on average, 75 percent of the benefits came from substantive changes that enhanced support services by redesigning them or restructuring how or where they were done.
  • Building efficiency through improved supply-chain management is a second big opportunity to convert cost savings in a downturn into sustainable competitive advantages for the rebound. Downturns are the right time to benchmark supplier performance, strip out complexity from materials forecasting, and streamline decision-making processes. Significant supply-chain efficiencies are achievable through direct material sourcing. Ordering and forecasting can be sharpened to reduce inventory and shave warehousing costs. Bain analysis found that utilities that adopt best practices can bank improvements of between 5 percent and 7 percent on a year-in, year-out basis.

Seizing opportunities to boost workforce productivity offers a third—and perhaps the biggest—opportunity to emerge stronger from a downturn. The dimensions of potential savings can be striking. Reeling back nonproductive work time that tends to creep up during economic expansions can be a major source of cost reductions. For example, stepping up planned preventive maintenance to avoid costly emergency overtime at one utility opened up the potential to lower repair and replacement costs by one-third. Sharper labor utilization disciplines (such as better management of basics like dispatch and scheduling procedures), tighter control of budgets to eliminate overruns, and the systematic application of best demonstrated work practices across all divisions can yield tens of millions of dollars in cost reductions. A typical in-depth cost review uncovers potential savings opportunities of between 15 percent and 20 percent across the board.

Successful companies innovate and expand. With their traditional regulated generation and distribution businesses under assault, electric utilities will need to innovate within their core business and scout opportunities to diversify into new ventures and technologies. But companies first must face the question of where to begin.

Operating as regulated monopolies for the better part of a century, risk-averse power companies don't have a great track record in innovation and entrepreneurship. But they can apply lessons from other industries that have faced existential challenges. Among companies that had to redefine their businesses in the face of disruptive turbulence in their industries, many found promising opportunities to a more sustainable new path by applying their accumulated competitive strengths in new and untried ways.

Research shows that nine out of every 10 companies that successfully renewed themselves found the solution in mining their hidden assets—assets they already possessed but had failed to tap for maximum growth potential. Those assets typically come in one of three forms.

  • First, they may be locked up as an undervalued business platform. For utilities, the most obvious of these, of course, are their decades-old, one-way energy distribution grids and the large geographically dispersed field crews deployed to maintain it.
  • A second hidden asset may lurk in untapped customer insights—an area where utilities have unparalleled resources they can mine. With 20/20 insight into virtually every detail of their customers' electricity consumption patterns, utilities can profile customers by segment based on past use, anticipate evolving needs, and develop products and services that help meet those needs.
  • The third hidden asset that companies use as a springboard for business redefinition are underutilized capabilities-skills acquired over time that can be applied to new ends. Utilities are replete with these unique abilities. Prominent among these is their unparalleled experience dealing with regulatory commissions, relationships they and their potential joint venture partners can draw upon as they push against the traditional boundaries of the industry.

Smart Business

Some industry executives are beginning to tap elements of all three hidden assets by embracing smart-grid technologies to upgrade their transmission and distribution infrastructures. Using advanced sensors and communications systems, smart grids expand a utility operator's business platform by enabling the company to draw efficiently upon renewable solar, wind, or geothermal energy sourced from far-flung suppliers to supplement electricity generated by conventional central-power stations running on fossil fuels. Smart-grid infrastructure also allows utilities to better use their customer insights to help consumers reduce energy use during periods of peak demand. And the advanced communications and information technologies used in smart grids allows utilities to build on their underdeveloped capabilities for load balancing across their transmission and distribution networks. They will be able to toggle in real time between electricity produced through photovoltaic solar arrays, small wind turbines, and micro-hydro sources to capture cost savings and develop more robust safeguards against catastrophic cascading power-grid failures.

Still early in the rollout, only a small percentage of utility providers are currently planning or actively deploying smart grids. The slow pace of adoption reflects some formidable obstacles. Consumers have yet to be won over to the idea of utilities taking a more active role in managing demand. With a few exceptions, regulators have not thrown their support behind the idea or mandated the use of smart-grid technologies on a broad scale. And there remains plenty of uncertainty over which groups—consumers, technology partners, regulators, or utility shareholders—will reap the economic benefits from the sizable investments they will be required to make. Solving this complex problem will take foresight and deft bargaining skills.

But initial results from early adopters like Austin Energy hint at smart grid's promise. Serving 388,000 customers with more than 2,600 MW of generating capacity, the Texas-based company is the ninth largest public power utility in the United States. Under a mandate imposed by local regulators to reduce the level of demand by 15 percent and boost efficiency to cut peak loads by 700 MW by 2020, Austin Energy began phasing in a smart-grid system. To date, the utility has linked most residential customers' homes and apartments by fiber-optic cable to monitor consumption patterns. Last fall, the company began installing software that will enable it to offer time-of-day pricing, adjust power flow remotely to balance loads, and purchase electricity directly from customers who install solar collectors. Already, the smart grid has helped Austin Energy conserve sufficient electricity to power 45,000 homes.

Adopting smart-grid systems will sharpen utilities' talents for integrating new technologies into their operations. As they learn to do more with this underutilized capability, utility companies will strengthen their hand in forging joint ventures with promising green-tech start-ups, turning potential competitors into partners.

In an environment fraught with so many potentially game-changing challenges, utility company leaders have to be ready for any contingency. Those who can navigate today's economic tumult while preparing for the disruptive trends that lie ahead are likely to emerge as tomorrow's winners.

Joseph Scalise ( ) and Neil Cherry ( ) are partners at Bain & Company, and they lead the firm's North American energy and utilities practice.


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