Is the avalanche of financial reports right? Is the centralised utility model past its sell-by date?
Catherine Mitchell, IGov Team, 6th October, 2014
Citi (1) is the latest financial institution to publish a short report on the future of the centralised utility model, but with a specific focus on GB. They argue that due to increasing competition the market share of the Big 6 will decline from 98% in 2013 to below 70% by 2020; and that the total profit pool available to them will decline by 40% by 2020. Ultimately, they say, all of the large utilities will need to restructure their supply business and improve customer services to remain competitive.
There has been an avalanche of financial analysis reports (reviewed in a recent paper and presentation) over the last year which have given a similar, overarching sentiment of where they see the energy system going: that disruption to the conventional centralised utility model is coming and that conventional centralised utility models are going to have to restructure or else will no longer fit for purpose.
It is not that each financial report is necessarily ‘right’, indeed there are differences in the numbers they use, and the predictions they make. Moreover, some of these reports focus on the impact on the large utilities and others focus on the opportunities for new entrants. More, the reports reflect the signs of change; and are important in signalling and validating the maturity of the arguments about the increasing importance of decentralisation and the increasing challenges paid to the centralised models. These generally cautious institutions have been recognising the consequences of the changes afoot globally. They have noted changes in different pockets around the world and they have put the possibilities of the separate social, economic and technological changes together.
In one sense, these financial analysts were open to change in the energy system. They have lived through the huge speed of change related to information technology; mobile phones / telecoms; print /media provision; and the music business. They can see that the power sector is ripe for change given social concerns and the availability of new technologies.
Over the last two years the view that structural change in the utility sector is coming has consolidated in the financial reports. However, it is still unclear from their reports what the range of business models, actors and scales will be that will form the new ‘sector – i.e. whether the large utility companies can transform and survive (or not).
How important are these reports for GB?
The current GB electricity system is large, centralised and dominated by incumbents. Not only is it like this but there is self-reinforcing Governance in place which keeps it so; and current GB energy policy (i.e. EMR) continues to entrench it. In a few countries, Germany, Denmark and California, real change is happening in energy systems. The recent paper and presentation asks whether this GB web of inter-related bias towards the conventional centralised utility model is strong enough to keep the economic and technological change – which the financial reports argue is coming and which are reviewed in the paper – at bay – or are the changes so great that Britain will also be forced to change in the not too distant future, albeit in a more disruptive manner than necessary?
The web of inter-related bias in favour of the conventional, centralised utility model in GB is made up of a few key, but powerful, material factors: the details of privatisation in the 1980s and 1990s, which were introduced to reduce the risk of failure for incumbents so that investors would not lose their money, has proven to be a bulwark against innovation; network governance encourages sales rather than efficiency; and then a whole number of issues (i.e. electricity market design and rules, which reduce transparency of prices, including transfer pricing; poor liquidity of customers and trading; vertical integration which suits the volume sales model; retail market regulation, which has favoured supplier rather than customer interests; a Code governance, which constrains change and is not fit for purpose; and a supplier hub model which does not recognise embedded benefits) which increases transaction costs, reduces transparency and increases risk all at the expense of new entrants or smaller companies and customers, who pick up the bill. When these factors are taken together it becomes possible to understand why so little practice change has occurred in Britain since 1990.
Fundamental Electricity System Change: only in a few countries
GB is part and parcel of the limited change going on in the utility sector globally. Electricity systems in Europe were, very broadly, privatised in the 1990’s – albeit with very different structures. The 50 States which make up the United States of America (USA) has also seen varying degrees of privatisation and liberalisation over the last 20 or so years. Most of these countries or States have had sustainable energy policies in place for much of that time – the goal of which has been, again broadly, to reduce pollution for either clean air or climate change goals. However, the outcomes of these policies have been marginal to the practice of those electricity systems, except within a few countries: Denmark, Germany and California. In other words, most energy systems have continued to be operated and managed in similar ways (despite some technology change, usually from increased percentages of renewable electricity); by companies with similar business models; selling to customers, who continue to have the same relationships to their energy use.
However, a few countries which have sufficient variable power renewable electricity or have incorporated demand side response into their electricity markets have moved beyond this conventional model of operation (or are hoping to move beyond this model). They are either enabling fundamental change in the operation and distributional impacts of their own electricity systems or are instigating a ripple effect in to other electricity systems. These changes are broadly (1) that within conventional electricity market rules, zero marginal cost renewable electricity generation is bought first, thereby shifting the supply curve over to the right thereby pushing out increasing amounts of fossil fuel generation as increasing amounts of renewable generation occurs. Not only is fossil fuel generation pushed out of the market, but at peak times it loses its expected high rates of payment for their electricity. The combination of this is that fossil fuel generation is becoming less profitable, if not positively unprofitable; (2) if zero marginal cost variable power is reducing conventional utility profits, then adding in demand side flexibility will reduce them even further. So far, these two factors are happening and existentially affecting the conventional utility model but they are not as yet happening anywhere together, with the possible exception of California; and (3) a plethora of new non-energy companies are entering the electricity and utility sphere, particularly from the field of IT or knowledge transfer, with new business models and new service offerings.
Factors challenging the conventional utility model in GB
As discussed above, a web of factors bias the rules and incentives of the energy system towards the traditional utility model. Furthermore, the relationship between the Regulator, the conventional utility companies and Government appear to be aligned and reasonably content with this bias. In this sense, one might argue, that incumbents still hold the power in Britain, and challengers find it difficult to get much purchase.
However, in addition to the uncertainty caused by the few countries making fundamental changes to their energy operation discussed above, there are a number of factors which appear to be building up pressure on this alignment and which may have an impact on this top-down, narrow energy policy decision-making world – and which these financial reports pick up on. These factors are: growing household dissatisfaction with energy companies, prompting some customer engagement or re-engagement with energy via switching or prosuming; an increasing presence of new entrant suppliers with dynamic business models; the CMA investigation, which is exploring the extent to which Ofgem has fulfilled its remit, may make recommendations for change which, one imagines, would not be unhelpful for the new Chief Executive, Dermot Nolan; the media has played an important role in keeping energy at the forefront of consumer’s minds, and this combined with elections – the Scottish Referendum and 2015 General Election – is keeping energy in an important political place in Britain; and, as describe earlier, the increasingly powerful voice and consistent message of respected, credible financial analyses which question the conventional, centralised utility model is impossible to drown out or outright ignore.
So what does this mean for GB?
From a global energy system perspective, it seems clear that the unquestioning dominance of centralised energy systems has been broken. There is a slow but steady move from centralised to decentralised energy systems which results from a complex mix of social preference, technological ability, regulatory flexibility, political processes, and economic reward. That some countries, for example Britain, are more at the centralised rather than the decentralised end of this spectrum is due to the same but opposite set of complex inter-relating factors – regulatory inflexibility, a lack of economic reward, a top down determination to build nuclear and insufficient consumer drive, arising from political governance and institution issues.
However, while a potential new alignment of ideas, institutions and interests is more visible in GB it has not as yet become powerful enough to alter the dominance of those ideas, institutions and interests which are biased towards the conventional, centralised utility model. Certainly, the institutions and their rules and incentives have not yet been fundamentally affected. Indeed, if anything, the recovery paradigm – ie how companies make money – has, via EMR, become more retrenched in favour of the traditional utility mode.
Nevertheless, even in this situation, these financial reports are predicting fairly major changes – i.e. a 40% drop in a profit pool for the Big 6 is a significant change. If GB governance (rules, incentives and institutions) altered to maximise the opportunities from the new technologies (whether supply, demand, operation etc) and to enable new business models and greater connection with customers, then much more fundamental change could (and should) occur, to the benefit of UK Plc.
Note 1: UK Energy Policy: Unwinding the Big 6. Citi Research Equities. 1st October 2014
Download Associated Paper: Stuttgart conf paper – Draft 1
Download Associated Presentation: Mitchell Stuttgart Final 2014