Energy efficiency (EE) is the lynchpin of any strong U.S. climate policy. In the power sector, efficiency will provide somewhere between 15 and 40 percent of our total electricity “supply” between now and 2050, in addition to displacing substantial amounts of other fuels.1-3 In the next 10 years, efficiency will play an even greater role, as many utilities conclude that there are no other carbon-saving options readily available at comparable costs. Energy efficiency is really the “plug” in our climate strategy—the one resource we can draw on at an increased pace if other key technology solutions fall short. Nothing short of a massive national effort to save energy will allow the U.S. to meet its climate goals.
This reality has profound implications for American energy utilities. Total sales of electricity and gas, which have steadily increased since the dawn of the 21st century, are already flattening out and may soon decline.4 Under these conditions, the business model on which these industries financed and built America’s energy infrastructure will no longer work.
At the same time, utilities and their investors will soon be called upon to rebuild and modernize the vast U.S. electric and gas infrastructure with unprecedented speed —and great technical risk. Our preliminary estimate for the investment needed to decarbonize the electric sector is $1.5 trillion through 2030, not counting the cost of consumers’ own new technology outlays. And that does not count the risks involved in developing, scaling, and integrating low-carbon electric generation.5
To raise and spend capital on this massive scale, the utility industry must represent a sufficiently attractive investment vehicle. Part of the attraction will come from carbon markets, which will reward investors in low-carbon technologies and the utilities that deploy them. But a growing segment of the industry is rate-regulated, which caps its upside earnings, and is also on the hook for financing many of the EE measures that will drive its own sales growth negative.
Common sense tells us that a business with declining long-term sales is not a good candidate for massive and expensive reinvestment in its production plant (or infrastructure). Rapidly raising the average price of its commodities will not offset decreasing revenue, and will only exacerbate the decline in sales. State regulators and governors, who directly or indirectly control most utility prices, are likely to moderate price increases to help consumers. These moderating steps will hurt investor returns. Investors will respond by raising utilities’ borrowing costs. All this will hinder utilities’ ability to raise capital and further exacerbate the cycle of price increases, making our climate goals that much harder to attain.
Fortunately, there is a possible solution. In the coming era, the commodity utility business might be replaced by an Energy Services Model, where utilities sell specific end uses, such as heat, light, screen hours, and so on, to customers. This change in the business model, enabled by the so-called “Smart Grid,” will disrupt decades of old thinking and regulatory practices, as well as some current dividing lines between industries. It will make utilities a unique hybrid between wireless network providers and regulated public works.
Curtain Call for the Old Ways
The Energy Information Administration (EIA) now predicts that electricity sales will grow by only 0.7 percent per year—and that is before factoring in scaled-up efficiency efforts that will likely accompany U.S. climate policies.6 One reason why sales are rising very slowly is that power and gas prices have already increased substantially, prompting consumer cutbacks. In addition, a variety of EE policies—building and appliance standards, utility-run EE programs, state and local programs, and others—are also reducing usage greatly. As a result of these trends, many planners are forecasting or advocating for negative-growth utility scenarios.
The “old” financial architecture and regulation of utilities has succeeded, in part, because sales of electricity and gas have climbed steadily as unit costs have declined. Continually higher sales meant that revenues increased even if rates were stable or declining. Higher revenues allowed the industry to service the capital required to supply higher sales. With scale and scope economies, rates might even decline, as they did from the 1950s to the 1970s.4 Even with roughly constant marginal costs, higher sales implied higher absolute earnings and stable rates—still a highly attractive proposition to investors and consumers. But what of an era in which marginal costs are rising rapidly and sales are falling, yet utilities still must spend billions in new capital additions to decarbonize and modernize power generation and implement the Smart Grid?
Why Save Utilities?
If electric and gas services have become zero-growth industries, why should we care? Generally speaking, it is a good thing that industries come and go in gales of creative destruction. Moreover, although they don’t arouse much excitement in the pages of The Wall Street Journal, some industries go through long periods of zero or gradually declining growth and still deliver good products.
In this case, however, there are at least two reasons why the financial health of the utility industry matters. First, there is a worldwide imperative to change our energy system away from high-carbon fuels and a similar need for greater energy security. Both factors will require the investment of trillions of dollars in U.S. power systems in the coming decades (as well as in the power systems in other countries). While part of this will come from public entities (including publicly owned utilities), a creditworthy private industry will be an irreplaceable investment vehicle for this transformation.
Paradoxically, the second reason has to do with the very energy efficiency investments that will cause sales to decline. These efficiency investments are extremely capital-intensive—they require energy consumers to spend a lot of money up front to get a future stream of cheaper energy services. Real-world experience with getting consumers to make these investments, thereby achieving our ultimate climate and savings goals, shows that utilities have some unique advantages to help finance and install energy efficiency measures. But to do this, a utility must be able to raise and deploy lots of capital—in effect financing the destruction of its own top line!
There are many policy levers that increase the overall energy efficiency of the American economy. Higher electricity prices play an essential role in stimulating conservation, including time-varying prices by day and season. The need for better time-varying price signals is a critical starting point—one that is likely to be met as overall electricity prices are inevitably driven higher in the next few decades and appliances and grids become controllable or “smart.”
Building codes, appliance and auto efficiency standards, and other, similar policies also play an enormous role. By some estimates, increased building and efficiency standards have contributed about 70 percent of efficiency gains in California during the last decade.7 Educational programs and other state and local government initiatives, including grant and loan programs, are all valuable. Research and development, sometimes assisted by state and federal agencies, is also essential.
But electric and gas utilities will probably play a pivotal role in the coming efficiency transformation. To understand why, start with the reasons why homes and businesses do not readily adopt more efficient technologies:
- Energy efficient devices initially cost more than inefficient ones and pay back the savings over time.
- Even when consumers invest to save energy, they limit their purchases to only those with the quickest return on investment and consequently under-invest in efficiency.
- It is time-consuming to search for efficient technologies that reliably save energy. Calculating the cost-effectiveness of these investments typically takes economic and technical skills well beyond the reach of typical consumers.
- It is time-consuming and potentially quite disruptive to retrofit a home or factory with new technologies or to alter initial construction plans.
To overcome these well-known efficiency barriers, utilities have advantages that are second to none. First, regulated or publicly owned utilities are able to effectively loan their customers money to make energy efficiency investments without requiring further collateral from them. More accurately, the utilities partially finance these investments on behalf of society at large.
A second set of advantages has to do with transaction costs and reputation. The decision to install unfamiliar energy-saving hardware is vastly simplified if someone you trust vouches for the fact that the technology works well, lasts a long time, and is worth its cost. But who to trust for this information? And in addition to finding the hardware, one needs to find a trusted installer or contractor. Anyone who has ever supervised a remodeling or new construction job knows that this is a daunting task, especially for consumers without a lot of spare time or construction expertise.
While it is common to demonize utilities for a variety of sins, experience shows that most consumers are far more likely to adopt an energy-saving measure if a utility is involved in the process. The comfort level in choosing to install efficiency measures, and thus the market acceptance rate, is increased by a utility’s involvement in the value chain—especially when the utility helps finance the measure.
These market barriers also help explain why private-sector (unregulated, profit-making) EE companies have not made large inroads thus far, other than in the government sector and where utilities facilitate their involvement. The new generation of private energy efficiency companies often bundles behind-the-meter Smart Grid services with distributed energy sources and storage. This model is an alternative to utility involvement, but it must raise capital and deliver profits at very high rates. By contrast, utilities have traditionally lower capital costs and less profit pressure and may therefore invest more deeply in the efficiency resource (i.e., to tolerate longer payback measures). Utility EE programs are best understood as vehicles for searching out good EE technologies and good private-sector vendor installers and creating low-cost financing for these measures with a minimum of paperwork, no collateral, and repayment built into utility rates.
The Energy Services Model
In the near term, implementing EE incentives inside the framework of traditional utility regulation is an essential start. The industry is at a point where aggressive EE is essential for meeting capacity shortages, moderating bill increases, and making rapid progress toward climate goals. For the next decade or so, the costs of adding supply-side capacity are so high, and the costs of reducing demand so low, that reducing the rate of capital additions through EE may well be accretive to utility shareholders. The same thing is true, in approximate terms, for the customer-owners of cooperatives and others in this segment of the industry, as well as for ratepayer-taxpayers of government-owned utilities. The underlying economic fact that new supplies are much more expensive than reductions in demand means that average rates will go up more rapidly with higher rates of supply growth and concurrent demand. In all segments of the industry, reductions in demand reduce bill increases as they help meet climate goals.
The long-term alternative is to change the industry to one that sells units of delivered energy services rather than energy commodities. Energy services such as light, heat, and computer hours are the real reasons we buy energy. Inside our homes and businesses, we combine energy commodities with energy-using hardware that we buy privately to produce the services we desire.
Ironically, the Energy Services Model was the industry’s original platform. Thomas Edison sold light by the light-hour, not the kilowatt-hour (kWh), to his first customers.8 As the number of electric appliances grew, J. P. Morgan decided that the company that sold juice and the company that sold end-user appliances should be separated. At this moment, Edison General Electric became a commodity energy marketer and the appliance division became General Electric (GE). Over time, GE was joined by thousands of firms that now make electric and gas “end-use” technologies.
From the consumer’s standpoint, how, exactly, would this work? The consumer’s bill would look nothing like today’s relatively simple power bill. Instead, the detail of charges on the bill would list services such as:
- Lumen-hours of interior light
- Lumen-hours of exterior light
- Heating-degree hours of heat supplied
- Cooling-degree hours of cooling supplied
- Cooking and other kitchen energy
- Water heat supplied
- Other miscellaneous commodity load
Each of these services would have its own price; only miscellaneous load would continue to be sold on a per-kWh basis. Pricing plans would undoubtedly treat public and safety services differently, just as every cell phone can make a 9-1-1 call even if it has no other service.
The Energy Services Model will necessitate great changes in the industry. Utilities will get back into the business of deeply influencing, and sometimes leasing or owning, the end-use hardware in homes and businesses. An industry that has been largely absent from the hardware business will have to coexist with thousands of unregulated hardware manufacturers.
While this may sound unacceptably intrusive, the product and technology mix is very similar to that of today’s wireless communications providers. These providers sell bundles of specially-developed hardware (locked cell phones that work only on their networks) and wireless network services. Although the underlying commodity on their network is really bits per second, they do not sell this commodity. Instead, they separately price and sell talk minutes, text messages, video downloads, internet minutes, and a plethora of other services. All these services use the same underlying commodity, but they convert the commodity into a useful (and priceable) service using an end-use appliance they select and market to the customer.
Déjà Vu and the Smart Grid
In 1980, a former Ford administration energy official named Roger Sant wrote an article for the Harvard Business Review called “The Coming Market for Energy Services,” in which he suggested that utilities start selling energy services in competition with “Honeywell, General Electric, IBM, Carrier, General Motors, and many others, large and small.” The Energy Services Model was also suggested by Amory Lovins and other leading energy policy thinkers of this era who were ahead of their time.9-12
The sale of energy services did not take root in the utility industry. A few utilities and non-utilities started energy services companies (ESCOs), but these have not yet flourished outside the military and government customer segment, where customers are able to meet the special business terms these companies require to remain viable. Meanwhile, federal and state policymakers reacted to the electric and gas price shocks of this era by adopting new planning processes that tried to mesh least-cost service calculations with new expansion plans and the first utility-administered EE programs. These changes marked an important transition, but every utility’s financial performance and rates remained denominated in commodity units—kilowatt hours or therms.
Today, changes in industry economics and technology make the Energy Services Model much more possible—and perhaps more compelling. One of the most sweeping changes involves a set of breakthrough technologies typically referred to as the “Smart Grid.” During the 1970s, it was flatly unworkable for utility providers to measure and keep track of the many types of energy services demanded by the nearly 140 million different customers across the nation. Sensors and energy measurement gear were primitive and expensive, and there were no wide-area communications or data management systems remotely capable of gathering and processing the data needed for monitoring, managing, or billing.
The Smart Grid will reduce or remove many of these barriers. There are now low-power wireless energy sensors, such as those developed by the Lawrence Berkeley National Laboratory, that continuously transmit energy-use data to building monitor systems. Many utilities are already installing electric meters with advanced two-way communications features and WANs capable of collecting boatloads of consumer data. Energy management software, which automatically manages the major energy hardware and collects all the data needed by utilities, is already standard in every new commercial and industrial building and will soon be standard in homes. And appliance manufacturers are starting to sell appliances pre-equipped to send precisely the information utilities need for services model billing. In a nutshell, the Smart Grid is the key enabling technology for the Energy Services Model. It didn’t exist in the 1980s, but utilities are steadily increasing their Smart Grid investments, and government policies are starting to accelerate the process.
For almost a century, utilities have supplied electricity to a power-hungry American economy. Most of this supply came from investor-owned companies whose prices were set to equal their costs plus a fair return on invested capital. The more they invested, the larger the supply and the greater their earnings.
This approach to regulation created an industry whose regulatory processes, financial well-being, and business culture were tied directly to continuing growth in both sales and invested capital. Long-lasting economies of scale ensured a virtuous circle in which utilities expanded their supplies, regulated prices diminished, and utility earnings on invested capital rose steadily. Households and businesses loved cheap and abundant supplies of energy, and Wall Street loved stocks whose dividends rose steadily year after year after year.
For a variety of truly historic reasons, this era is coming to an end. Climate policies and rising prices will end the era of commodity sales growth, while massive supply and grid investments are, nonetheless, necessary. The industry must fashion a new regulatory compact, and a new business model, if it is to survive.
This article introduces only one possible business model—the Energy Services Model—but there are many paths to be considered. The Energy Services Model is a thought experiment for how we might design a business model that promotes sustainability by turning a product into a life cycle service. In reality, there are an enormous number of practical issues and barriers that must be dealt with before we can begin to remold and regulate the utility industry as an energy services business. In my new book, Smart Power: Climate Change, the Smart Grid, and the Future of Electric Utilities, I examine how deregulation has impacted the regulatory environment for energy services and the Smart Grid. I also explore additional business models with alternatives to utility-based energy efficiency and expanded roles for distribution companies. As decarbonization advances and the Smart Grid matures, the utility industry will have to examine and experiment with the elements of these models to find the best way to provision itself for change and long-term growth.
We are in an era that demands new thinking and massive changes in our energy production, delivery, and use. We are in a race to rapidly reinvent a global energy system that is deeply dependent on high-carbon fuels. The solution will require new industries, business models, and government institutions everywhere in the world, starting with a trillion-dollar market for carbon emission permits that does not even exist yet. At the same time, disruptive technologies such as the Smart Grid will change the industry as well. New modes of working with our local utilities, new core competencies within these firms, and greater control over our end-use purchases may simply be some of the inevitable changes needed to manage the American portion of the world’s all-too-pressing carbon budget.
This article is based on the author’s book Smart Power: Climate Change, the Smart Grid, and the Future of Electric Utilities (www.smartpowerbook.com). He thanks Joe Wharton, Heidi Bishop, Matthew McCaffree, Steve Hauser, and all those acknowledged on the book’s website. The views in this article are those of the author and do not represent the views of any other individuals or organizations.