Creative Destruction in The Energy Sector: From Disruption To Transformation

CREATIVE DESTRUCTION IN THE ENERGY SECTOR PAPER SERIES 2014
CREATIVE DESTRUCTION IN THE ENERGY SECTOR

From Disruption to Transformation
GUILLAUME XAVIER-BENDER IAN MUIR ALBERT BRAVO BIOSCA JOHN W. JIMISON GERARD REID
2014 The German Marshall Fund of the United States. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means without permission in writing from the German Marshall Fund of the United States (GMF). Please direct inquiries to: The German Marshall Fund of the United States 1744 R Street, NW Washington, DC 20009 T 1 202 683 2650 F 1 202 265 1662 E info@gmfus.org This publication can be downloaded for free at http://www.gmfus.org/publications/index.cfm. Limited print copies are also available. To request a copy, send an e-mail to info@gmfus.org. About the Creative Destruction in the Energy Sector Paper Series The Creative Destruction in the Energy Sector paper series presents timely policy analysis on emerging trends reshaping traditional dynamics in the energy sector including how innovations outside the sector, such as telecommunications or information technology, could transform existing systems. The paper series is conducted in close collaboration with GMFs Energy Transition Forum (ETF), which was created in 2012 to provide a regular venue for open, structured, and fact-based dialogue among senior leaders from the private and public sectors in the United States and Europe about the market conditions and policy frameworks needed for a timely transition to a secure, affordable, and low-carbon energy future. ETFs intention is to bring together a coalition of leaders to produce new thinking on how to address the key challenges facing the global energy system. This paper series would not have been possible without support from the Enel Group. Enels mission is to create and distribute value in the international energy market, to the benefit of their customers needs, their shareholders investments, the competitiveness of the countries in which they operate and the expectations of all those who work with them. GMF Paper Series The GMF Paper Series presents research on a variety of transatlantic topics by staff, fellows, and partners of the German Marshall Fund of the United States. The views expressed here are those of the author and do not necessarily represent the views of GMF. Comments from readers are welcome; reply to the mailing address above or by e-mail to info@gmfus.org. About GMF The German Marshall Fund of the United States (GMF) strengthens transatlantic cooperation on regional, national, and global challenges and opportunities in the spirit of the Marshall Plan. GMF does this by supporting individuals and institutions working in the transatlantic sphere, by convening leaders and members of the policy and business communities, by contributing research and analysis on transatlantic topics, and by providing exchange opportunities to foster renewed commitment to the transatlantic relationship. In addition, GMF supports a number of initiatives to strengthen democracies. Founded in 1972 as a non-partisan, non-profit organization through a gift from Germany as a permanent memorial to Marshall Plan assistance, GMF maintains a strong presence on both sides of the Atlantic. In addition to its headquarters in Washington, DC, GMF has offices in Berlin, Paris, Brussels, Belgrade, Ankara, Bucharest, Warsaw, and Tunis. GMF also has smaller representations in Bratislava, Turin, and Stockholm. On the cover: Transmission lines and turbines. TBE/istockphoto
Creative Destruction in the Energy Sector

From Disruption to Transformation
Climate & Energy Policy Paper Series March 2014
Guillaume Xavier-Bender,1 Ian Muir,2 Albert Bravo Biosca,3 John W. Jimison,4 and Gerard Reid5
Preliminary Findings and Recommendations Guillaume Xavier-Bender. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Workshop on Creative Destruction in the Energy Sector: Summary Ian Muir. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Creative Destruction and Innovation: Views from Outside the Energy Sector Albert Bravo-Biosca. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 A Changing Future for U.S. Electric Utilities John Jimison. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Appendix: Financing the Energy Revolution Gerard Reid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Guillaume Xavier-Bender is a program officer in the Brussels Office of the German Marshall Fund of the United States.
2 Ian Muir is a fellow for GMFs Energy & Society Program. He holds a bachelors in chemistry from Trinity College, Dublin, and is currently pursuing a masters in international relations from the Johns Hopkins School of Advanced International Studies. 3 Albert Bravo Biosca is a senior economist at NESTA, which he joined in 2007. He holds a Ph.D. in economics at Harvard University, a masters in economics from the London School of Economics, and a bachelors in economics from Pompeu Fabra University in Barcelona, Spain. 4 John W. Jimison is the managing director of the Energy Future Coalition. Prior to joining the Energy Future Coalition in 2011, he served as senior counsel to the Energy and Commerce Committee of the U.S. House of Representatives. Jimison practiced energy and regulatory law from 1987 through 2006 in Federal and state forums. 5 Gerard Reid is the founder and managing director of Alexa Capital, a firm that provides advisory and financial solutions in energy, energy infrastructure, and technology sectors. He holds a higher diploma in education and a masters in business & economics from Trinity College, Dublin.
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Preliminary Findings and Recommendations

Guillaume Xavier-Bender
Complimentary discussions took place in Warsaw in November 2013, on the official sidelines of the United Nations Framework Convention on Climate Changes (UNFCCC) 19th session of the Conference of the Parties (COP19). At this occasion, GMF and Duke Universitys Nicholas Institute for Environmental Policy Solutions organized a panel discussion on innovation regarding decarbonization. It shed light on transatlantic policies and technological advancements changing the way we produce, sell, and consume energy. Paul Bledsoe, senior fellow at GMF; David King, special representative for climate change for the British foreign secretary; Jonas Monast, climate and energy program director at the Nicholas Institute; Simone Mori, executive vice president for regulation, environment, and innovation at Enel; and Jonathan Pershing, deputy assistant secretary for climate policy at the U.S. Department of Energy took part in the discussion. Implications These activities and reports are part of GMFs broader work on Energy & Society. As such, they complement existing initiatives conducted on energy, economic, technological, and social transitions. Disruptive technologies can have a determining impact on the future of utilities in Europe and the United States. In turn, they also have the potential of radically changing the way the power sector is financed and organized. Much depends as well on existing and future symbioses with other economic sectors. When it comes to the implications of creative destruction in the power sector, they often depend on challenges and opportunities for the system as a whole. As such, they can include: for utilities and investors: the transformative role of innovation in the power sector; lessons learned from other network sectors such as the
he German Marshall Fund of the United States is publishing the preliminary findings of its project on Creative Destruction in the Energy Sector. The project examines, through convening and analysis, the disruptive effect of innovation on the energy sector, particularly focusing on the electricity sector. In the fall of 2013, GMFs Brussels office hosted a half-day workshop bringing together a group of experts from the private sector, EU institutions, member states, and non-governmental organizations from the United States and Europe. To inform the discussion, input papers were commissioned by Albert Bravo-Biosca, senior economist at NESTA; John W. Jimison, managing director of the Energy Future Coalition; and Gerard Reid, head of European operations at Alexa Capital. Miriam Maes, non-resident senior fellow at GMF, chaired the meeting, which focused on the growing pressures facing utilities as innovation disrupts their traditional business models, and the new opportunities that could potentially emerge. In his summary of the workshop, Ian Muir, nonresident fellow at GMF, highlights the disruptions of traditional utility business models by non-energy players. Additional dialogue between all key actors is required to ensure smooth transformation of the power sector. John Jimison examines market trends and technical innovations that are destined to reshape the operations of the U.S. electric utility sector and its institutions, anticipating major change in a service integrated into every element of modern life. In his paper, Albert Bravo-Biosca explains why the process of creative destruction is so important; particularities to the electric power sector and externalities such as technological advances suggest it may be at the early stages of transformation. Gerard Reid looks at the technology-driven ongoing energy revolution with a particular emphasis on the impact of that revolution on investors and the power markets.
Internet industry; adapting business models to evolving technologies; and unlocking the potential of energy storage for policymakers: the governmental support of technology champions; helping bridge the Valley of Death (the financial gap between the development of a technology and its commercialization); promoting private-public partnerships for technology; and the role of renewables in energy efficiency for consumers: understanding the power of demand side management; enjoying affordable clean electricity; and better living with smart appliances for non-traditional energy industries: the impact of cross-sectoral innovation on the power sector; taking stock of the implication of ICTs in the grid; and not perceiving incumbents as the blockers of change Findings & Recommendations From the discussions and analysis conducted throughout the project, a number of preliminary findings and recommendations can be drawn: Change in the electric power sector is happening, and it is happening much faster than expected by many. The process of creative destruction in the power sector is transformative, and one that affects all levels of the energy system. For major transformations to take place in the electric power sector, mindsets need to change as well. Common insights and understanding are necessary in order to move toward an affordable, low-carbon, and secure energy economy.
Technology trends are driving the energy revolution, and the intersection between these technologies, policies, and consumers is a game changer for the power sector. New business models need to be determined in order to create a sustainable utility of the future built on smart investments. Creating the utility of the future involves having figured out where the value is created in the power sector, where the benefits go, and what power consumers have in the process. Cross-sectoral innovation will be instrumental in driving the transformation of the power sector, as external technologies will increasingly rely on a smarter network. The way the Internet sector developed can provide an insightful model for the grid of the future both in terms of business development and regulation. The role of non-traditional actors in the power sector, such as ICTs, will be instrumental in bringing utilities closer to the consumer with the possibility of ICTs becoming larger energy service providers themselves. Incumbents are not blocking transformation, and transition toward a more efficient electric power system involves greater cooperation and coordination among all stakeholders.
The German Marshall Fund of the United States
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Background
Workshop on Creative Destruction in the Energy Sector: Summary

Ian Muir
of lower-carbon energy sources. The stability of the planets climate hinges on both more rapid decarbonization and the more efficient use of energy. A major transformation in the electricity sector is inevitable, but outcomes that ensure energy affordability, security, and minimize climate impacts are not. Holistic discussions are required to complement specific innovations and to ensure the occurrence of the necessary knowledge transfer that will benefit society as a whole. Selected interrogations: We see balance sheets going down and utility business models under stress. How can we help utilities given that we dont want them to disappear? Wouldnt new market-based mechanisms such as a real-time consumer electricity price drive energy efficiency at all levels? How can we further encourage demand response? How do we Finance the Energy Revolution? The financial markets look at utilities in their own way. Notably, they have identified the existing wave of industry developments as an energy revolution driven by shale gas, increasingly cheap renewables, and information technology. Smart utilities have reacted to this and gotten involved in these burgeoning arenas; the rest have faltered. And traditional investments have become riskier given that renewables production earns priority dispatch. EU power prices have fallen from 70 per megawatt-hour in 2008 to just 35 per megawatt-hour, putting considerable pressure on generators that have not hedged prices at higher levels. Moreover, prices are now often defined by the weather, namely if the wind is blowing or the sun is shining. These uncertainties have stressed utilities to the point that they are no longer considered safe financial
n September 19, 2013, GMFs Brussels Office hosted a half-day workshop on Creative Destruction in the Energy Sector. The workshop brought together two dozen participants with diverse backgrounds, representing a range of private-sector, public-sector, and nongovernmental organizations from both the United States and Europe. GMF Senior Fellow Miriam Maes chaired the meeting and guided the ensuing discussion, which centered on the growing pressures facing utilities as innovation disrupts their traditional business models, and the new opportunities that could potentially emerge. The discussion was informed by input papers commissioned by Gerard Reid, head of European operations at Alexa Capital; Albert Bravo-Biosca, senior economist at NESTA; and John W. Jimison, managing director of the Energy Future Coalition. Their insights fueled the discussion on the potential for innovation in the electricity sector as well as the challenges that are likely to accompany such innovation. Seeding the Discussion: The Major Transformation in the Power Sector The worlds energy systems are undergoing a period of rapid evolution. Many developed markets are seeing demand stagnate just as alternative, distributed power supplies are becoming increasingly cost-competitive. In the electricity sector, these trends are putting remarkable pressure on utilities, calling into question the staying power of traditional business models. At a minimum, these models are expected to evolve considerably to accommodate new realities. However, a lack of innovation through coordination risks hampering the rollout of a smarter system that both reduces uncertainty for utilities, encourages good behavior, and fosters integration
A major transformation in the electricity sector is inevitable, but outcomes that ensure energy affordability, security, and minimize climate impacts are not.
bets, thus requiring higher dividend payments, and effectively driving up their cost of capital. Fortunately, there are opportunities for Europe to emerge from this so-called trough of disillusionment. Utilities need to get into the renewable energy game and to take advantage of the price certainty offered by feed-in-tariffs (FITs). Such investments have proven successful even at returns under 5 percent. The integration of the European electricity markets will pose additional challenges but at the same time promises considerable benefits in terms of cost-efficiency and greenhouse gas emission reductions. And the faster that industry leaders act and innovate, the greater the benefits to utilities and consumers alike. Selected commentary: The utilities have already failed. Some are on the verge of bankruptcy. But dont worry; I think its a good thing if they go bankrupt. It helps bring creative destruction into the world. This is the issue that we [the utilities] need to find business models and landscapes for, otherwise were going to be dead We need [to become involved in] the biggest game-changers, namely small-scale renewables, which are changing the game and making customers far more involved. The EU really needs to push for one market. Its not that the grid needs to become bigger but that it needs to become smarter. We need to change the whole incentive structure so were pushing more technology and not just more cables. Europe is in the trough of disillusionment. In the United States, its very different because there is a focus on costs. The United States invested more in wind last year than all other areas put
together. And there a lots of exciting new businesses and business models emerging. Storage needs to come at the local level. For PV [photvoltaics], thats definitely going to happen. If as a consumer, I can take electricity at a negative price, save it, and feed it back in or create gas from it. An engineer will tell you its inefficient, but its not about efficiency, its about cost. Utilities are not going to build nuclear, coal, etc., if their returns cant be guaranteed. So theyre looking to new markets because the cost of capital is too high. The renewable movement has been all about capacity and not enough about intelligence. No one in Germany talks about demand management, and I think thats a big mistake. Its a significant contrast with the United States. What are the Lessons on Creative Destruction from Outside the Energy Sector? Innovation is a product of both coordination and competition. An electric car, for example, has little value if there is no way to charge its batteries. And innovation is a continuous process, often initially involving many players competing vigorously, followed by consolidation and a handful of remaining winners. With respect to creative destruction, there are significant differences between the United States and Europe. Companies in Europe tend to be older and more static whereas in the United States, they are younger and there is a greater distribution of high- and low-growth firms. It should be little surprise that static firms do not have a tendency to drive innovation. Comparing the internet and the electricity grid is a useful exercise in that it can highlight key similarities and differences. Moreover, could smart grid
Innovation is a product of both coordination and competition. An electric car, for example, has little value if there is no way to charge its batteries.
The Internet
Decentralized Low capital intensity Low cost of experimentation Low cost of deployment Easy market access Difficult to block new entrants Limited policy uncertainty High creative destruction
The Electricity Grid

Centralized High capital intensity High cost of experimentation High cost of deployment Difficult market access Easy to block new entrants Considerable policy uncertainty Low creative destruction
an element of the political power. And that preserves [utilities]. Were bringing this fastgrowing, fast-shrinking ethos into the industry and the incumbents dont know how to deal with it. There are no policymakers against company growth, but there are many against companies failing. But you cant have one without the other. You cant protect incumbents and expect to have high growth companies. The [electric] industry is decentralizing. With solar, you can have an 8 kW system that is almost the same cost as doing 5 MW. Thats the game changer as size no longer seems to matter so much. I look at Africa and India and see that theyre going to decentralize. Think about telephony in these parts of the world where they skipped landlines completely. I think we also need to acknowledge the limits of decentralization. Take the U.K., which is really trying to meet its decarbonization targets. It needs to balance the intermittencies, which is more difficult in an island system. You need someone to take that role. I think its important to reflect that role. I still agree that it will be a hybrid system. What is the Future for Electric Utilities in the United States? Technology is driving this energy revolution, and there are a number of market trends that are affecting the way we think about the future of the power system. The continued electrification of energy services illustrates the value of electricity as a means of providing energy to consumers. And this value is further evidenced by the increasing cost of electrical downtime, which can now reach millions of dollars per hour for single firms.
Outstanding questions remain in terms of adapting business models that reflect the impact of new technologies and of the creative destruction process.
technology bring the electricity system closer to the internet model? When it comes to the electricity sector, outstanding questions remain in terms of adapting business models that reflect the impact of new technologies and of the creative destruction process: where will value be created? Which bits of the value chain will be completely commoditized and who will capture the profits? What are the platforms and systems that will emerge? Selected commentary: Who is likely to dominate the industry? Startups or incumbents? I cant think of any utilities that sell solar panels to their customers. [Incumbents do not] have a monopoly of ideas, and companies are often not as good as they should be about creating and adopting ideas. They also have a fear of cannibalizing their own products and assets. In the end, entrepreneurs support radical innovation whereas incumbents look to incremental innovation. Were institutionally very rigid. And regulatory rigidity is not likely to change since thats
IT and service companies see considerable opportunities to profit through the disruption of traditional utility business models, while utilities themselves often get caught playing catch-up.
To meet future demand and reliability expectations, the consensus is that massive capital investments are required. The increasing competition in the utility business ought to increase the efficiency of these capital allocations, but uncertainties regarding payback times are stifling investment. And while clean energy has grown popular, existing policies will likely need to be strengthened if the United States is to play a proactive role in climate change mitigation. The emergence of the smart grid is expected to revolutionize the operational system, allowing players to be able to react more efficiently as demand comes and goes. Furthermore, a breakthrough in low-cost electricity storage would be a game changer, radically reducing the need for backup and peaking generation. And lower-cost renewables will only spur additional decentralization of generating assets. There are significant implications for U.S. utilities going forward. By 2030, there will be a different customer relationship whereby utilities are rewarded for performance rather than kilowatthours sold. The high-risk aspects of the business will likely be spun off, competing with third-party entrants, while a healthy balance of distributed and centralized generation resources will emerge. Selected commentary: The hourly costs of outages are phenomenal. For a brokerage, it averages $7 million per hour! There is a tremendous reliability premium on the market now. I see financial markets forcing these changes by 2020. The financial markets are what are really driving changes. Despite being the only country still having a debate on climate change, the United States still wants clean energy no matter what.
One point to pick on is what the investment market would look like, namely the monopoly nature of the sunk parts of the value chain. Theres critical national infrastructure where the government deems that its vital to go ahead you might find if the market didnt do that, then other players would need to step in. Utilities fear this vicious cycle where lost revenues require rate increases that further incentivize distributed generation. There is not going to be a guarantee of a return like before, but there will be opportunities for large returns. It will be a significant, difficult migration. Disruptive Innovation in Practice: Private-Sector Experience Private-sector players have been reporting a wide range of experiences as the electricity sector undergoes its transformation. IT and service companies see considerable opportunities to profit through the disruption of traditional utility business models, while utilities themselves often get caught playing catch-up. Greater proactivity on behalf of the incumbents will be required if they are to achieve new profit streams that can offset dwindling revenues upstream. While we are still only in the early days of the electricity sector transformation, fast movers will have the opportunity to capture a greater share of new revenue streams. Moreover, innovative use of IT can help ease supply and demand imbalances, limiting further incidence of stranded generation assets and reducing the need for costly new infrastructure. Selected commentary: The utility industry itself is going to have to become the biggest consumer of telecommuni-
cation services. To take all of the [data] from these smart meters, process them, and learn from them. I see potential for major convergence between the electricity and telecommunications sectors. Regarding telecoms, its true that utilities are going to become big consumers of telecommunications services. Perhaps [their] past error was trying to compete with the incumbents in this area... We will probably see very interesting business models in the near future. The Market and Regulatory Framework As traditional power sector business models undergo a range of challenges, many are questioning how governments and regulatory agencies might react to potential change. In certain countries, there is a risk that governments will move to protect state-owned utilities, thereby stifling innovation. However, in others, there is evidence of considerable public-sector willingness to support greater leverage of technology, increased competition, and innovative business models. But positive impacts will be limited without further coordination. The uncertainty regarding future regulatory trajectories remains palpable and is surely a significant impediment to more rapid, widespread innovation in the power sector. Governments and regulators will need to do more and coordinate more carefully if they are to drive positive change while mini-
mizing negative impacts on ratepayers and those investing in progress. It is clear that, going forward, additional dialogue will be required between all the key actors in this increasingly vital sector. Selected commentary: The European Parliament [is] unable to say unequivocally that something needs to be done. All of the companies here are active in umbrella organizations that have a tendency to act to protect their slowest movers. If there is a way to bring together the companies not so interested in slowing things down, it could go a long way. How do you build coalitions for change? The question is whether there are some blocking elements in the way. Surely the large consumers of electricity have an interest in seeing progress on this front, and thus cheaper electricity. I think a dynamic market needs technologyneutral regulations that take care of externalities But theres also the question of investment certainty. We dont know how targets and regulations will change. We need to be careful not to overregulate and create lock-ins. The less information we have, the more careful we need to be about regulation Given the 28 members states in Europe, we need a more harmonized market. For investors, its very difficult to judge the average direction when countries move in different directions.
The uncertainty regarding future regulatory trajectories remains palpable and is surely a significant impediment to more rapid, widespread innovation in the power sector.
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Incumbents tend to have an advantage at undertaking more incremental innovation, continuously improving their products and processes, since it builds on their accumulated strengths and capabilities.
Creative Destruction and Innovation: Views from Outside the Energy Sector
Albert Bravo-Biosca
Entrepreneurs and firms experiment with different approaches to take advantage of this opportunity, and eventually the industry consolidates around a few successful dominant players. Creative destruction is also more important as industries converge on the global technology frontier. Far from the frontier, firms can improve their productivity by imitating what others have already invented, but at the frontier they need to innovate. However, innovation is risky and the outcome uncertain, so only the successful few expand while the unsuccessful ones shrink. A puzzling question is how entrepreneurs can ever be successful when challenging incumbents? Incumbents have access to finance, a good customer base, strong networks, and an up-andrunning organization, while entrepreneurs have none or very little of these. But incumbents do not have a monopoly on ideas, sometimes listen too closely to their existing customers (ignoring the needs of other potential customers) and can also be too afraid of cannibalizing their own products by launching new ones. In addition, they also have inflexible bureaucracies optimized to deliver existing processes rather than to adapt to change, sunk investments that depreciate very quickly if new technologies make them obsolete, and have a series of legacy costs that make it difficult for them to re-invent themselves. As a result, incumbents tend to have an advantage at undertaking more incremental innovation, continuously improving their products and processes, since it builds on their accumulated strengths and capabilities. Instead, when it comes to radical innovation that is, imagining totally new ways of tackling new or old problems some of the incumbents strengths can quickly become weaknesses, providing opportunities for entrepreneurs wiling to exploit them.
nnovation activity happens in a system, and it is the result of two opposing dynamics that complement each other: one of competition and another one of coordination. Our understanding of the process of innovation would be incomplete if we didnt consider both of them, and so would be our analysis of the policy levers to support this process. In this chapter, I consider both of these dynamics, and draw some tentative implications of what they may mean for the energy sector. Why Creative Destruction Matters Innovation activity is an uneven process. Many try to innovate but only a few succeed. As a result, only a minority of businesses and entrepreneurs introduce really novel products, services, processes, or business models. Even among large U.K. businesses (250+ employees), only one in five says that they have introduced a new-to-market product innovation. This is what makes the process of creative destruction so important. Entrepreneurs, but also existing firms, experiment with new ideas. Some work, most do not. Successful ones scale up and grow to challenge incumbents. Some incumbents are able to react in time, while others fail to do so and are replaced, shrinking and exiting the market. But a new generation of innovators emerges and the cycle starts again. It is this creative destruction the combination of experimentation, selection, and adoption that ultimately drives productivity growth. Experimentation is even more important when new opportunities or challenges emerge. Innovation, after all, is a discontinuous process. It is better characterized as a series of waves rather than as a continuous flow. When a new radical technology is discovered, be it the internet or the combustion engine, a flurry of experimentation follows, sometimes accompanied by a speculative bubble.
Figure 1: Average firm size relative to entry by age There are, however, large differences between Europe and the United States in the business growth dynamics that underlie creative destruction and productivity growth. Both Europe and the United States Source: Bartelsman, Scarpetta, and Haltiwanger (2004) have highly successful Entrepreneurship, collaborated with researchers companies, but the European ones are generally and statistical agencies in eleven countries across much older. A study by Bruegel shows that only 2 three continents to collect new and comparable percent of the European companies in the worlds data on business growth. The resulting database largest 500 firms by market capitalization were measures how quickly businesses grow or shrink in founded after 1975, compared to 14 percent in the each country, drawing on individual records for 6 United States (Vron, 2008). million businesses.
European policymakers have long worried about Europes inability to generate an equivalent to Google or Microsoft.
This is not just about differences in rates of entrepreneurship. Researchers at the Organisation for Economic Co-operation and Development (OECD) and the World Bank have shown that the main differences between the United States and Europe lie in the rate at which new firms grow rather than the number of new firms. U.S. start-ups grow several times faster in their early years than their European counterparts (Figure 1).1 European countries also have fewer high-growth firms than the United States (OECD, 2008). To shed further light on the dynamism of Europes business landscape, FORA and Nesta, with support from the International Consortium for
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European policymakers have long worried about Europes inability to generate an equivalent to Google or Microsoft, innovative start-ups that grow quickly to dominate their markets. But this database shows that this is only part of a wider picture. Figure 2 summarizes distribution of business growth for private sector firms in Europe and the United States Each column indicates the share of firms with ten or more employees with average annual employment growth rates over a three-year period falling within that growth interval.2 Four key findings emerge from this analysis (BravoBiosca, 2010): 1. Europe has a much larger share of static firms, while the United States has more
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Bartelsman, Scarpetta, and Schivardi (2003) assemble a new dataset for the 1980s and mid-1990s based on harmonized national microdata sources and provide measures of survival and growth of new entrants for up to seven years for 10 OECD countries, later expanded to 17 with the inclusion of some developing countries (Bartelsman, Haltiwanger, & Scarpetta, 2004).
With the range covering 11 intervals from less than -20 percent to more than +20 percent employment growth per annum.
Figure 2: Business growth and contraction in Europe and the United States
European countries have a lower share of high-growth firms than the United States But they also have fewer medium-growth firms and fewer shrinking firms.
and fewer shrinking firms. At the same time, Europe has a much larger share of firms that remain static, that is, firms that neither expand nor contract over time. This gap is common across different size classes (although there is some evidence suggesting that it is particularly difficult for medium-sized firms to challenge large firms in Europe). Similarly, it is not explained by differences in industry composition, and it arises across all major sectors (even if it is much lower when looking specifically at utilities).
Source: Bravo-Biosca (2011)
fast-growing and fast-shrinking firms. Differences in growth dynamics go beyond the much documented gap in high-growth firms. European countries have a lower share of high-growth firms than the United States But they also have fewer medium-growth firms
2. Creative destruction is at work. The faster successful companies grow, the faster unsuccessful companies shrink. In other words, there is a strong negative correlation between the growth rate of firms at the top and the bottom of the growth distribution across industries and countries. So if the aim is to have more
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high-growth firms, this may require letting other firms shrink as well. 3. High-growth firms account for a disproportionate share of new jobs, but the full growth distribution should be considered. The debate on high-growth firms often considers them in isolation. But policies targeted solely at high-growth businesses, such as improving the climate for venture capital, are not enough to address the lack of dynamism that hampers Europes productivity. They need to be combined with deeper structural reforms that remove not just barriers to entry, but also barriers to growth and contraction, such as improving product and labor market regulation and tackling access to finance. 4. A less dynamic business growth distribution, with more static firms as in Europe, is associated with lower productivity growth. Importantly, both a higher share of growing and shrinking firms are correlated with higher productivity growth, which is consistent with a faster reallocation of resources (both labor and capital) toward successful innovators. Specifically, we find that a five percentage point (pp) increase in the share of static firms is associated with 1pp lower annual productivity growth. Consequently, the lack of dynamism observed across European business may help to explain why they are less productive than those in the United States, a gap that had been widening for over a decade before the recession took hold. Why Systems Matter The competitive pressures that sustain creative destruction are a key driver of innovation, but not the only one. Coordination is as well. No one would buy a DVD if DVD players were not available in the market. Yet no one would buy a DVD player
without DVDs in the market. This is why the introduction of DVDs into the market required coordination between content producers and electronics manufacturers. Moreover, how well coordination works can determine which innovation succeeds at dominating the market, as the past success of VHS over Beta shows (despite being an inferior standard, VHS triumphed thanks to having more content available). While this is not a new idea, some argue that it is becoming more important as innovation activities shift from creating new products toward creating new systems. Geoff Mulgan and Charlie Leadbeaters recent discussion paper on systemic innovation sum up why it matters, what new challenges it involves, and how to address them to make it happen (Mulgan & Leadbeater, 2013). The starting point in their argument is that systems matter more than products. Innovative products, such as electrical cars, cannot function without the systems that would support them, such as charging stations for their batteries. More generally, the success of an innovative product relies on innovation in other parts of the system, given the strong complementarities that exist. This makes coordination much more important, and may suggest that policy has a more important role to play, whether helping to set up a common vision or supporting its development. Systemic innovation also has implications about where value is created and who captures it. As the example of Apple shows, most value is likely to be captured by system innovators that create new platforms rather than by the product innovators that just launch a new product as part of it (even if they will still get a share of the benefits, as app developers do). Systems can take many different shapes and forms, so how systemic innovation happens (including
The success of an innovative product relies on innovation in other parts of the system.
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These are the times for disruptive innovation, when after much experimentation new dominant players can emerge and replace existing incumbents.
who, if anyone, is in the driving seat) depends on several of their characteristics. If it requires large capital investment, those that have access to finance will have more influence. If there is already a system in place, adapting it or creating a new one that competes with it will typically involve conflict. System dynamics will also be very different if it is dominated by someone (e.g., Apple) or if power is distributed across different players. What About the Energy Sector? Defining the boundaries of what we mean by the energy sector is not trivial. Are we talking only about those firms that sell energy? Or also those that sell the key inputs used in the production of energy, such as wind turbines or nuclear reactors? Or those that help us to avoid consuming energy, whether they are creating new insulation materials or digital tools? Or also those that intensively use energy, and can dramatically shift consumption patterns, such as automotive manufacturers developing electrical cars? If one lesson emerges from other sectors, it is that it is difficult to understand innovation in one part of the system without considering others, given how interlinked they are. For instance, developments in energy storage solutions can radically change not only transport systems but the whole make up of energy production. Despite this, the discussion that follows focuses on the utilities that produce and distribute energy. The changing landscape in the energy sector, driven by technological advances, the climate change challenge, and geopolitical shifts, suggests that it may be entering a major phase of transformation, even if the destination is still unclear. These are the times for disruptive innovation, when after much experimentation new dominant players can emerge and replace existing incumbents. Whether this is likely to happen in the energy
sector is yet to be seen, given the unique characteristics of the sector, which have traditionally limited creative destruction. After all, most major players in Europe are the successors of state monopolies, and until very recently vertical integration made it very difficult to enter the market. Even with the more level playing field being currently developed, it is still difficult for start-ups to enter and challenge incumbents. Silicon Valley provides an interesting contrast. The cost of experimentation for web entrepreneurs is very low. They do not even need to a buy a server anymore. They also can get almost immediate feedback from customers, learning very quickly whether their innovation is worth something, or whether they should give up on that one and move onto other things. In other words, it is very cheap and quick to resolve the uncertainty, whether it ends in success or failure. (The advantages of being able to fail cheaply and quickly are too often underestimated!) Not only is the cost of experimentation low, but so is the cost of deployment. Energy entrepreneurs on the other hand not only need significant investments to test new technologies, but also to roll them out, given their capital intensity. Moreover, these may be difficult to finance, since tangible assets are not such a good collateral when they can become obsolete very fast, which is definitely a possibility in these uncertain times. Successful digital start-ups can quickly get millions of customers around the world by exploiting the web; in contrast energy entrepreneurs need to deal with national regulators (and incumbent competitors) to access markets. Operating in a regulated market also makes energy entrepreneurs subject to policy uncertainty. And the long life length of investments in the energy sector decades rather than years makes incumbents extremely resistant to change. In the digital world, incumbents quickly adapt (even if sometimes not fast enough). In the energy sector, given their sunk investments, their
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incentives are not to adapt but to resist, and, if possible, block any change that can make their investments obsolete. Ultimately, the internet and the grid are both networks, but of very different nature. The former was set up to be decentralized, without a central command-and-control center, unregulated and open to all, making it easy to experiment and difficult to block competitors. The latter is tightly regulated, controlled from the center, and limits access. Even if there are good reasons for this, it also makes it much easier for well-connected incumbents to influence regulators and limit competition. The question is whether the grid will become more like the internet in the near future. Smart grids have the potential to seed such a transformation, but what happens will ultimately depend on how the overall system evolves, and who pilots this transition. In a nutshell, electricity markets need systemic innovation, and the opportunity is there. But as with other systems, its future will depend on a combination of factors, including what technologies become available, what alliances are formed, how infrastructures evolve, and how consumer behavior changes. A Few Questions Worth Considering What the future of the energy sector will be is still an open question, and so is the role that policymakers will play in this transition. So rather than providing answers, this chapter ends with a set of three questions that can help to inform the debate.
Where will value-added be created?
will emerge? For instance, will most profits in the industry be captured by energy producers, by the networks that distribute it, or by those that sell services that allow reducing energy consumption (or shifting peak demand)? In other words, what will be the distinctive features on which competition in the energy sector will be based? And, closely related to this, where will most of the innovation happen (upstream, production, distribution, or demand-side)? Taking the internet analogy somewhat further, it has been the companies that have created new platforms that have profited the most from the internet revolution, not the telecom companies that sustain it with their fiber optic networks. The internet contains a series of systems within a large system, as the examples of Google or Apple show, and so can the smart grid. The challenge is to identify where the systems (or platforms) will emerge and what business models will sustain them.
Who is likely to dominate the industry?
The question is whether the grid will become more like the internet in the near future.
The value chain in the energy sector is being broken into smaller pieces, unbundling a previously vertically integrated process. The question that follows is which bits of the process will be totally commoditized, only being able to compete based on low prices, and what new sources of value
Will creative destruction reach the electricity sector? It depends is the typical answer from an economist. Ultimately, where value is being created will determine how difficult it is for incumbents to maintain their leading positions, and this depends in part on the direction of technological change. The potential for disruption is higher if start-ups can innovate at the margins, tackling new markets that did not exist or developing new technologies that make existing investments obsolete (assuming incumbents lobbying does not block them). If innovation at the core dominates, is complementary with existing capabilities, and is capital intensive, dominant firms have a better chance to continue to dominate the market. There is, however, another source of creative destruction: large business in other sectors (such as some of the internet giants) challenging energy incumbents with their deep pockets and their digital capabilities.
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Energy policies will have to encourage both better technologies as well as their adoption.
But many other factors can have an impact on the sectors landscape. Energy firms may develop a similar symbiotic relationship with start-ups as pharmaceutical companies have been doing for a while in their own sector: letting start-ups do much of the radical innovation as well as take on the risk, in order to buy the successful ones later on to scale them up, taking advantage of their size, expertise, and comparative advantage in deployment. (This is not necessarily bad if it is not used to prevent the development of the technology.) How competitive the market becomes is also a factor to consider. The smart grid allows for a much more distributed model of energy generation, which means that a larger number of energy producers is sustainable. Moreover, energy producers may also have to compete against their own customers, as the option of self-generation becomes more feasible, which is already starting to happen. Much value will therefore be captured by consumers rather than by producers. However, profitable opportunities will continue to exist in those segments of the market where competitive pressures are counterbalanced by some other sources of scale economies such as network externalities, even if those are not linked to the grid per se but to the platforms that are built on top of it.
What is the role for policymakers?
maximize innovation and adoption, in other words, to create a system that makes experimentation cheaper, facilitates wide learning, and where best solutions are selected and widely adopted. Several choices and tradeoffs are likely to emerge: Markets vs. governments: Is governments role to take the back seat and let the private sector take the initiative, or should it be actively setting direction and providing the funding to make it happen? Incumbents vs. start-ups: Should the focus be on incentivizing incumbents to make the most of new technologies, or on supporting start-ups to challenge incumbents, or both? (Or none?) Picking winners vs. diversified portfolio: How diversified should the portfolio be when backing new technologies, since they are expensive and many benefit from externalities? Is picking winners a good strategy, and if so, should the focus be on sources of energy, specific technologies, or particular companies? Early vs. late adoption: What is the right time to adopt a new technology? Given the risks of lock-in into inferior and more expensive technologies, a wait and see approach can be a temptation, both for governments as well as for industry. But by acting too late, they will miss the opportunity to lead an industry. They may have been investing into much older technologies that become obsolete very quickly. (Alternatively, technology and policy uncertainty may generate a risk of paralysis with investments stopping given their long life length, constraining future energy supply.) Energy policies will have to encourage both better technologies as well as their adoption. New solutions are more likely to emerge if policymakers combine classical instruments, whether SBIR-
Given the energy sectors important role throughout the economy, being an input to all production sectors and a significant item in households expenditures, lower innovation and creative destruction in the energy sector can have a significant negative impact on downstream sectors, households budgets, and, ultimately, on economic growth. In addition, the climate change challenge makes achieving innovation in the energy sector a societal priority. The challenge for policymakers is how to encourage both creative destruction and coordination to
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type schemes3 or technology grants, with other approaches to encourage new radical ideas, such as challenge prizes. For instance, Nesta is currently running a new Dynamic Demand Challenge Prize to encourage thinking out of the box on how to shift peak demand. Re-thinking how the role of regulation changes in this new environment may also encourage innovation and adoption, for instance by learning from other network-based regulated sectors such as telecoms (including some attempts to facilitate disruptive business models). Adoption is likely to be faster if governments tackle coordination failures, going beyond standardsetting (which also plays an important role); if they align incentives, being extremely careful when designing schemes in order to avoid unintended consequences (e.g., Spanish solar premiums); and if they take advantage of nudging and transparency to induce behavioral change.
References Bartelsman, E. J., Haltiwanger, J., & Scarpetta, S. (2004). Microeconomic Evidence on Creative Destruction in Industrial and Developing Countries. World Bank Policy Research Working Paper No. 3464. Bravo-Biosca, A. (2010). Growth Dynamics: Exploring business growth and contraction in Europe and the U.S.. London: FORA-NESTA Research Report. Bravo-Biosca, A. (2011). A look at business growth and contraction in Europe. Nesta Working Paper No. 11/02. Mulgan, G., & Leadbeater, C. (2013). Systems Innovation. London: Nesta. OECD. (2008). Measuring Entrepreneurship: A Digest of Indicators. Vron, N. (2008). The Demographics of Global Corporate Champions. Bruegel Working Paper no. 2008/03.
Adoption is likely to be faster if governments tackle coordination failures, going beyond standard-setting.
Small Business Innovation Research program in the United States.
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4
Introduction
A Changing Future for U.S. Electric Utilities

John Jimison
lable, silent, pollution-free at the point of end use, versatile, capable of producing the entire range of temperature and motion, and uniquely qualified to produce light and operate electronic equipment. It is remarkably affordable throughout the industrialized world. Thanks to generation, transmission, and distribution investments made at huge scale and priced at their cost through government regulation as a natural monopoly, electricity service has become ubiquitous in the United States and other advanced societies, and it has become affordable to almost all their participants for business and individual applications. It is now clearly indispensable to modern life, perhaps especially in the United States. A second ongoing trend, balancing the implicit growth of the first, is the improving efficiency of major end use applications. In lighting, heating, cooling, motors, appliances, data centers, and electronics, the ability to achieve the desired work from ever smaller amounts of electricity keeps improving. As a result, the Energy Information Administration (EIA), often accused of unduly high projections for future U.S. energy growth, currently projects electricity demand growth at less than 1 percent per year for the projection period to 2040. Many other estimators see demand growth falling to less than 0 percent declining sales of power despite ongoing electrification of the United States. This originates from productivity improvements as older equipment is gradually replaced or upgraded with on-the-shelf technology. Even as we power more devices with electricity, we will use less. These competing forces are complicated by a third factor in the electricity market environment: the increasing frequency, impacts, and costs of outages. Unnoticed by many consumers, their increasing dependence on electricity to operate more of the critical functions they depend on has actually raised the real value of electricity. They use less, but it is worth more. Americans have increasingly
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Six compounding market trends have combined to put the utility industry under growing economic and operational pressure.
he U.S. electric utility industry is responsible for a greater capital investment in the U.S. economy than any other industry, constructing a unified electric grid that the U.S. National Academy of Sciences called the single greatest engineering achievement of the 20th century. So it is somewhat ironic that the early decades of the 21st century will see this achievement radically altered by market forces, new technology, and its customers new options. This chapter notes the market trends and anticipates the technical innovations that are destined to reshape the operations of the U.S. electric utility sector and its institutions, anticipating major change in a service integrated into every element of modern life. The Market Trends Without accounting for imminent changes in its basic technology, the U.S. utility industry would nonetheless already be confronting significant change from a rapidly evolving market environment. Six compounding market trends have combined to put the utility industry under growing economic and operational pressure. First, the ongoing migration to energy services delivered to consumers in the form of electricity is not a new trend. It used to be that direct use of fuels was a major part of an advanced life-style. Virtually every energy service used in a modern society can now be provided by an electric-powered device. Electronics and computing are only the most obvious. Our lighting, heating, motors, cooling, communication, manufacturing, and now even our personal transportation increasingly run on electricity. A gas furnace cannot operate without it. This is the latest stage of a centuries-long process of users deciding what form of energy they wanted for the purposes that they could afford. Electricity is almost perfect energy infinitely control-
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had their attention called to this when a storm takes out the grid for more than a few hours. They find themselves helpless, unable to be productive, threatened with the deprivation of basic human needs, and angry at their utility company even as it struggles to restore service. The wealthier may find it warranted to invest several thousand dollars in a back-up single-home generator to assure service of a commodity for which they are accustomed to paying less than $100 per month. With a warming climate, scientists have warned that the greater strength and number of destructive weather patterns experienced in recent years will continue. Our typically overhead electric infrastructure is hanging in harms way, and has taken many of these natural hits. But perhaps even more threatening is the potential for man-made intrusion via the internet in a massive cyber-attack or a focused physical attack on critical transformers or control centers, which could deprive huge regions of electric service for months with potentially devastating impacts on economic productivity, human need, and social stability. There is an unspoken awareness throughout the powerconsuming public that electricity is both more necessary than ever and more threatened in its reliability, and some private citizens are beginning to act on that understanding. A fourth ongoing market driver, recognizing that electricity generation is itself the greatest global contributor to greenhouse gas emissions, is the need to decarbonize a largely-carbon-based generation infrastructure. While this is still a matter of debate in the U.S. Congress, it is no longer a matter of debate in the U.S. electricity industry. In many ways, this could be seen as a measure of self-defense for the electricity grid, the most vulnerable energy system to extreme climate events. But one will not hear many utility executives express eagerness to back away from expensive and often recently built coal and gas-fired generators.
This factor points in a back-handed way to the great weakness of the electricity system: generating electricity embodies a huge waste of energy in conversion losses. Simple-cycle steam generators, which provide the great majority of the worlds and the United States capacity in coal, nuclear, and other fossil-fired power plants, cannot convert more than about 40 percent of the raw energy they consume into the electricity they produce. They waste on average two-thirds of their energy input, emitted into the atmosphere as hot combustion products or warm water. Combined-cycle gas plants can push that to about 60 percent used, 40 percent wasted. The even lower percentages achieved by renewable energy generation are forgiven by many because the energy they waste is not emitted as globe-damaging combustion products. Their inefficiency is not, however, forgiven by capital markets. The fifth market reality, connected to the others, is the need for massive new and continuing investment. Such investment should keep the system operating, capable of connecting and supporting new service, of operating under extreme conditions, of maximizing productivity, and of responding to the need for global environmental protection. Trillions of dollars are needed to sustain the current system, never mind the new system that is coming. This requirement will reinforce both the political pressure on regulators, state governments, and utility companies, as well as higher electricity prices even in the face of falling demand. Finally, perhaps the most significant market trend that is certain to change the U.S. electricity sector is the advent of competitive market forces at all levels of an industry that for a century was immune to them as a government-sanctioned and -controlled monopoly that owned and operated all necessary infrastructure. The genie of competitive forces is clearly out of the bottle. Starting with independent generation in the 1980s as a function of laws favoring cogeneration, and expanding to
Trillions of dollars are needed to sustain the current system, never mind the new system that is coming.
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At once the greatest environmental threat and cleanest form of delivered energy, electricity is at the crux of dealing with climate change.
include non-discriminatory and then independent transmission services, competition in the United States is now driving new customer behaviors and threatening to leave major rate-base investments in generation and transmission stranded and useless. From passive recipients of monthly invoices that they could neither limit nor avoid, customers have increasingly become active participants in electricity markets, selling their own willingness to be curtailed back to utilities in the form of demandresponse, bidding their future efficiency gains into capacity markets, and participating in price-setting through time-of-use electricity markets where regulators have permitted them, timing their use to take advantage of cheaper hours and to avoid expensive peak power. The emergence of competition in electricity markets does not merely challenge utilities investments and market share; it challenges their fundamental economics. Under standard U.S. regulatory economics, they are assured the recovery of their capital investments, debt, and the opportunity to earn a reasonable profit; under competitive economics, investments are largely sunk costs, debts are at the risk of the success of the debtors business, and profits are the rents that can be collected between the sellers cost and the market price, whatever that happens to be. To the extent utilities are drawn or driven to compete for their own continued business, they will be driven to and by this new and much harsher regime. Whether utilities can maintain their traditional role as safe investments with access to low-cost capital lies entirely on their success in negotiating these competitive forces where they arise, and in relying on their regulatory protectors where they do not. As a result, the U.S. electricity market is a strange one, one in which a critical commodity is selling in stagnant or declining volumes but demonstrating ever higher penetration into societal needs and developing ever greater dependence from
its customers. For these customers, electricitys essential nature combines with the grids vulnerability and unreliability to create incentives to move toward independence and self-reliance from the utility despite the costs. At once the greatest environmental threat and cleanest form of delivered energy, electricity is at the crux of dealing with climate change. It is produced, transported, and sold in a market that remains necessarily regulated for system governance, largely regulated for siting of new facilities, optionally regulated in most areas for commodity pricing, and increasingly unregulated where competitive forces can operate in bulk power markets and utility services. Customers and other stakeholders have found little political consensus on where regulation should stop and competition should start, but the United States has 3,200 separate utilities with individual service areas where such judgments will make a lot of difference. Mix in Some Breakthrough New Technologies Starting from this set of market realities, any prognostication of the future for the U.S. electric system must then add to the key influences accounted for a set of technological developments already under way and accelerating in the timing and scale of their potential impact. Some of these are clearly responsive to the insecurity, vulnerability, environmental insults, inefficiency, cost, and monopolistic character of the current system. Others are coming into being because they can. They break into a few large categories of technological change.
Computerization
The essence of the smart grid that is coming is the integration into all facets of the electric system of digital monitoring and controls, and the ability to process this information for operational and planning purposes. In other words, the infrastructure industry that provides the essential power and lifeblood for computers is becoming computerized itself seemingly the last of the major
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economic sectors to embrace digital information processing. Over coming years, machine intelligence will continue to rapidly penetrate generating plants, transmission systems, distribution networks, and individual customer services and applications (and probably in that order). Myriad functions that today still require a human beings thoughts and actions will be programmed. They will be instantaneous, and, unfortunately, also vulnerable to the malicious intervention of other human beings. Programmable remotely accessible appliances and building systems able to respond to variable prices and system conditions will not merely require computerization for the systems sake, but also because the modest cost savings their individual efficiencies will generate would not be worth the time of a human being to accumulate by direct control. Only if they are programmed to save money will they pay for themselves, and only then will they achieve their value on the electric grid. The millions of monitors that in coming years will watch and report the activities across every part of the grid on the utility side of the meter will be multiplied by billions that track the operations of individual consumer applications. Together, these will generate quintillions of bits of computer data that must be transmitted, received into databases and control systems, distinguished by origin, processed, analyzed, and acted upon. Utilities will either need major server and processing installations of their own, or they must become perhaps the largest and most demanding tenants of the cloud. Whether utilities and their critical functions can be trusted to third-party computer storage and processing facilities is a troubling question. Whether the United States 3,200 utilities can manage their own computer systems at that level of data input and integrated operation is an equally troubling question. And whether such computerized operations can be protected from cyber-attack,
and restored to operation quickly after intrusions, is perhaps the most troubling question of all. Concomitant with the computerization and data requirements this technological revolution is bringing to utilities is a parallel (but less recognized) expansion of the utilities requirements for telecommunication services. As the electricity industrys ability to sense and control its operations remotely down to the last water heater increases, the need to send information in both directions will demand massive incremental communications capacity. Ideally, much of this could take place through wireless radio, but the radio-wave spectrum is a limited resource of rapidly increasing value, and an industry that is by definition completely wired might be thought to be one with the least priority for precious wireless band-width. But broadband over powerline continues to face technical hurdles, and the utility industry cannot afford for communications to be disrupted precisely when power flows are. Thus the utility industry must participate in the telecommunications technology revolution as a major projected customer for its services, in order to continue rendering its own services in a fully digital era. This represents a further massive necessary investment to be made. Increasingly, electric utility communications are being appropriately seen as sharing the same privileged access to wireless spectrum as first-responders and emergency workers in the event of catastrophe, but privileges only go so far as the available capacity can honor them. It is also not clear that taxpayers will pony up the costs of such access in the place of ratepayers.
Storage
The utility industry must participate in the telecommunications technology revolution as a major projected customer for its services.
Electricity has been, from the beginning, a commodity that had to be consumed as it was being generated, since it traveled and could not cost-effectively be stored. That is about to change. Storage of electricity is now practiced in a few loca-
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Called a game-changer, electricity storage will change the game the electricity industry plays about as much as putting 11 balls on the field would change the game of soccer.
tions blessed with the topography to pump water up into reservoirs that offers hydroelectricity on its way back down. Utilities with customer permission are also achieving indirect power storage by dispatching surplus energy to well-insulated water heaters, curtailing them at peak while the extra-hot water effectively stores that surplus power. New approaches, however, appear likely to make storage of electricity affordable and ubiquitous over coming years. Already, utility-scale batteries and super-capacitors are being tested in commercial utility applications, installed to levelize the generation of variable-output wind-farms, and used to capture the power of braking trains to boost their acceleration after a station stop. It seems inevitable that one or more of the various large-voltage battery storage technologies under test and development will prove viable over coming years. And these batteries will compete with compressed-air storage, flywheels, and possibly other demonstrated utility-scale options that are working on coming down the cost curve. At a smaller scale, however, commercial electricity storage devices are already being rolled off automobile assembly lines on a daily basis. The lithium-ion battery is a proven technology rapidly penetrating portions of the electricity market that were thought beyond its wattage only a few years ago. And rumors of dramatic further improvements in vehicle-battery power density and weight make them sound imminent. The fact that every major vehicle manufacturer is creating a line of battery-electric vehicles is eloquent testimony to the near-term viability of electricity storage in huge amounts, albeit divided into thousands of mobile platforms. The question is not whether battery-electric storage will change the utilities own operations and markets even as it adds a welcome new transportation load. The question is instead how
thoroughly personal power storage will change our electricity consuming practices other than for mobile applications. The answer depends more on institutional than on technological factors. Vehicle manufacturers argue that they cannot tolerate their warranties having to cover the vehicle batterys use for anything but moving the vehicle. And utilities are leery of accelerating customer independence from the grid, and therefore are slow to facilitate vehicle-to-grid applications. The fact remains that a full vehicle battery could power most of the critical functions of a typical residence during at least a brief outage. One with a portable battery charger (i.e., a gasoline engine in the vehicle) could power critical functions for an extended outage. At some point, it seems inevitable that electric vehicle batteries will have stationary uses as well, if only for emergencies. For utilities themselves, given the increasing premium on reliability and resiliency in their mandate to serve the public, it seems likely that putting storage devices downstream on the customers side of potential outages would make more sense than siting large-scale power storage next to large generators or elsewhere upstream of all those exposed wires that are implicated in outages. Putting storage devices into the customers own applications and premises will not be a big step from putting them in substations, on utility poles, or elsewhere on the closest part of the utilitys property. It will depend on how the utility can make and get paid for making the accompanying investments. Called a game-changer, electricity storage will change the game the electricity industry plays about as much as putting 11 balls on the field would change the game of soccer. Utilities could forget the distinctions between baseload, midrange, and peaking generators, as the fluctuations of demand would more economically be matched by dispatching power from storage, either centrally or at the point of consumption. Generation could
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rely exclusively on the cheapest means, or, increasingly, on the cleanest, because the intermittent timing of renewable generation could be mitigated as effectively as the intermittent timing of customer demand. A struggle might ensue between advocates for 24/7 operation of major nuclear or coal plants to keep storage batteries and other devices at full charge, versus advocates for using integrated storage as the key means of utilizing variable renewable generation to meet variable load. Eventually, the latter perspective is likely to win. The variable operating costs of the renewable generators, like those of the storage devices themselves, are likely to verge on zero, while fossil and nuclear generation may never be able to avoid fuel costs as well as emissions or waste. Storage is the ultimate enabler to allow a fully clean power sector.
Decentralization
Even as the utility industry inevitably is drawn into the modern central systems for telecommunication, digital information, and control, and as costeffective power storage finally emerges to eliminate time-sensitivity as a critical factor for utility operators or planners, a third technological revolution is threatening to flood over the industry and divide it into small pieces. Insecurity, environmental impacts, and declining costs are motivating a rush toward distributed resources, programmable smart controls, and individual self-sufficiency in power, which in turn is motivating advances in small-scale electricity technology. Distributed power will come from generating resources of various types: fuel cells, micro-turbines, heat-engines, solar arrays, small windmills, generators operating on locally produced biofuels, etc. Distributed resources will include local controls, inverter technologies, smart appliances, and the above-described potential for individual storage. One must add in the potential for combining electric generation and use with thermal requirements that can only be served locally.
Ultimately, decentralization has the potential for an entirely different grid architecture, one centered on many small and islandable microgrids interconnected with each other and a central backbone grid for cost and convenience. These microgrids would be self-controlling, self-sufficient, and potentially free-standing economically and in load-service priorities. Microgrids are essentially sub-parts of the larger grid with automatic sectionalization and reclosure. This would enable the area to be cut off from the surrounding system, after which one can potentially employ independent generation and load controls to sustain service even when the larger system is down. As the generation, distribution, and end-use technologies at the retail level continue to improve in efficiency and remote operation, the opportunity to segregate them into self-sufficient microgrids is becoming attractive for economic, reliability, and resiliency reasons. In this case, one can easily imagine that customers of an economically successful microgrid would argue that they should avoid sharing in some of the costs of the central system, causing further economic stress for the central utility. Heat does not transport well. While electricity can readily be moved hundreds of miles (albeit with a transmission loss averaging almost 10 percent in the United States), heat or cold cannot be transported outside a local area. Since heat makes up more than two-thirds of the huge conversion loss in fossil-fired power generation, a major fuel and emission savings is available from generating power locally where the heat can be captured and put to beneficial use. Combined heat and power (CHP), cogeneration, or waste-heat recovery technologies, often sized from 2 to 50 megawatts, are not only attracting interest from larger users, but are increasing the interest in microgrids. They provide the potential ability to serve machine loads in a baseload manner, local steam requirements, as well as district heating and cooling system requirements.
Insecurity, environmental impacts, and declining costs are motivating a rush toward distributed resources, programmable smart controls, and individual self-sufficiency in power.
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No remote central thermal plant can compete with the net energy efficiencies a well-designed CHP plant can achieve some exceeding 85 percent. It still seems a bit too much, however, to expect microgrid economics to improve enough to make the central grid entirely disposable. The back-up power of massive generation, and the stability of a wide regional grid is a major advantage when significant loads come and go at odd intervals. CHP systems could fill that need, but only if they are governed by the grid, and not by the thermal requirements they also serve. The best of the renewable resources are often remote from major loads, so a clean grid will require high-voltage transmission investments even if it can dispense with existing high-emission generation. It would be a rare microgrid that could provide perfectly stable supplies of high-quality power based on renewable energy alone. Nonetheless, redesign of electric utilities into severable and potentially self-sufficient microgrids may well be an optimum solution in the face of growing natural or cyber threats to the system. These decentralized if not miniaturized technical options are changing the economics, regulation, and politics of electricity service. Already in the United States, the costs of power generated by roof-top solar photo-voltaic (PV) arrays in some markets are crossing over the costs of retail power sold by the local utilities. Major fights are brewing over whether those utilities should have to pay retail rates for the surplus PV power fed back into their systems, and the extent to which such selfgenerators depend on and should have to pay for the utilities system costs. These fights are creating effective new political alliances between ultraconservative Tea Party activists who very much want to escape the control of a state-sanctioned monopoly provider of a critical service, and liberal environmental activists who want solar energy to be encouraged at the expense of utility-generated
The experience with telecommunications and other industries shows that cuttingedge innovations and disruptive applications should be expected to proliferate even as the initial changes take hold.
fossil-fired power. Such an alliance can prevail even in areas where traditional utilities have long been seen as the champion political heavy-weights, such as in the case of Georgia Power, the largest Southern Company affiliate, recently defeated by such an alliance that called itself the Green Tea Party.
And Other Unpredictable but Likely Breakthroughs
Beyond these three large categories of emerging electric system technology trends that are certain to make a huge difference, others will come from the engine of technological innovation that is driving toward a new electricity industry. The experience with telecommunications and other industries shows that cutting-edge innovations and disruptive applications should be expected to proliferate even as the initial changes take hold. Entrepreneurs will hurry into electricity services in search of the next big thing. Further high-efficiency consumer innovations in lighting, variable-drive motors, heat-pumps, cooling, electronics, and renewable generation are already on lab benches throughout the United States, and will be moved into commercial applications and production as they offer clear advantages in cost or convenience. In particular, the increasing efficiency and proliferation of lowwattage lighting, electronics, and telecommunication devices puts enough of a premium on access to low-voltage power that new and existing buildings may be wired with separate low-voltage systems (perhaps 12-volt systems) that can power these devices directly without transformer losses, with modest voltage stabilization and storage from leadacid batteries, and that can recharge the batteries from small renewable sources. This would ensure a level of critical functionality to the occupants of that building under almost any conceivable weather or cyber event. Although most of the unexpected technology breakthroughs are likely to continue the trend
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to distributed small-scale electric systems, other innovations would primarily help maintain a central power system. Super-conductor transmission and lower-cost undergrounded transmission systems could make a huge difference in central system land-use impacts, lead-times, and costs. Lower-cost inverters for high-voltage direct-current systems could open a new world of lower impact and greater efficiency for the bulk power transmission system. New nuclear generation technologies that can avoid the risks of meltdown and release of radioactive elements into the environment by virtue of their design can go far to restoring the validity of that option in the eyes of central-system governors. Successful innovation in carbon dioxide capture and storage could put coal-fired power back into the generation mix in the United States, and make it much less worrisome in China and elsewhere. Anyone who would utterly discount the possibility of success in such technologies has not been paying attention in recent decades. The Bottom Line This chapter has attempted to outline the market trends that are driving electric sector reinvention, and the technology innovations that will both respond to and lead that reinvention over coming years and decades. One general observation is that
these market and technology factors are generally recognized by leaders and students of the industry, its regulators, its customers, and others. There is no secret about them. There is little if any dissent that they are soon going to be having dramatic effects throughout the market. But it is neither the market nor the technology changes that will make the most important differences for U.S. electricity consumers. It is the ability of utilities themselves to anticipate and incorporate changes into their operations, economics, and customers relationships, accompanied by the ability of government and regulators to accommodate those changes, which will matter. Utilities and regulators alike must recognize the imminence of these changes, embrace their advantages, protect consumers and investors alike from their potentially cruel effects and disadvantages, and restructure their institutions around the new architecture of the electric utility business in a positive manner. If we in the United States could have the same confidence that our institutional and legal structures would accommodate the new technology of electricity service that we have that the new technology will indeed emerge to take its place in our lives, we could be very confident indeed of a smooth transition to a very different but much better electricity-driven future.
Utilities and regulators alike must recognize the imminence of these changes, embrace their advantages, protect consumers and investors alike from their potentially cruel effects and disadvantages, and restructure their institutions around the new architecture of the electric utility business in a positive manner.
23
5
T
Europe is sitting in the trough of disillusionment with investors slow to invest into new technologies or companies.
Appendix: Financing the Energy Revolution

Gerard Reid
markets where share price falls, increasing costs of debt and restructuring has become the norm. And today from an investment point of view, Europe is sitting in the trough of disillusionment with investors slow to invest into new technologies or companies. That said, the United States is coming out of this trough and Europe should soon follow as there is a whole range of exciting business models and companies on the horizon. In addition, renewable technologies have become highly competitive with alternative technologies and there are real growth opportunities in this area. But there are still huge issues that need to be solved. How do we finance energy efficiency? How do we create a real and open European power market? How do we best finance the needed investments in the grid? And finally, how will utilities adapt their business models for changing times?
he following presentation looks at the energy revolution we are currently going through with a particular emphasis on the impact that the revolution is having on investors and the power markets. The revolution is all about technology and in particular three renewables, shale gas, and energy efficiency which together are ripping apart global energy markets. This revolution has seen huge capital flows in recent years and although it has come largely from private hands, it would not have happened without government supports, particularly in Europe (through FITs) and the United States (through tax credits and government grants). However investing in revolutions is never easy and there has been a lot of capital destruction and money lost in renewables and venture capital, and these technologies have caused both wholesale gas and power prices to fall. This can be clearly seen in the European power
24
1) Background 2) Investing in a revolution 3) The future 4) Issues that need solving
Regulated by the FCA
Thanks to Germany and the United States, we are at the start of another energy revolution
German Renewable Energy Capacity

140.000 Wasserkraft 120.000 Biomasse * Windenergie Photovoltaik EEG: August 2004 EEG: April 2000 Novelle BauGB: November 1997 60.000 StromEinspG: Januar 1991 - Mrz 2000 EEG: Januar 2009
100.000
GWh
80.000
40.000
20.000
0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
* Feste und flssige Biomasse, Biogas, Deponie- und Klrgas, biogener Anteil des Abfalls; 1 GWh = 1 Mio. kWh; Aufgrund geringer Strommengen ist die Tiefengeothermie nicht dargestellt; StromEinspG: Stromeinspeisungsgesetz; BauGB: Baugesetzbuch; EEG: Erneuerbare-Energien-Gesetz; Quelle: BMU-KI III 1 nach Arbeitsgruppe Erneuerbare Energien-Statistik (AGEE-Stat); Hintergrundbild: BMU / Christoph Edelhoff; Stand: Mrz 2012; Angaben vorlufig
The confluence of massive renewable generation, combined with information technology and significant gas shale exploitation in the United States, has enabled the digital energy revolution
Huge levels of investment have poured into these sectors in recent years
1. Renewable energy
Wind capacity has grown from 48GW in 2004 to 283GW today Solar has grown from 4GW to 100GW over the same period
Source: Bloomberg
2. Utilities Utilities have increased their CAPEX significantly across Europe in recent years Current yearly CAPEX by European utilities is 40bn above 2006 levels
Source: Credit Suisse
3. U.S. fracking and shale gas boom
Technological advances have spurred investment U.S. CAPEX in 2012 was 2.5 times 2009 levels
Source: E&Y
Source: Baker Hughes
Where has the capital come from?

1. European government incentive schemes (1 of 2) By introducing Feed in Tarrifs (FITs) and other incentives, European countries have created a new, low cost way to finance capital expenditures
14
Return %
12 10 8 6 4 2 0
Power Plant ROCs FITs
FITs ROCs
Risk %
Fixed payment to power producer under long term contract for all power produced Payment to power producer is a combination of wholesale price, ROC price, and other levies
Power Plant
Payment to power producer is purely based on wholesale price

1. European government incentive schemes (2 of 2)
Capacity in MW
Ownership of German Renewable Energy Assets
Individuals
Willing to accept 6% returns

Farmers
Big 4 Utilities
Need 10% returns
FITs have allowed a whole new group of investors to participate in the power markets These groups are willing to invest at lower rates of return than utilities This has resulted, for example, in utilities being unable to invest in renewables in Germany

2. U.S. tax incentives and equity markets
U.S. shale gas was initially supported by U.S. Department of Energy grants as well as tax credits and other incentive structure
Early shale fracturing and directional drilling technologies developed by government R&D labs and programs Section 29 production tax credit for unconventional gas, in effect from 1980-2002
Some $40 billion was invested through the public markets into U.S. gas shale plays over the last five years The American Recovery and Reinvestment Act of 2009 has lead to large investments $8 billion) in the U.S. grid. This gave U.S. companies a lead in smart grid
But revolutions are painful places to invest

1. New technology hype
250
200 Price Performance (%)
150 NEX 100 NASDAQ S&P 500
50
0 Jan-01
Jan-03
Jan-05
Jan-07
Jan-09
Jan-11
Jan-13
New technologies have been a disastrous place to invest in recent years The sector went through a major hype cycle from 2006-2008 and has significantly underperformed major indices
Source: Capital IQ
Revolutions are painful places to invest

2. Competitive price pressures
Competition has driven prices down, resulting in a large number of high profile solar bankruptcies:
Even more have been acquired or exited the industry
Source: Wacker Chemie and Greentech Media

3. Massive gas price reduction in the United States
Source: Jefferies
The shale boom in North America has led to eight-year lows in gas prices But in Europe, the gas price is twice that of the United States, with no improvement in sight

4. Dramatic power price reduction in Europe
Utilities can no longer control the power price Power prices across continental Europe have fallen and are close to ten-year lows
Source: Fraunhofer

5. European power price volatility and weather dependency
And the weather, not the utility, determines the European power price One impact is that pumped hydro has become unprofitable, as have gas plants

6. The squeeze on European utilities (1 of 4)
The energy sector rallied before the financial crisis Investors left then re-entered utility stocks as wider markets peaked, causing inversely correlated share price performance Wider markets were flat so investors entered utilities Historic behaviour has now ended
European utilities have been the worst performing stock market sector in recent years Investors always used to invest in utilities during bad times; that has now changed

Spreads between European dividend yields and U.S. and Asian have never been as high
EU utilities have been forced to offer higher dividends to keep investors happy Investors do not trust their future earnings and question the viability of their business models

European utilities have not benefited from the low interest rate environment The spreads between utility dividend yields and government bond yields are at ten-year highs

The transformation of the power sector is also driving cost of debt up for utilities Again, utilities have lost their defensive status on the stock market

7. Retroactive legislation cuts
Utilities are fighting for their lives and blocking change everywhere Investors in renewable energy projects lost money thanks to retroactive cuts in legislation In Europe, there has been a huge drop off in renewable investments
Source: Bloomberg
Europe is sitting in the trough of disillusionment

The United States focus on cost has pushed it earlier out of the trough
20092010
20052008
There are lots of exciting new businesses and business models in the United States, but very few in Europe
But there is light at the end of the tunnel

1. Strong performance in 2013
140 135 130 Price Performance (%) 125 120 115 110 105 100 NEX NASDAQ S&P 500
Jan-13
Feb-13
Mar-13
Apr-13
May-13
Jun-13
Jul-13
Aug-13
Sep-13
The new energy sector has been a very strong performer this year
Source: Capital IQ

2. High investor demand for renewable assets
1.4 1.3 1.2 1.1 1.0
Share performance of UK listed infrastructure funds has been strong

HICL 3IN INPP JLIF GCP BBGI UKW
Renewable energy-focused IPOs alone have raised ca. 1 billion so far this year
Date of IPO 12 Jul 2013 29 Jul 2013 22 Mar 2013 22 Jul 2013 Size (m) 130 300 260 300
Entity
Market focus
large scale agricultural and industrial solar assets Onshore wind and solar assets across UK, Ireland and France Onshore and offshore wind farms, typically >10MW US-based contracted renewable and conventional generation and thermal infrastructure assets
0.9 Jul-09
Jul-10
Jul-11
Jul-12
Jul-13
Net dividend yield ranges: 5-7%
There are lots of investors willing to invest into power generation at low costs of capital But this makes it more difficult for utilities to compete

3. New and very exciting business models are coming our way
4. Finding shale oil alongside shale gas has made exploration viable, even at current low prices
U.S. oil production, which was said to have peaked, is on the rise after 30 years of decline
Source: EIA

5. Decentralized solutions are now as cheap if not cheaper than centralized ones
Solar payback model S. Germany 80.0 950 76,000 3,800 2,280 6,080 12.0% 84,096.0 80% 200,000 67,277 17 11,437 5,357 1,682 7,039 20.7% 10,839 7.0 7.8 Commercial Spain 80.0 950 76,000 3,800 2,280 6,080 16.0% 112,128.0 80% 200,000 89,702 14.5 13,007 6,927 2,243 9,169 31.6% 12,969 5.9 6.6 Italy S. Germany 80.0 4.0 950 1,200 76,000 4,800 3,800 240 2,280 144 6,080 384 15.0% 12.0% 105,120.0 4,204.8 80% 50% 200,000 4,500 84,096 2,102 15 28 12,614 589 6,534 205 2,102 210 8,637 415 28.8% 32.9% 12,437 655 6.1 7.3 6.9 9.3 Household Spain 4.0 1,200 4,800 240 144 384 16.0% 5,606.4 50% 4,500 2,803 22 617 233 280 513 51.8% 753 6.4 8.4 Italy 4.0 1,200 4,800 240 144 384 15.0% 5,256.0 50% 4,500 2,628 20 526 142 263 404 44.9% 644 7.4 10.1
Solar system capactiy (kW) Capex (EUR/kW) Total capex (EUR) Annual depreciation (20 years) Annual cash opex (3%) (1) Total annual cost of solar system Load factor Solar electricity generation (kWh) Self consumption ratio Total electricity demand In-house solar electricity consumption Grid electricity tariff (EURct/kWh) (2) Saved annual cost for grid electricity Net benefit (solar cost less saved cost for grid electricity) (3) Sale of excess electricity at spot (EUR35/MWh) (-1)+(2)+(3) Total annual savings (including depreciation) Total annual savings as % of electricity bill Total annual cash savings Payback time on investment (years) assuming FIT of EUR100/MWh Payback time on investment (years) assuming price of EUR35/MWh
The trend toward decentralized power will increase even without subsidies, especially in the developing world
There are still huge issues to be resolved

1. How do we finance energy efficiency?
Remember the McKinsey curve?

Getting people to invest to save is not simple, despite short payback periods And most energy suppliers have no incentives to save money Financing energy efficiency from potential savings is not easy
Source: McKinsey
We need to incentivize energy efficiency

2. There is no single power market in Europe
Countries with the highest power prices have the least connectivity

3. The grid needs to become smart not bigger
Smart Grid
Datacenters
Centralised generation
Things
Digitalization
Transmission & distribution Residential buildings
Commercial & industrial buildings
Decentralised generation
Allowing new players to enter the market as well as offering a range of new services

4. Utilities are fighting for the lives, but the reality is their current business models are dead
We need to be brave and not let them block progress
OFFICES
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www.gmfus.org

Creative Destruction in The Energy Sector: From Disruption To Transformation

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CREATIVE DESTRUCTION IN THE ENERGY SECTOR PAPER SERIES 2014

CREATIVE DESTRUCTION IN THE ENERGY SECTOR

Creative Destruction in the Energy Sector

Preliminary Findings and Recommendations

Creative Destruction in the Energy Sector

The German Marshall Fund of the United States

Workshop on Creative Destruction in the Energy Sector: Summary

Creative Destruction in the Energy Sector

The German Marshall Fund of the United States

The Electricity Grid

Creative Destruction in the Energy Sector

The German Marshall Fund of the United States

Creative Destruction in the Energy Sector

The German Marshall Fund of the United States

Creative Destruction in the Energy Sector

Source: Bravo-Biosca (2011)

The German Marshall Fund of the United States

Creative Destruction in the Energy Sector

The German Marshall Fund of the United States

Creative Destruction in the Energy Sector

The German Marshall Fund of the United States

Small Business Innovation Research program in the United States.

Creative Destruction in the Energy Sector

A Changing Future for U.S. Electric Utilities

The German Marshall Fund of the United States

Creative Destruction in the Energy Sector

The German Marshall Fund of the United States

Creative Destruction in the Energy Sector

The German Marshall Fund of the United States

Creative Destruction in the Energy Sector

The German Marshall Fund of the United States

Creative Destruction in the Energy Sector

Appendix: Financing the Energy Revolution

The German Marshall Fund of the United States

1) Background 2) Investing in a revolution 3) The future 4) Issues that need solving

Regulated by the FCA

German Renewable Energy Capacity

Source: Credit Suisse

Source: Baker Hughes

Where has the capital come from?

Power Plant ROCs FITs

Where has the capital come from?

Ownership of German Renewable Energy Assets

Willing to accept 6% returns

Need 10% returns

Where has the capital come from?

1) Background 2) Investing in a revolution 3) The future 4) Issues that need solving

Regulated by the FCA

But revolutions are painful places to invest

200 Price Performance (%)

150 NEX 100 NASDAQ S&P 500

Revolutions are painful places to invest

Even more have been acquired or exited the industry

Source: Wacker Chemie and Greentech Media

Revolutions are painful places to invest

Revolutions are painful places to invest

Revolutions are painful places to invest

Revolutions are painful places to invest

Revolutions are painful places to invest

Revolutions are painful places to invest

Revolutions are painful places to invest

Revolutions are painful places to invest

Europe is sitting in the trough of disillusionment