Power companies caught in a tight solar spot

It’s an incredibly easy thing to say that the rise of solar photovoltaics means utilities need to change their business models. Even the blue blood management consulting business, McKinsey, is getting in on the act of urging power companies to change their business models to adapt to solar. In the latest edition of the McKinsey quarterly, David Frankel, Kenneth Ostrowski and Dickon Pinner observe:

The utility sector represents a fascinating example of the potential for significant disruption as costs fall, even as solar’s scale remains relatively small. Although solar accounts for only less than half a per cent of US electricity generation, the business model for utilities depends not so much on the current generation base as on installations of new capacity.

This is only partly true, but what McKinsey get right is that solar’s impact on power company profits can be disproportionate to its share of the overall electricity energy market, particularly in a market that’s shrinking. This is already being experienced in Europe:

Over the last several years, the demand for power [in Europe] has fallen while the supply of renewables (including solar) has risen, driven down power prices, and depressed the penetration of conventional power sources. US utilities can learn many lessons from their European counterparts, which for the most part stood by while smaller, more nimble players led the way. Each US utility will have to manage the risks of solar differently. All of them, however, will have to do something.

But a power company changing its business model is far easier said than done. 

– First and foremost, a power utility might not actually be any good at running a business model suited to solar playing a large role in the energy market. They may have other better options for how to redeploy their existing capabilities.

– Two, it could cannibalise its existing investments in billions of dollars worth of assets.

– And third, government regulations might actually make it difficult, or almost impossible, for them to rearrange their business model. This is especially the case for Australian network businesses.

Given these three factors it might actually be in the best interests of a shareholder in power companies – who has a diversified portfolio of shares in other companies – for the power company to just shrivel up and die.

To illustrate with an example, one needs to ask why is EnergyAustralia going to be any good at rolling out energy management services to customers instead of just selling straight electrons?

It’s taken EnergyAustralia several years to get its basic vanilla billing system in a reasonable state. So how is it going to manage a wide range of sophisticated energy management products that need to be customised to different customers? 

It has had a group of senior staff who have spent a fair proportion of their time white-anting government initiatives to reduce emissions and encourage demand management and renewable energy. Why would they suddenly be any good at this stuff that they’ve been convincing others will amount to nothing and is exorbitantly expensive?

Yes, they have a solar PV retailing business, but is it a particularly competitive one?

And then there’s other urgent pressing issues they’ve had to manage, like a coal mine that for a period of time looked more like a hydro facility.

Now, Origin Energy has shown far greater aptitude in this space. But selling solar systems has not been a particularly profitable business even for those specialised in this space. Origin has had to make choices about how to deploy its constrained amount of capital:

1. Does it sink money into a solar business with narrow profit margins that might someday in the future be pivotal to its energy retailing business; or
2. Does it direct it into their gas business which offers vastly better profit margins and that is a near certainty to payoff in the next few years?

Also, the regulatory landscape has not been conducive to either electricity network or retailing businesses capturing the full value of saved energy.

Networks are actually specifically restricted from energy retailing and energy generation. There’s a good reason for this: ownership over the powerlines bestows incredible market power. Imagine a network business is also in the business of selling solar and battery systems, they might decide they’ll favour the connection of solar systems they sell themselves while going slow on the connection of solar systems sold by others.

They might even place onerous restrictions or charges on the connection of rivals’ systems. If you don’t like it you can’t then go to another network business because are a monopoly. 

Still, network businesses can theoretically capture value from the rollout of technology – other than poles, wires and transformers – to reduce peak demand. But to do this networks require regulator approval and there isn’t a clear pathway for this to occur. Plus, the returns aren’t necessarily there to justify the extra effort.

Even if it was absolutely certain that the future was distributed energy, and it’s still far from certain, for some power companies their options as to what to do about it are heavily constrained.