Can the power industry change quickly enough?
It’s become conventional wisdom that rapid-fire change is rocking many sectors of the economy including the power industry, and that in order to survive, energy companies need to embrace if not lead the major innovations ahead. Increasingly important is the question of whether the power industry is truly prepared for the pace of change ahead.
While innovation-driven restructuring sounds reasonable in principle and is for many people exciting to contemplate, there is a serious disconnect. Certain obstacles within the industry could effectively prevent most power companies from taking advantage of new technology until many years after it’s available. In some examples the technology could be largely outmoded by the time certain parts of the industry are able to adopt it. Most parts of the power industry have to raise long-term money on private capital markets. Other parts of the industry can only move as fast as their regulators will allow. Regardless of whether there are huge opportunities to benefit consumers, and money to be made for business, large swaths of the energy industry could be saddled with outdated long-lived installations that deliver few of the consumer benefits of the newer systems. The other side of the coin of course is that those consumers using long lived assets are probably squeezing great value out of legacy investments.
Because large parts of the power system are effectively shared assets, the consumer base as a whole, with help from regulators and policy-makers, will have to make collective decisions about how quickly to adopt new technology. It’s a little like deciding when to buy a new computer: Do you want to get the latest features and performance, or persevere with your existing hardware for another year, in hopes that the options will be better next year? Move too fast and you might pay more than necessary. Move too slow and you might be left behind, and pay more than necessary in another way.
The energy industry, regulators, government and consumers are all facing a challenge in terms of making the energy industry ready to embrace change, without driving up costs unnecessarily.
Rivalries are growing between opposing camps of several types. There are different schools of thought about which generation technology, and what kinds of grid configuration, justify getting the most attention in the near term. Competitors naturally make the case for their own product lines and associated assumptions about the timing of change. No doubt there are tensions with even within companies. One faction wants to drive forward with a new consumer offering based on the latest available technology. Another faction, typically the one holding the purse strings, believes that sticking to established revenue streams might be a better bet than a leap into the unknown. After all, many people will be happy to keep getting their power over copper wires, with assurance that both technology and rates are being overseen by a regulator. Yes, internet-connected software can reshape billing and marketing systems relatively easily. Yet at the same time, critical parts of the system will remain dedicated to building and maintaining those relatively traditional (“old school”!) physical wires, transformers and generation assets. There is truth in both points of view, but that does not mean it will be business as usual for either side.
Society wants both innovation and low prices from its energy system. Unfortunately, any capital-intensive sector relies on stable, predictable utilization of major assets over long periods of time to keep costs and prices down. The two objectives, innovation and low prices, are not polar opposites, but they can easily work at cross-purposes in any number of situations. Mid-life capital expenditures are likely to become more contentious for example.
This kind of tension however is only the first part of the unfolding story of transformation in the energy sector. There are parallels in many industries with online retail facets. But the parallels are questionable if you are comparing high turnover consumer-driven industries to a capital-intensive sector that depends on long-term investment to control costs.
How energy companies need to think
The unfolding challenge goes way beyond a traditional utility company hiring a few bright young minds to develop a trendy interface to bolt on top of their existing business. In the longer term, future-proofing a business involves nothing less than asking if the core functions of society’s most capital-intensive industries can accept being placed under the control of entrepreneurial actors who watch trends and operate more like startup companies – instead of relying on asset managers used to securing long term capital intended to shave a few basis points off the underlying cost of capital.
Cultivating or hiring a change-friendly outlook is a tall order for a company that has been built to manage and maintain assets with 20 and 30 year amortization schedules. The obvious risk is that by focusing on the potential new systems of the future, the company may fail to derive full benefit of its existing assets, and it could simultaneously weaken customers’ interest in the company’s core product.
However a closer inspection reveals less of a dichotomy. Many of the new technologies have their roots in existing systems. Other innovations will be well-suited to pairing with technology already installed by incumbent energy companies. And most important, albeit hardest to assess in advance, the process of improving both new and existing installations will be enriched to the degree that each is connected to the other within a single company’s product offering.
The fact is, it doesn’t matter if your assets are old or new, long lived or leading edge. The nature of the industry and the all-important fundamentals for investment have been thrown into question for just about everyone, merely because common assumptions about the pace of change are being re-examined. The key question is whether your company’s management of its assets is built to account for the likelihood of change.
Building the capability to deal with change, given the typical configuration of power companies, has at least 4 components:
a) Developing and designing new systems that are themselves responsive and make the most of new technology and the changing business environment
b) Ensuring that existing assets can be adapted to respond to new conditions as they evolve, to the extent reasonable
c) Maintaining analytical capabilities to ensure that management is cognizant of how critical success factors may be changing as the technology and business environment evolve
d) Watching the competitive environment respond to change and extracting lessons from it quickly.
Note that none of these practices requires an assumption that existing assets will be disused or discarded before they’ve reached the end of their normal amortization period. On the contrary, astute management of existing assets is part of any credible framework for embracing change.
The agile company abandons neither its existing assets nor its ability to identify what’s ahead, as both are essential to create viable solutions in an environment of change.
To help deal with this change many companies are looking at revising the nature of their workforce and recruiting staff, often younger people, for whom the concept of constant change feels entirely normal. See “Energy companies advised to cultivate young professionals as part of long term strategy” elsewhere in this issue of IPPSO FACTO for a report on how Young Professionals in Energy are advising companies to prepare.
APPrO has established a mentoring program to assist companies make the connections across generations and learn their way through what appears to be a burgeoning “Culture of change.”
The policy overlay
In terms of the preferred timeframe for asset turnover, there is a distinct possibility that a fundamental mismatch will remain for some time between the financial and technical perspectives. From a technical perspective the optimum speed for capital turnover could be relatively short – say ten years or less. Yet from a traditional investor perspective, the optimum speed for capital turnover is much longer – twenty years or more. It is entirely possible that in pursuing the benefits of 20 year financing, the industry may implicitly be accepting a range of risks:
• Higher costs than necessary as the adoption of new lower-cost core technology is delayed until older equipment is paid off (both capital and operating costs can be lower with new technology)
• Unnecessary investment in common grid infrastructure as new technology may make fewer net demands on the upstream system
• Less flexibility as the newer systems are likely to integrate better with the internet of things and respond to consumer preferences to control operations on a granular level, share assets locally, and update themselves.
• Higher environmental footprint as new technology can be less burdensome on the environment
• Difficulty maintaining and servicing older technology
• Cybersecurity complications as older systems may need more patches to stay current with evolving threats.
No one knows how serious each of these risks may be. It’s possible that some may prove inconsequential or that long-lived assets may demonstrate unexpected value in the economy of the future. In reality each component of the power system has specific characteristics that create its own very specific optimum life-span, while many types of equipment are often replaced on a schedule designed to ensure co-ordination with the replacement schedule of a key related central component. There will likely be tough questions asked about what to retire when. But you can be sure that prudent investors, and those who oversee them, will be looking for solutions to questions of what time frames are appropriate to use in a world where long lived assets are subject to rapid change.
At some point it will become a matter of public policy to decide whether to risk a longer run with the tried-and-true key asset, or to face the deeper questions of expediting transition to newer systems. If government doesn’t take a position, the market and regulators will of course make their own judgements, likely taking a variety of approaches driven by the characteristics of each specific setting.
Can agile responsive business models become the norm given the inevitable constraints that exist where long-term capitalization is necessary?
Although many feel the answer is already apparent in the marketplace, a parallel question is more important to government and society as a whole: Do we really want to make the power industry a leading proponent of change? That would almost certainly mean higher costs in the short run as existing investments become riskier and the cost of capital for both new and existing capacity climbs skyward. But it could also prepare the ground for innovative systems with lower costs in the near future and countless savings in the long term. Very likely this is part of the reason the Ontario Energy Board and other regulators have spent so much time in recent years working on how to determine the appropriate pace of change.
It’s not clear if anyone has found the right formula, although it’s pretty certain that the pressure to pick up the pace is only increasing.
— Jake Brooks, Editor
An update of this editorial is published on LinkedIn at this location.