Vertical Integration Revisited

CUSTOMER AS KING

Published In: EnergyBiz Magazine November/December 2009

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ELECTRIC UTILITY RETAIL CUSTOMERS today face possibly the greatest risks and potential cost increases of any generation of American ratepayers. In addition, it is uncertain if the present industry structure or the rules under which it plays will be able to effectively manage these risks for the ultimate benefit of customers.

Our nation has developed a patchwork of competitive and noncompetitive wholesale markets, retail choice programs and transmission planning practices that mostly confuse customers without providing demonstrable benefits. Usually, where deregulation occurs, new services and products proliferate and prices decline. This has clearly not happened in the U.S. power industry. Simple analyses of retail price trends reveal that since 1990, residential rates in states with competitive retail models increased about 17 percent more than rates in states without retail competition. Industrial rates appear to have increased about 20 percent faster.

Instead of benefiting from competition, utility customers now face a plethora of risks and costs, with many being the result of a failed competition experiment. These risks include volatile retail energy prices based on the short-term prices that typically drive deregulated markets. There is also uncertainty over the reliability of the transmission grid and its ability to connect remote, renewable energy resources and defend against cyber attack. Further, there is the undetermined cost of greenhouse gas emission mitigation, as well as the price volatility that carbon emissions trading will create. These converging factors mean an inevitable upward trend in retail power prices.

You could make the argument that customers would reap the benefits of a competitive power market if politicians would stop interfering with free markets by imposing price caps and continuously Monday morning quarterbacking the decisions of market operators. There is some validity to this position. However, even a correction here would not remedy what I believe to be the clear disadvantages of our balkanized and pure profit-seeking planning and operating practices in regions where organized markets exist. Each of the generation, transmission and distribution segments is now understandably focused on optimizing its particular piece of the competitive pie. We know that when the individual parts of any system are optimized, the whole suffers. Here, the “whole” is the retail customer, who relies on the entire chain of generation, transmission and distribution services. The customer really doesn't care if the pecuniary needs of all the pieces are satisfied. It seems that at a national – and even state – policy level, we have somehow lost the connection to our customers.

I believe we need a return to the old, tried-and-true, vertically integrated business principles. It's impractical, of course, to put the deregulated genie back into the bottle, but we can at least make adjustments at the margin. Some of the better customer satisfaction ratings come out of utilities that do not have retail competition. Why is that? Vertically integrated utilities control the full value chain; they can optimize the whole. They pool the risks of all three segments and avoid price volatility by contracting for fuel and purchased power supply through long-term fixed prices and cost accounting. This vertical structure can employ deferred accounting and cost recovery strategies more effectively than their competitive counterpart “local distribution company” entities. They can also provide the assurance of cost-based rates verified by local regulators that are closer to the customer base. Other than customary rate and siting case intervention, vertically integrated utilities are unimpeded by complex stakeholder processes that delay the timely and best-cost construction of new infrastructure. Financially, the sum total of risks across the generation, transmission and distribution value chain can be reduced, with resulting capital cost reductions.

As the U.S. electric customer faces the looming onslaught of higher energy costs, we should revisit the vertically integrated model. Centralized control over integrated resource planning, construction activities and cost accounting can help control the potentially adverse economic effects of a multitude of issues. These issues include costs associated with greenhouse gas legislation and increased levels of renewable energy resources, as well as the need for large capital investments to deal with cyber security threats and the development of a smarter grid. At the same time, the costs of duplicative management would also be reduced as coordination among generation, transmission and distribution segments would be more efficient with investments made in a synchronized manner.

It's time for regulatory commissions, legislatures and the utilities themselves to think more openly about utilities re-acquiring or building generation capacity on a regulated, cost-of-service basis. By re-integrating generation into the utility rate base, customers will be assured of improved reliability, less price volatility, and lower overall costs

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