Deregulation in the Energy Industry: A Vision of the Future...................................................... by Robert B. Handfield Bank of America University Distinguished Professor of Supply Chain Management College of Management North Carolina State University and Bart Moore Tech Transfer Specialist College of Engineering Michigan State University Copyright 2000 by the Center for Advanced Purchasing Studies. All rights reserved. Contents may not be reproduced in whole or in part without the express permission of CAPS.
Table of Contents Preface... 2 Acknowledgments... 3 Tables and Figures... 7 Executive Summary... 9 Introduction... 9 The Players in the Electricity Supply Chain... 9 The Politics of Deregulation... 9 The Case for Deregulation...10 Problems with Implementing Deregulation...10 Developing an Electricity Purchasing Strategy...10 Critical Success Factors and Lessons Learned...11 Communication and support...11 Information systems...12 Training/hiring...12 Organizational structure changes...12 Future Trends...12 Implications of the Study...13 How to Proceed in the Transition...13 Design of the Study...15 Research Questions...15 Deregulation in the Energy Industry: A Vision of the Future...16 Introduction...16 The Players...17 The Politics of Deregulation...17 Implementing a Purchasing Strategy in a Deregulated Market...17 Methodology...18 The Players in the Evolving Energy Market...18 Changes in the Structure of the Energy Supply Chain...18 System Reliability...20 The Energy Supply Chain...21 Input Suppliers to the Energy Industry...24 Power Marketers...26 Brokers and Aggregators...26 Generation Companies...26 Transmission...26 Distribution...28 The Politics of Deregulation...30 Current Status of Deregulation Legislation...30 The Case Against Deregulation...31 Residential versus commercial use...31 4 Deregulation in the Energy Industry: A Vision of the Future
Private use restrictions...32 Jurisdictional issues...33 States Rights...33 The Case for Deregulation...33 ELCON...33 A Historical Perspective of State Deregulatory Actions...33 Problems with State Actions...34 Federal Legislation Required to Create an Open Market...36 Creating Competition: Deregulated Market Structures...37 The components of restructured markets...37 Developing an Electricity Purchasing Strategy...39 Introduction...39 Energy Purchasing Process...40 Energy Sourcing Decision-Making Process...40 Best Case Data Collection...43 Cost Factors Affecting the Price of Electricity...48 Time of day/load...48 Base load generation...48 Peaking generation...50 Intermediate load generation...50 Stranded costs...50 Fuel costs...50 Interruptibility...50 The power factor...51 Location...51 Cost Reduction Strategies...52 Additional Criteria to Use in Evaluating Electricity Suppliers...52 Reliability...52 Interruptibility...52 Best Case Sourcing Energy in a Steel Manufacturer...52 Company A...52 Company B...53 Company C...53 Company D...53 Decision...53 Critical Success Factors and Lessons Learned...55 Communication and support...55 Information systems...55 Training/hiring...55 Organizational structure changes...55 Best Case American Home Products...55 Future Trends in the Energy Market...56 Introduction...56 The Status of Customer Choice...56 Continued Reductions in the Price and Cost of Electricity...57 New Innovations in the Energy Industry...57 Purchasing Electricity Third-Party Providers...58 Automated Metering and Billing...58 Technology-Enabled Residential Consumer Choice...58 Large Customers Will Aggregate Loads and Leverage Purchases...59 The Emergence of Price Risk Management Tools...59 Rationalization of Manufacturing Facilities...60 Emerging Green Electricity Products in Restructured Retail Markets...60 Automobile Fuel Cell Batteries...61 Aging of the Generation Base...61 Firesales of the Nuclear Generation Base...61 Center for Advanced Purchasing Studies 5
The Emergence of Three Major National RTOs in the United States...63 The Reemergence of Nuclear Energy...64 Conclusion: How to Proceed in the Transition...64 References...66 Appendix: Cases...68 Glossary of Commonly Used Acronyms...96 Center for Advanced Purchasing Studies...98 6 Deregulation in the Energy Industry: A Vision of the Future
Executive Summary Introduction America s electricity industry, valued somewhere between $215 and $250 billion per annum, is undergoing massive change. The electricity industry has been a monopoly for more than a century and is now moving toward an open retail market. A number of states, such as California and Pennsylvania, have already restructured their electricity markets. The electricity system in most of the United States is vertically integrated. One large utility owns and operates all three primary aspects of electricity operations generation, transmission, and distribution in a given service territory. A number of state-by-state deregulation (or restructuring) proposals mandate the unbundling of these processes, meaning that utilities must divest one or more of them. Restructuring electricity is proving to be a challenging and complicated process. Although the telecommunications and transportation industries were deregulated relatively effectively in the past, utilities arguably involve a more difficult set of issues. Electricity requires a complex set of functions for delivering the product to market in a timely, efficient, and reliable manner. From an electricity purchaser s perspective, deregulation means many potential benefits; however, the learning curve that must be scaled to realize those benefits will be steep. co-ops that may both generate and transmit energy. Nonutility generators independent power producers and exempt wholesale generators do not own wire systems for transmission or distribution. They have traditionally sold power wholesale to transmission-owning utilities such as IOUs. In the deregulated market, non-utility generators will have access to retail markets as well, and will sell directly to end consumers such as residential customers, commercial customers, and large industrial customers. A spiderweb of possible configurations can exist within any particular energy supply chain. For example, a generator may sell to a broker, who also generates electricity, who in turn sells to an industrial customer. The industrial customer may have a substation that provides some of its electricity, which in turn may be returned to the grid and sold to the local municipal utility, which in turn sells it to local customers. There are a multitude of possible combinations of electricity generators, brokers, non-utility generators, municipalities, and customers buying and selling electricity into and from the power grid, to and from each other. Generally, only retail generation of electricity is in process of being deregulated. Federal open access requirements have already effectively deregulated electricity generation in the wholesale market. Transmission and distribution will continue to be regulated, at least for the short term. The Players in the Electricity Supply Chain The electricity supply chain begins with suppliers who provide fuel, material, and services to the producers (generators) of electricity. Producers include investorowned utilities (IOUs), publicly owned utilities, non-utility generators, and power brokers. They may also consist of rural utilities, which are essentially community-run The Politics of Deregulation As of this writing, 22 states have taken steps to deregulate electricity and provide customer choice. (For an updated summary of the current status of state deregulation, visit the website www.eia.doe.gov.) Robust debate continues regarding whether the federal government has jurisdiction to force deregulation measures onto the states, and Center for Advanced Purchasing Studies 9
whether it should do so. Several states, such as California, have created complex, intrastate systems and agencies to support their deregulation initiatives. Currently, the actions being considered by the House and Senate committees on electricity deregulation include enacting electricity deregulation law, determining the rights and responsibilities of individual states, and determining the rights of municipal utilities to participate in competitive markets. Related legislation includes measures such as Renewable Portfolio Standards (RPS), which mandate that electricity providers purchase certain minimums of renewable energy. At this writing, a comprehensive federal deregulation measure does not exist. The Case for Deregulation Not surprisingly, the charge toward electricity deregulation is being led by commercial users at the state level. Industries (such as automotive) that are captive customers of incumbent utilities in states with high electricity costs (such as Michigan) covet a competitive market. An association of large industrial electricity users called ELCON (Electronic Consumers Resource Council) was organized to promote the development and implementation of public policies that assure reliable electricity service at competitive prices. ELCON and its members envision an openly competitive electricity market with a variety of purchasing options, including direct purchases from generators, marketers, or aggregators. ELCON members want the ability to contract with energy service providers (ESPs) such as Enron that can help finance and/or manage energy facilities or groups of generators. ELCON maintains that prices in the regulated monopolies are too high and vary too much state to state, and that the product and service innovation in the industry is far behind that of other industries. ELCON also maintains that competition in the electricity industry will ensure that electricity providers regard consumers of electricity as their customers instead of regulatory agencies. Problems with Implementing Deregulation It is possible that individual state actions may be insufficient to drive a competitive electricity market in the United States. Although deregulation of electricity has moved forward in states such as California, Pennsylvania, New Hampshire, and Texas, a number of lingering problems remain. Many state actions still contain monopolyfriendly provisions that preclude competitive and efficient electricity markets. Four major problems include: Mandatory recovery of stranded costs by incumbent utilities Utility mergers that tend to preserve monopoly status Failure (or inability) to eliminate market power of incumbent utilities Reliability concerns that overwhelm commercial markets Regarding the first problem, some degree of stranded cost recovery has been elemental to all state restructuring initiatives. It essentially requires ratepayers to pay for unrecoverable costs associated with investor-owned utilities (IOUs) nuclear generation assets and second-party electricity purchasing contracts. Put simply, stranded cost recovery has been the price paid by states to preclude IOUs from tying up deregulation initiatives with legal challenges. In addition, utility mergers will likely continue as competition renders inefficient firms prey to larger, more robust utilities such as Duke Power and American Electric Power. Finally, some deregulation initiatives (such as California s) have mandated rate cuts by incumbent utilities that create such a low default rate that competition from outsiders is often precluded. Also, most deregulation initiatives have tackled the problem of incumbent utilities market power by forcing these transmission-owning utilities to either (a) divest their generation assets and operate strictly as wire companies, or (b) pool their individual systems into a larger, independently managed system designed to insure open access and competition. However, inefficiencies caused by separating ownership from management of these restructured wire systems have often exacerbated reliability problems. At the federal level, the primary vehicle for ensuring open access and competition is formulation of large, independent regional transmission organizations (RTOs). RTOs, like the state-level ISOs, would create independently managed transmission systems. In a recent federal order, the Federal Energy Regulatory Commission (FERC) increased the pressure on transmission-owning utilities to join RTOs. Developing an Electricity Purchasing Strategy Electricity purchasing strategies in the newly deregulated markets will be very similar to any other type of commodity strategy development process. However, the fact that energy procurement has usually been the domain of functions other than Purchasing for many years means that the process must be modified to include the input of these stakeholders, so that ownership of the process can be established across groups. The process is shown in Table 1. This process map assumes that the organization has not yet obtained a directive from top management to address nontraditional spending. Those organizations that have received such approval can bypass the first three steps of the process. 10 Deregulation in the Energy Industry: A Vision of the Future
Table 1 Process Map: Energy Sourcing Strategy Development Step 1: Aggregate data on business needs, volume, and tariff rates collected on current providers for major energy purchases across the organization to determine total usage and patterns. Establish business requirements for the business units. Step 2: Determine strategic impact of electricity purchases at organization-wide and business-unit level, and ease of attaining energy cost reductions. Establish rate structures and establish targets for energy cost savings through purchasing involvement. Step 3: Obtain top management support and directive for purchasing involvement in energy purchases, and establish stakeholder involvement at the functional level. Step 4: Strategic planning team identifies focus areas of spending. Team appoints energy experts from business location/stakeholder groups as focus point of communication for cross-functional/cross-divisional electricity sourcing teams. Step 5: Energy sourcing team amasses input on individual ideas and suggestions from key stakeholders and experts. Team finalizes volumes, performs total cost analysis on various energy portfolio strategies, identifies suppliers, and seeks proposals. Proposals should identify a total cost solution to energy consumption patterns across the enterprise. Step 6: Team evaluates proposals through follow-up presentations/visitations, networking, etc. Establish relationship with selected supplier through top management meeting. Communicate decision to strategic planning team. Develop performance measures and incentives, agree on metrics, and award contract (establish terms of alliance agreement where appropriate). Step 7: Finalize the strategy and communicate the procedures for using defined set of suppliers for electricity across divisions. Step 8: Performance monitored over time, and report after given period to evaluate cost savings and strategic objectives evaluation. Tie performance improvements to bottom-line results. Focus efforts on continuous improvement and deployment of energy efficiency initiatives across facilities. It should also be noted that in some organizations, an internal client department such as Finance or Information Systems initiates the involvement of Purchasing in energy spending decisions. In this case, determination of strategic impact of nontraditional purchases may be initiated outside of the procurement function, and Purchasing may then become involved in obtaining top management approval. Finally, some organizations may also initiate Purchasing involvement via some form of control system, such as an internal audit of payments and matching purchasing orders. In this case, Purchasing may identify these areas and begin by drawing top management s attention to control problems regarding the traditional process. Critical Success Factors and Lessons Learned Managers described several factors that were considered to be critical in deploying the involvement of Purchasing in energy spending areas. These can be classified into four primary categories: Communication, training, information systems, and organizational changes. Communication and support Initially, the business case for Purchasing involvement must be made successfully to gain senior management commitment. Organizations that do not consider Purchasing a corporate-level function may require culture shifts to accept Purchasing involvement. The case must be made persuasively that Purchasing is focusing on effective supply chain solutions that are based on customer perspectives and are no longer internally focused. Corporate management must be both supportive and visible throughout the process to maximize effectiveness. Secondly, a cross-functional team must be formed with appropriate representation from technical experts and stakeholders. It is critical that team members actively Center for Advanced Purchasing Studies 11
solicit input from end users or others with an interest in the product/service. Team results and successes must be well-published, and credit should be shared. Energy spending is still considered sacred in many organizations, and centralization of the process should proceed slowly. It is possible that the current organization responsible for energy purchases has been practicing sound procurement, and this should be considered and recognized. Information systems Information system support and an integrated corporatewide planning and accounting system is crucial to sound energy procurement. Training on use of metering technology, where appropriate, is required to position the company for electricity deregulation. Training/hiring Most professional buyers do not have experience in energy purchases. It is highly recommended that the organization recruits and hires an energy expert who has detailed knowledge of rate tariffs and energy efficiency practices. Energy purchasing group members should have financial analysis skills, several years of structured procurement, training in change management and team facilitation, and the ability to communicate and sell their ideas. Some companies have taken talented personnel from other areas of the company and used them as content experts while teaching them the procurement process. Technology-enabled residential consumer choice, enabling small consumers to select meters that measure consumption at various times of day, as well as for selected appliances or other uses. Large customers ability to aggregate loads and leverage purchases, allowing them to apply cost-based rates for transmission, distribution, and related wires services. As a result of this structure, large customers will have the opportunity to aggregate their loads and leverage their purchasing power. The emergence of price-risk management tools, including futures, options, financial derivatives, collars, swap options, over-the-counter options, and other contractual forms. Companies will create a risk profile with which they are comfortable. Rationalizing of manufacturing facilities. Emerging green (environmentally benign) electricity products in restructured retail markets. Automobile fuel cell batteries. Aging of the generation base. Firesales of the nuclear generation base. The emergence of three major national regional transmission organizations (RTOs) in the United States, replacing the 10 existing regional reliability councils (RRCs) and the ISOs that have already been established. Possibly, each interconnection grid (East, West, and Texas) will be managed by a single RTO. Organizational structure changes A permanent, specialized energy procurement group should be considered in cases when the total energy spend across the organization is significant. This group would be tasked with monitoring the changing regulatory environment, reducing costs, and promoting energy efficiency practices across the organization. Future Trends Plausible future trends resulting from electricity deregulation are as follows: Continued reductions in the price and cost of electricity. New innovations in the energy industry, such as efficiency/load-shaping products, power quality/reliability products, self-generating options such as distributed generation, and energy management devices and processes. Information-based technologies include customer call centers (service and sales), automated/wireless metering, energy profiling and simulation, load profiling and simulation, load and price forecasting, PC-based pricing/purchasing, and World Wide Web interconnections. Third-party providers. 12 Deregulation in the Energy Industry: A Vision of the Future