The second digitisation of the electricity industry: chronicle of a revolution foretold

On Monday 12 September 2016, the German energy giant E.ON listed on the Frankfurt stock exchange a company called Uniper, following its decision to focus on its “green” activities (i.e. renewable energies, energy networks and customer services) and to entrust Uniper with the more traditional electricity generation business from hydro, gas and coal stations.  Less than a month later, on Friday 7 October 2016, it was the turn of the other major German energy company - RWE - to split itself into two, by listing on the stock market Innogy, which regroups its “green” activities. These splits are evidence of the major transformation of the electricity industry over the last 20 years, and they anticipate the major changes of the future. This blog post looks back at the first and considers a few areas of discussion for the second.

1. The 20th century: vertically and horizontally integrated players

In the 20th century, the electricity industry was characterised by significant economies of scale and technical requirements in terms of real-time coordination, which required integration of production, transport and customer service operations, thus encouraging the emergence of large vertically integrated players. These monopolistic players are either private companies regulated by public powers (USA, Belgium), or public companies owned by national governments (France, Italy, Great Britain, Scandinavian countries) or local authorities (Germany, Netherlands).

This structure, which was imposed by technology, was consistent with post-war government economic policies, which favored monopolies and government economic regulation.

2. The first wave of digitisation

Starting in the 1990s, advances in computing power made it possible to use markets to coordinate generation units in real-time, while respecting the various physical constraints of operations and safety.[1] This meant that the integrated monopolies of the 20th century were no longer the most efficient model for the electric power industry: the transport and distribution infrastructures were separated from other elements of the value chain. Producers started to compete against each other to sell their MWh into wholesale markets. [2] Suppliers purchased MWh on these wholesale markets, and in turn competed for end customers. The first wave of digitisation profoundly transformed the industry's structure but did not change the technology. Electricity was – and still is -- produced in large units, the power of which is measured in hundreds of MWs or GWs, and transported to customers using the grid.

This new structure for the electricity industry is consistent with a change in economic policy from the 1980s, which favours markets as mechanisms to allocate scarce resources.

3. Impact of the first wave of digitisation on incumbent energy companies

European energy companies were weakened by this initial reorganisation.  As we have seen, the E.On and RWE were forced to split into two.[3] German energy companies are not alone. Engie, which has just recorded two years of record losses, has undertaken a major asset disposal program. EDF was profitable in 2015 but faces structural difficulties, which were well documented in the press in spring 2016. Collectively, European energy companies have lost over €600 billion in value since 2008, more than half of their stock market capitalisation.[4]

3.1        Three apparent causes

European energy companies’ current difficulties have three causes: over-investment during the 2000s, the sudden drop in demand following the 2008 financial crisis, and the large-scale entry of subsidised Renewable Energy Sources (RES).

With the liberalisation of the industry, European energy companies embarked in aggressive expansion programs, including expensive acquisitions, which now weaken their financial performance (acquisition premiums weigh significantly in the accounts). They also massively invested in generation assets (in particular from natural gas) at the end of the 2000s.

The consequences of this over-enthusiastic capital spending spree were made worse by two other changes.

Firstly, electricity demand, which had been growing in Europe, dropped significantly following the financial and economic crises in 2008, and has never returned to its pre-crisis levels.  This means that energy producers cannot count on demand to absorb over-capacity.

Secondly, the energy transition imposed a complete paradigm shift, hardly consistent with liberalisation.  Since the first directive in December 1996, liberalisation has placed wholesale market prices at the heart of players’ decisions. For example, producers use their anticipation of future wholesale markets’ prices to decide whether or not to invest in new generation assets. Future prices are a self-regulating mechanism: if producers invest too much, future prices fall, which leads to closure of generation assets; if they don’t invest enough, future prices increase, which leads to investment.

During the 2000s, RES subsidies turned this architecture upside down: since an increasing fraction of generation assets is no longer financed by wholesale prices, these no longer reflect the total costs of electricity production. The price signal has therefore lost its value.

This situation creates two problems. Firstly, in the short-term, wholesale prices fall, which reduces the profitability of existing generation assets and contributes to the financial difficulties of incumbent energy companies.

Secondly, future prices are now largely determined by member states’ RES support policies. If these policies led to a clear and credible RES growth path, energy companies could estimate future wholesale prices and develop their investment strategy.[5] Unfortunately, public policies evolve permanently. Faced with this regulatory and political uncertainty, investors (correctly) refuse to finance new generation assets. This lack of investment is not a problem in the short-term, since generation capacity exceeds demand. However the problem will become more acute in a few years, when capital needs to be invested in new generation assets, or in renewing existing generation assets.

3.2        The responsibility of incumbent energy companies

Observers and players in the industry have different views on the responsibility of incumbent energy companies in their misfortune. This point is very important, since learning from past mistakes is essential to prepare for the future.

Observe first that European energy companies’ “failure” is comparable to that of American electricity companies at the end of the 1990s: they invested over-enthusiastically when markets opened, which led to overcapacity and various bankruptcies. Everyone remembers the collapse of Enron, the most famous of the American “merchant” energy producers, but other – perhaps less well-known -- firms also faced significant difficulties, for example Dynegy, Mirant, and Edison.

Some observers argue that energy companies are victims of a coincidence of impossible-to-anticipate adverse factors, particularly contradictory public policies: liberalisation on one hand, and RES subsidies on the other. Others argue that energy companies have completely misread the evolution of their industry, hence are responsible.

As is often the case, reality lies somewhere between these two views. It is true that public policies are constantly changing and are often inconsistent. However energy companies do not seem to be attentive enough to changes in technology and society. Two examples illustrate this point. Firstly, in the 2000s, most incumbents were convinced of the primacy of the technical/economic arguments about RES: since the production cost of megawatt hours using RES was (at the time) very high, governments would not adopt these technologies. They failed to appreciate the political resolve to adopt these technologies and consumers’ willingness to cover this extra cost. Secondly, German energy companies did not understand how little support they had amongst politicians and the general public. When they encountered significant financial difficulties, no one lobbied to protect them.

The first wave of digitisation has rendered the electricity industry similar to other industries: managers must now look outside of their organisations, and be attentive to changes in their environment.

4. The second wave of digitisation

In the 21st century, the invasion of computer chips and the development of smart networks will cause a new radical transformation of electricity systems: decentralisation.

4.1        A technological reality

Until now, the industry has had to demand variability: electricity demand at a given moment is not sensitive to price, but varies depending on the hour of the day, day of the week, and season. Producers’ objective was to satisfy this demand, which is insensitive to indications of scarcity, at the lowest possible cost. Since economies of scale significantly reduce costs, a small number of large generation assets were built to produce electricity, and, since demand is spread geographically, the transport and distribution networks were developed to deliver it.

The development of decentralised renewable energies, storage possibilities and (remote) measurement and (remote) control computer tools calls everything into question. In the future, consumers will be able to adapt their electricity demand to wholesale prices. They will be able to buy their electricity on the market, or use their self-generation capacity, or even resell on the market at any time the electricity they produce or have stored in their batteries.

It is unlikely that residential consumers will adopt such sophisticated optimisation strategies, for two reasons. Firstly, due to their small size, the savings made from this optimisation are too small to compensate for the cost of installing the necessary tools. Secondly, as pointed out in our previous blog post, experience shows that the majority of residential consumers are passive. They rarely change suppliers, so it is unlikely that they would spontaneously change their consumption pattern.

However, large consumers, such as manufacturers, businesses and local authorities, assisted by information and communication technologies, will tap into this source of significant savings. The French government has just created a legal framework for collective self-consumption, through an order published this summer. Some observers predict that this change will be very rapid, for example Jeremy Rifkin who is heralding a third industrial revolution in France. Others believe that technological, economical and behavioural inertia will slow down this change, so it will take several decades. Regardless of its speed, the transition has started.

4.2        Technology consistent with social aspirations

It is important to observe that this decentralisation is consistent with societal changes, which are pushing for more local responsibility. Decentralisation is a deeper transformation than liberalisation: the structure of the industry itself will be modified. Production will be partially decentralised, energy flows on the networks will be two-way, information on consumption patterns will be more valuable.

4.3        New entrants

Various players intend to profit from this evolution. For example:

• Oil companies, such as Total, which has recently developed a real electricity strategy, and invested significantly in the sector. It enters into the electricity industry through new technologies: RES and batteries. [6] It is probable others will follow.
• Data-centered firms. Silicon Valley entrepreneurs are looking for new opportunities to “change the world”. Their firms are rich and their teams are motivated and talented. The electricity industry of the future is a natural “playing field” for this type of entrepreneur. For example, Apple has applied for and received in the summer of 2016 a license to sell electricity in the United States.
• Equipment manufacturers like Nest (bought by Alphabet) and Schneider, which aim to assist their consumers in saving energy.
• Other manufacturers such as Tesla which has just bought SolarCity. This transaction is probably opportunistic but the prospect of an integrated low-carbon mobility and electricity supplier is intriguing.

5. Which priorities for incumbent energy companies?

Incumbent energy companies have a significant role to play in the future of the electricity industry, despite their weakened state. What should they do to avoid missing out on the second transformation? While it is impossible to give a single answer, experience suggests four priorities.

5.1        Technological innovation is essential

Technologies are endogenous. Progress takes place when entrepreneurs invest in anticipation of significant profits. In the electricity industry, technological transformation is well under way.

Historically, technological innovations in the industry were designed with or at major energy companies, who invested in R&D directly or indirectly (EPRI in the United States). Equipment manufacturers developed their new products in cooperation with them.

Currently various technologies that have the potential to transform the electricity industry are developed outside of the major energy companies. For example, Tesla is developing a gigafactory to produce batteries. Transatomic Power, a start-up founded by MIT graduates, develops small nuclear reactors. The entry of new players in the industry is probably the major success of liberalization. It will shape the future.

Incumbent energy companies must accept this new reality and adapt their behaviour as a result, in particular by being more open to and on the lookout for external innovations.

5.2        Microeconomics - like gravity - always wins

Economists cannot predict the structure of the electricity industry in 2050. However we are confident that innovations which increase the collective surplus - for example dynamic tariffs - will ultimately prevail. This ‘creative destruction’ was theorised long ago by Joseph Schumpeter.[7] It is at play in all sectors of the economy. The historic taxi model was inefficient: competition (known as “Uberization”) has increased the collective surplus and has spread worldwide, despite fierce resistance from traditional taxis who are fighting to protect their rents: a recent academic analysis shows that the overall consumer surplus generated by the UberX service in the United States in 2015 was $6.8 billion.[8] The historic model of network banks is inefficient and costly. “Fintechs” have developed new services like online banking and fund transfer services, which increasingly compete with the historic banking business.

For both taxis and banks, digitisation is breaking down barriers. The electricity industry will not escape creative destruction. New business models are emerging, that help increase the collective surplus and supported by smart networks. Electricity companies must therefore adapt to new business models: decentralisation of decision-making, small-scale experimentation and digitisation of processes seem to be priorities.

5.3        Government is sometimes a dangerous ally

Government structured the development of the electricity industry from the Second World War to the 1990s. The interlude of liberalisation lasted one or two decades depending on the country. Interventionist tendencies have now come back. Under the cover of remedying market failures, protecting the environment or achieving commendable strategic objectives, the visible hand of state intervention is returning in the electricity industry.

It is therefore likely that governments will be involved in the changes to the electricity industry in the 21st century. In particular they will distribute subsidies to new technologies “to encourage their development” and will ask market operators to implement extremely sophisticated rules to remedy market failures.

However government intervention, like technological progress, is largely endogenous. If industry players ask them for help, policy makers will gladly issue restrictive rules in exchange for subsidies. If players ask for no intervention, suggesting that competition and creative destruction are given free rein, it is possible - but not guaranteed - that governments will intervene less.

The natural instinct of incumbent electricity companies is to seek government policies to protect them. However in this field also, their monopoly is waning and new players are also influencing decision makers. German electricity companies have discovered this at their expense: RES developers have obtained extremely favourable rules, forcing these incumbent firms to split into two. In France, the company Voltalis has demonstrated a significant ability to influence the government, has lived off undue subsidies for several years. Consumers, thanks to social networks, do not wait for elections to put pressure on politicians.

Incumbent electricity companies must therefore think twice before systematically calling on the government for rescue. Perhaps they will be better off under free competition ... provided that they adapt.

5.4        We must learn to move on

In all industries, the most difficult managerial decision is to abandon activities and practices which have generated past growth in order to better concentrate on those which will generate future growth.

Energy companies have attempted to deal with increased competition without sacrificing their past structures. If they want to participate in the era of decentralisation, they must make painful choices. For example, what is the strategic value of integration between energy generation and sale on the one hand, and transport on the other? Is the long-term co-existence between decentralised decision-making and tariff equalisation possible? How can we mediate the conflict between electricity producers’ interests (selling more megawatt hours) and those of energy service suppliers (optimising - and therefore reducing - consumption of these megawatt hours)? These questions do not have a simple answer. All the more reason to study them in more detail and without bias.

* * *

The second wave of digitisation will help address the challenge of carbon-free human activity, and will open up a new golden age for the electricity industry. The European Commission’s 2050 roadmap targets the almost exclusive use of electricity as an energy source for homes and transport. We must continue to produce electricity in large volumes, but we must adapt technologies and usage patterns to locations, dates and the vagaries of nature. New entrants will compete with incumbent companies to create and capture these new opportunities. To survive, incumbents must make their digital transition as soon as possible.