The New Electric Industry: What's at Stake?
Heller, William J., Jansen, Paul J., Silverman, Lester P., The McKinsey Quarterly
Three new and different businesses will emerge
Many traditional industry players will have to close or sell large portions of their current business
No one has yet discovered the electric equivalent of call waiting, but they will
Market forces unleashed by deregulation are starting to reshape the US electric utility industry. As with banking and telecommunications before it, the sector is set to be transformed. Mergers and massive consolidation will take place. New competitors will emerge to redefine the economics and competitive dynamics of the business, just as MCI did in telecom, and Fidelity in banking. Some traditional players, like AT&T and Citibank, will make and mold the transition; others will dwindle, vanish, or be subsumed. The winners will create substantial value for their shareholders.
This vertically integrated industry is about to fragment into three separate but linked businesses - generation, wires, and power services - plus a dispatch function [ILLUSTRATION FOR EXHIBIT 1 OMITTED]. Each will have its own players and distinctive competitive dynamics.
Generation will be a cost-based commodity business. Wires, combining transmission and distribution functions, will consist of regulated open access networks. Power services, encompassing wholesale and retail commodity sales and including other energy and nonenergy products, will be provided by a third set of competitors. The dispatch function, responsible for scheduling, grid control, and price settlements, will be fulfilled by an independent regulated entity.
Tremendous value is at stake as the industry evolves into these three businesses. The delivered cost of electricity can be expected to fall by 10 to 20 percent, depending on the outcome of regulatory decisions on the recovery of uneconomic supply costs (so-called "stranded costs") and performance-based rate-making. Individual customer savings will vary widely, since future prices will reflect the real (rather than average) cost of service according to geography, load profile, and willingness to suffer interruptions in supply. Regulators may try to protect residential and small commercial customers, but economics will win out in the market-driven world of the future.
All told, investor-owned utilities (IOUs) could collectively lose nearly $30 billion annually - about 15 percent of today's industry revenues, and over 100 percent of the after tax profits of all utilities combined. Fortunately, the value created through restructuring and growth into new businesses could exceed this value at risk by as much as $15 billion. This suggests that if it is managed well, industry restructuring could benefit both participants and their customers. Each of the three businesses - generation, wires, and power services - offers different opportunities for value creation, and each has a unique risk profile. Equally important, the factors that will separate the winners from the losers will also vary from one business to another.
Despite fears of billions of dollars of stranded investments, changes in the generation industry could offset the shareholder value at risk. Generation is well on its way to becoming a highly competitive, regionally based commodity business. The new competitive regions will be defined by transmission limitations and are likely to be very large - far bigger than current reliability councils.
Bilateral and spot markets will exist in parallel. In each region, supply and demand dynamics will follow long cycles, causing prices to waiver between replacement and marginal costs. This typical commodity pricing pattern will produce unattractive average returns for many participants, with a great deal of variability between players.
Our analysis of plant assets indicates that just under half of all utility supply portfolios are uncompetitive, owing to a combination of high costs and low capacity value. …