Short circuits in power transmission: A coherent strategy for utilities in an uncertain environment
In August 2014, a District of Columbia circuit court unanimously upheld the authority of the U.S. Federal Energy Regulatory Commission (FERC) to require large-scale regional planning of the electrical grid and new cost allocation rules for transmission networks, a set of policies known as Order 1000. Although the ruling was a significant victory for FERC, some in the utilities industry doubt that it will hold up. Will future legal challenges succeed? Will the order be crushed under the weight of its own implementation?
Early returns under Order 1000 have been mixed, as regional transmission and independent system operators struggle to develop processes that would consider alternative grid solutions to relieve market congestion and deliver broader public policy benefits (for example, renewables interconnection). Moreover, the removal of incumbent transmission owners’ rights of first refusal in grid expansion projects has created a series of new competitors, both incumbents and entrants, moving into previously inaccessible markets.
One thing is certain, though: Whatever the ultimate fate of Order 1000, it has already introduced substantial disruption into the utilities industry — and startups as well as established firms are finding that competing on this precarious terrain is challenging. In this report, we explore the drivers and emergent trends in the utilities sector and define the capabilities and strategies required to chart a path to success in the current market.
Dollars and demands
Although annual capital expenditures in the U.S. utilities sector have risen significantly in the past decade, they are expected to remain at their present high level for at least the next 10 years (see Exhibit 1). Among the primary investment areas are expanding renewables interconnections, innovations in baseload generation, and improved infrastructure security. In addition, transmission upgrades and interregional system networks are needed to improve power flows across and within markets and minimize congestion.
Exhibit 1: Annual U.S. transmission investment
This level of sustained investment will make it possible for utilities to pursue new avenues for achieving meaningful growth.
However, Order 1000 of the U.S. Federal Energy Regulatory Commission (FERC) represents both a significant hurdle and an opportunity for the utilities industry. A historical review of FERC regulatory actions shows that Order 1000 is the natural evolution of policies adopted decades earlier (see Exhibit 2). Many of the rationales behind the first wave of generation markets’ restructuring in the mid-1990s — lower prices, need for innovation, energy security — are also used to justify Order 1000 and more recent transmission policy changes. More important, with Order 1000, FERC is attempting to harness the benefits of competition to enhance reliability and improve grid performance at a more effective cost.
Exhibit 2: Evolution of FERC’s transmission policy
Regional transmission and independent system operators (RTOs/ISOs) responsible for implementing Order 1000 are grappling with the complexities of balancing conflicting stakeholder demands and points of view. There is ample confusion about what types of projects should be subject to competitive bidding, the criteria for evaluating bids, and the best way to make apples-to-apples engineering comparisons of different electrical transmission approaches, to name a few.
Meanwhile, startups have complained that RTOs/ISOs are neglecting their mandate to provide opportunities for new entrants. Indeed, although there have been some notable exceptions in which new entrants have prevailed, a richly competitive utilities market with multiple successful participants has yet to materialize. To illustrate, in 2014, the California ISO (CAISO) and the 13-state PJM RTO, two of the leading RTO/ISOs, used open bidding for only about 23 percent and 12 percent, respectively, of their projects.
In this new era, incumbents will need to be flexible and smartly proactive to protect their existing franchises and seek new opportunities in adjacent markets.
As the RTOs/ISOs sort out the rough spots in their Order 1000 processes, each will come up with a unique approach that suits its regional and organizational needs and culture. At least seven different marketplaces, and perhaps many more, with disparate rules, investment drivers, and competitive dynamics, will be responsible for distributing an increasingly large fraction of total transmission dollars. Consequently, to be successful, new entrants and incumbents alike should seek to differentiate their solutions in new and compelling ways to compete under this plethora of rules.
New entrants, most often companies that are expanding their core businesses into locations or markets that they do not currently serve, may make the mistake of viewing their moves as modest steps. But this belies the complexity of the transmission business in markets with well-entrenched incumbents. In fact, such an expansion likely requires a set of knowledge and capabilities that is different from what was relied on in the past.
For incumbent utilities, the terrain may be even more difficult because state regulators and policymakers have traditionally dictated their participation in markets. In this new era, when they have more freedom to determine their own strategic directions, incumbents will need to be flexible and smartly proactive to protect their existing franchises and seek new opportunities in adjacent markets.
Competitors in the utilities arena will have to develop new approaches to meet customer needs and be willing to challenge the old rules. Already, some markets have seen an increase in aggressive pricing with cost controls and caps. In others, novel partnerships among companies with complementary capabilities have resulted in innovative proposals. The ability to adapt quickly to changing circumstances and competitive pressures will be essential to building a business that can consistently succeed.
A coherent strategy
To deftly navigate a disruptive industry environment, companies must devise a coherent strategy suitable to their skills, markets, and goals. In our view, strategic coherence has three dimensions: a “way to play,” which articulates how a company creates value; an aligned capabilities system, or the key strengths that set the company apart and allow it to execute its way to play; and a portfolio of offerings — opportunities and investments — that can allow these capabilities to be exploited. Viewed through the lens of a utility in today’s landscape, this strategy takes on the following configuration.
Firms must first identify their most advantageous business model. Are they going to just be builders or will they own the transmission asset?
1. A way to play. There are essentially three dimensions against which transmission market participants must determine their way to play: business model; market approach; and geographic focus, or where to play (see Exhibit 3). Historically, utilities constructed, owned, and operated transmission assets, connecting generation with distribution within the regulated franchise. The current environment is more complex than that. Firms must first identify their most advantageous business model. Are they going to just be builders — primarily taking on engineering, procurement, and construction — or will they own the transmission asset, either after building it or by acquiring it? Alternatively, some firms may choose to be developers, offering planning and licensing assistance, rather than asset operators.
Exhibit 3: Three dimensions of the way to play in the transmission market
Next, utilities have to decide their market approach or, put another way, their business structure. Will the firm focus on operating and investing in its existing utility franchise and take on operations and maintenance of other utilities’ assets outside its traditional zone, or will it create a transmission company, a subsidiary solely focused on transmission assets? Another option would be to partner with a separate utility, piecing together joint ventures in multiple regions.
And finally, utilities must focus their geographic ambitions — that is, whether to do simple interconnects of transmission with new generation in their current territories or to fully expand into building and operating multiple large projects in other regions.
2. An aligned capabilities system. As barriers to entry in utilities markets are removed, the importance of flawless execution will grow as firms seek to create value in an increasingly competitive marketplace. Matching capabilities (combinations of systems, processes, tools, and expertise) to the chosen way to play will become more critical, as will identifying capabilities gaps and investing in closing them. The traditional utility model — owning and managing end-to-end transmission facility life cycles — is an artifact of historical monopolies. However, in an era of competition, differentiation is no longer the result of regional dominance; rather, it is generated by the benefits outweighing the costs of a project. With all of the considerations that a utility now must take into account in any transmission development effort — electrical planning, engineering and design costs, right-of-way, permitting, technology evolution, construction constraints, outage windows, regulatory requirements, community impact concerns, risk management, business arrangements (joint ventures, partnerships, solo ownership, and the like) — the likelihood of a single company consistently possessing the necessary proficiency in all these areas is extremely low.
In an era of competition, differentiation is no longer the result of regional dominance; rather, it is generated by the benefits outweighing the costs of a project.
For many utilities, a review of the capabilities that are necessary to support a transmission business today (see Exhibit 4) quickly reveals a number of shortcomings. Some of these required capabilities, such as contract management, asset management, and project management, have been strong suits of traditional utility incumbents. And these capabilities are still the table stakes of operating a reliable and efficient network. However, there is also now a raft of new market-facing and market-support capabilities that utilities must consider developing. These include accurate market forecasting, understanding the complexities of bidding and partnerships, and capably navigating the obstacles in RTO/ISO regulatory agendas.
Exhibit 4: Capabilities required for the transmission market
3. A portfolio of offerings. The final component of a coherent strategy is a portfolio of target markets with attractive opportunities that logically suit the firm’s way to play and capabilities. Understanding both RTO/ISO and state policy objectives can provide some insight into which power markets are priorities based on the levels of investment and mix of projects — such as renewables interconnection, congestion relief, or any of an array of other possibilities. Also, markets with clear rules on Order 1000 implementation offer hints about which assets to consider for portfolio expansion. Increasingly, transmission projects that satisfy multiple public policy objectives have an advantage over more traditional efforts.
Moreover, when considering portfolio development, it’s important to think creatively: Projects need not be limited to a single jurisdiction or RTO/ISO, as bigger benefits might be gained by proposing a transmission solution across the “seams” of the grid infrastructure.
However, it is most essential that utilities match portfolio development strategies with required capabilities. If the choice is to simply maintain the existing footprint, table stakes (or execution) capabilities are most valuable; companies must have skills in project, asset, and contract management. For a market expansion approach, market-facing capabilities — understanding new buyers, stakeholders, and investment drivers — are paramount. And utilities opting for a diverse portfolio solution will primarily need market-support capabilities, such as market forecasting skills, technologies, and tools.
Charting the path
Although we have argued that a coherent strategy is required to compete in an Order 1000 environment, the avenues for creating that strategy could appear murky and the process overwhelming. For that reason, we have developed a structured framework that helps guide utilities through the complex effort to create an effective strategic methodology and tailored business model (see Exhibit 5).
Exhibit 5: Framework for strategy development
We suggest a market-back, capabilities-forward approach that begins with a detailed market assessment, including both the regional differences within the transmission market landscape and how other market participants are competing or plan to compete. Market priorities and constraints, policymaker priorities, competitors’ technological and financial wherewithal, and the company’s strengths and weaknesses should be evaluated.
The market assessment is a critical stage that sets the tone for the rest of the framework. However, many utilities make the mistake of rushing through this step, using only intuition to evaluate the market; they make a lot of assumptions based on what they think they already know, without a fact-based exploration of the market’s dynamics, constraints, and priorities. Other utilities fail to look inside during this stage and neglect to evaluate the capabilities and skill sets that enable them to best navigate market conditions. For this stage to be meaningful, utilities should be rigorous in identifying the real characteristics of their market even as it is shifting and in isolating their competition and their own strengths and weaknesses.
The next stage in the framework is developing the way to play. In this stage, the intelligence gleaned from the market assessment is used as the foundation for making decisions about the business model, market approach, and geographic reach — in other words, the priorities of the way-to-play calculation.
The last stage involves developing the capabilities — or enhancing internal capabilities — that are required to compete under the strategic rubric that has been identified in this framework, as well as building a portfolio that takes advantage of these distinct capabilities and market opportunities. Together, these crucial execution elements form the basis of the utility’s business strategy, which should include prioritized markets, delivery model, and market approach.
Implementing this framework often involves developing critical partnerships with other utilities. Typical of these is the decision by California’s PG&E to join forces with TransCanyon, a power grid infrastructure company. In this venture, the two companies will pursue new market opportunities offered by CAISO, hoping that the combination of local market knowledge and transmission construction and development expertise will give them a distinct advantage that neither would have alone over the many competitors fighting for the same contracts.
Considering the risky nature of the transmission market, the process by which strategies are conceived must help executives make objective trade-offs, balancing value and risk, in the midst of uncertainties. This cogent analysis can give a company’s leaders the confidence that they have fully assessed the potential outcomes and understand the opportunities as well as the obstacles. The result is a committed leadership team, capable of maintaining focus on the shared vision even as issues emerge and as challenges to doing something new must be overcome.
Leaders can exercise discretion in how they tailor this process. Setting guidelines to constrain way to play and capability design choices early can help direct the development effort toward a seemingly feasible set of outcomes, but it increases the risk of neglecting novel possibilities that can create real value. More comprehensive analyses consume more of a company’s time and effort, but they may be more efficient in the long run, as critical facts and issues surface earlier, helping to build support for the strategy over time and to address obstacles sooner rather than later.
Putting the genie back in the bottle is impossible — and in the utilities sector that genie is creating a new market that matches supply (generation) with demand (load) in efficient transmission networks governed by a set of policies designed to incentivize competition. In the future, coherent choices will be the most determinative aspect of a successful utility’s performance. Coherence allows a utility to identify its organic and inorganic growth opportunities and to embrace a winning set of capabilities to take advantage of them. This approach can differentiate a utility from its competition and create barriers to entry for less coherent competitors. In short, it helps to align strategic intent with day-to-day decision making.
Although challenges to implementation of a coherent strategy will always exist, utilities that overcome them will invest in a smarter way, embrace uncertainty, partner efficiently, and act with unity of purpose to deliver value to customers and other stakeholders. A fact-based, objective approach to understanding the new world, matching market opportunity with company capability, may seem difficult at first, but it’s a far better way to proceed than stumbling from one crisis to the next as external rules, regulations, and disruption alter the utilities sector’s landscape.