Winning in electricity generation

Winning in electricity generation

T Winning in Electricity Generation Should you be a buyer or a seller ofgeneration? In general, spot buyers should do ve y well, while many generation...

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T Winning in Electricity Generation Should you be a buyer or a seller ofgeneration? In general, spot buyers should do ve y well, while many generation owners will befortunate to recover their stranded costs. Success&l generators will capitalize on superior operating performance and market knowledge. Lewis Hashimoto,


Paul Jamen

and Gerrit van Geyn

he smartest natural gas strategy in the early 1980s was to

short natural gas. Will this lesson

strategies that simultaneously re-

of restructuring be written again

covered existing generation in-

of the electricity generation busi-

vestments while restructuring

ness of the late 199Os? We will ex-

their asset portfolios and reposi-

amine whether and how winners

tioning their plants to compete in

might emerge in the generation

the new market. Losers will have

business of the future.

spent the time mired in indeci-

The U.S. electric generation mar-

Lewis Hashimoto

is afornzer

consultant in the Los Angeles office of McKinsey

& Co. Paul Jansen is a

senior partner in their San Franscisco office, and Gerrit van Geyn is a consultant in McKinsey’s Toronto office.



The winners in year 2005 will be those who early on developed

sion, their strategies ultimately

ket, already marked by intense

forced upon them by regulators

competition for new capacity and

or competitors.

industrial demand, will become

We will begin by describing a vi-

even more competitive as it

sion of the future generation busi-

makes the transition from regu-

ness and then suggest possible

lated local monopoly to market-

paths for winners.

based commodity pricing. At risk is up to $150 billion of share-

I. Inevitable Competition

holder equity and the future vi-

Electric supply industries in

ability of half of the country’s in-

England/Wales, Norway, Spain,

vestor-owned utilities.

Chile, Argentina, and Australia

have already exposed their gen-

clever, value-adding, risk-manag-

eration sectors to market pricing.

ing packages. That said, there are

ticipated are consistently sur-

Their experiences demonstrate

important differences between

prised at how much the genera-

that the generation sector can ef-

electric power and other com-

tion business of the future will dif-

Utility executives who have par-

fectively use free markets to set

modities. Most important are the

fer from the markets they now

prices. They also show that con-

instantaneous nature of demand,

understand. Three characteristics

cerns about generation security, re-

high demand fluctuations, and

of these markets will be most im-

liability, and the risk of major dis-

the inability to store electricity eco-

portant for generation strategists

ruptions are largely unfounded.

nomically in significant amounts.

and operators:

Regulators in those countries believed that the competition would

These physical differences will play important roles in the micro-

be more effective at reducing elec-

economics of the emerging gen-

tricity prices than cost-of-service

eration market.

regulation. The same belief now underpins the thinking of an in-

Thanks to experience from overseas and regulatory initiatives to


Prices will be lower than most

expect, most of the time; l

Prices will be volatile; and


Patterns of supply-demand

balance, ownership concentration, and transmission access will play

creasing number of policy makers

a big role in shaping the financial

in the United States. Competition

results of competitors.

for new generation in the U.S. is

A. Low Prices

already quite intense. New capac-

Lessons learned from other capi-

ity requests are met with offers totaling 15 to 20 times the amount

tal-intensive commodity indus-

sought, or more. This competition

tries suggest that in fragmented

has significantly lowered the cost

markets with many owners of ca-

of new generation, with prices

pacity and excess supply prices

around $35/MWh now typical.

are driven down toward (and in some cases below) short-run mar-

The Federal Energy Regulatory Commission is reforming the

ginal cost by intensively competi-

rules for transmission access and

tive conduct. This is likely to be

pricing that will affect wholesale

the case for most U.S. electricity generation for many years.

access to power generation. State

date, we already have a good un-

regulators and legislators in over

derstanding of how this commod-

35 states have initiated investiga-

ity market will likely unfold. Ro-

tions into generation competition,

bust regional markets will emerge

10 mills at the California-Oregon

led by California, Massachusetts,

covering large territories. The

border to 30 mills for PJM in the

Michigan and Georgia. These

laws of supply and demand will

East. Some may argue that these

changes will produce real benefits

rule. Local supply-demand bal-

markets are illiquid, governed by

Spot prices in the U.S. are already quite low. Prices range from

for ratepayers. As a result, compe-

ances and transmission con-

existing constraints, or impacted

tition in all aspects of the genera-

straints will account for most of

by capital recovery in regulated

tion business is inevitable.

the differences in prices, but mar-

home markets. We agree. How-

kets will erode differences over

ever, combined with the emerging

time. Bilateral contracts and spot

longer-term wholesale market,

markets will exist in parallel, with

they provide useful indicators of

futures markets facilitating risk

pricing range likely to bound real-

trons look the same, despite the

management. We have conducted

ized prices for commodity gener-

urgent attempts of power market-

simulations of the bidding-driven

ators. At the low end, these prices

ers to wrap the commodity in

markets expected in generation.

barely cover cash costs and are in-

II. Generation Market Characteristics Electricity is a commodity. Elec-


The Electricity Journnl

dicative of how low prices can go in a down cycle. Most U.S. regional markets cur-

stations. Mothballed plants that

no longer be viable, exacerbating

are available to return to service

the stranded cost problem for

may also act as a ceiling over ac-

many utilities.

rently have excess generation ca-

tive participants in some cases,

pacity; this situation is likely to

preventing the market price from

B. Volatile Prices

continue for many years because

rising to the level of the full cost

Experience from international

of the surplus of supply implied

of a new entrant.

by excess reserve margins (see

These low prices will necessi-

markets and our modeling of likely pricing dynamics in se-

Figure 1). The onset of market

tate a hard look at generation port-

lected U.S. markets suggests that

pricing will further aggravate

folios. Plants requiring significant

hourly and seasonal price volatil-

oversupply conditions because

amounts of capital investment

ity in U.S. spot electricity markets

true cost pricing of peaking

will find it difficult to justify the

will be high. How high? Seasonal

power will depress peak demand

needed expenditures. High vari-

peaks can be lo-20 times the night-

relative to average demand, and

able-cost facilities will not sur-

time low (see Figure 2). These

profit-driven creativity will en-

vive. All aspects of plant costs will

high prices are necessary to allow

able generators to meet peak de-

need to be examined under the

plants that will operate very few

mand reliably with smaller re-

hard light of low market prices. A

hours in a year to recover their an-

serves than under traditional

quantum improvement in new

ticipated cash costs. In the U.S.,

regulation. These factors will only

capital, fuel, O&M and overhead

shifting marginal fuel sources and

be partially offset by demand

costs will be needed if profits are

other factors could make the vola-

growth spurred by lower prices.

to be delivered to shareholders.

tility even higher. We expect elec-

Despite recent improvements,

tricity price volatility to be higher

Even when new generation is needed, it is unlikely to provide

few utility generators have

than that observed in crude or natural gas markets.

the price umbrella hoped for by

reached the limits of cost reduc-

today’s high-cost generators. New

tion across their full range of cost

IPP contracts are typically for

inputs. Some nuclear plants, be-

prices well below the comfort

cause of expected capital require-

volatility means margins will

zone of most existing generating

ments or poor performance, may

vary greatly over the course of a

This volatility will have several implications for generators. First,

day or a season. It will be essential to be on-line when the market peaks because that is when profits will be earned. Assuming volatility, about 70 percent of a generator’s gross margin could be earned in the 25 percent of the hours where prices are highest. This creates an organizational imperative to improve forecasting skills, ensure availability, and increase operational responsiveness (both up and down) to a much greater extent than is the practice today. Second, volatility will put pressure on fuel suppliers. Absolute Figure 1: Reserve Margins in U.S. (1994)



price levels will be under greater


scrutiny than ever before as fuel

and supply-demand balance will

owners the opportunity to re-

cost pass-throughs will give way

be the most significant factors in

cover costs and make profits, at

to market prices. Innovative con-

determining how market partici-

least for now.

tracts that index full or incre-

pants conduct themselves and

mental fuel prices to electricity

what financial results they

such markets is guided by self-in-

prices will be needed to ensure


terest, based on an understanding

that plants can swing with the

The conduct of participants in

Comparison of the Eng-

of the likely competitor reactions

market. Delivery terms will need

land/Wales and Norwegian

to their pricing behavior. This is

to be equally flexible. Fuel suppli-

wholesale electricity markets

not surprising given the fre-

ers will need to be able to under-

shows how market structure has

quency of bids. A facile inference

stand, price and manage these

affected pricing conduct in gen-

that such markets are collusive is

new risks. Use of the rapidly

eration (see Figure 3). In the Nor-

unjustified, since these outcomes

growing financial markets to

wegian case, a large number of

are those that should follow from

hedge fuel or price risk will be in-

participants contending in a frag-

actions based on enlightened self-

mented market have driven

interest. The lesson for generators

prices down to short-run mar-

in the U.S. is that it may be possi-

C. Structure Matters

ginal cost, compared to full cost

ble for participants to meet quanti-

As we have observed in other

recovery prior to deregulation. In

tative antitrust tests for market

creasingly commonplace.

commodities and international

the England/Wales case, design

concentration, adhere rigorously

generation markets, the structure

of an oligopolistic market with

to laws and regulations prohibit-

of a local market can greatly influ-

three major participants (one of

ing collusion and anti-competitive

ence competitor profitability. In re-

which one is state-owned nuclear

behavior, and still earn reasonable

gional generation markets, the in-

generation operating under must-

returns. Long-run returns, how-

terplay between patterns of

run conditions) has resulted in

ever, will be capped by the threat

ownership, transmission access,

pricing that affords generation

of entry from new capacity so

. . . contribution earned in peak hours

Volatile spot prices lead to. . .




Percent of total contribution


n ”



-0 Half-hour







Percent of total hours

Figure 2: Price Volatility Impact


The Electricity Journal

low costs will remain an imperative. A second form of market power

tal or vertical market power. But

III. A Winning Strategy for

even if plants are divested, pres-


sure to reconsolidate, driven by

The advent of market pricing

is that represented by a plant in a

the potential for improved profit-

for generation and the unfavor-

critical location, either from a sys-

ability, will be substantial.

able starting point for generators

Regulators must seek a balance,

tem stability or transmission con-

in many regions means genera-

straints standpoint. While it is

however, as a more concentrated

tion owners must address three

likely that these facilities will be

structure can produce more stable

major strategic elements to pro-

able to extract some premium for

pricing, lessen the risk of capacity

tect shareholder interests and cap-

a period of time, regulatory over-

shortfalls, and reduce transition

ture some of the opportunity in-

sight, new generation and trans-

costs by creating a business envi-

herent in a restructuring of this

mission upgrade options will

ronment where reinvestment by


limit the long-term potential for

generation owners in reliability

above-market returns.

and ultimately new capacity is at-

A. Negotiate an Acceptable

tractive. A win-win solution,


the potential impact of market

where costs are driven out by

Most generators will have at

structure on returns. In California,

competition to the benefit of con-

least some transition costs, as in-

several approaches, including the

sumers and generation remains

itial pricing levels are unlikely to

partial divestiture of fossil-fueled

an attractive business, may be

provide a return even on embed-

plants, are being implemented to

within reach.

ded capital. The total U.S. expo-

Regulators already recognize

mitigate various forms of horizon-

Norway market share

England and Wales market share


100% = 272 TWh Other Pumped storage and interconnections

8 a 35

Nuclear Electric

National Power


26 @ Elektrisitetverk . .,. .’

Lyse Kraff


Kommunal Kraffselskap

: ....’ .; ,,::,;. :: ..:.:. ,,,,,., :,::;.:, :.:. .,...


Prices Pence/kWh, inflation adjusted

Prices OrelkWh 43-

Nov 90



Aug 94

Apr 90




Jun 93

Figure 3: Norway and U.K. Experience




sure of uncompetitive generation

staggered schedule of customer

charges for retail customers, fail-

could exceed $20 billion per year.

access to market prices.

ure to recognize social costs, and

While this aggregate figure in-

Figure 4 illustrates how some of

relationships between new gen-

cludes both low-cost winners and

these actions can mitigate the im-

eration companies and distribu-

high-cost losers, there is a huge

pact of market price deregulation

tion companies. Utility manage-

overall opportunity for wealth to

on a generator.

ment teams must remain active

be transferred from utility share-

Still, customers must see some

holders to customers, depending

immediate benefits if there is to be

helping regulators create the rules

on how deregulation proceeds.

a politically salable outcome.

that achieve social objectives with-

High transition charges appearing

out costly, unintended side effects.

At the same time, neither cus-

on their shareholders’ behalf,

tomers nor regulators have an in-

on a monthly bill will create

terest in destroying the financial

heavy pressure to undermine full

integrity of the generation sector,

recovery or reduce recovery peri-


particularly since price reduction

ods. Utilities must view transition

A second major focus for own-

benefits are achievable without

cost minimization as very much

ers of generation is to critically

this. All parties must agree on

in their own interest.

evaluate their current portfolio of

terms for an orderly transition to

In order to avoid unintention-

market pricing that preserve rea-

ally harmful transition outcomes,

B. Restructure the Generation

generation assets and identify how to transform it into an asset

sonable levels of shareholder

it is important that utilities remain

position that will survive an era

value while creating benefits for

active participants in shaping the

of cutthroat price competition to

customers. For example, terms

details of the transition. Market

yield a superior competitive posi-

might include:

design flaws can be observed in

tion. Strategists will need to ad-

each of the markets that have de-

dress plant-specific tactics as well

ductivity gains in generation and

regulated. These defects can im-

as overall generation portfolio

distribution and using them to

pact company financial perform-

strategy, including:

fund the transition;

ance dramatically Examples of


Aggressively pursuing pro-

0 Selling low-cost plants to offset stranded costs on high-cost fa-

a Aggressively reducing operating

this include poorly crafted rules

and maintenance costs and capital

governing metering, switching

outlays in a way that is sustainable.

cilities or uncompetitive purchased power agreements; l

Accelerating the recovery of


high sunk-cost generation assets and thereby exchanging reduced profits for more competitive generation later; l Looking for politically acceptable tradeoffs between the level of transition charges and the period over which they may be collected to deliver some customer benefits

9 1

Unmodified full cost Market price atommtlc competition


Full cost with accelerated amortization

early, while managing utility risk; and l

Phasing the transition from



Earliest date feasible )


Too late

cost-of-service pricing to marketbased pricing by delaying the start of competition or adopting a


Figure 4: Transition Strategy Options

The Elecfricit?y]ournal

For example, the England/ Wales

low and selling them into an over-

dustry structure may reveal paths

gencos profited by reducing per-

heated market.

to more stable industry structure

sonnel levels by 61 percent from

through mergers and acquisitions

A key decision for many gener-

1990 to 1995. Our experience with

ators will be the amount of com-

that can meet the rigorous scru-

performance improvement at

modity sales capability they will

tiny of antitrust regulators. The

utilities suggests that many gener-

need to ensure a home for their

answers will be region- and com-

ators are capable of reducing the

production. At a minimum, a ro-

pany-specific because of different

continuing cost of generation in

bust wholesale marketing organi-

demand profiles, growth rates,

the range of 15 to 30 percent.

zation will be necessary Beyond

supply positions, and competitors.

that, we believe retail sales and

Utilities whose regional market

turing supply contracts and weigh-

power trading can be left to the

structure already has these condi-

ing the cost of supply certainty or

large intermediaries or evaluated

tions must anticipate and protect

fuel quality against the pressure of

as an independent business.

the critical elements of their posi-

0 Improvingfuel

costs by restruc-

low market prices. Gencos in the

tion against the calls for forced di-

U.K. succeeded in reducing coal

vestiture and breakup. Lastly, utilities must consider ex-

fuel costs by about 20 percent from 1991 to 1995. U.S. utilities

iting the generation business alto-

are considering the option of

gether if there is no reasonable

burning low-value coal or elimi-

prospect for constructing a supe-

nating backup fuel capabilities

rior generation portfolio, or if

when this is acceptable.

regulators are unlikely to allow


utilities to compete on a level field

Targeting limited capital expendi-

tures to improvingflexibility

with other generators. This may

or re-

be the shareholders’ best chance

ducing variable costs. l

to extract the full value of their

Shutting down or mothballing

generating assets.

capacity that will be uneconomic to operate under market pricing. About

IV. Conclusion

15,000 MW of coal and oil-fueled capacity was retired by the Eng-

So, should you be a buyer or a

land/ Wales gencos between 1990 C. Create an Attractive Market

and 1995. l

seller? Spot buyers of power

Merging small systems to

achieve economies of scale across

should do well. On average, gen-


eration owners will be very fortu-

To the extent possible, utilities in

nate to recover their stranded

plants in non-plant fixed costs or

highly fragmented regions should

costs. We believe, however, that

outsourcing generation support

look to consolidated ownership or

there will be winners among own-

to cooperation to achieve a more

ers of generation, as well. Under-

sustainable market structure. As-

standing the drivers of market

sessing the level of concentration

prices and focusing on superior

most likely to lead to sustainable re-

operations will enable some to

services to capture efficiencies where a single utility is smaller than minimum economic scale. l

Selling or purchasing assets over

the course of the market cycle. Examination of other commodity markets suggests that the biggest winners are often those willing to play the contrarian: buying facilities when commodity prices are

turns and understanding which

win in a very challenging com-

combinations of assets best posi-

modity market. The industry lead-

tions a company to benefit is essen-

ers who boldly act on all three di-

tial to creating an appropriate struc-

mensions of strategy will create

ture. Numerical analysis and the

enormous value for their share-

application of game theory to in-

holders and customers. Competition will take care of the timid. n -