Throughout the world, the electric utility industry is undergoing rapid change. Its traditional attributes—monopoly status, government ownership, and government regulation—are giving way to more complex patterns. In the United Kingdom, for example, most of the industry has been privatized. Competition now sets the price of power, and large and medium-sized customers can already choose their electricity suppliers. By 1998, this choice will be extended to all customers.

The power businesses in Argentina, Chile, and Nova Scotia (Canada) have also been largely privatized, and Australia has taken the first step by corporatizing publicly-owned utilities. In China, India, and Mexico, among other countries, dozens of companies—from Exxon and General Electric to one-person enterprises—are attempting to build generating plants and sell power to utilities and businesses. Independent power producers in the US have built more than half of the generating capacity that has come on-line in the last two years. Wholesale customers now have direct access to all power producers, and California is proposing to extend this access to all customers.

These dramatic changes—and many more to come—will affect us all: customers, who are likely to benefit from lower prices but will also have to deal with complex new choices; investors, who can no longer count on utility stocks to be "safe"; employees, for whom the implicit guarantee of lifetime employment no longer holds; government officials, who have to balance diverse interests; environmentalists, consumer advocates, and politicians, who will find utilities much more resistant to "social" programs that might hinder competitiveness; and electric power executives, whose companies are moving into uncharted territory that offers huge challenges and opportunities.

To prepare for the future of the industry, these stakeholders need to understand the radical nature of the changes that are taking place—and so be prepared to abandon their old patterns of thought and behavior.

A brief history

"We will make electric light so cheap that only the rich will be able to burn candles," Edison declared

Thomas Edison's early vision of the electric power industry was that, as plants grew and became more efficient, they would generate electricity at lower and lower costs. "We will make electric light so cheap that only the rich will be able to burn candles," he declared. The consensus shared by Edison, Samuel Insull, and other early industry leaders was that electricity could be most efficiently supplied by vertically-integrated monopolies. For most of the industry's first century, the price of electricity did indeed fall. Economies of scale were achieved by building bigger and bigger generating plants—fossil, nuclear, or hydro. Utilities also achieved scale economies in transmitting and distributing power to meet varying customer demand at different times of the day and year, making it possible for large generating plants to operate on a continuous basis. As a monopoly, the utility naturally assumed the dominant role in determining what plants to build and what level of service to provide. Customers, of course, needed to be protected from the abuse of monopoly power, so government had a role to play. Insull and other industry pioneers, striving for scale economies, were willing to accept government supervision in return for open-ended franchises to supply electricity.

In most countries today, government bodies regulate the prices a utility can charge

In most countries today, government bodies regulate the prices a utility can charge, its financial performance, and such aspects of its business as the fuels it can use and the environmental standards it must achieve. In many, that control is exerted through government ownership.

In fact, public ownership of utilities is common around the world. It occurs in countries with a tradition of public ownership of vital services, like Canada and France. It also occurs in countries where the private capital markets needed to finance investment in power facilities simply did not exist. Even in the United States there are about 3,000 publicly-owned utilities, thanks in part to historical financing advantages.

Transition

The traditional characteristics of the electric power industry are not inviolable or inevitable, however. The restructuring currently under way in many parts of the world demonstrates that other forms of organization are possible. The industry could, for example, be structured so that customers were able to choose their supplier and their terms of supply—rather than the utility alone determining the service it will provide. Competition, especially in power generation, can replace government regulation as a means of setting prices and monitoring financial performance. Finally, the private sector can assume a growing role in owning and operating power plants as well as transmission and distribution facilities.

Such changes are driven by a number of strong forces at work: predominantly global competition, increasingly demanding customers, deregulation, government deficits, capital liquidity, the relatively low price of oil and natural gas, and concern for customers and the environment. These forces will play out—and be managed—in different ways from country to country and from region to region. No single solution can work for all countries and all regions, but they will each see, to some degree, more customer choice, more competitive markets, and more private ownership.

Increasing customer choice

Chief among the forces driving ever greater customer choice are three factors: government attitudes, the opportunity for lower prices, and the need for new products and services.

Pro-market governmental philosophy

During the past decade economic policy all over the world has favored breaking up monopolies and giving customers the right to choose

During the past decade or so, economic policy all over the world has favored breaking up monopolies and giving customers the right to choose. American customers, for instance, have benefited from wider choice in such industries as telecommunications, airlines, financial services, and natural gas. Many of these customers want to be able to exert choices in electricity too.

In the United Kingdom, the Thatcher government's ideological opposition to monopolies culminated in the breaking up of several, including the business of electric power generation and transmission. Margaret Thatcher's Secretary of State for Energy, Cecil Parkinson, said, "I wanted to introduce competition where possible, and regulation where it was not." When the UK restructuring took place in 1990, large customers were allowed to purchase electricity from any generator or distribution company. From 1994, medium-sized companies will be able to do the same. By 1998, every customer in the country will have a choice of electricity supplier, much as Americans can select their long-distance telephone company.

Lower prices

Customers who have a choice can get a better deal. As the large UK customers took advantage of their new-found choice—62 percent of them changing suppliers in the years immediately after restructuring—they were able, as a group, to reduce their electricity rates. Smaller customers, however, endured rising rates during the same period. When they too gain the right to choose their supplier, it may become difficult to impose price increases on any group.

Governments are not always the primary agents of change. Customers can apply pressure when they perceive opportunities for lower prices. As they see their competitors and neighbors benefiting from cheaper rates, customers in many countries are growing sensitive to disparities in electricity prices. Industrial customers that own plants in different utility service territories, for example, will push for price reductions from the more expensive suppliers.

Industrial electricity prices in Japan are almost four times higher than those in Canada

There are tremendous worldwide variations in electricity prices. As Exhibit 1 shows, industrial prices in Japan are almost four times higher than those in Canada. Significant differences can also be found within countries. Customers of some US utilities pay two to three times as much as their counterparts elsewhere in the country.

These disparities become more and more important as global competition heats up. Customers of high-cost utilities become agents for change as they seek access to cheaper power supplies. They can reduce their costs by improving the efficiency of their operations, by moving plants or production to lower-cost areas, by switching to alternative fuels such as natural gas, or by generating their own power. As industrial customers in the US have pursued these options, or threatened to do so, their rates have fallen relative to those of other customers.

The independent sector has shown that it can generate power at relatively low cost

As customers push for access to cheaper suppliers, their local utilities will attempt to cut special deals

Another option exists for reducing electricity costs: gaining access to cheaper suppliers, such as a neighboring utility with spare capacity or an independent power producer. This option has recently attracted a lot of attention, for two reasons. First, by using new technology and advantageous long-term natural gas contracts, the independent sector has shown that it can generate power at relatively low cost. Second, municipal and other wholesale customers have won access to the transmission grid, which allows them to search for inexpensive suppliers. One Pennsylvania township, for example, is acting to cut its power costs in half by switching suppliers. Large retail customers are looking for the same prerogative. As customers push for access to cheaper suppliers, their local utilities, often encouraged by politicians anxious to keep jobs in the economy, will attempt to cut special deals. But such deals can quickly put a utility on a "slippery slope" leading to access to other suppliers for most or all of its customers. Several states have already ventured down the slope by offering a choice of electricity supplier to, for example, large new load (in Georgia) and neighbors of cogeneration plants (in New York). Michigan has announced a limited experiment in access for large retail customers.

In a bold and unexpected move, the California Public Utility Commission has proposed a comprehensive restructuring of its electric power industry that will, over a six-year period starting in 1996, allow all customers to choose their electricity suppliers. Certain to be replicated (at least in part) elsewhere, this proposal is prompted by the primary goal of pushing electricity prices down for California's residential and business customers.

Brokers and other intermediaries could play an important role in aggregating customers and accelerating the move down this slippery slope. An intermediary in the United Kingdom, for example, will be providing electricity for all 500 McDonald's outlets there. Experienced brokers from the US natural gas market are entering the electricity business to serve wholesale and eventually retail customers.

Similar pressures are emerging in other parts of the world. As global competitiveness increases, customers paying relatively high electricity prices in countries such as Japan and Italy will push for change. German industrial companies located near the French border are demanding access to lower prices. Norwegian hydro-based suppliers are seeking access to industrial customers in Sweden and northern Germany. Though Canada as a whole has relatively low rates, industrial customers in Ontario, which pay 35 percent more than in other parts of the country, will certainly be a force for change.

Need for new products and services

Reasons other than price are motivating customers to look for change; many are experiencing a growing need for different products and services. In Southeastern China, Hopewell and New World Development wanted a more reliable power supply for their hotels, so they entered the power generation business themselves. Industrial companies in Italy and elsewhere are building cogeneration plants both to guarantee a reliable supply for their own power needs and to take advantage of opportunities to sell surplus power to the state-owned utility on attractive terms. Australian mining giant Comelco has sought to purchase public generation assets to secure the quality and price of its power.

At the same time, in the UK, increasing customer choice has brought such innovations as appointments for service, 24-hour call centers, and a variety of payment plans, such as prices that are indexed to natural gas or oil prices.

Inhibiting factors

In most countries, utilities are a traditional instrument of social and economic policy

Several strong forces are also working in the opposite direction, away from wider customer choice. In most countries, utilities are a traditional instrument of social and economic policy. The commitment to nuclear power in France, for example, has resulted in a highly centralized system that presents only limited opportunities for customer choice. Germany has traditionally protected its coal industry. Elsewhere—in Japan, for instance—environmental concerns have been paramount. Many people fear that allowing customers a wider choice will jeopardize the sound agenda previously implemented by utility monopolies.

Another worry is that if the largest customers leave utility systems and make their own deals, the price to "captive" customers—those that have no other options—will increase. The same concern has, of course, been aired every time an industry goes through deregulation, although even the captive customers often benefit from a more efficient industry and new products and services. Because of this concern, however, the representatives of certain consumer groups have opposed widespread access for retail customers in the US. One key utility concern about widespread retail access is that they will retain the obligation—and thus the cost—to serve all customers, even those that move to new suppliers.

National differences

The forces supporting and opposing increasing customer choice have played out differently from country to country (Exhibit 2). Norway and the United Kingdom currently offer the greatest degree of customer choice; Japan and France have the least, with Germany better; US customers can choose to cogenerate and are increasingly gaining access to new suppliers; large customers in Spain can opt out of the utility franchise market and enter into contracts with suppliers. More countries are likely to move toward the right of this scale as the benefits of choice become clear and as mechanisms are developed to handle the legitimate concerns that are presently inhibiting change.

Market prices

The second major change in the worldwide electric power industry is the use of competitive markets to set electricity prices—specifically, the price of power at the generating plant.

New entrants

The major force behind this shift is the new entrants to the power generation business: independent power producers (IPPs) that are prepared to build, own, and operate plants in return for contracts to purchase the power they generate. There are many of these IPPs—several hundred in the US alone. The largest include utility subsidiaries, fuel suppliers, and industrial companies, as well as developers. Their involvement has created a very competitive market for new power, which has eliminated the need for governments to set prices in many cases.

In the US, for example, the market is driving down the price of new generation at the power plant. Over time, requests by utilities for new capacity have led IPPs and neighboring utilities with spare capacity to offer more and more power (Exhibit 3). In recent years, some 16 mega-watts of new capacity have been offered by IPPs and others for every megawatt solicited by utilities. (The most recent solicitations have resulted in even greater responses.) Thanks to this competition, recent contracts have been in the range of 3 to 4 cents per kilowatt hour levelized in real terms for 10 to 20 years, well below both the price of just a few years ago and the average full cost of generation of most US utilities.

These bids—which are based on the latest combined cycle technologies (with very low pollutant emissions)—reflect the recent low prices for natural gas. But they are not as sensitive to gas prices as many expected, owing to the efficiency of the technology and the availability of long-term gas contracts.

Inhibiting factors

As with increasing customer choice, several forces are working against as well as toward this industry shift. Many utilities are concerned that competition will be extended from new generation only to all generation, and that the resulting low prices will make it impossible to recover the costs that were incurred in constructing existing plants, especially expensive nuclear facilities. They worry that their investment in these assets will be "stranded." Their concern is justified. Once market forces are set in motion, their impact tends to spread.

Concern about this and other issues led to UK nuclear plants remaining in state ownership, subsidized by the so-called nuclear levy. In the US, substantial generation costs are being recovered from customers at levels above the cost of power from a new IPP plant. The curve in Exhibit 4 is an estimate of the full cost of generation—fuel, operations and maintenance, and capital recovery—and power purchase commitments for all US private utilities. The full generation cost ranges from below 2 cents per kilowatt hour to more than 8.

Almost two-thirds of the power generated by US private utilities has a full cost above a "benchmark" of 3.5 cents per kilowatt hour (the low end of the IPP cost from Exhibit 3 plus a half cent for transmission.) The shaded area under this cost curve arguably represents potentially uneconomic generation costs, and adds up to a huge number—about $20-25 billion per year. If any significant share of this cost could not be recovered from customers, many large US utilities would have severe financial problems. (They could, of course, simply write off or write down their assets and become competitive overnight, but their investors would not be very happy.)

Allowing competition to set electricity prices makes it impossible to collect the social costs incurred by power generation

Another concern about allowing competition to set electricity prices is that it makes it impossible to collect the social costs incurred by power generation, such as environmental damage. Believers in command and control regulation would prefer to retain a strong role for government. However, as society grows more comfortable with the use of market forces to deal with such problems—as, for instance, with the tradable allowances for sulphur dioxide emissions in the US—much of the resistance to market pricing is likely to fade.

Because distribution and transmission facilities (for example, wires, substations) are natural monopolies, the use of these assets is likely to remain regulated. Even here, however, incentive regulation is likely to be used to simulate competitive market pressures. The price caps used in the US telecom industry and the UK transmission and distribution sectors are one example. California's restructuring proposal calls for performance-based regulation in noncompetitive segments and mentions the use of price and/or revenue caps explicitly.

National differences

In spite of the forces acting against change, the electric power industry as a whole is irresistibly moving toward a more competitive market basis. Exhibit 5 shows how far different countries have gone in this direction.

Under the UK system, for example, competition to run generating units during the following day sets the short-term price. Norway is even more competitive since it has many more potential suppliers. In addition to having a competitive market in new generation, the United States allows wholesale competition and tends to include incentives in government regulation. In China, India, and other developing countries, competition is now setting the price for new sources of generation. France relies on a government-established formula for setting its rates, although there has recently been talk of introducing competition there too.

Increasing private ownership

The third major change in the electric power industry is the trend toward private ownership of once-public assets.

Capital needs

Twenty percent of all industrial equipment in China remains idle because of power shortages

One factor underlying this trend is the industry's need for capital—primarily for new generation, but also for refurbishing existing plants for environmental and efficiency reasons. This capital need can be enormous, easily adding up to over $1 trillion worldwide in the next decade. Many countries, especially in Asia, have daily blackouts because their electrical generating capacity has not kept up with the growth of their economies. Twenty percent of all industrial equipment in China remains idle because of power shortages. Other countries with rapidly developing economies, such as Mexico and Brazil, will need to add substantial new capacity in the future.

Traditional financial sources are unable to meet these capital needs. Funding from multilateral agencies, such as the World Bank and Asian Development Bank, will only provide about 15 percent of the sums required. Private capital will clearly be needed. Moreover, for governments struggling to cope with deficits in countries such as Argentina and Australia, the sale of utility assets looks increasingly attractive.

Efficiency improvements

The inefficiency of many utilities is another argument for private ownership, given the belief that this imposes a discipline on management that governments cannot emulate. The wide variations in employee productivity worldwide (see Exhibit 6) suggest that such a discipline may be necessary. Even though the United States tops the list, the productivity of many of its utilities has plenty of room for improvement. In the past few years, utility employment has been cut by 22,000, but this represents only 4 percent of the workforce.

By contrast, the UK industry has achieved an overall headcount reduction of about 20 percent since privatization. The privatized generating companies there have reduced their staff by over 50 percent (with more cuts to come) while increasing the productivity, environmental performance, and safety of their plants.

Inhibiting factors

Strong reasons remain for the public sector to continue its involvement

Despite the push toward private ownership and financing, strong reasons remain for the public sector to continue its involvement. On the domestic front, government's sovereign guarantees are needed to reduce project risk. IPP developers in India, for example, requested and received government guarantees for electricity payments. On the international front, government involvement helps to secure funding from the World Bank, the International Finance Corporation, and other multilateral lenders. Moreover, private investors may simply stay away from some assets—such as expensive nuclear plants—thus making continued government ownership unavoidable.

Infrastructure needs also call for involvement from the public sector. Airports, roads, ports, and the like are often built in conjunction with electric power systems. And finally, some countries will not be comfortable with foreign ownership of such vital public assets as electric power facilities.

Once again, different countries have reached different points in this general movement toward private ownership (Exhibit 7). Over time this movement is likely to accelerate, given the sector's capital needs and the potential for greater efficiency, accountability, and responsiveness. Many developing countries are encouraging private participation in the development of new generating capacity. The United Kingdom, New Zealand, and Argentina have gone furthest in privatizing existing facilities.

Implications

The electric power industry is in transition, moving away from its traditional structure, regulation, and ownership. Some countries are moving faster than others, but the underlying trend is the same. Though it is not possible to predict exactly how things will shake out, we can speculate about what might differentiate successful participants from others as the transition proceeds.

Customers are likely to be the main beneficiaries of restructuring, as in other industries where monopolies have ended. But they will also face greater complexity

Customers are likely to be the main beneficiaries of restructuring, as in other industries where monopolies have ended. They will enjoy lower prices and wider choices, but they will also face greater complexity. Large customers, in particular, will have to develop purchasing and supplier management skills and apply them to the purchase of electricity. Careful assessment of their needs will help them to identify potential tradeoffs between price, power quality and reliability, and related services. Increasingly complex packages will become available as utilities unbundle their services and new suppliers and intermediaries enter the industry with diverse offerings, such as indexed prices.

Investors also face a far more complex environment. Rising interest rates in the US, coupled with deregulation and mounting competition, caused utility stocks to drop by 30 percent between September 1993 and May 1994. When Florida Power and Light cut its annual dividend earlier this year by 32 percent, ending 47 years of rising dividends, its CEO said, "It's not the safe, predictable industry that it was 10 years ago."

Utility investors need to become much more discerning about the strategic position, regulatory environment, and—most important—management prowess of the companies in which they invest. As in any industry undergoing deregulation and hence increased competition, the performance band in electric power will widen considerably. From a situation where most companies earned roughly their regulated rate of return, some companies will emerge as winners and others as losers. In the US natural gas industry, for example, several pipelines went bankrupt, and only a few have emerged as major investment successes.

Investors in independent power projects and their promoters should also be wary. Despite the size and growth of this market, in Asia and elsewhere, intense competition will lead some companies to make commitments they cannot keep. Investors should therefore look for companies with focused strategies based on a clear understanding of their strengths and the use of partners to fill competitive gaps. They should also check that power purchase agreements are soundly anchored by large industrial companies and/or solid government commitments.

Where should competition be introduced and over what time frame?

Governments also have some hard thinking to do. Issues to settle include: What balance should be struck between lower prices to help customers and higher prices to improve utilities' finances? Where should competition be introduced and over what time frame? What form of regulation should be used in the segments where competition is not feasible? And, critically, how should transition issues, such as stranded investment and power purchase commitments, be handled?

How should transition issues, such as stranded investment and power purchase commitments, be handled?

California's approach to these issues will be watched carefully. The principles underlying its regulatory reform are sound: where competition exists, replace regulation with the discipline of the market; where no competition exists, replace traditional cost-of-service regulation with performance-based regulation. Implementing these principles fairly will be a major challenge—again, with stranded investment the key issue.

If the transition is handled skillfully, countries are likely to benefit both from competition in power generation and from regulation that provides market-like incentives in the remaining pieces of the business. Once an appropriate balance is struck with regard to customer choice and competitive markets, the question of how far to go toward private ownership probably matters less, at least in developed countries. For developing countries, however, private ownership can be an important route to meeting sectoral and national aspirations for growth, as well as to improving the industry's reliability and performance.

Where governments are in favor of social programs, they will have to find equitable ways to impose them and pay for them

Environmental and consumer groups—and others that have used utilities over the past two decades as instruments of social policy—are in for a frustrating time. Faced with greater competition, especially in power generation, utilities will be far less receptive to social programs that increase their costs without having the same impact on their competitors. California, a proponent of many such programs in the past, acknowledges that the restructured industry it now seeks will put pressure on the environmental and social agenda. Where governments are in favor of social programs, they will have to find equitable ways to impose them and pay for them.

The utilities themselves can prepare for the new environment by taking four steps.

As the electric power industry fragments, utilities will have to identify the specific businesses in which they can create value

First, as the electric power industry fragments under increasing competition, utilities will have to identify the specific businesses in which they can create value. They need to make an objective, hard-nosed assessment of their skills, opportunities, and challenges. Many will exit the generation business; a few will acquire assets and become regional generators; and some will seek to participate through unregulated subsidiaries, perhaps in partnership with others. Utilities can also attempt to grow by developing new products and services for their customers, such as maintaining and operating the energy plant of large industrial companies.

Second, a reenergized focus on cost competitiveness will be necessary. Utilities can learn from companies that have made continuous performance improvement a part of their culture.

Third, as markets continue to segment in unpredictable ways, utilities should endeavor to understand not only the needs of customers, but also what is driving those needs, the role of price and other factors in their decisions, and what services they want. Competitive industries resegment their customers again and again as they learn more about them. They are also able to respond quickly—a skill that utilities, with the cooperation of regulators, will have to develop.

Finally, regulatory reform will be crucial. Industry leaders will need to reshape regulatory thinking by developing pragmatic and well-reasoned approaches to issues such as competition, stranded investment, obligation to serve, pricing flexibility, and incentives.

These four steps represent a huge challenge for the many utility companies that still feel comfortable with the sheltered environment of the past. They will have to begin to hold their people accountable for performance, bring in new talent, continuously improve on cost, look externally, and think entrepreneurially—not traits commonly associated with the typical utility. If experience with other industries is any guide, those utilities unable to develop the leadership, commitment, and strategies needed to succeed will ultimately disappear, acquired by or merged into larger, more responsive organizations.

When Edison's first power plant lit up bulbs in lower Manhattan in 1882, he said, "I have accomplished all that I promised." Indeed, the vertically-integrated, government-controlled utility that he envisaged served the world well for a century. It is now time for a new vision—one with more customer choice, more competitive markets, and more private ownership.