FSR Topic of the Month

by Nicolò Rossetto and Piero Carlo Dos Reis

New business models in a changing industry

Electricity grids – both transmission and distribution – are caught in between the greening of electricity and the digitalisation of retail-size units. On the one hand, the rapid expansion of renewables in the generation mix, in particular wind and solar PV, calls for a quick adaptation of the electricity network and its operation. This is necessary to integrate the massive amount of new generating units, sometimes located far from the load centres and sometimes so small and dispersed that they must be connected directly to the distribution grid. On the other hand, the activation of smaller network users enabled by digitalisation creates a more complex environment where the use of the grid can be less predictable, some actors can free ride the system, and digital firms may enter the scene and disrupt the traditional organisation of the sector.

Electricity grids are usually a regulated activity whose business model relies on the pair “assets-revenues”. Grid companies must connect network users by investing in long-lived physical assets, whose cost-recovery is then ensured, up to a certain extent, by the regulatory framework and the tariffs defined by the regulator.[1] Grid companies, in other words, have a set of obligations to perform and limited room for manoeuvre in the decisions they can take over the services they offer and their pricing. The greening of generation and the digitalisation of retail-size units challenge the traditional regulatory compact as well as its ability to provide an efficient service and fair treatment of customers. Let us consider briefly two examples to understand the point.

The first example concerns offshore electric grids. The decrease in costs and the abundance of the primary resource is fostering the exploitation of offshore wind for electricity generation. In the Northern European seas, several GW of capacity have been installed in the past decade. A new grid had to be created to connect the offshore wind farms to the main onshore transmission systems. Experience suggests that doing so efficiently and effectively is not easy. In particular, according to a recent study by DIW Econ, the development of offshore transmission assets by the coastal TSO, under a monopolistic regime and in separation from the offshore wind farm developer, does not ensure cost efficiency. By comparing the German case to the British one, the study argues that the traditional approach to grid development can lead to an increase in the cost of transmitting electricity of around 10 euro/MWh.

The second example focuses on onshore electricity grids. The reduction in PV and battery costs is allowing consumers to produce their electricity at a cost close to the retail price of electricity (socket parity). This is particularly the case in jurisdictions where network costs and levies are charged according to the volume of electricity withdrawn from the public grid. In those cases, active consumers can “push back”, by investing in PV and batteries, turn into prosumers or prosumagers, and leave the cost of the grid and the public policies to passive consumers. The implications in terms of efficiency and equity are clear, as well as the risks for the grid company. On the one hand, it has to deal with an increase in costs – the grid must be expanded to augment the hosting capacity of distributed generation – and, on the other hand, it has to deal with a decrease in its revenue drivers – the amount of electricity flowing in the grid or the capacity “sold” to the network users go down.

These and similar examples show how the business model of electric grids is directly affected by the greening of generation and the digitalisation of retail-size units. They also highlight the importance of a change in the regulatory framework to enable grids’ adaptation to the new reality. In particular, regulation should protect grid companies and their investors from excessive risks, while at the same time induce them to experiment with innovative technologies and non-wire alternatives, possibly less capital intensive than the traditional solutions. The development of flexibility markets at the local level, potentially in cooperation with other parties like power exchanges and software companies, is an example of such a move beyond the usual “fit & forget” approach and the tendency to solve problems by using more iron and copper.

Unfortunately, regulatory changes currently look like slow and tentative. This is not surprising, given the political sensitivity of certain regulatory choices and their distributive implications, not to mention the concerns over unbundling and the preservation of a level playing field for market players. Moreover, although there are some concrete experiences, like the RIIO model in Great Britain, and some theoretical blueprints, like the MIT Utility of the Future, practical implementation of new regulatory principles is not that simple and straightforward.[2]

Grid companies seem aware of the challenges and, at least in the most advanced cases, are willing to embrace the opportunities that decarbonisation and digitalisation of the sector are providing. The idea is to turn from “dumb” pipes into platforms that put the customer at the centre, control the flow of data on the electric system status, and enable new services to be developed (also) by third parties. This transition to a business model driven by the pair “characteristics-customers” may allow grid companies to resist the entrance of digital companies in the electricity sector and manage its growing decentralisation.

Nonetheless, grid companies do not enjoy the same freedom that innovative companies in other economic sectors like clothing or consumer electronics have. Grids are vested with a public interest and a series of public service obligations. They are mandated to provide access to all network users based on predictable, transparent and non-discriminatory tariffs, exactly the opposite of what other well-known platforms do. In addition, grid companies may be blocked by legacy investment, a less innovative company culture or the lack of specific skills and expertise.

Electricity grids today are in the middle of the energy transition. Everything is moving around them. Will they move too and lead the change or follow it? Only time will tell.

[1] Incentive regulation does not ensure the automatic recovery of the costs incurred by a grid company under all circumstance. Indeed, the incentive lies in the possibility for the firm to lose money, if it is not able to deliver the service requested by the regulator or to contain its costs vis-à-vis the expectations set by the regulator.

[2] The limited development in the “Reforming the Energy Vision” adopted by the New York regulatory authority in 2014 is a good example of that.