Risk Management Savvy Vital Under Deregulation

Issue 8 and Volume 103.

In the Face of Tremendous Upheaval in the Electric Utility Industry, There Have Been Many Winners

Computer-based risk management tools are becoming commonplace throughout the power generation industry.
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and losers. But for the bulk of the market’s participants, the picture is still cloudy as to what strategies and tactics will lead to long-term success and reward for their customers and shareholders. Sustainable market value still needs to be determined and there are hidden risks waiting to be revealed.

With risks, however, come opportunities. Consideration of the industry’s fundamental value drivers and a review of other industries that have gone through massive market restructuring can provide a glimpse of an operational profile of a successful player in the deregulated era.

Study History, Don’t Repeat It
The U.S. history of restructuring and deregulation of key infrastructure industries really is quite short, beginning in the late 1970s. Before then, the world was stable and simple, certainly by today’s standards.

It was 20 years ago this year that the Civil Aeronautics Administration (CAB), the economic regulator of the airline business, was eliminated. The CAB controlled service standards, routing, pricing and scheduling within fairly narrow limits. But a growing demand for lower-priced airline tickets and the building pressures of new technology manifested by larger and faster aircraft led to the Carter administration’s decision to remove essentially all controls other than the safety role of the FAA from the industry.

The telecommunications industry was launched into restructuring in a very different way. In 1984, Federal District Court Judge Harold Green ruled that the AT&T system of affiliated and vertically integrated companies (manufacturing, long lines and local service) had to break itself up, resulting in the creation of independent long distance, local service and research/manufacturing companies.

The path to restructuring can be varied. Compare the experience of the natural gas industry with that of airlines and telecommunications. In 1981 Congress passed the Fuels Use Act, dramatically restricting the use of natural gas because of perceived shortages in this critically important commodity. It was not until several years later that the natural gas industry began moving towards restructuring and deregulation, and the prime mover in this case was the primary federal regulator, the Federal Energy Regulatory Commission (FERC)-a very different initiator than in the case of airlines or telecommunications.

The Storm After The Dawn
The aftermath of serious restructuring in the airline, telecommunications and natural gas industries challenged all participants’ survival skills.

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The economic turmoil that unfolded with restructuring in airlines was prolonged and extremely painful, but airline tickets became cheaper (a result now being reversed by an extended period of economic growth). Many traditional players disappeared, some traditional players grew in market share and dominance, and some new players appeared, often passing quickly off the scene. In the process, price wars became the norm and the industry went through two decades of consolidation, liquidation and nonexistent profits.

The restructured telephone industry soon became the telecommunications industry. An explosion of new products appeared. The industry found that the unwillingness of state regulators to loosen the reins often could be sidestepped not by legal arguments, but by the introduction of technologies that simply made state regulation moot. Old market participants were rolled up in massive consolidations and previously unheard-of participants grabbed center stage.

Natural gas restructuring proved no more immune to upheaval than airlines and telecommunications. Pipelines went bankrupt, gas prices plummeted as undreamed of new sources were found, consolidations became commonplace and entirely new participants appeared and, in some cases, became dominant market makers.

Lessons Learned
History seems to be telling us the next decade is not likely to be pretty. There is undoubtedly real benefit to be gained by considering the likely directional changes in the electric industry by drawing upon the very real and painful lessons of these other recently restructured industrial cousins.

In the age of deregulation, the old rules of economic valuation and capital recovery clearly no longer apply, and the new rules haven’t yet been fully developed. The few rules that do exist may be subject to substantial change, even after they have been promulgated. Certainly, the risks associated with this new, unregulated and restructured world for electric generation are legion. Price uncertainty, operational uncertainty, and demand uncertainty all create risks that were not characteristic of the old regulated environment. The good news inherent in all this are the market opportunities that were unavailable in the previous regime.

Keys To Success
A successful participant in this new marketplace must move fast, embrace risks, have capital, and, possibly most important of all, see opportunities where others see peril. This successful operator will look at both sides of the financial equation, examining every conceivable opportunity and vehicle to maximize the revenue stream while minimizing costs.

Tomorrow’s successful entrepreneurs will recognize that the traditional plain vanilla products of the past (kW and kWh) will remain part of the future. But the future will hold the potential for many other ancillary products, such as voltage support, reserve generating capacity cover, and emergency start-up capability, among others. Every revenue stream will be examined to be sure that it is fully utilized. At the same time, there will be an unrelenting emphasis on cost control.

These participants will embrace price volatility as it becomes commonplace in electric energy markets. The frequency of large price excursions such as those seen over the past two summers in various parts of the United States will increase (Figure 1). At the same time, successful participants will have to be extremely competent at maximizing the utilization, the operational performance, and more importantly the financial performance of their generating assets. Thus, a successful generating facility in a market-driven environment will maximize three components: economic availability and reliability, O&M costs, and output capability.

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Enhanced Economic Availability
High availability will become a hallmark of successful asset owners in the future. Market volatility will be such that the bulk of revenues and the overwhelming majority of profitability will be achieved during the relatively few hours in a year when markets clear at extremely high prices (Figure 2). In fact, all the profitability for a year may actually be achieved during a period comprising less than 1,000 hours of high market-clearing prices. Therefore, it will be absolutely essential for a successful operator to have generation availability during those relatively few high market-clearing price hours.

There are many ways to assure high availability. Clearly, avoiding unplanned outages or trips during high-load, high-price market conditions is essential. Another vehicle is to assure that planned outages are done when necessary, and only when necessary. The past tradition of outages being done on a regular basis based upon industry experience as opposed to a formal, technologically-driven, risk-managed basis will no longer be sufficient. As an example, Hartford Steam Boiler’s Turbine Outage Optimization Program (TOOP) methodology provides a fact-based vehicle utilizing the exact plant design and the actual operating history of all major plant components to determine required outage schedules and component maintenance with a level of confidence not previously attainable. An outage optimization initiative can maximize availability by avoiding unnecessary scheduled outages, and also help to minimize costs by recognizing the expensive nature of any planned outage.

Cost Control
In a regulated environment, prices are established in a bottom-up fashion: price equals the sum of all costs plus an allowed return. In a market environment, pricing is determined in a very top-down fashion. There is competition among many suppliers and the market clears at a price generally equal to the marginal cost of production of the highest priced successful bidder. A market participant is successful only if its costs are low enough to make a profit at the market-determined price. In such an environment, it no longer matters if the participant has “reasonable and prudent” costs. It only matters if the participant can attain low enough costs to profitably clear the market.

The result will be an unrelenting and unceasing emphasis on controlling costs. A successful player in a market environment will be one with an unwavering realization that the market will clear at the marginal cost of production of the least efficient unit connected to the grid, including capital recovery. Not only must technology-driven expert systems be deployed, but historic fundamental approaches and management and cultural changes must be examined. Using system databases and benchmarking capabilities, for example, power plants can reduce non-fuel O&M expenses by at least 20 to 30 percent.

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Optimal Output
In a similar fashion, programs that allow optimization of electrical output capability, sometimes with relatively minor changes in practices, will become more widely used. Such programs are aimed at attacking both the pricing and the cost ingredients to enable successful plant operations. Risk management tools are now available to help ensure successful operations in a new market environment, using a technology-driven, expert system approach to determine maximum feasible output capability. Figure 3 shows a typical risk assessment profile for a low-pressure turbine, which allows output maximization by identifying high-risk components where maintenance should be concentrated.

New Relationships
Finally, service providers in this new environment should recognize that a traditional, fee-for-service approach to products and services may no longer be congruent with the needs of facilities’ operators. Certainly, some operators may desire such an approach, but others may feel more closely linked if the advisor suggesting changes to plant practices or maintenance schedules participates in the risk. This can be done by the advisor placing some, and possibly all, of its fees into a risk framework where the rewards are higher if enhanced and more competitive operational outcomes are achieved. The compensation for advisory services is steeply reduced or eliminated if desired outcomes do not result. p

Salil Donde is senior vice president and managing director of power generation for The Hartford Steam Boiler Inspection and Insurance Company.

Bernard Fox is the retired chairman, president and CEO of Northeast Utilities.