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Two future worlds for a Zero Marginal Cost power supply

Updated: Jun 18, 2021

In the congressionally mandated report on the future of electric power, published this February, the National Academy of Engineering has called out a finding on the growth of zero marginal cost power supplies.

Finding 3.5: The performance of current market designs in organized wholesale electricity markets in some regions of the country is being challenged by the changing composition of the resource mix and increased reliance on power supplies with zero marginal costs. One limitation to current wholesale market designs is the lack of sufficient price responsiveness on much of the demand side of the market. More economic and other social science research and analysis is needed to inform future market designs and policy making related to them.

What strikes out here is the growth of zero marginal costs power sources fits interestingly into a larger migration towards a zero marginal economy, a term popularized a few years ago by Jeremy Rivkin in his book - “The zero marginal cost society”. The book’s treatment goes into a broader economic argument - on the shifts in market economy, even going as far as questioning the foundations of capitalistic society - all on the basis of changing fundamentals of price differentiation and competition.

This is an area that needs deeper examination in the power sector and we are barely scratching the surface. If we focus on the power resources, the growth of zero marginal cost renewables are already exposing the limitations and challenges in existing business models and the profit formula that make current markets work. There is no question that the economics would change and the industry participants have to change their ways on how they make money. In places with a higher percentage of zero marginal cost resources, namely deeper penetration of wind and solar, we are already finding growing economic concerns which are also manifesting as other issues. The ways projects are financed have created uncertainty of supply that resulted in unique hedging instruments to deal with risks. Pricing for curtailment with ceiling and floor constraints have created challenges to economic and financial modelers investments and returns. Certain gaps and imbalances are getting exposed in capacity and resource adequacy, as we saw in California and Texas. So the question is where are we headed and what future worlds should the power sector consider in making decisions today.

Here are two broad future worlds that are possible: a move towards fully regulated scenario or a move towards competition where price discrimination will be based on customer choice and service contracts.

1) A fully regulated infrastructure model This model follows the way most highways, bridges, etc. get built. Highways in the US are funded through the gasoline tax as an example. Something similar in the power sector would translate to a fully regulated industry - which is almost a throwback to how the power infrastructure was built in the first place. Pricing is based on average costs and will account for access, usage and other parameters as volumetric consumption becomes less of a determinant in the future value equation. For wholesale markets in particular - it would be difficult to make competition work to drive market efficiency under a zero marginal cost situation. The cost of service will depend on the fixed capital costs and how well they are operated, which are in most cases fixed O&M - payroll, general and administrative. Regulated pricing will have to designed properly to prevent the possibility of windfall gross margins - a real possibility since revenue scaling does not involve any direct costs, and is limited by the scale of the infrastructure. Companies can grow in scale into mini empires, in the name of efficiency, and at the same time increase its cash generation. Such expansion entices monopolistic behavior which is why regulations have to be ahead of the game. It needs to be designed to check runaway behavior at the cost of reliability, universal service and affordability. In such a world, innovation will heavily reliant on what regulatory and policy drivers are and the incentives they provide. Rate base increase, and improvement of performance across all operating areas will hold the keys to growth. Without proper oversight, and incentives for risk taking, it can also breed complacency and a bias towards status quo over innovation. Even though it may look like the traditional regulated setup, the expectations will be quite different.

2) Competing on customer choice and service contracts: This is akin to the shift that the telecom industry made over the last several years. As the marginal cost of voice and data fell dramatically, all the costs of providing the service got concentrated into the "build and maintain" of the telecom network and switching infrastructure. Given the wide array of services that became possible with voice and data - telcos began to provide choices to customers based on their needs and preferences - reliability, quality and quantity of data and the various combinations with those options. Customer choice determined the willingness to pay and created a price differentiation. How creatively telcos could bundle these services for a variety of customer segments shaped the competitive forces in the industry. This curve is moving towards hyper-personalization, now possible with the aid of digital technology - data and analytics. Industry structure changed and is still evolving as network companies moved into content and so on. In the utility sector, the trajectory will not be the same due to obvious limitations of content services with electrons, but customer choice and experience can still drive competition and rate differentials. Differences in preferences for reliability, sustainability, self-generation, and demand flexibility can all be attributes to craft different service and rate options. Prosumer choices, microgrids, demand response - can all be possible service vehicles. The question that need to explored is what happens to the utility value chain and how generation, transmission and distribution networks and customer and retail services interact and transact. In theory, service contracts can be established at all levels and how customer preferences ripple through the other parts of the value chain. In theory, much will be much guided by transaction costs and how it can make the arrangement efficient. This will be determined on a case by case basis before these businesses mature.

Both these future worlds present two extremes with different set of market economics from where the power business is set up today. The purpose of visualizing these two worlds is not to make a claim that the industry will land in one or the other. It is an exploration to prompt what are decisions and choices we may consider today based on where we believe the future might go. It also can act as a quick exposition to find where certain utilities can take deliberate actions to shape its future. While one may default to a more familiar regulated world, the demands of the future customer may drive things to the world of service differentiation.

© 2021 by Greenelectrons Consulting, LLC.

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