This article is a follow up to “A Faster Horse” in which I briefly discussed the origin of investor-owned utilities. In that article, I referred to five characteristics of natural monopolies; in this first of five follow-up articles, we take a brief look at one of those five characteristics and the impact of current technology developments on it. In this article, I focus on the capital-intensive nature of the industry and how historically this has required a minimum economic scale to participate.
The title of this article comes from a quote from Bethany McLean who wrote about the Enron scandal. The full quote: “In capital we trust. Capital is our savior, our holy grail, our fountain of youth, or at least health, for banks.” This is a stark reminder of the importance of capital to this industry because providing electricity is and has been a capital-intensive business for the past 140+ years.
Whether it has been small local DC systems before the advent of regulated franchises or the centralized systems that really started developing in the mid-1900s, building and operating a system to provide electricity has required investment in generators capable of supplying anywhere from one block to many towns. Then the power ultimately has to be delivered to customers using distribution systems and also using transmission systems for centralized/large generators. Each of these facets requires a lot of assets and, therefore, a lot of capital investment.
With businesses that are capital intense it is normal to see increased utilization of assets and reduced average cost as the scale of production increases. Franchised service territories give utilities the opportunity to make large-scale investments to support and serve large numbers of customers. So long as the average cost of serving customers decreases as the number of customers increases, larger, heavily capitalized utilities will serve customer bases more efficiently.
Since these assets are typically very long-lived compared with most industries, it also means that a lot of work is involved inspecting and maintaining these assets. The systems that comprise these assets are complex and thus any investor needs not only the assets themselves to provide the infrastructure for the industry but also a significant workforce to look after and operate them. Not surprisingly, therefore, capital investment is a central component of the way the industry has been shaped.
This combination of large capital investment, significant workforce requirements, and longevity of assets creates a significant barrier to entry. As Andrew Carnegie noted, access to capital is important for all firms, but it's particularly vital for startups and young firms, which often lack a sufficient stream of earnings to increase employment and internally finance capital spending. So, how do you overcome barriers to entry like these?
As the industry explored vertical unbundling in the 1990s, generation became competitive. Regulatory restrictions were loosened, enabling competition. It became possible to find enough capital to build a generator without having to support a transmission and distribution infrastructure as well, effectively lowering the capital barrier. It also created the opportunity to compete in markets where the profit was not capped through regulation, so we saw more risk takers and smaller generators appearing. Lower capital barriers and increased potential profits brought change to the industry.
So, are there other ways to break down capital barriers to entry and reduce costs without increasing the size of customer bases? I believe that the answer is yes. I have already shown how competitive bulk generation has reduced the barrier but what about other areas? Reducing the transmission and distribution infrastructure is not a feasible alternative without competitive and duplicative infrastructure—unless, that is, the infrastructure is smaller and can complement the traditional grid.
I am of course talking about microgrids and the surge of interest in them over the last decade. New technologies including microgrid controllers, improved communications, micro phasor measurement units, and many other technologies have led to more and more microgrids. The capital barrier to creating a microgrid is significantly lower than creating a full distribution system and most microgrids have a baseload generator available that allows the microgrid to operate as part of the main grid or in islanded mode. It is not that microgrids are a new concept but the technology pricing and availability is now making this a very attractive proposition for many groups.
Microgrids present an ideal way to integrate renewable resources on the community level and allow for customer participation in the electricity enterprise. Wind generation is another area of increasing interest and the uptake of photovoltaics has been huge in recent years as the cost of technologies has dropped while the efficiency has improved. This has allowed individual customers to invest in generation and has led to retirement of some conventional generators. For individual customers, the cost barrier is low and this has resulted in significant aggregated investments, but in many small individual amounts.
So, while the cost to invest in centralized systems is still massive, the need has reduced. It is nowhere near going away since most microgrids and net-zero buildings still rely on the grid but newer technologies have enabled non-traditional participants to enter the system through avenues with much- reduced cost barriers. These barriers will continue to drop as distributed energy resources become more prevalent and once solutions like transactive energy take off it will be interesting to see how the traditional grid elements adapt.