It’s a tough time to be an electricity utility in Europe. A confluence of factors, including the rising use of renewable energy, falling wholesale market prices, and the growth of distributed generation and energy efficiency are eroding traditional utility market shares and sending profits into free fall.
While European energy policy priorities have exacerbated several of these factors, current trends in Europe may simply preface broader revolutionary forces under way across much of the global electric power sector.
With market shares and profitability of conventional centralized generation assets declining, electricity demand growth stagnating, and emerging technologies enabling new ways to meet consumer demands, electric utilities may be facing a stark new reality: they must evolve or die.
“The EU power sector is going through one of the most profound changes in its history,” according to a recent report authored by Eurelectric, the trade association representing the electricity industry in Europe.
While the introduction of competitive retail and generation markets in the 1990s and early 2000s brought about a dramatic restructuring of the electricity industry and regulatory environment, the underlying power sector paradigm changed little. Large, central-station power plants continued to supply the vast majority of electricity, delivered to customers over a hierarchical chain of high-voltage transmission lines and lower-voltage distribution networks.
Today, new forces are upending much of that traditional paradigm, sparking changes at least as profound as those unleashed by the earlier era of industry liberalization.
According to Eurelectric, four major trends are reshaping the power sector.
1. The Growth of Renewables
The increasing penetration of renewable energy sources, including wind, solar, and biomass, are eroding market shares for conventional generation and depressing wholesale market prices. The result is declining revenues for owners of conventional generation.
Since 2000, renewable energy sources (RES) have accounted for the large majority of new capacity additions in Europe (see graphic). The share of non-hydro renewables has grown more than five-fold in Europe from 2 percent in 2000 to 11 percent as of 2011, on track to reach an EU-wide target of 20 percent of electricity from renewable sources by 2020. Many nations have already reached higher renewable shares, including 31 percent of electricity in Denmark, 22 percent in Germany, and 21 percent in Spain and Portugal combined.
In many European markets, renewable energy generators receive preferential treatment, with grid operators required to purchase available renewable energy outside of normal wholesale markets, often at premium rates known as feed-in tariffs. This arrangement reduces the available market for conventional generators and lowers wholesale market prices. Where renewables do bid into markets, their near-zero marginal costs of operation have largely the same affect. German year-ahead power prices dropped 27 percent over the past 12 months, for example, according to data compiled by Bloomberg.
At the same time, the variable nature of wind and solar energy is putting new pressures on the operation of conventional generators and electricity systems. Much greater system flexibility is needed to match the varying output of renewable generators.
As a result, power plants originally designed for baseload operation are being put into service providing variable output, reducing their efficiency and increasing wear and tear. Some 13 GW of new flexible hydro capacity has been added throughout Europe since 2000, and owners of many gas-fired plants are also making investments to increase the flexibility of their assets. These all present new cost drivers for owners of conventional generation assets, even as declining wholesale power prices are reducing operating revenues.
2. A More Decentralized System
While much of the recent growth in renewable energy capacity consists of large, centralized wind farms, the European power sector is also moving in parallel towards a more decentralized system of electricity generation.
According to Eurelectric, “Small generation units with capacities of below 10 MW grew significantly in prominence, from around 10 GW in the year 2000 to more than 70 GW currently installed.” Solar photovoltaics (PV) are the strongest factor behind this shift, with 59 GW installed in Europe at the end of 2012, but other distributed generation technologies are emerging as well, including small wind turbines, combined heat and power or “co-gen” units, biogas-powered generators, and microturbines.
As technology costs fall for these new distributed energy resources, Eurelectric envisions an increasing decentralization of power generation in Europe. This implies important changes to the operation of distribution networks, which must now evolve to accommodate bi-directional power flows, changing profiles for system use, and the growth of “prosumers” – system users that may shift between being a producer or consumer at different times of the day or season.
Small-scale power producers are also giving rise to new ownership structures and business models, some of which directly compete with conventional utilities. More than 3 million households have started producing their own electricity with solar PV, says Eurelectric, while 133 “bio-villages” have emerged in Germany since 2000, generating more than 50 percent of their electricity and heat from bio-energy resources. Community-owned wind farms are also common in Denmark and other markets.
3. Foundations of the Smart Grid
The EU has also taken large steps towards a smarter grid. The European Commission’s Third Electricity Directive requires all EU member states to equip at least 80 percent of consumers with intelligent metering systems by 2020, wherever cost effective, and 49 million smart meters have already been installed across Europe as of the end of 2012. European utilities are also taking steps towards a more intelligent and controllable distribution grid.
While these changes do not present direct challenges to traditional utilities, they do represent new cost drivers for distribution network companies. More importantly, the growth of smart metering and smart grid capabilities can support innovative new business models, from demand response programs to “virtual power plants” (aggregations of multiple distributed generators). This puts further pressure on utilities to evolve – and take advantage of new ways to deliver value to their customers – or see new challengers emerge to seize the opportunities created by a smarter grid.
4. Retail Competition and New Services
Finally, the emergence of competitive retail electricity supply in European markets “has given customers a new, active role in managing their power supplies,” says Eurelectric. More than 510 million customers in Europe reside in markets with liberalized supply and retail markets, nearly five times as many as in the United States. In 2011, around 6 percent of European households exercised their new freedoms and switched to a different electricity suppliers.
Increasingly competitive retail markets are creating new opportunities – and pressures – for innovative ways of delivering value to electricity users. Greater product differentiation is possible now than ever before, and consumers are becoming more engaged, looking for ways to get more out of their relationship with their retail supplier. Those retailers who evolve to meet customer demands will thrive, while others will see their market share wither away.
Core Utility Profit Center Under Threat
Together, these “profound changes” are hitting European utilities right where it hurts: the traditional focus of their core business and historical source of the majority of their profits, conventional generation assets.
“Between 2011 and 2012, the profit pool in this [conventional generation] segment fell by nearly 10%,” reports Eurelectric, “from an aggregate EBIT [earnings before interest and taxes] of €62 billion to €55 billion, and it may fall to less than €50 billion in 2020.”
Largely as a result, European utilities’ stock market performance has rapidly deteriorated, falling much faster since the European economic crisis than just about any other sector besides banking.
Bloomberg recently reported that two of Germany’s largest electric utilities, EON SE and RWE AG, saw their combined market values fall 76 percent since 2008. Both firms saw stocks slump to a decade-low in the last month.
EON reported this week that earnings for the first half of 2013 that are almost halved from the year prior, and profits are down 40 percent.
“A significant part of our business model is now facing new challenges,” RWE Chief Financial Officer Bernhard Guenther told Bloomberg. “Whatever we do in terms of cost and capex-cutting won’t fully compensate the profit loss we see in conventional power generation.”
Eurelectric points the finger at several factors, including “slow underlying demand growth, energy efficiency gains, and the entry of new [renewable energy] capacity.”
These forces may spell the end of the traditional source of utility profits in Europe. “Even with possible changes such as the introduction of capacity payments, higher commodity prices, or large-scale industry consolidation, the 2020 profit pool appears unlikely to grow larger than that seen in 2012,” concludes Eurelectric.
Evolve or Die
With the European electricity industry itself pointing to a potential peak in profits from traditional generation assets, utilities must now become “powerhouses of innovation,” says Eurelectric.
With declining profitability in their core business areas, the future of the electric power sector rests on capturing the growing pool of value associated with renewable and distributed energy generation and other emerging technologies, capitalizing on their existing relationship with customers, and finding novel ways to serve customer needs through new business models and services.
“As change in the [electricity] sector accelerates, it will also increase the importance of innovation,” the Eurelectric writes. “In order to capture the opportunities related to the growing value pools, the power sector will need to create new products, processes, and business models. Innovation will be a precondition for the sector to grow.”
The large-scale renewable energy sector will continue to grow in value, says Eurelectric, with the EU adding 135 GW of new renewables capacity by 2020, creating an additional €14 billion value pool.
So far, European utilities have failed to capture a substantial share of these new value pools. Germany’s four largest power producers control less than 5 percent of renewable capacity as of 2012, for example. According to Eurelectric, utilities will have to do better in the future at capturing value from the growth of renewables and other emerging technologies that “have the potential to transform the utility landscape.” This includes energy storage, electric vehicles and charging, demand response and home energy management systems, and a growing set of distributed generation technologies.
At the same time, a smarter power network and a changing set of technology options will enable new services and solutions to customer needs. Eurelectric identifies several possible new “downstream products and services” which the evolving utility of the future may be poised to deliver:
- “The ongoing take-up of distributed generation creates business opportunities to provide, install, and maintain new equipment at customers’ premises, as well as additional potential services, such as virtual power plant generation models.
- Continued energy efficiency improvement will create a market for a wide range of technical solutions and, equally importantly, new business models to unlock the potential value that energy-saving solutions entail.
- As part of providing system flexibility, the importance of demand response aggregation will grow. A market involving B2B [business to business] customers is already emerging and is likely to extend to the B2C segment through two-way digital communication enabled by smart grids and the increased penetration of smart appliances and home control technologies.
- Future adoption of electric vehicles will require e-mobility solutions for private and fleet customers, spanning the development of charging infrastructure (public charging stations and private charging boxes), power supply, and automatic billing and data management.”
Eurelectric estimates that these new downstream market opportunities could collectively be worth €10 billion by 2020.
Capturing these opportunities may require a fundamental shift in the way utilities view their primary product, from electricity suppliers to electricity service providers.
As Eurelectric describes it, for the energy user of the future, “energy services (heating and lighting, but also mobility, etc.) would be met not solely, or even primarily, through the supply of energy – but through a range of channels including decentralised generation technology, improved energy efficiency across a range of applications, and sophisticated control technologies. At the end of this journey, therefore, lies a potentially dramatically different business model for serving customer needs, defined not in terms of energy supplied, but directly in terms of the benefits that end-users perceive themselves to be deriving from various energy-consuming services.”
Europe the Bellwether?
Europe’s aggressive suite of energy policies, from renewable energy incentives and climate mitigation efforts to energy efficiency and smart grid roll-out targets are driving or at least accelerating many of the forces described above. It’s tempting then to dismiss Europe’s struggling utilities as the casualties of fast-moving policy measures.
Yet Europe is not all that unique.
A majority of U.S. states have implemented renewable portfolio standards or targets driving the increasing uptake of new renewable energy sources. Federal and state incentives further encourage solar and other renewables, electric vehicle adoption, and smart meter installations. While the United States may lag Europe in some regards, the EU may be more a bellwether of things to come than an unique outlier.
Don’t take my word for it. Here’s the Edison Electric Institute, the industry association representing America’s large investor-owned utilities, in a recent report that echoes their European counterparts:
“Recent technological and economic changes are expected to challenge and transform the electric utility industry [in the United States]. These changes (or “disruptive challenges”) arise due to a convergence of factors, including: falling costs of distributed generation and other distributed energy resources (DER); an enhanced focus on development of new DER technologies; increasing customer, regulatory, and political interest in demand-side management technologies (DSM); government programs to incentivize selected technologies; the declining price of natural gas; slowing economic growth trends; and rising electricity prices in certain areas of the country. Taken together, these factors are potential “game changers” to the U.S. electric utility industry, and are likely to dramatically impact customers, employees, investors, and the availability of capital to fund future investment.
Trends in Japan, Australia, and many other developed economies are similar, where markets are characterized by growing renewables, increasing efficiency, and stagnant or declining electricity demand.
At the same time, the steadily declining cost and improving performance of many emerging technologies, from solar PV and smart grid technologies to batteries and electric vehicles, are driving the electric power sector towards a variety of key tipping points. At a certain price point, what were formerly policy drive trends become self-perpetuating forces.
Across much of the electric power sector, then, the imperative facing utilities will be clear sooner or later: they must evolve and thrive or retrench and die.
Are utilities up to the task?
- Eurelectric, “Utilities: Powerhouses of Innovation,” May 2013.
- Edison Electric Institute, “Disruptive Challenges: Financial Implications and Strategic Responses to a Changing Retail Electric Business,” January 2013.