Going off the Grid

by Naimish Patel

A week after the industry’s biggest conference, DistribuTECH, I was surprised to see the Utility Death Spiral conversation resurfacing. For those not familiar, you can read the original Edison report or William Pentland’s piece for Forbes where he framed it as myth that did not stand up to closer inspection.

The original study ignited speculation about the growth prospects for distributed generation technologies and their impact on the long-term viability of utilities. But rather than succumb to this malady, the industry began to develop an antidote. Now, it is more than an article of faith that utilities will need to embrace new business models and redefine their relationship with customers, but not just to survive imminent disruption induced by distributed generation, but to embrace changes in customer demand and unleash new revenue opportunities. With properly designed regulatory changes, the whole ecosystem can thrive, much as the telecom industry did since market reform in 1996.

The inventively named, though dubiously argued, Utility Death Spiral, is a classic example of an illogical extrapolation from a present truism. The prototypical scenario consists of customer adoption of distributed generation (DG) leading to lost utility revenues and higher energy prices to compensate for those lost revenues, further incentivizing customer adoption of DG. Indeed, under the current prevailing utility revenue model, this is true. However, consider iterating this cycle ad infinitum to a future market state in which electricity prices are so high that every customer relies exclusively on self-generation, entirely obviating the need for the grid and rendering the death of the utility.

One obvious problem with this theoretical outcome is that just because DG could become lower cost than alternatives, it does not mean it will be broadly affordable for all customers. Let’s ignore that shortcoming for a moment. Some may view the culmination of this spiral as the Utopian scenario of true energy independence, perhaps even the penultimate democratization of energy. But let us consider if such a market state is efficient, stable, or even practically attainable. Firstly, it should be noted that in this scenario, each customer has sized their DG system (possibly including storage) for their peak load, and is using it exclusively for her own needs, affording no ability to share resources. Could not a new entity come along, acquire legacy grid assets, invest in larger generation facilities and offer energy at a lower price than the self-supplying consumer?

Of course, and for two fundamental reasons:

  • Energy generation enjoys economies of scale, independent of its underlying technology. Take solar, the bastion of DG — a recent Brattle Group study found that a 300 MW utility-scale solar plant provides a levelized cost of electricity (LCOE) less than half that of a 5 kW residential scale system, independent of assumptions on tax credits, inflation, and financing schemes.
  • Larger generation plants additionally allow for sharing of their capacity across many customers, allowing their peak capacity to be dimensioned lower than the sum of independent smaller plants serving fewer customers, due to something called load diversity

The market end-state theorized in the utility death spiral is therefore both inefficient and unstable, but it is also unattainable, because such restoring market forces are already at play today. Independent Power Producers (IPPs) continue to invest in new utility-scale generation plants, many of them based on solar and wind technologies, operating under efficient wholesale markets. These wholesale markets, in of themselves, create long-term deflationary pressure on energy prices, ensuring that total grid defection due to customer-owned generation won’t run away without limit.

Despite the benefit of wholesale markets in regulating consumer prices, there’s nothing to stop customers from choosing to invest in distributed generation, whether for economic, environmental, or other reasons. Some may disconnect entirely from the grid, but most will retain their grid connection because of the intermittency of their supply, cost of storage, or because their DG investment case relies on export of excess power back to the grid. After all, those that are totally disconnected certainly can’t sell into energy markets.

In fact, the utility should welcome such customers; they offer energy resources akin to the IPPs. However, net energy metering (NEM) programs in many states value DG energy export at retail rates rather than wholesale rates. Unsurprisingly, customers have responded by maximally sizing their DG systems, independent of their own energy needs, in order to reap the financial benefits of energy export while they’re not at home. The resulting over-investment in DG creates numerous challenges for distribution operators, the least of which is exacerbated lost revenues and reverse subsidization (the death spiral mechanisms). The bigger challenges relate to managing voltage and grid capacity under reverse power flow while cost-effectively maintaining overall system reliability.

Of course, DG can provide systemic benefits. Areas of the grid with high energy demand (and high electricity prices) can economically benefit from local DG, alleviating transmission, generation, or even distribution bottlenecks, thereby deferring capital investments that would otherwise be needed. The key point, which has reached near universal consensus across all stakeholders, is that DG must be valued based on supply and demand, just as in the wholesale markets, lest system stability and market price distortion become ever-more severe issues.

Though the death spiral scenario ignores the restoring effects of wholesale markets, it does serve to highlight a core issue confronting the energy market today: the need to evolve the utility revenue model. Today, the distribution operator’s revenue is denominated in units of energy (kW-hrs). Though the distribution system is indeed a conveyer of energy to its customers, its value is not in the energy per se, but rather in its ability to reliably and efficiently connect energy demand with energy supply. Furthermore, the utility’s real costs are in the capacity of the distribution system (wires, poles, transformers, etc.) and associated operational and maintenance costs, rather than in the actual electrons conveyed. As such the distribution operator’s cost to support a customer is dependent primarily on how much peak capacity they will require, rather than how much energy they will consume or produce, in stark contrast to the way they derive revenue. Note that your Internet access fee scales with your desired bandwidth rather than the number of bits you actually consume or produce. And it’s this connection and capacity that allow each of us to choose a wide range of services from content providers who are often separate from our internet access provider.

Fortunately, many state regulators have begun proceedings on how to evolve the utility revenue model to address challenges both present and future. Broadly speaking, three mechanisms are under active consideration:

  1. Rate design changes to better align revenues with associated costs, including capacity and fixed access charges to account for real costs incurred to accommodate PV and EV customers for example. Time variation of these rates is also under consideration.
  2. Replacement of NEM with wholesale prices (location marginal price) plus adjustments to account for DG-derived distribution system benefits
  3. Performance-based incentives to drive capital efficient grid upgrades and investments in system efficiency.

With these changes, we are seeing the evolution of the distribution system toward an energy exchange: a market-driven platform for dynamically balancing local supply and demand, akin to the operation of the transmission system. However, with a more dynamic environment come greater challenges in maintaining system stability and safety. The distribution system must evolve ‘immunity’ to changing conditions through new mechanisms for reliable regulation of power flow and scalable management of distributed energy resources.

The role of the utility is rapidly changing. Customers are demanding new capabilities from the electric grid, while also providing new resources with the potential for systemic benefit if properly marshaled. Distribution operators are taking pole position in evolving their systems into platforms for the delivery of diversified energy services. Far from a death spiral, we are witnessing the beginning of an industry growth spiral that will benefit customers, service providers, and technology innovators alike.

Those who choose to go off-grid will not only forego these benefits, but also miss out on all the fun!

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