1 THE CURRENT UTILITY ENVIRONMENT & ARISING CHALLENGES FOR THE ELECTRICITY SYSTEM
Since the end of the last century, Germany has been the international role model for promoting an agenda for a transition towards a sustainable power economy. The term Energiewende since found world-wide acceptance and was associated with the push coming from various stakeholders in Germany. Under these specific circumstances, the German electricity industry has therefore been chosen as the case-study basis for this thesis.
The beginning of this chapter lays out the historical growth and current situation of renewable energies in Germany and what actually triggered this development, which goes far beyond the energy production by renewable sources. The second part then gives an overview of the current situation of utility providers in their environment and the key characteristics of the business model in general before discussing the major challenges utilities are faced with due to the evolution towards a sustainable energy society.
The herewith provided information is the necessary background knowledge to fully understand the purpose and meaningfulness of this thesis' research questions, which will be discussed in Chapter X.
1.1 Overview of the electricity sector in Germany
As the sixth largest economy in the world, ranked by total Gross Domestic Product, Germany consumes around 500 million Megawatt hours per year, which a majority of is generated by an installed capacity of 204 Gigawatt in total (Central Intelligence Agency, 2018). This portfolio of national power plants is well diversified amongst the fuel source categories, with a majority of 60 percent based on fossil-fueled plants, 20 percent on nuclear power and the remaining 18 percent of installed capacity found in renewables such as wind turbines, solar panels or various hydro power plants. This has not always been the case, as can be seen in Figure 1, as renewable energies have seen a rapid growth especially since the beginning of this century. The average annual growth rate from 2000 until 2017 averages out at 12.3 percent. At the same time, additional conventional power sources are not nearly installed at the same scale as renewables, which constantly decreased the share of gross electricity consumption, effectively since the year 2000, to close to 60 percent in 2017 (Federal Ministry for Economic Affairs and Energy, 2018).
Fig. 1: Gross electricity generation by renewables in Germany (Federal Ministry for Economic Affairs and Energy, 2018)
Based on the recent development, stakeholders in the energy sector are eager to know if the observed trend will continue, moving towards the defined targets for sustainability and the fight against climate change . In a recently published report, the Federal Network Agency approved different scenarios which will in the future serve as the foundation for the network development plan. The transmission systems' experts predict the share of conventional power to be further reduced to a range between 30 and 24 percent of the overall installed capacity, concluding that distribution networks will play a significant role, while transmission systems will lose importance in the electricity grid (Bundesnetzagentur, 2018).
With these scenarios in mind, the energy industry can expect a fundamental change in the basic understanding of the value chain of the electricity sector and in the underlying relationship between the different stakeholders, such as the energy supply companies and their current customers. The key drivers initiating the above described development are laid out and discussed in the following chapter, providing a better understanding of the motives behind it.
1.2 The evolution towards a sustainable society
The warming of the earth's atmosphere and its root causes have been investigated since the nineteen-hundreds. In 1899 for example, Thomas Chrowder Chamberlin, an American geologist from Illinois, conducted research on the question whether changes in the climate, and especially in the average surface temperature, result from alternations of the carbon dioxide concentration in the Earth's atmospheric layers (Chamberlin, 1899). He was accompanied by other scientists from Europe on the quest to determine the reason for this phenomenon.
Fig. 2: Historical data of the GHG concentration in air (ETH Zürich, 2016a) (ETH Zürich, 2016b) (ETH Zürich, 2016c) and of the global land-ocean temperature index (NASA, 2018)
The first and second industrial revolutions both had a tremendous impact not only on the structure and definition of the world's economy but also on the energy demand, which soared to levels that were never reached before, supported by the extensive use of fossil fuels such as coal and crude oil. Since then, human activities, along with the growing use of resources, have contributed to the rising concentration of greenhouse gases (GHG) in the atmosphere. Figure 2 displays the recent historical development of this concentration alongside temperature anomalies in the global land-ocean temperature index (LOTI), with which each of the GHG shows a correlation coefficient of 90 percent or higher. The shift away from the atmosphere's components original equilibrium and the level of confidence for a correlation didn't develop unnoticed, which prompted efforts on the isolation of the driving causes and the assessment of the likelihood of certain scenarios should the trend continue.
Following numerous reports and conferences, which drew a growing level of attention over the years, the concern of climate change made it onto the international political agenda. Following the United Nations Conference on Environment and Development in Rio de Janeiro in 1992, the United Nations Framework Convention on Climate Change (UNFCCC) has been adopted, which sets guidelines, restrictions and limitations such as on a specific country's emission allowance of GHG, although an enforcement mechanism was not put in place (UN General Assembly, 1994). Each year the Conference of the Parties (COP) is held, such as the Kyoto Protocol of 1997 or the Paris Agreement of 2015, to discuss the progress of stopping climate change and further proceedings. Although the harmonization of the different global interests and standpoints proved to be a great challenge, the contribution to the awareness of climate change, also on the national social levels around the world, is unquestionable.
As discussed in the previous chapter, renewable energy sources have shown a steady climb in the German generation mix. A major contribution to this push can certainly be credited to the efforts of the government to provide the right incentives and catalysts as to reach and exceed the set targets of the UNFCCC. The following list contains three of many goals Germany aims to reach by 2050 (Federal Ministry for Economic Affairs and Energy, 2016):
• Reduction of GHG emissions by minus 80 to 95 percent (compared to 1990)
• Share of renewables of gross electricity consumption of at least 80 percent
• Reduction of gross electricity consumption by 50 percent (compared to 2008)
Different regulatory restrictions and incentive schemes have been introduced to guide the stakeholders of the energy transition towards those goals. They were addressed not only at corporations and institutions in the energy industry but also at the general public to communicate the mind-set of the Energiewende. A major contribution to the awareness for climate change has also turned out to be the nuclear disaster of Fukushima, Japan in 2011, which prompted chancellor Angela Merkel to announce the complete phase-out of nuclear energy by 2022 (Merkel, 2011), although nuclear power plants per se make no major contribution to climate change in form of GHG emissions for example.
Fig. 3: Yearly total feed-in remuneration for different power sources during 2002-2017 through the Renewable Energy Act (Amprion, et al., 2017)
Calling the general public for action, the government introduced a heavy-budgeted support program within the Renewable Energy Law (EEG) in 2000 for the construction and operation of renewable energies. The most known mechanism within the program is a feed-in tariff, which effectively protects tightly financed plants from the fluctuations of the electricity price on the market. The remuneration payments reached a peak in 2011 when € 16.7 billion were paid to asset owners for delivered electricity and are now dominated by the support of solar plants, as shown in Figure 3. Replacing the feed-in tariff, the government introduced the concept of a flexible market premium, which producers receive additionally to the revenue from the electricity market price (Gesetz zur grundlegenden Reform des Erneuerbare-Energien-Gesetzes und zur Änderung weiterer Bestimmungen des Energiewirtschaftsrechts, 2014) . The intention is to gradually integrate renewable sources into the open market and to fade out any subsidies, as the simple feed-in tariff has been criticized to suppress innovation, to unnecessarily increase the costs of climate protection and to lack a demand-sensitive component (Mihm, 2014).
As mentioned before, the awareness about climate change and environmental pollution on the other hand profited from the attractiveness of renewable energies. The following chapters will analyze the current situation for utility companies in Germany and what challenges are of growing concern that result from the demand for sustainability by the consumers.
1.3 Utilities in their current environment
Utility providers in a narrower definition are only engaged in the delivery of private and commercial end consumers with grid-bound energy commodities, such as electricity, gas and heat. It is important to note that the grid infrastructures, which facilitate the supply, have a monopolistic nature and are therefore subject to special regulation and public supervision. Since the Energy Industry Act (Energiewirtschaftsgesetz) of 2005, vertically integrated utilities have to be unbundled from their grid-related business segments on a legal, operational, informational and accounting level (Bundesnetzagentur, 2018). In addition to the provisioning of the above-mentioned services, utilities are on an individual base also engaged in the delivery of non-grid bound fuels, such as heating oil or wooden pellets, or in various segments of the supply chain such as the operation of power plants or wholesale trading, which will all be discussed in greater detail in the following chapter. In certain cases, a municipal utility is also engaged in the local management of water supply facilities, waste collection and treatment or other communal facilities. The following sections are inspired by the Porter's Five Forces framework to briefly analyze the current environment of a utility's business in Germany with a focus on the electricity segment.
In the German market, currently around 1280 businesses are active on the delivery of electricity (BDEW, 2018). Although many companies' services and products are only available in certain geographical regions, such a number of incumbents created a healthy competitive environment, putting the average EBITDA-margin of utilities to around 15 percent (Papenstein, et al., 2017). As they often have a unique profile of additional products besides electricity sales, each has its distinct character which is directed towards a certain target group of customers.
The amount of companies at the same time gives the customer a great power of choice, with the process of changing your supplier being fairly uncomplicated. This opportunity is used more and more often, as the frequency of changed suppliers by private households has seen a steady growth of eleven percent over the last ten years (Bundesnetzagentur, 2017, p. 217) .
On the other hand, new utility entrants have been entering the market since the privatization and unbundling in the electricity sector, further increasing the pool of suppliers for customers to choose from. The average amount of locally available electricity utilities available to an end-user has therefore increased by ten percent on a yearly basis since 2012 to a total of 130 by 2017 (Bundesnetzagentur, 2017) (Bundesnetzagentur, 2016) (Bundesnetzagentur, 2015) (Bundesnetzagentur, 2014) (Bundesnetzagentur, 2013)4. The competitional pressure can certainly be expected to have a noticeable downward effect on the current industry margin mentioned before, should this trend of communalization continue in the upcoming years.
The generation infrastructure on the other side of the supply chain is undergoing a change as well. Renewable energies are pouring into the market, running at close to zero marginal costs and putting pressure on gas- or nuclear-based facilities. The pressure on price can be seen as a welcomed advantage for electricity providers. But renewables introduced uncertainty in the form of unpredictable volatility for the electricity market. What challenges and problematic situations are arising as a result for the whole industry, will be discussed in great detail in chapter X.
1.3.1 Analysis of the supply chain
Continuing with the insights of the analysis in the last chapter, this section explains the interaction of the different forces and where value is created alongside the ecosystem of the electricity supply chain.
Fig. 4: Value chain of the electricity market (source: own analysis).
Starting from the tactile perspective, all electricity generated originates from some form of primary energy, such as gas, coal, solar radiation or potential energy in the case of water. It is then exploited and transported to generation facilities, which transform it into electricity, also known as secondary energy. From there transmission and distribution grid lines ensure the connection to the demand by the consumers. In the case of local production, in most cases referring to photovoltaic facilities or on-shore wind farms, the step of transmission is skipped. From the business perspective, the wholesale market is an important step as this is the trading platform between the operators of the large-scale generation, electricity providers with end-users as their customers and large-scale consumers. Electricity providers then package their offers for electricity through sales and marketing to their consumer base, often consisting of households and small to mid-sized businesses. It is important to keep in mind that the steps of transmission and distribution are the role of the grid operators, operating on a regulated monopoly basis and, as explained in Chapter 1.3, unbundled from the liberalized market of utility providers. The following chapter will now go into the details of a utility's business model inside this ecosystem and will analyze the breakdown of the revenue streams.
1.3.2 Analysis of business model and profit streams
Perfect would be partnership with a utility to also get numerical data on the different profit streams to better assess the impact later on.
“...utilities need to move beyond the old commodity-based model in which the primary goals were cost-effective supply acquisition, modernization of industrial process equipment, and total bill reduction.” - 2017_PwC_Power & Utilities Industry Trends (S. 7)
Current profit streams:
- Energy (revenue of energy sales, house connection costs, grid utilisation charge, etc.)
- Provision of energy related services (contracting!)
- Consulting (smaller “contracts” are used for cross-selling)
1.3.3 Analysis of utility-customer relationship
Currently the relationship between an electricity provider and its customer is purely based on the delivery of electricity according to the meter reading which is done on a periodic basis such as every year. As the equipment is owned by the local distribution grid operator (DSO), the reading is done by them and the data forwarded to the supplier or in many cases the consumption is simply estimated on the historical behavior of the consumer. Although especially utility providers have an extensive portfolio of other services, such as additional commodities mentioned in Chapter 1.3, e-mobility services or efficiency contracting for example, the frequency of communication is limited. A study done by a consultancy company discovered that the understanding of the customers' needs by the providers does not align with reality, despite the long-term contract relationships that already exist . Also, PricewaterhouseCoopers (PwC) mentioned in a report that in cases of outages in the year 2015, only 40 percent of affected customers were directly informed about the incident by their electricity provider (Flaherty, et al., 2017). Those examples can very well be the motivation behind the current trend of increasing numbers of consumers switching their supplier of choice as discussed in Chapter 1.3.
In summary, the relationship between utilities and their customers can be characterized as a funnel-shaped channel with a therefore limited feedback-loop. Smart meters would enable the detailed collection of time-stamped usage data, allowing for a great improvement of the understanding of consumption behavior. This has the potential to replace the estimation-based standard load profiles, most customers are currently grouped into. Nevertheless, the communication is not only based on the exchange of data but should of course further be improved on the actual conversational aspect.
1.4 Challenges of the development towards decentralized power generation
So far, the chapter has touched on the recent development of the electricity industry and the utility's business environment analyzed through the Porter's-Five-Forces framework. This final section of the introduction will now go into detail of challenges that are being faced by the sector today, based on the information presented in Chapter 1.1 and 1.2 about the rise of decentralized and distributed power generation. It is important to note that decentralization nowadays in most cases refers to the power generation of the supply chain. The inclusion of demand and information intelligence in the concept will be discussed later in Chapter 3.
1.4.1 Transmission and distribution infrastructure facing increased alternating load and bi-directional flows
As already discussed, Figure 1 shows that the portfolio of the electricity producing facilities is in the process of undergoing a fundamental change. Up until the beginning of this shift, the planning and development of the grid infrastructure has always been based on a one-directional flow perspective – from the production in conventional and central power plants, through the transmission and distribution lines to the demand source. But renewable energies are now confronting the infrastructure with power flows it was not originally designed for. The distribution level is especially affected, where 95 percent of the EEG-supported decentralized generation is connected and potentials for flexibility relocate to it as well (Edelmann, 2017). In a more practical sense, during hours of saturated supply through high solar radiation and low demand, the grid experiences over-voltage while in the opposite situation of high demand caused by heat-pumps or an increasing number of electric cars and batteries, under-voltage occurs.
Already today, a change in the reactive power caused by an increase in photovoltaic generation on the distribution level is observed and different counter-measurements such as controllable local grid transformers (“regelbare Ortsnetztransformatoren”, RONT) or the installation and extension of current grid lines (Brückl & Haslbeck, 2016). As reactive power (especially the greater the distance to the next grid junction is) pushes the boundaries of the current infrastructure, designed for a certain maximum of apparent power, the actual level of effective power needs to be reduced in order to avoid congestion, transmission losses and an accelerated abrasion of the equipment and power lines. Based on two different scenarios, the Germany Energy Agency (Deutsche Energie-Agentur, dena) estimates that financial investments of between €27.5 billion and €42.5 billion into the national grid infrastructure will be necessary until the year 2030, with roughly 60 percent of the amount dedicated to the low-voltage distribution level (2012).
Clearly not the whole investment sum will be used to expand the already installed infrastructure, but also already existing equipment has to be replaced and retrofitted – another challenge for grid operators on an accounting level as the majority of the components are depreciated over a timespan of 25 to 50 years (Stromnetzentgeltverordnung) . When a replacement is necessary at an earlier point in time, the system operators will have a visible negative effect on their balance sheet, which will be passed on to the consumers through an increase of the network charges.
1.4.2 Progressive unpredictability and uncontrollability of power supplies
The increase of the renewable energy share in the mix of Germany does not only have an effect on the grid infrastructure but affects the supply and demand of the electricity industry as well. The very nature of photovoltaic panels and wind turbines is that their primary energy, solar radiation and movement of air masses respectively, cannot humanly be controlled or guided. A hardly predictable (long-term) and highly fluctuating output of electricity is the result, which in no way considers the actual demand of the consumers.
One more important attribute of those renewable energies to consider is that they are operating at close to zero marginal costs. Coming from a market situation where nuclear- and coal-based power plants were responsible for the provision of a steady and constant base supply, renewable energies push those and all following assets further up the Merit Order of the market effectively reducing their margins. At the same time, it is the remaining generation portfolio's responsibility to counteract and rebalance the fluctuations at all times – a task the power assets were not intentionally designed for. Especially the technical limitations of nuclear and coal power plants do not allow for much flexibility as start-up times can take up to several days and the output level is only variable to a certain degree. As a result, during hours of very high input by solar and wind power plants and low demand, the described assets will continue to feed electricity into the grid, despite the fact that the overgeneration actually results in negative prices. In 2017 for example, the EPEX Day-Ahead market experienced a total of 146 hours of prices below zero, an average negative price of € 26.47, continuing a steady decline of the previous years (Agora Energiewende, 2018).
The development of the share of renewable energies in the electricity mix and the ambitious goals of the government will certainly intensify the observed effect on the wholesale market and further pressure the profitability of conventional power plants, which in the end increases the costs for the end-consumers as lost margins are recaptured. What might seem as an apparent paradox in the situation of growing negative price situations, actually shows how the market design is extradited to the uncontrollable production funded by feed-in tariffs. It can be seen as the beginning of a death-spiral at the expense of security of supply and the consumers who in the end will have to bear the costs, should a redesign not happen in time.
2 LITERATURE REVIEW
After the introduction throughout the first chapter, this section will present the visions for the electricity industry experts agree on and locates the specific literature gap the research questions then try to fill with answers.
2.1 Decentralization as the solution
The concept of decentralization is no unfamiliar idea to the electricity sector. It was indeed originally seen as the key driver and tool of the energy transition in Germany, in support of the goals for a sustainable future, although the definition in this context primarily stands for the decentralization of power generation – solar panels and wind farms feeding-in electricity on the mid- and low-voltage level of the grid. But since major complications, such as described in Chapter 1.4, made the flaws of the ambitious but miscalculated concept visible, the term decentralization was further expanded to now include amongst others the following concepts:
- Demand side management
- Smart grid
- Smart metering
- Electricity storage systems
Going into detail of each concept would be beyond the scope of this thesis, but an observable pattern in each one is the importance of giving actors the power of active participation through (information) connectivity and the regionalization of the action radius and impact. This is supposed to go to the very local root of the problem, reshaping the fundamental structure, instead of counteracting the symptoms with large centralized counterbalance facilities. In the course of an analysis of the energy transition in Germany, Agora Energiewende jumps to similar conclusions, emphasizing that decentralization has to be justifiable on multiple layers (network-topological, economic, social and political) and a fundamental restructuring of the current construct of fees, allocation and taxes is necessary to support the promoted redesign (2017).
2.1.1 Current literature on decentralization
The remodeling of the energy system in the form of decentralization is currently viewed as the most promising solution for the many challenges the industry faces today, the ones described in Chapter 1.4 being only two of them. Many papers, reports and books are therefore already published and reflect the opinion of experts in the field. One of the more extensive literatures are the books “Distributed Generation and Its Implications for the Utility Industry” and “Future of Utilities – Utilities of the Future” published by Fereidoon P. Sioshansi. Both analyze in detail the historic developments and discuss future scenarios, giving insight into different aspects such as pricing-mechanisms, regulatory hurdles, changing relationships or emerging business models and present case-study analysis of other industries that underwent a similar crisis.
2.1.2 Research questions/literature gap
The above-mentioned literature already extensively covers the different aspects of decentralization. But one aspect that has been left out until now is the evolution towards the described scenarios and the inevitable consequences for the existing business model in this process. Especially the market concept in the case of the D3A, presented in the following section, proposes a radical transformation and has not been covered by any paper, reason being that it is still a work in progress itself. Nevertheless, the foundational idea is set and is in need of a discussion of its impacts on the whole industry environment. This thesis therefore aims to answer the following research questions:
• Why and how will the current grid structure be reshaped into a decentralized electricity distribution system?
• What effect will it have on the electricity supply chain, the utility's business model based on it and the utility-customer relationship?
In order to make the concluding findings more practicable, the constructed hypothesis will be applied in a case study of a currently existing utility company, presented in the chapter hereafter.
2.2 Qualitative basis
After defining the main literature gap, this section is meant to introduce the tools used in this thesis to answer the above written research questions. This includes the specific design of decentralization of the electricity market, the utility company which generously provided the necessary internal data for the case study and various frameworks used as guidance for certain analysis through this thesis.
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