Identifying the costs to provide service as a prelude to restructuring

Many countries change their electric utility market structures in hopes of creating incentives for efficiency. There are several structures available and they differ in their complexity and their effectiveness.

The simplest market structure is to combine the elements of the supply chain into what we call vertical integration, where one company provides all the functions in the electricity market—generation, transmission, and distribution—and has responsibility for all those functions.

One advantage to vertical integration is that you know who to call if the lights go out. And don’t overlook that advantage, because in areas where we have separated out generation, transmission, and distribution, it is very easy for one element of the supply chain to blame another when service is not being provided. But if it is one company providing everything, you know exactly who to call.

Many countries have moved away from vertical integration, however. Motivations vary, but a common concern with vertical integration is that we’re always left with a nagging question: How do we know that the utility is as efficient as they can be if it is only one company providing all of the services?

A common initial step in reforming a vertically integrated industry is restructuring generation, so that you separate out the company that is generating electricity in some way and introduce additional generating companies. It is a popular step because, depending on the country and the system, generation costs can be anywhere from 50% to 70% of the total cost of providing service. So, policy tends to focus on the generation portion first.

But what does that really mean? How does that correspond to lower costs and greater efficiency for consumers?

Fundamentally, if we can take the current costs of generation—the operating characteristics of the plant and fuel prices—those costs can be used to establish a “price to beat” for new generation. This price to beat reflects the costs of the existing generation. Then we can compare that with the generation costs of new suppliers. The difference translates into value for the people.

But there are a couple of important assumptions that go into that. The first is the assumption that you understand all the costs necessary for your utility to provide service. The second is that you can separate those costs into generation costs and transmission and distribution costs.

Accounting tools, such as a uniform system of accounts, can be beneficial in this instance. More specifically, a uniform system of accounts that functionally separates costs into generation, transmission, and distribution can be useful in any restructuring of the supply chain. If the accounting has not already separated these costs, then you have to dig through the details and separate the costs by hand. But even if the accounting system has given you a good place to start, identifying the costs required to provide service is more complicated than it initially appears.

In fact, hundreds of utilities around the world don’t know what their costs are, especially by type of service. That can be a problem.

But it’s more of a problem when people don’t acknowledge it. Some people don’t want to admit that they don’t understand all of the costs of providing service because they think that other people may see that as incompetence.

But that’s not incompetence. Incompetence means you lack ability. That’s not what’s going on here. What you lack is information, data, and experience. That raises three challenges. How will you begin gathering the data and other information that you need? How will you develop the skills you need to answer the right questions? And perhaps the most challenging problem: How will restructuring change the answers?

When we start changing the structure of our industries, when we start changing the structure of our utilities, we don’t change the flow of electricity. We still have sinks, we still have sources, and we still have a network over which electricity flows.

What changes when we start to restructure is how work is done and money flows. In order to make sure that people are receiving commensurate value for the money that they’re being asked to provide to the system, we need an understanding of how costs will change, where the money flows, who it flows to, and under what circumstances that money flows. Knowing this will help us to create a system that is beneficial to all the people.