Unleashing Innovation in Electricity Generation

This nation’s electric power industry is undergoing profound change. Just when lawmakers are replacing regulated monopolies with competitive entrepreneurs, a new generation of highly efficient, low-emission, modular power technologies is coming of age. Yet surprisingly little policy discussion, either in the states or in Washington, has focused on how to restructure this giant industry in ways that spur technological innovations and productivity throughout the economy.

Sheltered from competitive forces, the fossil-fuel efficiency of electric utilities is lower today than in 1963. Regulated monopolies have had no incentive to take advantage of technological advances that have produced electric generating systems that achieve efficiencies approaching 60 percent, or as much as 90 percent when waste heat is recovered. As a result, traditional power companies burn twice as much fuel (and produce twice as much pollution) as necessary.

Developing an electricity-generating industry that thrives on innovation will require much more than simply increasing R&D expenditures. Government programs and futuristic technologies are not the answer. Rather, progress will come when the barriers to competition are removed and entrepreneurial companies are freed to recreate the electricity system along market-driven lines.

Utility restructuring, if done this way, can unleash competitive forces that will disseminate state-of-the-art electric systems, foster technological innovations, double the U.S. electric system’s efficiency, cut the generation of pollutants and greenhouse gases, enhance productivity and economic development, spawn a multibillion-dollar export industry, and reduce consumer costs. But helping this new electrical world emerge means overcoming numerous legal, regulatory, and perceptual barriers.

An industry in flux

With assets exceeding $600 billion and annual sales above $210 billion, electric utilities are this nation’s largest industry-roughly twice the size of telecommunications and almost 30 percent larger than the U.S.-based manufacturers of automobiles and trucks. The pending changes affecting this giant industry will have a profound impact on this nation’s economy.

Rapid change and innovation marked the industry’s founding almost a century ago. Thomas Edison, William Sawyer, William Stanley, Frank Sprague, Nikola Tesla, and George Westinghouse competed with an array of new technologies. Each struggled to perfect dynamos that generated power; transformers and lines that delivered it; and incandescent light bulbs, railways, elevators, and appliances that used this versatile energy source.

Their competition sparked a technological and business revolution in the late 19th century. But this early competition created chaos as well as opportunity. Unique electrical arrangements conflicted with one another. More than 20 different systems operated in Philadelphia alone. A customer moving across the street often found that his electrical appliances no longer worked.

To ensure order and to protect themselves from “ruinous competition,” executives initially tried to fix prices and production levels among themselves, but the Sherman Antitrust Act of 1890 rendered such efforts illegal. The more effective step, led by J. P. Morgan and other bankers, was to merge and consolidate.

Within the next few decades, the electricity business changed dramatically. On the engineering front, larger and more efficient generators were built, a new filament constructed of tungsten produced an incandescent lamp that was preferable to a gas flame, and long-distance transmission lines sent power over great distances. As the cost of a kilowatt-hour from a central power station dropped from 22 cents in 1892 to only 7 cents three decades later, electricity became a necessity of life.

On the business front, electric companies became integrated monopolies, generating, transmitting, and distributing electricity to consumers in their exclusive service territories. For some 60 years, electric utilities provided reliable power in exchange for guaranteed government-sanctioned returns on their investments.

Recent policy and technological changes, however, are enabling entrepreneurs to generate power below the average price, ending the notion that this industry is a natural monopoly. These small-scale electricity generators are introducing competition into the electric industry for the first time in three generations. Nonutility production almost doubled from 1990 to 1996 and now contributes some 7 percent of U.S. electricity.

Three pieces of federal legislation opened the door to this limited competition. First, the Public Utilities Regulatory Policy Act (PURPA) of 1978 enabled independent generators to sell electricity to regulated utilities. Second, deregulation of the natural gas market lowered the price and increased the availability of gas, a relatively clean fuel. Third, the Energy Policy Act of 1992 (and subsequent rulings by the Federal Energy Regulatory Commission) made it possible for wholesale customers to obtain power from distant utilities.

Noting the development of wholesale competition, some states (Massachusetts, California, Rhode Island, New Hampshire, Pennsylvania, and Illinois) have adopted specific plans to achieve retail competition, and most other states are considering the issue. Several lawmakers have introduced federal legislation to advance such retail competition, to ensure reciprocity among the states, and to restructure the Tennessee Valley Authority and other federal utilities.

To prepare for competition, some utilities have merged, others have sold their generating capacity, and still others have created entrepreneurial unregulated subsidiaries that are selling power in the competitive wholesale market. It appears that integrated utility monopolies are being divided. A likely scenario is that the emerging electricity industry will include competitive electricity-generating firms producing the power, federally regulated companies transmitting it along high-voltage lines, and state-regulated monopolies distributing the electricity to individual consumers and businesses. Federally chartered independent system operators would ensure the grid’s stability and fair competition.

In addition to PURPA and the Energy Policy Act, several other factors are spurring the drive toward competition in the electricity-generating industry. The paramount concern is cost. The Department of Energy (DOE) estimates that restructuring will save U.S. consumers $20 billion per year; some analysts predict a $60 billion annual savings, or $600 per household. Businesses that consume a substantial amount of electricity have been leading advocates for competition among electricity suppliers.

Environmental concerns further the call for innovation-based electric industry restructuring. The bulk of greenhouse gas emissions responsible for climate change-fully one-third of U.S. carbon dioxide emissions-comes from burning fossil fuels in electric generators. Another third comes from production of thermal energy, and roughly half of that amount could be supplied by heat not used by the electric industry. To appreciate the opportunity for improved efficiency, consider that U.S. electric generators throw away more energy than Japan consumes. Unlike the regulated pollutants that can be scrubbed from power plant smokestacks, the only known way to reduce net carbon dioxide emissions is to burn less fossil fuel. Fortunately, modern technologies can cut emissions in half for each unit of energy produced.

Also pushing utility restructuring are the desire of nonutility power producers to sell at retail, protests about regional disparities in price, and failures of the old planning regime. Proponents of the status quo abound, however. Several analysts concentrate on the potential problems associated with change. Some environmentalists, for instance, fear the potential increased output from dirty coal-fired generators and the potential demise of utility-based demand-side management programs that are designed to help customers use electricity more efficiently.

Most of the debate about utility restructuring, however, has focused on just two issues: when to impose retail competition and whom to charge for the “stranded costs” of utility investments, such as expensive nuclear power plants, which will not be viable in a competitive market. The two issues are related because the longer retail competition is postponed, the more time utilities have to recoup their investments. The strategies proposed for dealing with these issues vary dramatically. Utilities argue that current customers that no longer want to buy electricity from them should be forced to pay an “exit fee” to help pay for the stranded costs. Independent power producers maintain that utilities could pay for stranded costs by improving the efficiency of their operations.

Both approaches raise questions. Although high exit fees would retire utility debt, they also would discourage the growth of independent producers. And one cannot state with certainty how much utilities could save through efficiency improvements, though the potential appears to be substantial. For example, utilities could eliminate the need for an army of meter readers trudging from house to house by installing meters that could be read electronically from a central location. Adding computer-controlled systems that constantly adjust combustion mixes in turbines could increase efficiency by as much as 5 percent.

Only the beginning

The arrival of wires early in this century introduced lights, appliances, and machines that lengthened days, reduced backbreaking drudgery, and sparked an industrial revolution. Still, we are only on the threshold of tapping electricity’s potential value. Innovation can improve the efficiency with which electricity is generated and transmitted. It can enable a wealth of new electrotechnical applications within U.S. industries and for export throughout the world. It also can spark an array of new consumer services.

Consider first the potential for vastly improved electricity generators. Efficiencies of natural gas-fired combustion turbines already have risen from 22 percent in the mid-1970s to 60 percent for today’s utility-sized (400 megawatts) combined cycle units that use the steam from a gas turbine’s hot exhaust to drive a second turbine-generator. Simpler and smaller (5 to 15 megawatts) industrial turbines have electrical efficiencies of about 42 percent and system efficiencies above 85 percent when the waste heat is used to produce steam for industrial processes. Small-scale fluid-bed coal burners and wood chip boilers also produce both electricity and heat cleanly and efficiently. Since 1991, production of thin-film photovoltaic cells has increased more than 500 percent, and more efficient motors and new lightweight materials have reduced the costs of wind turbines by 90 percent.

Several other technologies are on the horizon, including fuel cells that produce electricity through intrinsically more efficient (and cleaner) chemical reactions rather than combustion. The first generation of commercial fuel cell units is expected to achieve 55 percent electric efficiency when they appear on the market in 2001; when used to produce both power and heat, the total system efficiencies will approach 90 percent.

Innovation also is possible in the transmission and distribution grid. Insurers, environmental groups, and others have raised concerns about the grid’s stability and reliability, and growing numbers of digital technology users are concerned about power quality. More and longer-distance exchanges of power in an open electricity market could push the limits of our human-operated electricity dispatch system. Very small errors can become magnified and ripple through the system, increasing the risk of overloadings, fires, and transformer explosions. Fortunately, a host of software, hardware, and management technologies are on the horizon. Sophisticated software based on neural networks (a type of self-organizing system in which a computer teaches itself to optimize power transfers) could greatly increase power quality and reduce the risk of overloads. More robust and efficient distribution technologies, such as high-temperature superconducting transformers and wires, could further cut that risk. Several engineers also envision a distributed or dispersed energy system in which information links increasingly substitute for transmission lines, and most electricity is used in efficient “power islands.” Two-way communication and control between generator and customer can dramatically reduce the need for overcapacity. The more intelligent the system, the easier it will be to ensure that electricity takes the shortest and most efficient path to the customer.

Even the near-term possibilities for new consumer services are substantial. “Imagine the elderly and the poor having a fixed energy bill rolled into their mortgage or rent,” suggests Jeffrey Skilling, president of Enron Corp., one of the new entrepreneurial power producers. “Imagine an electric service that could let consumers choose how much of their home power is generated by renewable resources. Imagine a business with offices in 10 states receiving a single monthly bill that consolidates all of its energy costs.” Because power companies already have a wire connection to virtually every home and business, they are exploring their potential to provide a host of other services, including home security, medical alerts, cable television, and high-speed Internet access.

One promising option is onsite electricity production. “In ten years,” predicts Charles Bayless, chairman of Tucson Electric Power, “it will be possible for a 7-Eleven store to install a small ‘black box’ that brings natural gas in and produces heating, cooling, and electricity.”

In addition to avoiding transmission and distribution losses, onsite power generators offer manufacturers and building owners (or, more probably, their energy service companies) the opportunity to optimize their power systems, which would lead to increased efficiency, enhanced productivity, and lowered emissions. A study by the American Council for an Energy Efficient Economy suggests that such gains ripple through the industrial operation, as productivity benefits often exceed energy savings by more than a factor of four.

Mass-produced, small distributed generators could be a viable alternative to large centralized power plants. To illustrate the practicality of this option, engineers point out that Americans currently operate more than 100 million highly reliable self-contained electric generating plants-their cars and trucks. The average automobile power system, which has a capacity of roughly 100 kilowatts, has a per-kilowatt cost that is less than one-tenth the capital expense of a large electric generator.

Improved electric generators will also spark new technologies and systems within U.S. industry. Noting that electrotechnologies already have revolutionized the flow of information, the processing of steel, and the construction of automobiles, the Electric Power Research Institute (EPRI) envisions future applications that offer greater precision and reliability; higher quality, portability and modularity; enhanced speed and control; and “smarter” designs that can be manufactured for miniaturized end-use applications. Innovative electrotechnologies also will dramatically reduce the consumption of raw resources and minimize waste treatment and disposal.

U.S. development of efficient generators and modern electrotechnologies could also open a vast export market. The growth in global population, combined with the rising economic aspirations of the developing countries, should lead to significant electrification throughout the world.

Such benefits are not pie-in-the-sky ramblings by utopian scientists or overenthusiastic salesmen. According to a study by the Brookings Institution and George Mason University, restructuring and the resultant competition have generated cost savings and technological innovations in the natural gas, trucking, railroad, airline, and long-distance telecommunication industries. “In virtually every case,” they concluded, “the economic benefits from deregulation or regulatory reform have exceeded economists’ predictions.”

Consider the competition-sparked innovations in the telecommunications market. Within a relatively short period, consumer options increased from a black rotary phone to cellular, call waiting, voice mail, paging, long-distance commerce, and video conferencing. Similar gains could occur in the electricity industry.

What’s needed, however, is a policy revolution to accompany the emerging technological revolution. Laws and regulations must become innovation-friendly.

MIT meets the regulators

Although modern electric technologies can provide enormous benefits, implementing them is usually problematic, even for a technological supersophisticate such as the Massachusetts Institute of Technology (MIT). In 1985, MIT began to consider generating its own electricity. With its students using PCs, to say nothing of stereos, hair dryers, and toaster ovens, the university faced soaring electricity costs from the local utility, Cambridge Electric Company (CelCo). Many of MIT’s world-class research projects were also vulnerable to a power interruption or even to low-quality power. At the same time, MIT’s steam-powered heating and cooling system, which included 1950s-vintage boilers that burned fuel oil, was a major source of sulfur dioxide, nitrogen oxides, carbon monoxide, and volatile organic compounds.

The university finally settled on a 20-megawatt, natural gas-fired, combined heat and power (CHP) turbine-heat recovery system. The system was to be 18 percent more efficient than generating electricity and steam independently. It was expected to meet 94 percent of MIT’s power, heating, and cooling needs and to cut its annual energy bills by $5.4 million. Even though MIT agreed to pay CelCo $1 million for standby power, the university expected to recoup its investment in 6.9 years.

MIT’s first major hurdle was getting the environmental permit it needed before construction could begin. Because it retired two 1950s-vintage boilers and relegated the remaining boilers to backup and winter-peaking duty, the CHP system would reduce annual pollutant emissions by 45 percent, an amount equal to reducing auto traffic in Cambridge by 13,000 round trips per day. Despite this substantial emissions savings, plant designers had problems meeting the state’s nitrogen oxide standard. Unfortunately for MIT, the state’s approved technology for meeting this standard, which was designed for power stations more than 10 times larger than MIT’s generator, was expensive and posed a potential health risk because of the need to store large amounts of ammonia in the middle of the campus. MIT appealed to the regional emission-regulating body, performed a sophisticated life-cycle assessment, and showed that its innovative system had lower net emissions than the state-approved technology that vented ammonia.

Although MIT overcame the environmental hurdle and completed construction in September 1995, that same year it became the nation’s first self-generator to be penalized with a stranded-cost charge. The Massachusetts Department of Public Utilities (DPU), looking ahead to state utility restructuring, approved CelCo’s request for a “customer transition charge” of $3,500 a day ($1.3 million a year) for power MIT would not receive. MIT appealed the ruling in federal court, arguing that it already was paying $1 million per year for backup power, that CelCo had known about MIT’s plans for 10 years and could have taken action to compensate, and that the utility’s projected revenue loss was inflated. But the judges ruled that their court did not have jurisdiction. MIT then appealed to the Massachusetts Supreme Judicial Court, which in September 1997 reversed DPU’s approval of the customer transition charge, remanded the case for further proceedings, and stated that no other CelCo ratepayers contemplating self-generation should have to pay similar stranded costs.

Although MIT now has its own generator, which is saving money and reducing pollution, the university’s experience demonstrates the substantial effort required to overcome regulatory and financial barriers. Very few companies that might want to generate their own power have the resources or expertise that MIT needed to overcome the regulatory obstacles. As states and the federal government move to restructure the electric industry, they have an opportunity to remove these obstacles to innovation.

Barrier busting

Lack of innovation within the U.S. electric industry is not due to any mismanagement or lack of planning by utility executives. Those executives simply followed the obsolete rules of monopoly regulation. Reforming those obsolete rules will give industry leaders the incentive to dramatically increase the efficiency of electricity generation and transmission.

Part of the problem is perceptual. More than two generations have come to accept the notion that electricity is best produced at distant generators. Few question the traditional system in which centralized power plants throw away much of their heat, while more fuel is burned elsewhere to produce that same thermal energy. Few appreciate the fact that improved small-engine and turbine technology, as well as the widespread availability of natural gas, have made it more efficient and economical to build dispersed power plants that provide both heat and power to consumers and that avoid transmission and distribution losses. Because utilities have been protected from market discipline for more than 60 years, few challenge the widespread assumption that the United States has already achieved maximum possible efficiency.

Mandating retail competition will not by itself remove the many barriers to innovation, efficiency, and productivity, as the recent history of monopoly deregulation shows. Federal legislation has deregulated the telephone industry, but some of the regional Bell operating companies have been able to preserve regulations that impede the entrance of new competitors into local telephone markets. The same is likely to be true in the electricity market, particularly if state and federal initiatives do not address potential regulatory, financial, and environmental barriers adequately.

Regulatory barriers

Unreasonable requirements for switching electricity suppliers. Most states adopting retail competition allow today’s utilities to recover most of their investments in power plants and transmission lines that will not survive in a competitive market. These so-called stranded costs are being recovered either through a fee on future electricity sales or a charge to those individuals or businesses exiting the utility’s system. High exit fees, however, would be a significant barrier to independent or onsite generators. In the wake of the MIT case, Massachusetts banned exit fees for firms switching to onsite generators with an efficiency of at least 50 percent. Other states should avoid exit fees that discourage the deployment of energy-efficient and pollution-reducing technologies. They might introduce a sliding scale that exempts new technologies by an amount proportional to their increased efficiency and decreased emissions of nitrogen oxide and sulfur dioxide. States should also resist the efforts of dominant power companies to impose lengthy notice periods before consumers can switch to a different electricity supplier.

Unreasonable requirements for selling to the grid. Dominant power companies also could limit competition by imposing obsolete and prohibitively expensive interconnection standards and metering requirements that have no relation to safety. To prevent that practice, the federal government should develop and regularly update national standards governing electricity interconnections and metering for all electric customers.

Requirements that discourage energy self-sufficiency. Many consumers now have the ability to cost-effectively generate some of their own electricity. However, large electric suppliers could block these potential competitors by penalizing customers who purchase less than all of their electricity from them or by charging excessive rates for backup or supplemental power. In order for all consumers to be able to choose their supplier of power (including backup and supplemental power), tariffs for the use of the distribution grid must be fair and nondiscriminatory. In addition, although some companies can use waste fuel from one plant to generate electricity for several of their other facilities, obsolete prohibitions on private construction of electric wires and other energy infrastructure often prevent such “industrial ecology.” States should follow Colorado’s lead and permit any firm that supplies energy to its own branches or units to construct electric wires and natural gas pipes.

Financial barriers

Tax policies that retard innovation. Depreciation schedules for electricity-generating equipment that are, on average, three times longer than those for similar-sized manufacturing equipment discourage innovation in the electric industry. Such depreciation schedules made sense when a utility monopoly wanted to operate its facilities, whatever the efficiency, for 30 or more years. They make no sense in the emerging competitive market, when rapid turnover of the capital stock will spur efficiency and technological innovation. Electric equipment depreciation therefore should be standardized and made similar to that of comparable industrial equipment.

Monopoly regulation that encourages the inefficient. Because they were able to obtain a return on any investment, utilities had an incentive to build large, expensive, and site-constructed power plants. They also had no reason to retire those plants, even when new generators were more economical, efficient, and environmentally sound. Moreover, monopoly regulation provided no reward to the utilities for energy-efficiency savings. What are needed instead are state and federal actions that advance competitive markets, which will impose incentives to trim fuel use and make better use of the waste heat produced by electric generation.

Environmental barriers

Unrecognized emissions reductions. U.S. environmental regulations are a classic case of a desire for the perfect-zero emissions-being the adversary of the good-lower emissions achieved through higher efficiency. Highly efficient new generators, for instance, are penalized by the Environmental Protection Agency’s (EPA’s) implementation of the Clean Air Act, which fails to recognize that even though a new generator will increase emissions at that site, it will eliminate the need to generate electricity at a facility with a higher rate of emissions, so that the net effect is a significant drop in emissions for the same amount of power generated. In order to reduce emissions overall and encourage competition, the EPA, in collaboration with the states, should instead develop output-based standards that set pollution allowances per unit of heat and electricity. The federal government should measure the life-cycle emissions of all electric-generation technologies on a regular basis. EPA or the states should also provide emissions credits to onsite generators that displace pollutants by producing power more cleanly than does the electric utility.

Subsidy of “grandfathered” power plants. The Clean Air Act of 1970 exempted all existing electric generating plants from the stringent new rules that would shut down a new generator that has excess emissions, even though an old plant producing 20 times as much emissions would be allowed to operate. This perverse policy puts new technologies at a disadvantage, and some analysts worry that deregulation will enable the grandfathered plants, which face reduced environmental control costs, to generate more power and more pollution. Others argue that true competition, in which electric-generating companies are forced to cut costs dramatically, will make inefficient grandfathered plants far less attractive. The bottom line is that the old plants need to be replaced, and federal, state, and local governments should adopt innovative financing programs and streamline the permit process in order to speed the introduction of new facilities.

Lack of a market approach for all emissions. As it did with sulfur dioxide, the federal government should establish a pollution-trading system for all major electricity-related pollutants, including nitrogen oxides and particulates. The system should allow flexibility for emissions/efficiency tradeoffs. It should also gradually reduce the pollution allowances for all traded pollutants on a schedule that is made public well in advance.

Reliance on end-of-pipe environmental controls. One reason why industries neither generate electricity themselves nor use the waste heat for process steam is that current environmental regulations rely on end-of-pipe and top-of-smokestack controls. Such cleansers are expensive and increase electricity use dramatically. A more efficient solution would be for EPA and/or the states to allow process industries to trade electricity-hogging end-of-pipe environmental control technologies for increased efficiency with its accompanying reduction in pollution.

The innovation alternative

The United States is on the verge of the greatest explosion in power system innovation ever seen. The benefits of an innovation-based restructuring strategy for the electric industry will be widespread. Experience elsewhere in the world suggests that ending monopoly regulation will save money for all classes of consumers. In the four years since Australia began its utility deregulation, wholesale electricity prices have fallen 32 percent in real terms. Restructuring will also reduce pollution and improve air quality. The United Kingdom in 1989 began to deregulate electricity generation and sale and to shift from coal to natural gas; six years later, carbon dioxide emissions from power generation had fallen 39 percent and nitrogen oxides 51 percent.

Timing, however, is critical if the United States is to capture such benefits. In the next several years, much of the United States’ aging electrical, mechanical, and thermal infrastructure will need to be replaced. For example, if U.S. industry continues to encounter barriers to replacing industrial boilers with efficient generators such as combined heat and power systems, the country will have lost an opportunity for a massive increase in industrial efficiency.

Maintaining the status quo is no longer an option, in part because the current monopoly-based industry structure has forced Americans to spend far more than they should on outmoded and polluting energy services. If federal and state lawmakers can restructure the electric industry cooperatively, based on market efficiency and principles of consumer choice, they will bring about immense benefits for both the economy and the environment.