Abstract
Throughout the United States, most customers continue to receive service from their hometown utility companies, regardless of the status of retail competition in their state’s electric industry. Recent turmoil within the industry has focused attention once again on a crucial responsibility of those utilities: electric-resource portfolio management. Effective portfolio management requires a fully integrated approach to identify customers’ electric service needs and to select demand- and supply-side alternatives to meet those needs through a portfolio that minimizes the total cost and environmental impacts and has an acceptable level of risk. To enable effective portfolio management, regulators must align utilities’ financial incentives with customers’ interests. Traditional regulation creates a substantial financial disincentive for utilities to meet customers’ energy service needs through cost-effective energy efficiency or other demand-side resources, but regulators and governing boards can and should eliminate this disincentive.
Every utility’s current resource mix and its cost of providing energy is largely inherited from past portfolio managers’ investment decisions. Long-term, integrated resource planning provides an opportunity for portfolio managers to work with their regulators or governing boards, customers, and other stakeholders in an inclusive and transparent manner to create a plan to meet future energy service needs. The resulting long-term plan should enable stakeholders to understand what the resource mix will be in ten or twenty years, the expected costs of the resource plan, and its environmental impact. Long-term plans provide a common basis for both the utility and the regulator upon which to found subsequent resource investment decisions.
The long-term planning process begins with a forecast of customers’ demand and an accounting of the resources that are available to meet that demand. The portfolio manager should conduct a comprehensive analysis of the costs, risks, and environmental impacts associated with all resource options, including both demand-side and supply-side resources, that could be included in the portfolio to meet customers’ needs. A number of potential resource portfolios should be tested against the portfolio manager’s primary objectives. The final long-term plan should document this analysis and describe the elements of the preferred resource portfolio.
PROVIDING ENERGY SERVICES: THE ROLE OF UTILITIES IN SOCIETY
The overriding purpose of any utility or energy service provider is to meet its customers’ energy service needs in an affordable, reliable, and environmentally sensitive manner (Throughout this entry, I often refer to the portfolio manager as a utility, since utilities are the most common entity to perform the portfolio management function; however, as I discuss in a later section, other entities also perform this function). While this may sound simple in concept, achieving these goals in practice is difficult and requires expertise in managing a diverse portfolio of resources to achieve sometimes conflicting objectives.
Managing a portfolio of demand- and supply-side resources is complex in part because the services that energy utilities provide customers vary widely. Utility customers do not purchase electricity from a utility for the sake of the electricity itself. Instead, customers pay the utility in order to receive the services that the electricity can provide. Customers want light to read by, cool and comfortable homes in the summer, and clean clothing, all for a reasonable price. As such, customers generally care more about the total bill they will pay to receive those services than about the rate for each kilowatt-hour of electricity consumed. In order to best meet customers’ needs, utilities must focus on the broader scope of providing the energy services that customers want, rather than just the energy itself as a commodity.
Moreover, many of the services that utility customers demand, along with access to shelter, food, and water, are considered essential to achieve even a basic quality of life in modern times. As the single largest source of air pollution in the United States, the electricity industry must also be a key contributor in the effort to provide all people with another basic human right: access to clean and healthy air to breathe. Thus, how utilities provide their customers with energy services is fundamentally intertwined with a broad range of social and political issues.
THE BENEFITS OF PLANNING AND PORTFOLIO MANAGEMENT
Perhaps nothing in recent history demonstrated the need for long-term planning and portfolio management in the electric industry as clearly as the California energy crisis of 2001. (In 2002, the California Legislature enacted Assembly Bill 57, returning the utilities to the role of portfolio managers.[1] The California Public Utilities Commission has adopted several subsequent decisions providing guidelines for the utilities’ portfolio management activities.[2'3]) That experience showed forcefully that simply relying on a spot market to meet customers’ needs will not achieve the industry’s overriding goals of providing customers with energy services in an affordable, reliable, and environmentally sensitive manner. To achieve these goals, utilities and other service providers must assemble a diverse portfolio of resources that will be robust in the face of the many uncertainties prevalent in the electric industry. Such a portfolio is likely to include demand- and supply-side resources with a mix of long-, medium-, and short-term commitments, owned and contracted resources, and supply-side resources with a variety of fuel sources, along with financial instruments to help manage any remaining risks.[4] Careful diversification along a number of different dimensions will help to avoid the classic pitfall of putting all the portfolio manager’s “eggs in one basket” and can provide protection against risks, including those related to fuel prices, future loads, fuel supply availability, and future environmental regulations.
Who is Responsible for Portfolio Management?
Throughout the United States, the most common electric-resource portfolio manager is the hometown utility. This includes publicly owned utilities that are governed by local boards, as well as investor-owned utilities that are regulated by state Public Utilities Commissions. These boards and regulators are responsible for guiding the utilities’ portfolio management and long-term investment activities.
In states that have restructured their electricity industry and established a competitive retail market, energy service providers (ESPs) also perform the portfolio management function on behalf of their customers, while the management of the distribution system remains with the utility. Most ESPs are required to sign up each individual customer that they serve; however, a few states, including California, Massachusetts, Ohio, and Rhode Island, have enacted legislation that enables local governments to become portfolio managers, commonly known as community choice aggregators (CCAs), by providing energy services to utility customers in their jurisdictions on an “opt-out” and aggregate basis.
The Long-Term Planning Process
Long-term planning is an essential responsibility of portfolio managers. A long-term view is necessary because the electricity industry is characterized by the need for capital-intensive investments with sometimes long lead times. These investments are often lumpy in nature, and portfolio managers’ investment decisions must be made based on uncertain information. In addition, many new resources will continue generating or saving electricity for thirty to forty years or more, so the costs and benefits of investing in a particular resource must be analyzed over an extended time period. Moreover, the various resources from which a portfolio manager can choose to meet its customers’ needs expose it and its customers to various types and levels of risks, which must be analyzed in the context of the overall portfolio of resources.
Portfolio managers should conduct integrated analyses of various resource portfolios and investment options on a regular basis, for example, every two to three years. These long-term plans can build off of the experience utilities and regulators gained with Integrated Resource Planning over the past quarter-century. Regular long-term planning processes enable a portfolio manager to compare resource alternatives in a manner that captures interactive portfolio effects. Without long-term, integrated planning, a utility that analyzes procurement options one by one is likely to “miss the forest for the trees.” Each individual investment decision may seem like the best decision, but the additive effect of the decisions and the impact on the overall portfolio would not be considered without true long-term plans. The preferred resource plan generally has, among other factors, the lowest lifecycle cost (i.e., the lowest anticipated long-term revenue requirement) and is most robust in the face of various risks.
Long-term plans provide a portfolio manager and its regulators or governing board, customers, and other stakeholders with a common roadmap toward the future. Importantly, the process of developing a long-term plan provides a crucial opportunity for portfolio managers to engage all of these stakeholders in a collaborative, public process to understand the risks and benefits of alternative portfolios and to seek a general consensus on the best path forward. (Montana’s guidelines for electricity procurement provide a good example of the policies governing, and the processes used for, portfolio management.[5]) Such a public process not only benefits the various stakeholders who have an opportunity to help determine the future of the portfolio, it may also help the portfolio manager to avoid potentially lengthy and adversarial regulatory hearings.
While long-term plans must delve into the technical details of load forecasts and the characteristics of resource alternatives discussed further below, a plan should also be able to answer key policy-level questions. For example, a long-term plan should enable policymakers and the public to understand what the portfolio manager’s resource mix will be in ten or twenty years under its preferred plan and how it will differ from the present resource mix. The plan should also clearly present the expected costs of the resource plan (and the impact on average customer bills over time), the accompanying risks, and its impact on pollution emissions.
UTILITIES’ FINANCIAL INCENTIVES MUST BE ALIGNED WITH CUSTOMER INTERESTS TO ENABLE EFFECTIVE PORTFOLIO MANAGEMENT
Effective portfolio managers should analyze both demand-and supply-side resources to meet their customers’ needs. In many instances, it is more cost-effective for a utility to help customers use energy more efficiently than to buy power (or build a power plant) to serve inefficient uses of energy. However, traditional regulation creates a substantial financial disincentive for utilities to meet customers’ energy service needs through cost-effective energy efficiency or other demand-side resources.
This disincentive arises because once a utility’s rates are set, its revenues are tied to the volume of electricity that is sold. If actual annual electricity sales diverge from the forecast that is used to set the authorized revenue requirement, the utility will either under- or over-recover the fixed-cost element of its revenue requirement. While this problem is most often discussed in the context of investor-owned utilities, publicly-owned portfolio managers, including municipal utilities and CCAs, can face similar “conflicts-of-interest” with demand-side resources if their governing boards use a similar process to set rates. Fortunately, this disincentive can be eliminated through the use of modest, regular “true-ups” in rates to ensure that any fixed costs recovered in kilowatt-hour charges are not dependent on sales volumes. This solution has been implemented successfully by a number of regulators to remove utilities’ disincentives for investments in energy efficiency and other demand-side resources. (For a complete discussion of the conflicts of interest that portfolio managers can face relative to demand-side resources, and the solutions to it, see the reference section.[6])
In addition to eliminating these disincentives, development of the most reliable, affordable, environmentally responsible energy service portfolio requires, among other things, a balanced, performance-based incentive system that provides the portfolio manager with risks and rewards to the extent it achieves (or does not achieve) these objectives. More than a decade ago, the national association of regulatory utility commissioners (NARUC) urged its members to “ensure that the successful implementation of a utility’s least-cost (investment and procurement) plan is its most profitable course of action.”[7] The resolution framed the term “least-cost” over an extended time period. Congress endorsed NARUC’s objective in the National Energy Policy Act of 1992, for both electric and gas utilities, although the final decision remains with state regulators.[8] NARUC’s stated objective remains an important prerequisite to enable effective electric-resource portfolio management, although in most states, current regulatory incentives do not achieve this objective.
KEY ELEMENTS OF A LONG-TERM PORTFOLIO MANAGEMENT PLAN
The process of developing a long-term plan begins with a forecast of customers’ demand and an inventory of the resources already at the portfolio manager’s disposal to meet that demand. Next, the portfolio manager should conduct a comprehensive analysis of the costs, risks, and environmental impacts associated with all available resource options, including both demand-side and supply-side resources, that could be added to the portfolio to meet customers’ needs. Finally, the portfolio manager should test a number of potential resource portfolios against its primary objectives, conduct a risk analysis under various scenarios, and assemble a plan for an optimal portfolio.[9]
Forecasting Demand and Existing Resources
Forecasting customers’ energy service needs (both energy and peak-load demand) is the first step in long-term planning. The changes in demand over time are a function of many factors, including population, economic conditions, weather, and how energy is used by customers (known as “end-uses”). Portfolio managers can use both econometric and end-use forecasting techniques to project future customer demand.[10] Econometric models use a “top-down” approach to project future demand by extrapolating trends based on past relationships between demand and key metrics such as population, weather, and economic growth. End-use forecasting models produce “bottom-up” forecasts based on the penetration and energy consumption of various identifiable end-uses such as refrigeration, lighting, air conditioning, and other electrical equipment.
Together, these types of models can capture the key variables affecting changes in customer demand over time. However, since forecasts are inherently uncertain, portfolio managers should also conduct sensitivity analyses to understand the full range of possible future demand scenarios. These sensitivity analyses might, for example, analyze a low load-growth scenario under which population and economic growth estimates are at the low end of the range, and conversely, a high load-growth scenario with higher possible population and economic growth forecasts. In states with retail competition, these scenarios might also include forecasts of various levels of customers switching providers. This forecasting and scenario analysis process often results in a “jaws” forecast of future demand, defining both the best estimate of future demand as well as the potential range of future demand.
Once a portfolio manager has forecast the range of possible demand, the next step is to assess the existing resources that it either owns or has under contract, and to compare these available resources to the demand forecast. The difference between the two will determine the portfolio manager’s remaining need for additional demand- or supply-side resources. During the planning process, the portfolio manager should also assess whether the portfolio could be improved by replacing or re-powering any of the existing resources.
Analysis of Resource Alternatives
To fill that remaining need, the portfolio manager should analyze the costs, risks, and environmental impact associated with the full range of potential resource options. These options include energy efficiency, distributed generation, renewable resources, thermal resources (such as natural gas-fired plants and integrated gasification combined-cycle coal plants), transmission, and more.
Energy efficiency is the most cost-effective, reliable, and environmentally friendly resource available to portfolio managers. Assessing the potential for energy efficiency resources requires an analysis of the various end-uses (i.e., how customers use energy), how much more efficient those end-uses could be, and what level of efficiency is achievable through voluntary programs that provide incentives and information to customers to improve their efficiency or through mandatory standards that set the minimum level of required efficiency. (California’s recent analysis of the potential for cost-effective energy efficiency provides a good example of this type of study in potential.[11])
Determining what portion of that energy efficiency potential is cost-effective requires an analysis of the total cost to society of procuring the energy savings; the total resource cost (TRC) test is the cost-benefit test most commonly used by regulators and portfolio managers to determine what level of energy efficiency is cost-effective.[12] The TRC test accounts for the total cost to society of acquiring efficiency resources, including the incremental cost to customers (if any) of implementing more efficient technologies or practices and the cost to the portfolio manager of offering the programs. Since energy efficiency resources are comprised of many smaller resources, portfolio managers often shorten the analysis of determining what portfolio of programs is cost-effective by comparing the costs of the efficiency resources to a static estimate of avoided costs (including avoided costs of generation, transmission, distribution, and environmental pollution), rather than putting the energy efficiency programs into the iterative portfolio analysis alongside the supply-side resources.
Assessing supply-side options requires an analysis of the costs, attributes, and risks associated with each resource. Every resource’s fixed and variable costs should be assessed either over the lifetime of the resource or over some fixed period, often thirty years. In order to allow all resources to compete on a level playing field in this assessment, portfolio managers must use accurate operating and cost assumptions for each resource. For fossil-fueled resources, forecasting fuel prices (with a sensitivity analysis) is a critical element of this cost assessment. In analyzing renewable resources, assumptions regarding capacity factors and integration costs must be realistic in order to accurately reflect the cost of these resources.
Different resources have different operating characteristics, which may make them more or less valuable to a portfolio manager. For example, some resources are designed to operate at a relatively constant output to serve baseload demand, whereas other resources are dispatchable and can ramp up and down quickly to follow load or to meet peak demand. The portfolio manager must consider these attributes in order to design a portfolio that enables it to maintain reliable service.
Each resource exposes the portfolio manager to certain risks while mitigating other risks.[13] For example, natural gas-fired resources expose the portfolio manager to fuel price risks, whereas renewable resources should help mitigate exposure to this risk in a portfolio. Conversely, some types of renewable resources are intermittent and expose the portfolio manager to reliability risks, whereas natural gas-fired resources are more dispatchable and can help mitigate this risk. Conventional coal-fired generation is particularly vulnerable to financial risks associated with the potential regulation of greenhouse gases. These are just a few examples; all of the significant risk attributes of each resource must be well understood so that the various portfolios of resources can be tested against the variety of risks and designed to minimize both risks and costs.
Finally, resources have widely varying environmental impacts. By analyzing the environmental profile of each type of resource, the portfolio manager can assess the projected environmental impact of various portfolio options to help select a portfolio that meets the objective of providing energy services in an environmentally responsible manner. This information is also necessary to assess the financial risk exposure due to pollution emissions, as we discuss further below.
Determining the Optimal Portfolio of Resources
The final steps in assembling a long-term plan are to test a number of potential resource portfolios to determine their total long-term costs, conduct a risk analysis of those portfolios under various scenarios, and select an optimal portfolio that best meets the portfolio manager’s objectives. While optimization models have been used to help determine the preferred plan, most utilities construct dozens of potential portfolios “by hand.” These portfolios should span a wide spectrum of possible options. The operation of these portfolios is then modeled over the timeframe addressed by the plan (often 30 years) and the portfolios’ total long-term revenue requirements, environmental impacts, and other metrics are compared. As the analysis illuminates the components of the portfolios that are more or less desirable, new portfolios may also be constructed and tested.
This application of “base case” assumptions in the initial analysis should produce useful information, but given the numerous risks in the electric industry, it is essential to conduct a risk analysis to test how robust each portfolio is in the face of various uncertainties. There are generally at least three different types of risks: (1) risks that can be quantified and for which historical experience can inform assessments of the future risk (e.g., load forecasts, natural gas price risk, etc.); (2) risks that can be quantified but for which no historical experience can inform the assessment (e.g., future regulation of carbon dioxide emissions); and (3) risks that cannot be easily quantified, but can be assessed qualitatively (e.g., a change in FERC’s market design, public acceptance of new resource siting, etc.) PacifiCorp’s 2003 Integrated Resource Plan provides a good discussion of these different types of risks and develops a framework for analyzing the risks.[14]
Utilities have traditionally emphasized the first type of risk listed above in their analyses. However, the other two types of risks are no less significant or real; even if they can’t be quantified based solely on historical experience, they can often be quantified and incorporated into the integrated resource analysis. The financial risk associated with future regulation of carbon dioxide emissions is a prime example of the type of risk listed in the second category above that utilities have historically failed to assess or mitigate.[15] As the electric industry becomes more sophisticated with risk management, a number of utilities are beginning to conduct comprehensive risk assessments. Leading examples include PacifiCorp, Idaho
Power, Puget Sound Energy, and Pacific Gas & Electric.[16-19] The Northwest Power and Conservation Council is a leading public sector practitioner.[20]
Based on these cost, risk, and environmental performance analyses, the portfolio manager should select a preferred portfolio that best meets its objectives. The final long-term plan should outline the elements of that preferred portfolio, in addition to documenting the full analysis conducted to assemble the preferred portfolio.
TURNING A LONG-TERM PLAN INTO ACTION
The principal value of a long-term plan is determined by its translation into the actual procurement of resources by the portfolio manager. Long-term plans lay out the elements of a preferred portfolio over ten to thirty years or longer, but circumstances within the industry may change over time and affect the underlying assumptions that led to the selection of the preferred plan. As such, long-term plans should be living documents that are updated regularly, as needed. In the intervening years, the procurement of resources should be consistent with the long-term plan. However, if conditions have changed enough to warrant deviations from the plan, the long-term plan should provide a common basis for stakeholders and regulators to understand what has changed and how those changes affect procurement.
Different portfolio managers have utilized their long-term plans in resource procurement in varying ways. Some include a near-term action plan within the long-term plan itself, laying out the steps to be taken in the near future to work toward the long-term vision described in the plan. In some cases, utilities will build or contract for each specific type of resource described in the plan. In other cases, utilities will solicit competitive bids and determine whether to procure more or less of a certain type of resource based upon the offers that are received. Either way, it is important for the portfolio manager to remain flexible to respond to actual circumstances while still utilizing the guidance that is provided from the full portfolio analysis produced in the long-term plan.
CONCLUSION
Portfolio management is essential to enable utilities and other energy service providers to meet customers’ energy service needs in an affordable, reliable, and environmentally sensitive manner. Long-term integrated resource planning is a crucial tool for portfolio managers to balance costs, risks, and other objectives in an industry that is characterized by widely varying resource options and long-lived investments. Recent turmoil within the electric industry has put a spotlight on the benefits of portfolio management and, in particular, the tools it provides for risk management. Regardless of what type of
