Clean DG is a Strategy

When talking with investors and press who are new to clean energy, there is one misconception that I encounter over and over again. It’s usually phrased in the form of a blanket statement like “Clean energy will never be big until it can compete with 2-cent per kilowatt-hour natural gas fired central generated electricity.” 

Let’s leave aside for now the fact that the statement belies a lack of thoughtfulness about some very interesting and important fundamental questions (What is a big market? How do you compute the cost of energy? Is electricity a commodity for which price is the only competitive factor? How long can we bet everything on cheap natural gas?). In subsequent posts I’ll explore the relationships between competitive positioning, threshold pricing, and market size for clean energy technologies.

For this discussion, what is more significant is what the statement reveals about the speaker’s understanding of the electricity value chain and a failure to grasp the exciting competitive strategy that clean distributed generation (DG) enables. I’ll state my perspective on this question briefly here and then explore the key concepts in more depth below. Simply put, clean DG technology enables a company to compete effectively with utilities at the retail end of the electricity value chain where electricity is expensive and customers are hungry for alternatives. Clean DG is a sound business strategy, not a radical ideology.

Distributed Generation and the Electricity Value Chain

Disributed Generation (DG) is an important concept to understand for anyone interested in new opportunities in energy markets. Broadly speaking, DG refers to any generating equipment that is intended to serve a local energy need or load. Conceptually, DG is the exact opposite of “centralized generation” which has been the prevailing trend in electrical power over the last century.

Under the centralized generation paradigm, economies of scale are thought to derive from building ever-larger centrally-located generating plants. The increased efficiency of a large central plant has typically been thought to outweigh the costs associated with transmission and distribution of the energy to the cities and suburbs where the it is used. For much of the 20^th century, this approach resulted in ever-lower cost for delivery of energy from the plant to the customer’scurb. (link to Power Loss, Small is Profitable)

Most of us are familiar with “value chains” in other industries. The electricity industry has a value chain as well. That chain is typically diagrammed in its simple form as follows:

• Generation – The wholesale creation of electric power typically with a mechanical generator driven by some form of fuel or natural resource.
  

• Transmission – The bulk transfer of electricity at high voltage from the generation source to a distribution substation.
  

• Distribution – The local transfer of electricity at medium voltage from a substation to the point of retail service.
  

• Delivery – The connection, retail supply, and metering of electricity to end users.

As with any other value chain, there are costs imposed at each stage from production to delivery of electricity and, of course, markups are applied to cover these costs and realize a profit. From one end to the other in this chain, electricity that in bulk may cost as little as 2-cents per kWh is delivered to the customer for between 7-cents to 22-cents or more depending on the geographic location, type of service, and time of use.

DG runs contrary to the central generation paradigm. A core DG premise is that there are points in the electric value chain where it would actually be more efficient to generate power locally, bypassing the transmission system and parts of the distribution system.

When people talk about DG, they are typically talking about one of the two different DG flavors: (1) medium scale DG that is located on the distribution network, generating energy for retail sale to local utility customers, or (2) customer-sited DG that is located on the customer-side of the meter and primarily intended to generate power for use by the host customer.

For the most part, I tend to think the exciting opportunities for clean energy startups are in the latter, host-customer flavor of DG. That’s because for medium-scale DG the primary customer is still the electric utilities. As a target market, utilities are unattractive to startup companies because there are only a few decision makers, they have concentrated market power, and their legacy business is threatened by DG. Indeed, it is exactly these factors that have made energy technology in general unattractive to startups and venture investors for so many years.

The host-customer DG market is much broader and features a more diverse and diffuse group of buyers, many of whom are frustrated by the lack of choice and control they have with regard to where they buy energy. In this sense, DG represents a classic form of business opportunity based on disintermediating an existing value chain.

Clean Energy + DG — a Strategic Combination

If you accept the premise that DG is an exciting way to end-run or disintermediate the existing electricity value chain, the business imperative becomes clear: successful companies will position themselves to deliver better electric value to the underserved customers of the utility companies. They’ll do that by selling them turnkey generating equipment or by selling them energy generated on site as a service.

The first and most obvious implication of the DG approach is that to be successful a DG provider does not have to compete with wholesale electricity prices, but with more expensive retail prices. This makes beating the value target quite a bit easier—and it’s my biggest objection to the “you have to beat 2-cent per kilowatt-hour” statement that started this post.

Perhaps more important, however, is that DG power does not necessarily have to be cheaper than utility power; it just has to offer a greater value. At risk of stating the obvious, value is a function of both perceived benefits and price. While most people intuitively think of electricity as a simple commodity, the reality is that electricity has a number of attributes—quality, time of use, geographic location, dispatchability, emissions, etc.—that can be selectively packaged to deliver a higher perceived benefit. I’ll talk about these sorts of opportunities and the DG value proposition in greater depth in later posts.

If DG is the gateway to an underserved customer base, clean energy technology is the key that opens that gateway wide to new entrants. There are three principal reasons for this: (1) clean electricity is a premium product that is perceived as inherently more valuable than commodity electricity, (2) growing emissions regulations are making it harder to site traditional fossil-fuel generators on customer premises, and (3) clean electric generators are favored with incentives like fast-track interconnection, net metering, direct rebates, and feed-in tariffs.

As a result, when you combine a DG paradigm with a clean energy technology, you get an exciting new way to compete for electricity end-users. The DG approach focuses a startup to serve a market of frustrated customers with alternatives that offer greater choice and greater control. The clean energy component enables the startup to pursue a path of least regulatory resistance to serving a large portion of that market with a high-value product.

At this point in the discussion, I can imagine a number of questions and/or objections. Will this approach enable a startup to address the entire market for electricity? No, but the electricity market is huge and even a small slice is a big deal. Will customers accept clean DG at any price? Of course not, but the entry price threshold is a lot higher than most people think when you target retail rather than wholesale markets and you sell a premium product like clean energy. Is DG the only market for clean technologies? Clearly not—wind power is an obvious counter-example—but I believe strongly that clean energy entrepreneurs seeking a market entry niche can hardly do better than the clean DG opportunity.

In summary, clean energy startups don’t have to compete with lowest common denominator wholesale energy prices (or even the average price) to be successful in a big way. In fact, they don’t even have to be cheaper than utility energy; they just have to offer a better value. By focusing on the retail end of the market, where prices are high and customers are frustrated by lack of choice, a clean energy startup can find a highly receptive audience for a cleverly crafted value proposition. This approach leverages the special regulatory advantages that clean energy enjoys to compete more effectively against non-clean rivals and minimize operational friction. For all these reasons, I believe clean DG represents a compelling opportunity to startups for both market entry and long-term growth.