Vertical integration in the energy industry
Vertical integration in the energy industry refers to a business model where a company controls multiple stages of the energy supply chain, including generation, transmission, and distribution of electricity. This model allows companies to synchronize supply and demand, reduce transaction costs, and lower uncertainty, potentially leading to higher investment and market monopolization. However, vertical integration can also create challenges, such as inhibiting interoperability between technologies and discouraging competition. In the context of electric utilities, the conversation around vertical integration becomes more complex due to the essential nature of energy as a public good, the impracticalities of energy storage, and the intricate management involved in electricity distribution. The trend towards deregulation, particularly in the U.S., has aimed to foster competition and introduce independent power producers into the market. Legislation such as the Public Utility Regulatory Policies Act and the Energy Policy Act has encouraged utilities to "unbundle" services and source power from multiple providers. While deregulation has the potential to lower rates and promote cleaner energy sources, it also presents new challenges in maintaining reliability and accessibility within the energy grid. Overall, the dynamics of vertical integration and deregulation reflect ongoing debates about efficiency, sustainability, and consumer protection in the energy sector.
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Vertical integration in the energy industry
Summary: A vertically integrated business owns the intermediary stages of product development. In the energy and power industry, these stages include, most controversially, the generation, transmission, and distribution of electricity.
Vertical integration refers to the control and ownership structure and strategy of different aspects of a market. There are two main facets of vertical integration relevant to energy. The first is the degree of vertical integration within an energy generation sector, and the second is the degree to which an electricity utility is integrated in the generation, transmission, and distribution of energy.
When a business is vertically integrated, it controls or owns the various levels of product development that affect its end sale. The opposite of vertical integration is horizontal integration. For example, a vertically integrated oil company would control all levels of the supply chain involved in producing oil. This could include the ownership of the crude oil resource deposits, the drilling and extraction process, transportation, refining, the distribution process, and final sale. This is a common business model for multinational oil companies because it endows them with a large degree of control over all aspects of the business and therefore makes them less vulnerable to external shocks, which a horizontally oriented company may encounter. On a high level, vertical integration offers the benefits of synchronizing supply and demand, decreasing transaction costs, and lowering uncertainty, resulting in higher investment and the capacity to monopolize a market.
However, there are costs to a vertically integrated model. Vertical integration discourages interoperability between businesses and technologies. This in turn discourages communication about intellectual property and best practices and can select for technologies already in use, as opposed to letting the market select for the best technologies on a more level playing field. Therefore, vertically integrated businesses often face difficulty in developing competitive products and require a high degree of competition or regulation. Businesses, especially emergent technologies, may favor a more horizontal business model, so they can continually optimize all levels of the value chain. An example is a solar photovoltaic (PV) module manufacturer, which continuously is able to select from the best and cheapest of competing solar cell technologies to use in the manufacture of its product.
Electric Utilities
Vertical integration of energy-generation technologies is primarily a business strategy choice, but the subject becomes much more political, controversial, and complex concerning the integration structure of electric utilities. The controversial nature of vertically integrated electric utilities is primarily due to the unique characteristics of energy as a fundamental economic predictor, the degree to which it is considered a public good, the impracticality of storing electric energy, and the complex management that electricity requires. A vertically integrated electric utility is one that controls the generation, transmission, and distribution of electricity, and the movement away from vertical integration has been termed the deregulation of the electricity industry.
Historically, US electric utilities have been vertically integrated. Predominantly composed of investor-owned utilities (IOUs), cooperatively owned utilities (COUs), publicly owned utilities, and federally owned utilities, these utilities were granted local monopolies over their service areas. Monopoly standing allows for access to large-scale financing, which could not have been secured in riskier environments. Since all customers in the service area then use the utility, there is an assured return on investment, and these utilities are required to agree to a modest rate of return.
Several aspects of electricity management lend themselves to a vertically integrated model. Transmission and distribution lines are both expensive and potentially dangerous. In order to have transmission and distribution competition, multiple sets of power lines would be needed. The fact that energy is not discrete, traceable, or efficiently storable means that competing generators that use the same transmission system face complications in billing end users. These complications are surmountable but are evidence of the complex nature of the electric energy business. There may also be high losses if the load is not effectively managed.
Transmission and distribution lines must often be planned to accommodate additional generation. This type of planning is likely done more effectively through a single organization that has access to as much information as possible, as opposed to the proprietary effect of competition. Additionally, the complex monitoring and dispatch required for providing adequate power to meet the peak loads means that it is preferable to have one company that has the ability to coordinate the entire local system. Although there are many benefits of a vertically integrated utility system, it is not without its drawbacks. Just like generation technologies, vertically integrated utilities face difficulties in adopting the best product and providing it to the market. As the pitfalls of fossil fuel resources became increasingly apparent, a way to introduce new and cleaner energy generation into the market became necessary. It was thought that by separating generation from transmission and distribution and requiring utilities to acquire independently produced power, the resulting competition would both lower consumer rates and introduce more sustainable electricity into the grid.
Deregulation
In the United States, two major laws have effected a shift toward deregulation: the 1978 Public Utility Regulatory Policies Act (PURPA) and the 2005 Energy Policy Act (EPACT). These laws required utilities to “unbundle” their charges and purchase power from qualifying independent power producers, giving the Federal Energy Regulatory Commission (FERC) expanded power. Independent power producers thus gained access to the grid, which fostered the creation of transmission and distribution service operators and regional transmission organizations. In some areas, energy trading and auction-style markets were introduced to find the cost of the generation needed to meet the demand. The North American Electric Reliability Corporation (NERC) became responsible for the reliability, coordination, and planning of the interconnected power grids.
The impact of these changes on the price of electricity is debatable, and there are myriad other factors that affect it. This ambiguity is clear from the fact that some states have deregulated their utilities while others have not. What is clear is that renewable energy needed a way to enter the transmission system, which was not adequate under the former utility monopoly system. The competitive market mechanism of deregulation is not adequate to foster clean energy, as clean energy technologies remain more expensive than their competitors, which have enjoyed much longer periods of use during which they improved and became cheaper. Also, the transmission difficulty of a horizontal (or distributed) generator approach remains a twenty-first-century challenge. One option for improving the viability of distributed generation is demand management.
Bibliography
"Power Market Structure." US Environmental Protection Agency, 15 Jan. 2024, www.epa.gov/green-power-markets/power-market-structure. Accessed 7 Aug. 2024.
VanDoren, Peter M. “The Deregulation of the Energy Industry: A Primer.” Octobert 6, 1998. www.cato.org/sites/cato.org/files/pubs/pdf/pa-320.pdf.
Zaccour, Georges, ed. Deregulation of Electric Utilities. Topics in Regulatory Economics and Policy 28. New York: Springer, 1998. www.springer.com/engineering/energy+technology/book/978-0-7923-8134-1.