Hyperbole or revolution?

Nicholas Lenssen

Gerald Cler

E Source

Distributed generation technologies have been the subject of considerable hype in recent years. Analyzing the market readiness and potential competitiveness of these new technologies suggests that the impact of distributed generation may be less in the short term (less than two years), but greater in the long term than most observers now expect.

Generation costs from some of these new technologies will be competitive with utility service in many regions in the near term. Microturbines, for example, will likely generate electricity for between 7 cents and 10 cents a kilowatt hour (kWh). In cogeneration applications, the effective cost of power falls to around 4 cents to 8 cents/kWh.

E Source`s analysis suggests, however, the market for distributed generation is already larger than is generally recognized. U.S. and Canadian firms already buy about 3,400 MW of small generators each year, mostly for backup power but some as the primary power source for selected loads and facilities.

This demand is expected to double in 10 years. The global market for small generators is already more than 10 times this size, at 35,000 MW per year. Further, growth is accelerating, especially in developing nations.

Just how the emerging distributed generation technologies, such as microturbines, fuel cells and Stirling engines compete against-or surpass-conventional technologies will have a huge impact on their eventual commercial success.

Turning barriers into opportunities

The principal constraints to rapid deployment of these new technologies include the following:

– New distributed generation technologies will face entrenched competition, most notably from the reciprocating engine, as they attempt to enter the stand-by generation market. Reciprocating engines are relatively noisy, dirty, and require frequent maintenance, but they are also reasonably efficient, competitively priced and, perhaps most importantly, supported by extensive and mature distribution and service networks.

– To succeed, service providers will have to turn distributed generation technologies into integrated solutions for their customers. This will entail creating new customer service and support networks, developing streamlined siting and permitting procedures, creating innovative project financing, and other activities. Recognizing this need, some manufacturers are moving quickly to develop alliances with partners that can perform these functions. Service providers that deliver solutions for overcoming these market barriers will tap into lucrative business opportunities.

– To reach the necessary economies of scale for mass production of these new technologies, vendors will have to open up new markets for distributed generation. Such markets might include providing improved power integrity; ensuring power quality; improving emissions compliance; reducing the risks of fluctuating energy and delivery prices spawned by competitive, dynamic markets; enabling end users to bypass some stranded asset charges; and providing utilities with lower-cost alternatives to upgrades in transmission and distribution networks. For fuel cells, the largest medium-term application may be in hybrid electric vehicles.

New market players

Many utility companies, equipment manufacturers, and newcomers to the field are scrambling for competitive position in the distributed generation market. Recent notable industry activity includes:

– AlliedSignal Power Systems Inc. (ASPS), one of the frontrunners in the race to commercialize microturbines, has signed strategic alliances with PSEG Energy Technologies, Mercury Electric Corp., New Energy Ventures, Sonat Power Systems, and Unicom Corp. to create exclusive sales territories for ASPS` soon-to-be-commercialized 75-kW microturbine. ASPS has also signed an agreement that designates Honeywell as the exclusive authorized service agent for ASPS microturbines. ASPS` early success in establishing a network of partners for distribution and service should help the company move forward quickly once its initial microturbine product is released.

– Daimler Benz, Ford, and others have jointly invested about $800 million in a joint venture with fuel cell developer Ballard Power Systems to develop mass-produced fuel cell engines for vehicular applications. This partnership hopes to have 100,000 fuel cell-powered vehicles on the road by 2005. E Source believes that mass production of fuel cells for transport applications would bring costs down from the current level of $3,000 per kW to as low as a few hundred dollars per kW, opening up large markets in stationary applications.

– Edison Development Corp. (an affiliate of Detroit Edison) and Mechanical Technology Inc. established Plug Power in order to develop and manufacture proton exchange membrane (PEM) fuel cells.

– Duquesne Light`s affiliate DQE Technologies has invested in H Power Corp. to develop and commercialize residential or small commercial-scale PEM fuel cells.

– Elliott Energy Systems (EES) signed a joint venture with MagneTek to create a new company, Elliott MagneTek Power Systems Inc., that will package, distribute, and support EES` microturbine product line. EES has also signed an agreement with GE Power Systems that makes the GE unit the primary distributor of Elliott`s microturbine products worldwide.

Commercializing disruptive technologies

When should a marketer not listen to his existing customers? Who in their right mind would develop a strategy to invest in developing lower-performance products that promise lower margins? And why would a developer aggressively pursue small, rather than substantial, markets, while not listening to existing customers? By violating these basic tenets of “good management,” companies have successfully commercialized disruptive technologies that not only generated large profits, but changed the structure of the market in which they compete.

For disruptive technologies, defined broadly as the process by which an organization transforms labor, capital, materials, and information into products and services of greater value, new rules for commercialization apply. Developers of emerging distributed generation technologies such as microturbines, fuel cells, and Stirling engines need to learn how these rules can be used to their advantage in bringing their products to market.

Understanding the distinction between disruptive and sustaining technologies is critical in launching commercialization efforts. Sustaining technologies generally foster incrementally improved performance for existing products. Disruptive technologies, though, tend to offer worse product performance than available alternatives in conventional markets, at least initially. Then, through the commercialization process, they capture markets from suppliers of traditional approaches as performance rapidly improves. That`s partly because disruptive technologies tend to be simpler, smaller, and frequently more convenient to use, and less expensive over the long run.

Clayton Christensen, a Harvard Business School professor who has extensively studied disruptive technologies and their market impact, has found this to be the case in a number of success stories involving disruptive technologies. For example:

– Minimill steel making has eroded integrated steel mills` markets;

– Discount retailers such as Kmart and Target having overcome the traditional retail approach of Woolworth and Montgomery Ward;

– Hydraulic excavators having taken over markets from mechanical, cable-actuated excavators;

– Disk drives having been miniaturized, from 14-inch to 5.25-inch, 3.5-inch and now 2-inch drives.

In each of these instances, the incumbent players failed to stave off new competitors because they listened too closely to their existing customers` needs and did not focus on potential new customers and markets. This is why disruptive technologies tend to be successfully commercialized by small, autonomous firms that are not distracted by existing customers.

To take advantage of this, some large companies have established autonomous organizations to commercialize new technologies. For example:

– Entrance of Control Data Corp. into the 5.25 inch disk market after missing the 8-inch shift;

– Allen Bradley`s shift from mechanical to electronic motor controls while the other four major mechanical motor control companies failed to remain dominant;

– Hewlett-Packard`s move into the ink-jet printer business that appeared to be in direct competition with its laser-jet business. Both operating units are currently generating profits.

With the emerging distributed gen- eration technologies, some similar tendencies are developing. Consider the following approaches:

– Pacificorp has taken a 20 percent stake in the independently run Encorp, a provider of hardware and software systems for deploying stand-by generators as peak shavers;

– GPU International co-founded Ballard Generation Systems to develop and commercialize stationary proton exchange membrane (PEM) fuel cells;

– The Elliott Company created Elliott Energy Systems to develop microturbines;

– Southpower owns roughly 40 percent of Whispertech, an independently managed developer of an 800-W stand-alone cogeneration package based on a Stirling engine;

– DQE`s unregulated affiliate, Duquesne Enterprises, spent $3 million to buy a minority stake in H-Power, developer of PEM fuel cells;

– AlliedSignal Power Systems is a wholly-owned subsidiary of AlliedSignal, independently and internally managed to develop microturbine technology.

Firms successful in bringing disruptive technologies to market apply a very different value proposition than previously existed. Because they offer less of what customers in established markets want, they do not appeal initially to customers of existing technologies. Rather, they must find emerging markets remote from, and unimportant to, the mainstream. Further, they must improve product performance based on experience in niche markets before new technologies can outperform traditional technologies.

New power technologies

In the energy field, too, disruptive technologies are overtaking conventional ones. Historically viewed by utilities as inefficient peaking plants, gas turbines (and also combined-cycle gas turbines) have come to dominate international markets as the preferred generation technologies. Technological innovations garnered during the past two decades from research for military jet applications (such as advanced metals, new blade designs, and high compression ratios) made aeroderivative gas turbines far more efficient, cleaner, and less expensive than steam or conventional gas turbines-which, however, eventually benefited from many of the improvements. By the mid-1990s, gas turbines had surpassed steam turbines as the largest category of new generating capacity.

The change came about not from the actions of monopolistic utilities (which traditionally have invested in large steam power plants fired by either nuclear or fossil fuel), but from the rise of the independent power producer (IPP) industry. Limited by legal restrictions and by their own need to reduce financial risk, the independents spearheaded a return to small generators, seizing on improvements to gas turbines to capture increasingly larger markets.

Roughly half of the country`s new capacity built in the 1990s has been developed by IPPs. To a large degree, the move toward gas turbine-driven IPPs was the catalyst for the current worldwide restructuring of the electric power industry. The success of the IPPs has demonstrated that the monopolistic, integrated utility is neither a functional requisite nor the most economic model for the electricity generating system.

Companies commercializing new distributed generation technologies face huge challenges. In the bulk power market, distributed energy technologies probably won`t compete with the near 60-percent-efficient combined-cycle gas turbines as the design of choice for a power generator-at least not in the near or medium term. Nor will they initially displace reciprocating generators as the tried and true technology for emergency or backup generation for most end users who currently have them.

However, developers of these new technologies and related energy service providers may eventually compete in existing markets if they first think “outside the box” and create new niche markets. By taking this approach, developers and energy service providers can gain invaluable early experience enabling improvements in performance, production scale and costs. In the long run, emerging distributed generation technologies could expand beyond early niche markets to compete with and even overtake conventional technologies just as has happened in many of the industries cited above.

Market drivers

Based on interviews with more than three dozen energy users, E Source has identified areas likely to be early market niches for emerging distributed generation technologies. These include improving power quality and integrity, enhancing environmental performance, and better managing risk created by increasingly volatile energy prices. A fourth driver, regulation on wires companies that leads them to invest in distributed generation rather than distribution system assets, could also provide early market opportunities for distributed generation.

Quality and integrity: Rightly or wrongly, many energy users believe problems related to power quality and integrity will worsen with restructuring. The desire for high-quality uninterruptible power supplies appears to be a significant motivator in leading energy users to experiment with emerging distributed generation technologies. Among the current projects are:

– First National Bank of Omaha has decided to install four fuel cells at its new Omaha credit card processing center to ensure “seven nine`s” reliability for its main frame computer.

– American Home Products is developing a 5.3-MW cogeneration project at its Massachusetts-based Genetics Institute to protect against outages that can cost the company millions of dollars in losses.

– Hannaford Brothers, which already operates baseload generators at nearly a dozen of its supermarkets, plans to install more generators to protect against outages at other locations. Hannaford cites savings of up to $40,000 per day in the event of an outage.

– Tricon Global Restaurants is examining the use of distributed generation to expand into regions without reliable electrical supply. By using liquid fuels, propane, or natural gas (if available), companies can open outlets where they otherwise could not-an important consideration if they already operate worldwide but still seek growth.

Environmental issues: Environmental issues are a major concern for some energy users and may motivate them to use emerging distributed generation technologies. Their decision to do so may come about because distributed generation can allow an energy user to meet regulatory requirements, generate good public relations through voluntary corporate actions, and “green” a product, leading to increased sales. Distributed generation brings cogeneration into closer reach than central power plants can, and the emissions from the emerging technologies are the same, if not lower than conventional plants on a simple electric comparison.

Energy Price Risk Management: Electricity is probably the most volatile commonly traded commodity. With competition, energy managers anticipate increased volatility, and early experience with restructuring confirms that expectation. Witness the extreme volatility that beset North American electric markets in the summer of 1998. In the Southeastern United States, prices rose from a typical $38 per MWh to $4,900 per MWh in late June. Meanwhile, prices in the Midwest reached $7,000 per MWh, as some suppliers defaulted on contracts.

Distributed generation could play a role in efforts by energy marketers and users to reduce exposure to price volatility. If sellers, or even sophisticated energy users, can switch between buying natural gas for on-site generation or buying electricity from the market, they have more flexibility in reducing their exposure to price fluctuations for either fuel.

The challenge for energy marketers will be to build portfolios of distributed generation (or interruptible load) that they could dispatch based on price signals. Users could benefit if energy marketers would price such a service competitively (compared to existing or future financial instruments available to fix prices), and also through other advantages of on-site generation (such as increased power integrity).

Reducing wires investments: The initial impetus for much of the distributed resources analysis started in the early 1990s when Pacific Gas & Electric and other utilities began to explore using strategically located generation, storage, or demand-side management (DSM) resources to defer or outright avoid expensive transmission and distribution (T&D) projects. The analyses proved encouraging, though successfully implemented projects remained few and far between. In short, engineers responsible for the reliability of the grid were hesitant (if not outright hostile) to the idea of distributed resources ensuring the grid`s ability to handle peak demands.

In the middle 1990s, enthusiasm and funding for such efforts waned, largely because of the rising specter of retail competition. Utilities focused efforts on managing the regulatory timetable for direct access, the terms and conditions under which customer choice would apply, the recovery of stranded asset costs, divestiture of generation, and on mergers and acquisitions. The idea that T&D assets could be deferred through distributed resources in general, or distributed generation specifically, was far off the radar screen.

Only in the past year or so, as restructuring has proceeded in some regions, have the newly formed wires companies begun to consider how they can reduce their capital outlays for wires, poles, substations, and so forth. Just how far wires companies go with their ongoing round of study is unclear. One factor that`s not determined yet-but will eventually have a far reaching impact-is how the wires companies will be regulated. For example, if they remain regulated under traditional rate-of-return regulation based on their capital stock, then wires companies will have little incentive to defer or avoid capital upgrades.

However, if regulators employ a performance-based regulatory regime that aims to maximize the least-cost approach for utilities, then wires companies might see incentives to invest in distributed generation and other approaches to defer expensive capital upgrades. Under such a regime, wires companies could even lease services from portable generators, or customer-sited generators, in a market that would be open to all credible bidders.

Though wires companies are beginning to examine the approach of distributed resources once again, regulatory decisions might largely determine just how serious, and far, they go with it.

Addressing barriers

Future market predictions for emerging distributed generation range from roughly 5 percent to 50 percent of new generation capacity by the year 2010. Such a range provides an uncertain foundation for developing business plans. However, the inherent difficulty of quantifying future markets should not deter companies from investing in, or at least following the developmental path of these disruptive technologies. If these new technologies succeed in the marketplace, the winners will be those companies who are able to address market barriers and identify early drivers for customer acceptance.

Nicholas Lenssen is Research Director of E Source`s Distributed Energy Series. Gerald Cler is a Research Manager at E Source. E Source is a Boulder, Colo.-based information service company providing organizations with unbiased, independent analysis of retail energy markets, services and technologies. This article is based on the 1998 E Source report, “Selling Distributed Generation: What Buyers Want,” and a presentation the authors made at POWER-GEN International 1998 in Orlando, Fla. last December.

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Power to the people: Plug Power of Latham, N.Y., is working to commercialize the Plug Power 7000, a 7 kW fuel cell-based power system for small-scale distributed generation applications. GE Power Systems signed an agreement to form a marketing joint venture with the company. Plug Power expects the system to sell for between $3,000 and $5,000 when mass-production is achieved, which translates into end-user electricity prices of 7 cents to 10 cents a kWh.

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