On Managing Energy Costs
What do business leaders need to know about energy to prepare their business for the future?
Depending on the type of business, energy can be a significant cost factor. Any good manager should understand the costs of the business and the prudent risk management steps to address those costs. If you are everything from being a landlord who may have rolled the cost of the energy into your lease payments to an aluminum refinery in which energy is a very high percentage of the cost of the production of the aluminum and therefore is a critical factor, then you need to manage that risk. I think business leaders who are good cost managers examine those factors and make it the responsibility of someone in the business to understand and deal with them. Depending on the magnitude of their energy needs, they may need to actively manage them by arranging their own supply, and certainly by building efficiencies into the processes so as to use less energy.
I’ll give you an example. I know someone who owns a lot of drink vending machines. They bought a technology that measures traffic patterns to their machines using a timing device so they know when people buy sodas. They found out that in many places there is a distinct period of time in which purchases are made and a distinct period of time when they are not. The technology allows the temperature in the machine to rise during the offbeat times, thereby saving 50 percent of the energy consumption by shutting down the compressor in the machine. The temperature of the sodas will rise maybe 10 or 15 percent, so if you buy a soda in the off-hour, you’re going to get a soda that’s not quite so cold, but the machines save 50 percent of the energy. The business owner applied technological advances, but it is not rocket science.
On Energy Alternatives
What are the alternative energy solutions on the horizon?
There are no miracle solutions. There are technologies which offer alternatives to central station generation, but they have their own problems. For example, the fuel cell technology is still very expensive. There has been a flurry of articles about solar cells and solar panels. Compared even to today’s higher energy costs, the capital recovery period for solar panels is very long, maybe 15 or 20 years. Without subsidies, most of these technologies can’t compete economically. If you just let them come into the marketplace without some tax break or an actual subsidy payment, they just won’t be competitive with the other technologies.
Take for example the micro-turbine for a small business or a home. It’s about the size of a large refrigerator. It can be put in somebody’s garage. It would be fired by natural gas and would generate electricity and heat. The heat could be used in an exchanger to make air conditioning or heat, and the electricity could be used in the home. But these turbines make noise, and they emit; they’ve got an exhaust. If everybody’s garage has got one of these things in it, you are going to create low-level pollutants. People don’t talk about that or the neighbors complaining about the thing going “rahhhhh” in the middle of the night. In the central station power plant, you can monitor the efficiency and levy fines if noxious levels are too high.
There are those who argue that we are not properly assessing the cost to society of the current technologies. For example, if you build a coal plant, what is the actual cost of the impact on health and welfare of the particulates that come out of the stack and so forth? What are the visual impacts? What about the mining and the people who are killed by the mining? What about the disruption of the landscape? We talk about impacts, but we don’t put a monetary value on those impacts and then say, “Okay, it is costing society $X to do that.” If we did that, we could take actual money and apply it as a subsidy to avoid the cost of those impacts. You might in the end have a better society, but generally we don’t operate that way. I don’t see those technologies really being a factor for a long time.
Sempra Energy is very committed to Liquefied Natural Gas (LNG) as an alternative. Is there sufficient natural gas around the world to provide an adequate supply for the future at a reasonable cost?
There’s going to be plenty of natural gas brought in from abroad, and it will actually lower prices. If you look at the forward strip, natural gas prices on the New York Mercantile Exchange [August 2004] are sustainably high out to about mid- or late-2007. There’s a large open interest on the future contracts, then they drop, and there’s less of an open interest. The marketplace is saying directly that LNG is going to come in that time frame, and it’s going to cause the price of natural gas to go down; otherwise people would be bidding it up. As you get lower energy prices, alternative technologies become less attractive.
On the Energy Crisis
In 2000 and 2001, California faced critical energy problems[2] which rocked residents of the state and had far-reaching impact on finances and resources. The effects of the crisis were so broad the situation was widely covered in national and international news. The Department of Energy notes that “California’s energy crisis can be grouped broadly into three interrelated problems including (1) precipitous increase in wholesale electricity prices, (2) intermittent power shortages during peak demand periods, and (3) the deterioration of the financial stability of California’s three major investor-owned utilities (IOUs)…”[3] We asked Baum to speak with us about the crisis and how Sempra Energy, parent company of San Diego Gas & Electric (SDG&E), survived the storm.
What factors other than deregulation do you believe were responsible for the energy crisis?
Let me start with a very high fly-over by saying the energy crisis was a product of multiple factors. Sometimes there can be a convergence of very bad things which act together synergistically. My take is that the legislation [AB 1890[4], which was enacted by the California state legislature on Jan. 1, 1996] on paper could have worked, but for some other circumstances. The idea of the legislation was patterned on the English system, except England did it in stages and so could see how things were working, while it was kind of a “big bang” in California.
Secondly, the deregulation legislation was a bit of a pork barrel in the sense that because of the political process, all constituencies were given some benefit, which normally doesn’t work very well. For example, the residential and small commercial customers were given a 10 percent reduction in rates, which was financed by borrowing. The utilities sold rate-reduction bonds and Wall Street got a big commission out of the bonds. Large business was free to make its own contracts, which it did, and skimmed off some of the best stuff, if you will.
Another thing that happened was that much as we do today regarding water supply, California had relied upon neighboring states to deliver electricity. Nevada and Arizona were the traditional exporters to California, but their populations over the decade of the ’90s had risen dramatically. Las Vegas’ demand had grown 50 percent during that period. Phoenix blew by San Diego as the sixth largest city. So the energy that had been exported was starting to be consumed within those regions, leaving less available for California. Then of course, California hadn’t built any new generating capacity for quite a long time.
The utilities had also reduced their reserve margins from the traditional 20 percent to about a 5 percent level, figuring to avoid additional capital expenditures, partly to save money. With the independent system operator view that California could be administered as a whole, you wouldn’t need to have redundancy electrical generation in reserve margins.
None of this would likely have been fatal except that at the same time, we encountered a significant drought in the Northwest, coupled with new EPA [Environmental Protection Agency] regulations that required water to be released from reservoirs for salmon and other types of fisheries. So the normal exchange of energy that takes place in the West—when California gets energy from the Pacific Northwest in the summer and delivers it back to the Pacific Northwest in the winter—went away. Historically, there are non-coincident peaks in energy between these two regions.
All of these factors combined so that when we had a hot summer and the deregulation, it was a mix in which you could game the system, and the system wasn’t designed to avoid gaming[5]. The main problem was that when you have supply and demand, very slight imbalances will cause electricity prices—the most volatile of all commodities—to skyrocket.
Now add into that a price cap that was put on the utilities so they couldn’t charge more than 9.99 cents per kilowatt hour on average to their customers, while the prices on the wholesale market were anyplace between $2 and $5 a kilowatt hour. Obviously there was a huge cash flow imbalance. Because consumers weren’t seeing the increases, they didn’t conserve. There was no demand-side response. When the prices finally did go up as a result of the governor’s[6] action, there was a 20 percent reduction in demand.
We are creating another class of indifferent customers today. They don’t care what electricity costs because their price is fixed. That attitude may be comfortable for politicians, but it’s a tremendous stress on the economy. Even though the prices are at much higher levels, what we see today is that entire conservation effort has gone away. People are back to using the energy levels they used in the past. It’s kind of like the metaphor of boiling the frog: if you turn the heat up slowly enough, the frog is finally cooked without ever jumping out of the pot.
What is the biggest issue facing California in terms of energy, and what do you believe it’s going to take to solve that?
Probably the hardest thing to get built in California is transmission. We go through very elaborate layers of review here. There are some 13 different agencies that have a hand in energy regulation in California. Getting infrastructure built is a major issue in this state.
So what are the problems? Natural gas, like oil in this country, has reached the point at which our domestic supply—that is, North American supply, which includes Canada and Mexico—is inadequate to meet demand. That’s caused not so much by residential or even industrial consumption, but by power plants that use natural gas for the generation of electricity.[7] Since we don’t like coal because it pollutes the atmosphere, and we don’t like nuclear power because we’re afraid of it, all of our new electric generation is natural gas fired. It is the big driver in this power imbalance. About 28 percent to 30 percent of the natural gas in the U.S. is consumed for power production. About 26 percent is for residential use; the rest is industrial.
So we are going to repeat history. During World War II, the United States’ domestic consumption demand for oil exceeded the country’s ability to produce oil here. Even though we continued to produce more and more oil, peaking in about 1973, the demand was much steeper than our increase in production. The same thing is happening with natural gas that happened with oil. We will import LNG (liquefied natural gas) from abroad, and that’s one of the things Sempra is doing. We saw this need coming and secured sites in Northern Mexico and in the Gulf, and we will begin to help supply that imbalance. Fortunately, the Public Utility Commission [August 2004] agreed to allow this gas to enter the state through its southern border. This gas will help California address the shortage. We may be making some progress on that front, but history tends to repeat itself—or some of the themes do—and we will face many of the same issues that we’ve gone through with crude oil—refining capacity and all of that—but it will be with natural gas.
As a business leader, what would you like your legacy to be?
I’m going to retire in a year-and-a-half, and I would like my legacy to be that I have left the company a good place to work in, one that has made a lot of people’s lives better. My tendency is not to take great risks of any kind in the sense I don’t try to take ethical risks, and I don’t try to take big business risks. I want to know that I have protected people’s savings and their well-being and their jobs, and that they have been left feeling good about themselves with their, the company’s, and my reputation intact.
[1] Company profile of Stephen Baum: http://www.sempra.com//aboutus_baum.htm
[2] These websites offer additional resources for reading about the energy crisis:
http://www.lib.umich.edu/govdocs/dn01/dn01gen.html;
http://www.pbs.org/wgbh/pages/frontline/shows/blackout/california/;
http://www.eia.doe.gov/cneaf/electricity/california/subsequentevents.html;
http://www.calseia.org/CECPGC3web.html.
[3] Taken from “Three Major Problems” http://www.eia.doe.gov/cneaf/electricity/california/subsequentevents.html.
[4] AB 1890 is Assembly Bill 1890, which was the electricity industry deregulation legislation. See “Introduction” http://www.cbp.org/1998/bb980902.html.(no longer accessible)
[5] “Citing over 11,000 sales transactions from February 2001 that exceeded a threshold of $430 per megawatt-hour, FERC [Federal Energy Regulatory Commission] orders six companies either to refund $55 million to the California utilities or provide justification for high prices.” March 16, 2001, http://www.pbs.org/wgbh/pages/frontline/shows/blackout/california/timeline.html.
[6] Governor Gray Davis was in office from 1999 to 2003 during this energy crisis.
[7] “A major technological change, combined-cycle gas-fire generation, took place starting in the late ’70s and through the ’80s. A large jet engine fueled by natural gas turns a generator on, just like it would turn the turbine blades, and then the heat from the back end of the engine is put into a boiler and makes steam. The steam goes through another turbine, so you get two sources of electricity from one source of heat. It is very efficient, as it takes 7,000 BTUs [British Thermal Units] of heat to make one kilowatt hour of electricity from a combined cycle. It takes 10,500 or 11,000 BTUs from an old simple cycle or a coal plant.” From interview with Stephen L. Baum.
