MAISY

DG Market Reports summarize basic DG technology market issues and present detailed information on the economics of DG systems in typical buildings in six geographic regions of the US under alternative electric and gas prices.

The Reports are unique in their presentation of detailed DG economics for typical customer sites. Site analysis includes 8760 hourly loads detail, rate structure information and detailed DG technology characteristics. Baseload, peak clipping and combined heat and power (CHP) systems are included in the analysis.

For a report description including sample tables contact Jackson Associates

When Will the DG Market Take Off?

Distributed Generation Market Development and Investment Opportunities

Jerry Jackson, Ph.D.
President, Jackson Associates
4819 Emperor Blvd. Suite 400 Durham, NC 27703
919-967-9000 jjackson@maisy.com
March 19, 2003

Summary

For several years DG market proponents have anticipated a market takeoff that has not materialized. Results of a recent study, presented here, found $4.6 billion in unrealized annual DG profits in the commercial sector under current conditions. Why hasn't the market taken off?

This paper makes the case that the DG market has been slow to expand primarily because manufacturers and retailers have not provided DG product packages which combine modular design, maintenance, financing, commodity risk and other attributes which will permit mid-market customers to opt for reduced electricity costs, increased reliability and power quality with a "plug-and-play" decision.

The lack of comprehensive DG product packages and other factors including market barriers, project financing, technology development and field experience are considered in an evaluation of DG market growth potential with the conclusion that DG-related venture capital investments are likely to be the catalyst which propels the DG market onto a strong growth path within the next two to three years. Innovative marketing strategies introduced by VC-provided management will lead the way in transforming the industry to better meet mid-market DG customer needs.

Several general observations are provided about the likely success of companies marketing DG systems, concluding that current DG profit potential, the transitional nature of the market, the likelihood of an impending market takeoff, continuing reduction in DG costs and market barriers and availability of detailed customer information all point to perfect timing for investments in DG enterprises.

Background

Blackouts in California several years ago followed by sky-high electricity prices and supply shortages in a half-dozen east coast markets seemed to forecast a boom in the DG market. DG, or distributed generation, provides electric generation and waste heat applications (e.g., space heat, air conditioning) at, or close to, utility customer sites. (see "Applying Distributed Generation Strategies to Ease the Long Island Power Crisis" http://www.maisy.com/wpdglipa.htm for a more detailed description of DG applications). Recent advances in DG, including new microturbine products and the first generation of commercialized fuel cells shows considerable manufacturer activity; however, little seems to be happening on the customer side of the market.

The slow pace of DG market development stands in stark contrast to estimates of DG market potential. For instance, the Jackson Associates' market analysis reported in the next section, indicates that about 150,000 of the most profitable commercial sector DG installations, if made today under current conditions (i.e., with current standby rates and interconnection costs), would return annual profits of $4.6 billion.

The discrepancy between current market potential and actual market activity prompts several questions: (1) If this huge promise of profitable applications exists, why is current DG market activity so anemic? (2) When will the DG market take off? And finally, (3) How will the DG market evolve and what does this evolution imply about investment opportunities over the next several years.

The remainder of this paper answers these three questions. First, however, it's useful to evaluate current DG market potential.

Today's Commercial Sector DG Market Potential

Virtually all studies of DG potential identify large "technical potentials" and then describe barriers which prevent these potentials from being realized. Consequently, there is little useful information on actual investment potentials for DG projects in current markets.

The market analysis reported in this section provides a summary of the results of a recently conducted study of the potential for engines, microturbines and turbines in the US commercial sector market. The basis for this analysis is the MAISY Utility Service Area Customer Databases and DG Policy Models (http://www.maisy.com/dganal.htm ) which were applied to evaluate DG potentials given current conditions in utility service areas throughout the US. While these results reflect only commercial sector applications (office, hospitals, hotels, etc.), they include the overwhelming majority (about 80%) of remaining potential DG applications in the US mid-market (i.e., excluding large industrial customers). While smaller systems and newer technologies such as fuel cells and photovoltaic systems will continue to decline in costs and will become competitive at some point in the future, our focus is on existing systems and the market for those systems given current electric rates, gas prices, equipment costs and other factors which influence the economics of today's' DG applications.

Our market analysis indicates that about 150,000 of the most profitable commercial sector DG installations in the US, if made today under current conditions (including standby rates and interconnection costs), would provide annual profits of $4.6 billion. As current market barriers fade, the potential number of installations and profit will continue to grow.

Current DG Market Anemia

High standby rates, excessive interconnection costs and lack of manufacturing economies of scale (i.e., high equipment costs) are typically offered as reasons for the slow growth of the DG market. While these factors are important in the evolution of the DG market they do not explain the minimal penetration of DG systems within the 150,000 high value customers identified in our study of current DG mid-market potential.

DG systems are complicated technologies whose purchase requires consideration of maintenance and service, commodity risk associated with future electric and natural gas prices, reliability, environmental permitting, customer investment and other issues. It is no coincidence that most DG sales are made to the largest and most energy-sophisticated commercial and industrial customers. These customers typically have enough inhouse expertise to feel comfortable making decisions regarding issues uniquely associated with DG systems.

Marketing to large customers typically consists of establishing individual customer contacts, developing custom-engineered solutions and offering a proposal. This individual customer marketing approach is too expensive to apply on any sizable scale and requires large projects to cover the high costs associated with developing new projects.

However, focusing only on the largest customers ignores the majority of the market; 70 percent of potential commercial DG capacity is provided by customers with peak demands less than 2 MW. Currently, these customers are below the radar screens of most DG marketing efforts.

Marketing a DG system to the owner of a commercial building within this 70 percent of the market presents challenges which most DG manufacturers and retailers have yet to address. Consider marketing a 200 kW CHP system to the owner of a 400,000 square foot office building. The owner typically views power costs as a necessary expense which can only slightly be altered with conservation activities accomplished with semiannual HVAC system maintenance tune-ups. However, with annual electric bills of $600,000 and the potential for CHP systems that provide waste heat to supplement or replace space heating and water heating and even air conditioning energy uses, this is exactly the kind of customer DG manufacturers and retailers should be pursuing. Selling a technically complicated DG system to these customers, however, requires a different approach than selling to a large commercial or industrial customer.

The primary reason that DG market activity is slow, relative to current market potential, is the fact that manufacturers and retailers have not developed marketing and product development strategies that meet the needs of the vast majority of potential DG customers.

The most effective approach to marketing technically complicated systems to these mid-market customers is to combine system components, including financing and commodity risk management, in a series of product packages which remove the burden and uncertainty surrounding system design, installation and operation, financing, etc. Ideal product packages will, from the building owner's perspective, reflect a "plug-and-play" package that can be seamlessly incorporated in the building's energy system by the DG provider. From the suppliers perspective, these packages still require some customization; however, this level of development/ implementation effort is a fraction of that required in traditional large-customer DG implementation.

DG Market Takeoff

In spite of current conditions, four factors suggest a market on the verge of takeoff.

1. Technology Field Experience. The DG market consists of mature technologies (e.g., engines, turbines), new technologies (microturbines, fuel cells) and improved applications of existing and new technologies (CHP applications, controls, etc). The last three years have provided the kind of field experience required in the "shake-down" period required by every emerging market prior to rapid market penetration.
2. Market Potential. As illustrated in our study referenced above, equipment and installation costs, electricity and natural gas prices and other factors combine to provide high-profit DG application possibilities. Market potential will increase substantially over the next several years as current market impediments fade and as the cost of DG packages declines with manufacturing and marketing economies of scale.
3. Declining DG Market Barriers. As noted above, current barriers do not by themselves explain the current anemic DG market growth; however, as barriers decline, the size of the potential market grows. Barriers are clearly beginning to diminish. Niagara Mohawk recently lowered its standby rates by about one-third, the New York Public Service Commission recently required natural gas companies to offer DG gas rates, following a similar action in New Jersey several months ago. IEEE interconnection standards which will soon become ANSII standards for interconnection of systems less than about 10 MW, along with state streamlining activities in California, Texas, New York, Minnesota and Massachusetts promise to lower the cost of connecting DG systems to the grid, especially for systems geared to the mid-market. FERC's requirement for locational marginal pricing has just increased the economic return on DG applications in congested areas like Boston and southern Connecticut where a significant potential already existed.
4. Capital Investments. Investors are withdrawing money from the stock market because of the continuing market malaise; billions of dollars which would have gone into the stock market is parked on the sidelines in low-yield investments waiting for the next good market opportunity. DG-related investments provide a unique opportunity for some of the $90 billion in venture capital that is estimated to be currently sitting idle.

DG-related venture capital investments are likely to be the catalyst which propels the DG market into a strong growth path within the next two to three years While venture capital investment will provide funds to increase marketing and to finance new DG installations, a more important contribution will be the transformation of business development and marketing strategies from selling custom-designed DG systems to large customers into a new industry that packages and markets DG as a product that appeals to health clubs, restaurants, offices, nursing homes and other mid-market businesses.

DG Investment Opportunities

A strong expansion of the DG market provides a variety of attractive investment options ranging from companies involved in basic research on fuel cell materials to companies manufacturing DG prime movers and related technologies to companies marketing DG products to final customers. Since the focus in this paper is on DG marketing to final customers, however, investment observations are restricted to this part of the developing market.

An especially attractive feature of investments in this part of the market is that the return/risk ratio is substantially greater than in research, development and manufacturing. Recent stock market experience has dampened enthusiasm for the kinds of high-return high-risk investments that characterize most research and development areas. Manufacturer competition is increasing for some of the newer prime mover technologies such as microturbines while marketing strategies designed to gain market share will keep profit negative for some time to come.

DG marketing ventures can immediately tap into the profit potential described above. The 400,000 square foot high-profit office building mentioned can generate annual profits in the range of $35,000 - $65,000 (after deducting amortized equipment, installation costs and maintenance and other operating costs). These profits can be increased by at least $60,000 by incorporating a series of low cost energy management options providing a total annual profit of the package from $95,000 - $125,000. This investment is low risk because avoided electricity costs are reasonably certain and risk management instruments can be used to limit exposure to fluctuations in cost of natural gas required to fuel the prime mover.

While comparisons to successful business models in other industries are less relevant in the fragmented DG market, the model developed by Dell computer provides a useful strategy example. Dell's early success was a result of packaging technically complicated components manufactured by others into a small number of product packages sold via mail-order using mass marketing techniques. It addressed potential customers' primary reluctance to buy theses new computer products with "free" onsite one-year maintenance packages and prospered to become the second-largest computer retailer in the industry. The fragmented nature of the DG market described below suggests that many Dell-type companies are likely to be developed to service different niche and geographic markets. The fact that Dell started in a college dorm room underscores the fact that innovative business plans can overwhelm the deep pockets of competitors.

A variety of business types will be competing in this part of the emerging DG market including:

• Energy service companies (ESCO's)
• DG installation/service companies
• DG manufacturers
• Electric utilities
• Retail energy providers
• Natural gas utilities

Companies in each of the five business categories listed above are positioned differently, reflecting different competitive strengths and weaknesses. The most difficult challenge facing all of these companies is developing and applying effective business and marketing strategies that recognize the fragmented nature of the DG market. This fragmentation must be addressed by segmenting the market with respect to the following market and customer characteristics:

• Electric Utility Service Areas. Electric utility service areas differ substantially with respect to electric prices and DG interconnection requirements. Electric "rate structures" typically charge customers for total electricity used during the month and for the 15 or 30-minue peak kW within the month. Rates may also vary by time of day and season. Utilities also charge standby rates for potential electricity use when the DG system is down. While interconnection requirements are becoming more uniform across utilities within some states, differences in electric service and standby rates will always define individual utilities as separate markets with different DG potentials.
• Climate Segments. The profitability of most DG applications is heavily dependent on space heating and air conditioning applications which run, at least in part, with waste heat developed in the generation process.
• Customer Energy Use Segments. Customer segments are defined by their 8,760 hourly electric and thermal (space heat, water heat, air conditioning, process) use throughout the year. These characteristics help determine optimal DG package characteristics and profit associated with different DG systems. Detailed information on customer 8760 electric and thermal hourly loads is available for every utility service area in the US (see, for example, http://www.maisy.com/energy.htm ).
• Customer Firmographic Segments. Commercial and small-medium sized industrial customers can be grouped into segments whose members have similar needs and display similar behavior. For instance, decision-makers for government-owned buildings will have different needs than decision makers in the office rental market.

A necessary condition for successful DG customer marketing ventures is the use of quantitative information on customers and market segments in developing product and market strategies.

In summary, the large current DG profit potential, the transitional stage of the market, the likelihood of an impending market takeoff, continuing reduction in DG costs and market barriers and availability of detailed customer information all point to perfect timing for investments in DG enterprises.

Postscript on Fuel Cells

The market potential estimates of 150,000 customers and annual potential profits of 4.6 billion dollars presented above does not include fuel cells because the focus of this paper is on assessing the current potential of DG systems in today's market. Since fuel cells are not likely to become competitive until approximately 2006, except for very small niche markets, this technology was not included. However, results of this study have important implications for the fuel cell market. Fuel cells have greater electric generation efficiencies and, therefore, less waste heat; however, the market for fuel cells is almost identical to the market for other DG technologies addressed in this study. Marketing fuel cells also requires the same kind of business and marketing strategies described above. Given the later arrival of fuel cells to the DG market, companies who have already successfully developed and marketed other DG technologies will have a significant advantage over companies who plan to focus solely on fuel cell technologies.

About the Author

Dr. Jerry Jackson has over twenty-five years experience in energy technology and market analysis, energy forecasting and utility customer data development. He has advised equipment manufacturers, DG marketers, retail energy providers, ESCO's, start-up companies and investment firms on developing profitable energy market strategies.

He has also provided software, databases and energy market analysis services through his company, Jackson Associates, to electric and gas utilities, state and federal government agencies, research laboratories and energy trade associations in the US, Canada and Australia.

Dr. Jackson has provided innovative solutions in the energy sector since developing the first commercial sector end-use model at Oak Ridge National Laboratory in 1976. These models, which integrate econometric and engineering analysis in a single modeling methodology, provided a quantitative basis for US Department of Energy conservation analysis and the initial National Energy Plan.

In 1995, he developed MAISY® Utility Service Area Databases which have been widely used by companies competing in deregulated electricity markets throughout the US to develop customer profitability strategies. MAISY Databases have also become a standard customer data source in DG market analysis, providing 8760 hourly end-use electric and thermal loads for a statistically representative sample of customers for each utility service area. Dr. Jackson holds a patent on the MAISY software analysis processes.

Dr. Jackson is widely published in both academic and industry publications. He holds a Ph.D. in economics from the University of Florida with specialties in econometrics and regional economics. Prior to starting Jackson Associates in 1982, he was Chief of the Applied Research Division at Georgia Tech Research Institute.