Vertical Integration of Electric Utility

LG&E KU: A VERTICAL INTEGRATION

STUDY

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An evaluation of the make vs. buy decisions made within a utilities company. 

Prepared by: LG&E KU Project Connect Team

Braden Peyton, Kye Teeples, Ellen Reynolds, Brock Sigler

 July 28th, 2017

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Table of Contents

Introduction        3

Industry Analysis        4

Benefits        6

Supply        8

Labor        10

Distribution        10

Transmission        12

Conclusion        14

Resources        16

Appendix        19

Introduction

The company that grew to become LG&E and KU Energy (LG&E KU) began in 1838 with the founding of Louisville Gas and Water. Originally the firm was created in order to illuminate the dark streets of pre-industrial Louisville and provide clean water to the booming river town. Since that time, through numerous mergers and acquisitions, what was once a small supplier of gas and water service has grown into a regional power providing electricity and gas distribution to over a million people. LG&E KU’s commitment to providing affordable energy has resulted in cheap energy prices across the state (the 5th lowest in the nation). The cheap and reliable energy generated by LG&E KU drives demand for goods and services across the state.  LG&E KU not only employ several thousand Kentuckians, but indirectly create hundreds of thousands of jobs across the state through the industry that their cheap power attracts. Without LG&E KU, companies like North American Stainless or Toyota may have chosen to locate elsewhere and taken valuable jobs with them.  

Within any area of a firm there are two essential questions; 1) what products and services are we buying that we should be doing in-house and 2) what products and services are we doing in-house that we should be buying (Johnson, 2010). With these two questions in mind, the goal of this document is to give a general overview of the utilities industry as it currently exists in the state of Kentucky, provide context of the environment that LG&E KU operates in, and to discuss how that environment affects the way LG&E KU approaches the classic make or buy decision that all firms face in order to lower operating costs and maximize revenue.

Industry Analysis  

LG&E KU operates in a highly regulated sector of what is already a highly regulated industry. The company is a monopoly in the most basic economic sense of the word. LG&E KU is legally entitled by the Kentucky Public Service Commission (KPSC) to be the sole provider of electricity and gas to the customers they serve. This entitlement was given to the company in the early 20th century because of the extremely high capital costs associated with generating and distributing electrical power to both rural and urban customers. In exchange for this entitlement, LG&E KU must get approval from the KPSC on anything from electricity rate increases, to new power plant construction. As a legal monopoly, LG&E KU is mandated to provide cheap electricity to all the customers in the areas it serves, no matter how inconvenient. If a customer builds a house in a rural location, LG&E KU is required to create the infrastructure to serve that customer.  

LG&E KU is even limited on the amount of revenue it generates by the KPSC. If it exceeds these targets it’s forced to give back to its customers. Though it may not seem intuitive, this regulation is what has allowed LG&E KU to grow into the large corporation that it is today. The only substitute for electricity service comes from customers installing their own solar PV systems under Kentucky’s Net Metering laws (LG&E KU Net Metering). The company has a guaranteed long term revenue stream that allows them to make the sort of capital intensive investments necessary to provide reliable energy in real time to meet customer demand. The high initial capital expenditures and a legal monopoly granted by the KPSC virtually eliminates all threat of competitor entry into the marketplace.

LG&E KU is a traditional vertically integrated utility company that combines power generation, transmission, and distribution under a single firm. This strategy is typical of a regulated utility (Girouard and Wagner 2015). Given that LG&E KU doesn't have to compete for its customers, its major concern is supplying adequate power in real time to meet customer demands. A utility that houses all components of generation, transmission, and distribution in-house can gain efficiency by closely coordinating these functions to meet the demands of its customers.  

Although the company in the past was heavily involved in buying and selling power in the wholesale market, pressure from the KPSC and the evolution of the wholesale power market has limited their current involvement (Gayle 2006). Currently the vast majority of the power LG&E KU generates goes to its own customers, or is sold to partners like Tennessee Valley Authority (TVA) when emergencies require them to import power to meet their customer demand. Because the company’s profits and plant capacity are limited by the KPSC, there is no strong incentive to export large amounts of power to external entities or even build the infrastructure necessary to do so. LG&E KU in the past has come under intense scrutiny from the KPSC when it has chosen to add generation capacity beyond what could be justified by customer demands (Gayle 2006). Due to the restriction that KSPC places on the utility industry, rivalry in is limited. The regulated power industry in Kentucky can be more easily described as a club than the all out brawl typical of some industrial environments.

The single largest physical input to the power generation process is fuel input. The widespread use of fossil fuels in power generation, however, limits both buyer and supplier power in the power industry. Coal can be economically mined across Appalachia and the western states to fulfill demand from coal fired power plants, and coal power plants represent thirty percent of total power generation in the United States. There is no shortage of buyers and sellers (EIA Energy Statistics 2017).

Benefits

A major function of any substantial company is to provide employees with a benefits program. These programs include plans for health, wellness, finances, education, and work/life balance and are administered by Human Resource (HR) departments. To successfully manage these programs, significant time and resources must be allocated efficiently by company administration. This time and personnel requirement presents LG&E KU with the decision to “make or buy”.