Distributed Systems — Destruction of the Status Quo

One thing we can say for sure is that there will be a lot more start-ups. The monolithic, hierarchical companies of the mid-twentieth century are being replaced by networks of smaller companies. This process is not just something happening now in Silicon Valley. It started decades ago, and it’s happening as far afield as the car industry. It has a long way to run. —Paul Graham, Startup Investing Trends

This is one of my core beliefs, that the world is in the process of becoming much more distributed, that the traditional hierarchies (as articulated by Fred Wilson in his Le Web talk here) we’ve organized around are changing. It’s not just social or organizational hierarchies, though; enabled by technology, our infrastructure systems (energy, manufacturing, farming) are also becoming much more distributed. These newly formed distributed systems are having  profound consequences for large legacy institutions and creating opportunities for smaller start-up companies. What follows is a discussion of old versus new in myriad industries to illustrate this shift.

Mainframes vs. Data Centers

We’ve seen computation go from large mainframes in the 1960s (think of this as Big Computation) to personal computing in the 80s, with a desktop in every home and office, and now to data centers. We seem to have settled in on the right distributed size — distributed data centers with mostly laptops and mobile phones connected to them. And this pattern can be seen now in more traditional industries as well.

Power Plants vs. Distributed Generation

I think what happened to computers is a good analogy to understand what is happening in energy. In energy, we have Big Energy — giant nuclear, coal, and natural-gas plants that deliver our power over large transmission lines. These are the equivalent of the mainframe computers from the 1960s. Now we are seeing a large increase in demand for distributed generation, one form of which is rooftop solar — this is the personal computer of the 1980s. But it’s incredibly inefficient for each of us to build our own power plant. A similar thing happened to computers — rather than build your own data center, we are now moving to “the cloud.” The cloud is just a form of distributed computation — regional distributed data centers. My guess is that we’re going to end up with an integrated, multi-layered system of power generation that consists of regional distributed generation and small modules at the household level. This might mean that today’s rooftop solar companies will become the personal computer companies of tomorrow (whatever happened to Gateway?).

Factories vs. 3D Printing

Manufacturing is about to be disrupted by 3D printing and automation driven by increases in artificial intelligence (AI). To date, labor gains have offset transportation costs in manufacturing. This is why the world’s manufacturing routinely moves to the lowest-cost labor markets — to China and now to Southeast Asia — despite the fact that these locations are thousands of miles from where the product will ultimately be distributed. With 3D printing, the costs of both manufacturing and the necessary investments will collapse. In addition, much of the assembly is already being automated by robotics and AI. So Big Manufacturing (factories and assembly lines) is already being disrupted and is about to be displaced by distributed manufacturing (3D printers and robotics). We talk of local food, but we’re on the verge of local everything — why produce our goods halfway around the world? Local will be cheap. If your economy is driven by cheap labor, you’re in trouble. (This phenomenon could also collapse trade, leading to more insular economies, but this is a discussion for another day.)

Big Farming vs. Farmers’ Markets

Food is slowly following energy into a more distributed system as well. We’ve seen it with the abundance of farmers’ markets, the return of gardens, and the movement to grow food in cities. To this point, it’s been more small-scale hobby-sized projects. But like manufacturing and energy, there will come a time where the cost to produce is less than the labor and transportation costs. You’ll see distributed farming systems, not unlike data centers, that deliver local, fresh produce year round. This will become even more pronounced as protein-based alternatives chip away at traditional meat demand.

Universities vs. Online Education

Big Education is on the verge of a massive disruption. The value of a degree seems to be collapsing as all the information anyone might need is available free and online provided by sites like Kahn Academy, among others. Universities are struggling with new models — put classes online for free, extend online degree programs, or ignore it all and hope it goes away. If we follow the other trends and apply them to education, it probably means fewer big universities and more small schools. Or perhaps we move even more closely to virtual education: one can easily imagine students in groups of 25-50 in towns around the world gathering together to take online classes from the very best professors. In fact, this is exactly what the Acumen, a patient-capital fund, is doing. My prediction is that the best universities, by changing their business models, have a chance to take market share from the middle tier — the best and the boutiques will be okay — but the middle is in trouble. We’ll also see a surge in start-up colleges and universities as the barriers to entry are gone.

The Paper vs. Twitter

I grew up in a house where my parents got the paper in the morning. They physically walked to the end of the driveway, which seems so odd, so archaic, now. My paper today is Twitter and RSS feeds. The decline of the newspaper industry has been well documented — print journalism is being replaced with a global distributed network of millions of bloggers and tweeters around the world. If I’m interested in a news event, I simply find and “turn on” the hashtag on Twitter.

Federal- and State-Level Governments vs. Cities

There has been a lot written about cities and their rise on the global stage. In a sense, government has become more distributed. Here in the US, it seems that cities are more important than ever and are increasingly the only governable unit — state and federal government seems to matter less and to be less effective. As Richard Florida has observed, we will have a “spikey” world with concentrations of people, wealth, and ideas in the best cities. The effective unit size to govern — just like a data center — has become a city.

We’re moving from a large, hierarchical, centralized world to one that is small, networked, and distributed. It’s as if each industry is homing in on their own Dunbar number — the perfectly sized data center, solar installation, or global classroom. The amazing thing to me is the breadth of this phenomenon, from education to utilities to manufacturing. Over the next 10-20 years, many of the institutions that have been in place for the last 100 years will be fundamentally altered. These systems will be smarter, stronger, and faster than the previous ones.

The Energy.Me Thesis: Big-Utility Killer

In 2011, I cofounded Energy.Me with Marc Muinzer and Matt Garrison. I had been looking at the retail energy market in the US, and Matt was running an energy brokerage that helped customers procure power. Based on my interest and Matt’s experience, we put together a small team and started Energy.Me, serving our first kilowatt hour of electricity in January of 2012. As we kick off 2014, we have 21 employees and will provide customers with more than $70 million in electricity this year alone.

Retail energy and deregulation can be confusing. Here’s how the regulated energy market works: the utility company operates as a geographic monopoly providing power to customers in a delineated area. Each utility owns power plants that are connected to the grid and buys and sells power with other utilities to the extent they have a surplus or deficiency. The state agencies approve an acceptable rate of return for the utilities, controlling what they can charge—meaning there is no competition. This structure incentivized the utilities to build things and accumulate assets; after all, if you are going to get an 8% return, you’d rather get an 8% return on $200 than on $100, right? This had some weird consequences, like utilities that purchased and capitalized giant copiers just to print their bills, since they could “rate base” them. Needless to say, the utility industry isn’t one built on efficiency.

Deregulation changed this construct. As states began to deregulate the energy market, companies besides the local utility could supply power to customers. The delivery of electricity (via poles and wires) was decoupled from the generation of electricity (at power plants). New generation companies signed up customers, who pay the new companies for the electricity itself and the traditional utilities for the delivery of that electricity (the customers still receive just one bill, though, so their behavior doesn’t change). This system exists today in many states; if you’ve switched, you can see both parts — the delivery and the generation — on your electric or natural-gas bill.

Once deregulation spread, electricity generators, by necessity, got into the business of acquiring customers. The industry had to market itself for the first time, to become a consumer company. This led to the creation of a new industry—retail electricity suppliers—which built portfolios of customers around the country. For example, one of these suppliers may own power plants in Ohio and serve customers in New York. More often, they serve customers across the US and buy electricity from the grid each day instead of owning power plants (this is what Energy.Me and many others do). This created competition among generators to sell their electricity at a better price and competition among suppliers to acquire customers, which has all resulted in lower electricity costs in each state where the model has been adopted (lower natural-gas pricing has had an even larger effect).

We thought these market dynamics would create opportunity—it was an industry going through a tremendous change. We had a thesis and wanted to test it.

1. Sales Strategy: Most companies catered to brokers and also sold directly to consumers. This created a conflict within their organization and a disincentive for brokers to work with them. We also believed that at a certain price point, mostly commercial and industrial, the consumer is going to get competing bids and use a broker, period. Therefore, our thesis on the sales side was to focus on brokers for commercial and industrial customers and treat them incredibly well.

2. Low Overhead: Without a sales force, we could keep our costs and overhead low. At the end of the day, electricity is a commodity business—our electron doesn’t behave any differently than our competitors’. To compete, we needed to keep costs low. This meant hiring only when needed and building technology to automate everything we possibly could. To remind ourselves of this goal, we like to (only half-jokingly) call ourselves “the Costco of electricity.”

3. Better Pricing: We committed to custom price every deal we did—no assumptions. To do this, though, we needed to build technology. From the start, we planned to automate areas that we felt lent a competitive advantage—pricing and risk management. The rest of the technology we outsourced to best-in-class providers—basic billing, invoicing, etc.

4. The Customer is Valuable: We continue to believe that suppling electricity to customers has value above and beyond the electricity itself. Our business has allowed us to understand consumers and is opening the door to other products and services. Armed with what we’ve learned, we could offer solar panels, LED lighting, and natural-gas service, for example, or provide services like demand response.

The model has worked incredibly well. Matt’s intuition on the sales channel was dead on, and the broker business took off faster than we could have ever imagined. We were forced to build the technology faster than we thought possible as sales outpaced our plans, and we continue to keep overhead low.

We had a couple false starts trying to add residential business and are still experimenting. We’ve paid a lot of tuition on the power-market side—hot summers and cold winters have had their effect. There is always something you don’t know you don’t know, which is where the real learning happens. The one surprise to me, at least, is how fast and irrational competition has been. Utilities, suffering from deep losses as customers flee, have been very aggressive in the market, which has put downward pressure on margins.

It took us a year (2011) to get to first revenues—planning, compliance, hiring. The second year (2012) was scaling, adding to the team, and serving customers. Last year (2013) saw a major uptick as we expanded to new states. This year (2014), we expect to be operating everywhere in the US. This feels about right to me; it takes a good 3-4 years to really validate and scale.