Aligning utility regulation to support the future grid

Utilities today, for the most part, continue to set rates and revenue, and recover costs the way they have for more than a hundred years. The traditional vertically integrated utility business model has utilities owning and operating large central-station power plants, moving power over high-voltage transmission lines to the distribution grid through substations, and delivering one-way power to residents, businesses, and industry.

Whether utilities own generation directly or not, revenue requirements are determined by regulators in a similar manner based on cost of service. Revenue models, and the method for compensating utilities, are straightforward. Utilities receive an agreed-upon financial return on assets and are allowed full recovery of investments deemed prudent by regulators, with related operating expenses and fuel costs being passed through to customers.

The utility business model and the regulatory paradigm provided the incentives and penalties necessary to build and support a reliable and reasonable-cost grid. Economies of scale in building larger power plants, and the continual rapid load growth virtually all the past century through the beginning of the twenty-first century, led to ever-decreasing prices to customers for electric service.

Today the electric power industry is experiencing significant change, challenging the current utility business model and regulatory paradigm. New technologies and competitors are creating a more distributed grid with two-way power flow, and with generation increasingly owned by private entities. Additionally, increased focus from state and federal regulators on combating climate change and setting ever more stringent air emissions goals, coupled with energy-efficiency initiatives and technologies reducing demand for electricity, require that both the utility business model and regulatory paradigm be revisited. Utilities and regulators need to work together to support investment and revenue opportunities that better align utility financial stability with customer, public, and private interests.

In recent years, many states have begun exploring new regulatory paradigms outside of traditional cost-of-service ratemaking that align financial incentives with state climate policy goals, customer interests, and the changing market landscape. Performance-based ratemaking structures have garnered attention throughout the United States, and a number of states, especially New York and Hawaii, are implementing measures that reward utilities for beneficial programs that either eliminate or delay capital investments, enable third-party distributed resource technology, and improve customer satisfaction and service.

Regulation and Revenue Generation Simply Stated

Competitive businesses in the United States are virtually unrestricted in the products and services they offer customers and the prices they charge. Of course, all businesses must comply with federal, state, and local laws and regulations for siting and operating facilities, including complying with environmental regulations and oversight requirements of organizations like the Securities and Exchange Commission (SEC), and other similar agencies with industry oversight.

While the cost of regulatory compliance varies by industry and activity and the costs of compliance are generally able to be passed on to customers, businesses are free to price products and services as they see fit. The need to remain competitive and differentiate products and services from competitors, nonetheless, does factor into pricing. Competitive market forces tend to keep prices in check, with customers having the ability and right to choose the products and services they purchase based on perceived value.

Electric and gas utilities, however, due to their monopolistic nature and having been granted exclusive franchise rights to serve a given geographic region, operate under a fundamentally different model. The industry infrastructure required to reliably serve customers is very capital-intensive to construct and operate. The evolution of the industry followed a trend where multiple utilities having duplicative distribution and transmission infrastructures operating in the same geographic region consolidated to improve efficiency and reduce costs to customers. In the early twentieth century, steam turbines and alternating current power enabled efficient generation and transportation of energy far from populated areas.

These large power plants and long-distance transmission lines were very expensive to build and maintain, which created high barriers to entry for potential competitors, and large economies of scale for expanding existing investments to meet growing demands. Multiple electric utilities with large generation facilities and duplicative distribution and transmission lines operating in the same geographic region were extremely inefficient and would have resulted in much higher electricity costs for consumers. Therefore, most electric utilities were granted a monopoly over a specific set of customers in a geographic region.

To ensure utilities do not abuse their monopolistic powers, they are overseen and regulated by public agencies and commissions at the federal, state, and regional levels. Public utility commissions have the authority to rule on the prudency and cost recovery of capital investments and pass-through of operating and maintenance expenses to customers, and determine how much revenue and return on investment a utility is authorized to collect through rates.

Most public utility commissions set electric utility rates based on the cost of service. This provides utilities with an agreed-upon rate of return on utility investments (rate base), plus recovery of operating expenses (maintenance, interest payments, salaries, fuel, taxes, etc.). Rate base is defined simply as the investment in assets used to produce, purchase, and deliver electricity services to customers.

Allowable operating expenses include operation and maintenance costs, depreciation, and taxes, all of which are collected through rates charged. Adding to this cost, the agreed-upon recovery of investments and financial return on investments determines allowed revenue collection. The average rate (price) for utility services is determined by dividing revenue by forecast year-ahead sales—this is the amount of money a utility is authorized to collect by regulators. Rates generally vary based on type of customer, special programs, and even the type of rate a customer is enrolled on.

This article originally appeared in Natural Gas & Electricity. 

Amanda Aweh. DeCotis, Paul A. (Oct. 2019). “Aligning Utility Regulation to Support the Future Grid.” Natural Gas & Electricity Journal. 36/3, ©2019 Wiley Periodicals, Inc., a Wiley company.