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This Nevada company wanted to break up with its electric utility. The government said no.

He's the utility, she's the unsatisfied customer.
He's the utility, she's the unsatisfied customer.

There's a fight going on in Nevada that contains, in microcosm, all the struggles and challenges that face utilities in the 21st century.

It centers on a Las Vegas–based company called Switch, which runs power-hungry data centers in southern Nevada. Like many firms these days, Switch wants electricity that is cheaper and cleaner than what it can get through its local utility, NV Energy. In fact, Switch wants to go 100 percent renewable.

So it asked the Nevada public utility commission (henceforth PUCN) for permission to defect from the utility and procure its own power on the open market. Four big casino companies — Wynn Las Vegas, MGM Resorts International, Caesars, and the Las Vegas Sands Corp. — got in line behind it, requesting to jump ship as well.

Yesterday, the PUCN rejected the application, saying that Switch would have to stay in the fold a bit longer.

What's going on? How can a company defect from a utility at all? And why wasn't Switch allowed to do so? And what does it all mean? Good questions!

The loophole that allows Nevada companies to defect from their utility

Around the turn of the century, the Enron debacle was in full swing and the Western US power market was a mess. Panicking, the Nevada legislature halted the ongoing process of deregulation in the state, reverting to the old-fashioned, vertically integrated monopoly business model for electric utilities.

This meant the state's two utilities — Nevada Power Company and Sierra Pacific Power Company, which later merged as NV Energy — would continue to dominate all electricity services, from generation to transmission to distribution. ("Deregulated" utilities, by contrast, only oversee distribution; they buy power from generators in a competitive wholesale market.)

However, in 2001 the legislature also passed a law, AB 661, that provided for exceptions. A provision known as NRS 704B (catchy!) stated that Nevada companies with over 1 MW of average load could file an "exit application" from the utility and procure their own power. The only conditions were that a) the company pay an exit fee that compensated the utility for costs the exit would generate, and b) doing so would not hurt the public interest by raising rates on the utilities' remaining customers.

The logic behind AB 661 was that, at the time, Nevada's utilities didn't own enough generation to meet demand, so they had to buy expensive out-of-state electricity. The hope was that Nevada companies would branch off to build their own power plants, easing the in-state shortfall. In 2002, a couple of coal mines filed exit applications and did just that — they each built coal plants.

No one has filed an exit application (from Nevada Power Company) since. Until Switch.

Why Switch wants to leave the utility

Conditions have changed radically since the legislature passed AB 661. In 2003, Nevada Power Co. owned enough power plants to meet only 44 percent of demand, leaving it dependent on expensive imported power from volatile markets. Since then, the utility has gone on a building/buying spree and now owns enough generation to satisfy 72 percent of its load. There's no longer a shortage of affordable power. If anything, thanks to the overbuilding of natural gas plants in the West, there's a bit of a glut. Western power is pretty cheap right now.

And that is one of the reasons Switch wants to strike out on its own. Right now, NV Energy buys power on the wholesale market and then marks it up to reflect various ongoing costs (which we'll get to in a second). If Switch left the utility, it could get the same cheap power, without the added costs. In fact, it could get cheaper power even if it shifted to 100 percent renewable energy. (NV Energy's portfolio is a little over 20 percent renewables right now.)

Switch proposes to contract with Constellation, a division of energy giant Exelon, for "energy, capacity, and ancillary services." Constellation will procure energy for Switch from the wholesale energy market and sell it to the company at a much lower markup than what NV Energy offers. Switch contends that these "market resources" satisfy the NRS 704B definition of a "new electric resource."

From Switch's point of view, this is an easy call: it can reduce its power bills and offer its customers carbon-free energy. And if you're anything like me, your first instinct on hearing this story is to side with Switch. The hip IT company breaks free of the stodgy utility to champion clean energy! What's not to like?

The reality turns out to be considerably more complicated.

How much will it cost NV Energy customers if Switch leaves?

If it leaves, Switch has to pay an exit fee to NV Energy, which is supposed to cover any costs imposed on the utility or its customers by the exit.

That was the task put before the staff at PUCN: tally up those costs. To do so, it analyzed the three-year period following Switch's proposed exit. Three years is a pretty standard unit of analysis in these cases — it's what PUCN used for those other long-ago exit applications — but it ended up being controversial in this case.

The costs the staff came up with are quite revealing. I won't go through all of them, as some are quite technical, but a few are worth mentioning.

As background, remember how utilities determine their investments and rates. They do a three-year (varies in some places, but three for NV Energy) forecast of demand, estimate the resources they'll need to meet that demand, and project the rates they'll need to charge to cover those investments and provide a reasonable profit to their shareholders.

At around 34 MW of average load, Switch is one of NV Energy's biggest private customers, amounting to 1.33 percent of annual sales. If that amount of load vanishes, then all of a sudden NV Energy's projections are rendered screwy. It has now overestimated demand, it has overinvested in resources, and it is collecting less in rates than expected. That difference — between the original projections and the without-Switch projections — is what Switch is supposed to cover with its exit fee.

With that in mind, a few of those costs:

Lost base rates: If Switch leaves, it is "no longer paying for generation assets that were built in part to serve its load," which means the utility is missing out on some $10 million in base rates over three years. To cover that shortfall, it will have to collect more from other customers.

Lost contribution to expensive renewable-energy contracts: This one is interesting. Nevada has had a renewable portfolio standard (RPS) since the late 1990s, mandating that the state's utilities must buy a certain percentage of power from renewable energy sources. (It's been tweaked several times since then; the current target is 25 percent by 2025, one of the most ambitious in the country.)

That means NV Energy (or rather its precursors) was signing power purchase agreements (PPAs) with renewable energy providers way back in the early 2000s, when renewables were considerably more expensive than they are today. Those contracts, which include a lot of old geothermal projects, run around $100 to $190 per MWh. (For comparison, the Department of Energy says the average utility-scale wind power PPA in 2013 was around $25 per MWh.) And many of those PPAs were 20-year contracts, which means they are still in effect and will be for a while. NV Energy is required to purchase that expensive power; "these higher costs cannot be avoided," says the PUCN staff analysis.

If Switch stops contributing to these "average monthly system costs," which include fuel and purchased-power costs, NV Energy is out another $10 million over the next three years.

Pause here to note that this is a phenomenon you don't hear much about: negative unanticipated side effects of an RPS. NV Energy is going to be stuck with this expensive renewable energy for a good long while. Why wouldn't companies want to escape those costs and just buy new, cheap renewable energy directly?

Lost excuse to run cheap natural gas plants: This one is interesting too. Remember that NV Energy overbuilt natural gas generation capacity; it's got a bunch of combined-cycle natural gas plants sitting around. The more it runs those plants — the higher their "capacity factor" — the faster they get paid off and the cheaper power is on average.

And here's the great thing about data centers, from a utility's point of view: they're always running. Switch has a "load factor" of almost 90 percent, which means its demand for power from the utility is almost constant, around the clock. This is in contrast to most power demand, which tends to vary widely, peaking in the afternoon and evening and dipping during the night.

"Switch's load," explains PUCN's analysis, "allows [NV Energy] to economically operate its low-cost combined cycle units in the evening and shoulder/winter period." If that load disappears, the capacity factor of those plants will fall and average power prices will rise.

Lost contribution to coal shutdown and decommissioning: In 2013, Nevada passed a law that contained an amendment (proposed by the utility itself) accelerating the closure of the state's two coal-fired power plants. The 553 MW Reid Gardner plant — which has been an ongoing fiasco for the utility, but that's a different story — is in the process of shutting down and will close completely by 2017. In the next 10 years, NV Energy will also close down the 522 MW Valmy plant in northern Nevada and divest its 11 percent ownership interest in the 2,250 MW Navajo coal plant in northern Arizona. The result will be a coal-free utility by 2025, running on 60 percent natural gas and 40 percent renewables.

But it won't come without a cost. Reid-Gardner still had some book value, so there will be stranded, unamortized costs to pay for that. And the cost of site remediation — cleaning up the mess left behind — is expected to clear $100 million. There will also be site remediation costs at the Navajo station.

If Switch bails, it won't be helping to pay these regulatory costs. And crucially, no one, including PUCN staff, knows yet exactly what those costs will be.

Lost contribution to energy efficiency programs: Nevada has focused on demand-side management (DSM), i.e., shifting and reducing load to better match generation, and if a big chunk of load leaves, those costs will increase as well.

Tallying up all these costs, PUCN staff came up with an exit fee of about $27 million; it recommended charging Switch that much and then letting the company go. NV Energy countered that it should be more like $30 million. Switch countered that it should be more like $18 million. And that's where things stood when the PUCN commissioners took up the case.

Why not charge Switch an ongoing fee?

Here's the problem the PUCN faced: a three-year analysis does not capture all the costs imposed by Switch's exit. The costs of the high-priced renewable-energy contracts, the costs of coal plant remediation, and some of the other costs will extend out 10 or even 20 years.

One proposal, from NV Energy, was to extend the analysis period to five years, but that's unsatisfactory. It still wouldn't accurately capture costs, and Switch's lawyers (and some observers) were outraged at the very notion, since three-year analyses have long been the standard. Switch notes that there's no way for NV Energy (or anyone else) to predict whether the company will even exist in five years, or whether it will remain in Nevada.

One possible solution raised by staff was a "non-bypassable fee" charged to Switch every year it stayed in Nevada, to recapture some of these ongoing costs. But ... how big a fee? What if it turned out to undercharge or overcharge — could it be adjusted? And how would it be levied, through the general rate-making process or through some other, special process? Could it be a dynamic fee, changing from year to year as costs became clearer? But then, it doesn't seem reasonable for companies contemplating defection from the utility to not know, to be unable to know, how much it would cost them.

In the end, there were numerous questions raised about the idea of a non-bypassable fee — whether it's even legal, whether PUCN has the jurisdiction to impose it, how it would be administered — that PUCN simply wasn't capable of answering, certainly not within the time frame of the exit application. So it rejected the idea.

Why the public utility commission rejected Switch's exit application

Several things bothered the commissioners (who voted 2-1 to reject the application).

One was the issue of whether Switch, by buying power on the already-oversupplied Western market, would in fact be drawing on "new electric resources," per the law. In reality, most of the resources Switch would be drawing on already exist, are out of state, and/or are already owned by NV Energy, all of which seem contrary to the spirit of the law. (Though it's worth noting, as many have, that the law makes no explicit reference to market conditions and does not so much as hint that they should be a consideration in the processing of an exit application.) According to PUCN staff, Switch's failure to add new energy or services to the state's supply "is not consistent with, and may be considered contrary to, the public interest."

But the main thing was the issue of ongoing costs, as described above; commissioners referenced "evidence in this Docket that clearly shows the existence of costs that will not be covered under any of the proposed impact analyses offered in this Docket."

As the commissioners note, several of these costs (the expensive renewable energy, the accelerated coal decommissioning) were based on state energy policy and represent "exceptions to least-cost resource planning." They are democratic choices, adopted to reflect the values of Nevadans and the sacrifices Nevadans are willing to make for those values. It does not seem entirely fair for one Nevada company to be able to opt out of that sacrifice, even as it enjoys the benefits (e.g., cleaner air).

Remember, there are four casino companies also applying to exit the utility. None of them have promised to procure exclusively renewable energy — that's not why they're doing it. They just want cheaper power, and they want to get it, in part, by opting out of costs other Nevadans are paying to clean up the power system.

So in the end, commissioners decided that "it is inherently contrary to the public interest to expose remaining [NV Energy] customers to the risk that Switch's share of the long-term embedded costs in [NV Energy's] system will be reallocated to remaining ratepayers." And since the exit fee proposed by staff would not fully cover those embedded costs, and the non-bypassable fee, though more equitable, has not been adequately vetted and is currently legally unworkable, the commission "denies the Exit Application without prejudice."

What happens next?

The PUCN commissioners make clear in their ruling that they are open to Switch reapplying for exit, that this ruling was less a "hell no" than a "we still have unanswered questions." They want the costs more fully accounted for and the complex legal matter of a non-bypassable fee more fully vetted.

PUCN commissioners have never rejected an exit application before, especially not against the recommendation of their staff. It's not entirely clear whether it's legal. But Switch is unhappy and likely to sue.

If Switch does sue and win, a stampede of companies away from NV Energy is all but inevitable, which will leave a smaller and smaller group of customers paying the embedded costs discussed above. That could lead to political disaster. (Utilities have similar worries about solar homeowners defecting from the grid, but unlike in the case of Switch, solar homeowners still add value back to the grid, offsetting the fixed costs they aren't paying.)

The lesson: utilities aren't prepared to deal with retail electricity markets

This episode puts some larger issues into stark relief. The main lesson from all this is that NV Energy and the PUCN simply aren't ready. Technology and customer expectations are evolving rapidly, while the utility is slow-moving and saddled with all kinds of legacy costs.

What Switch is asking for, in the end, is retail competition. As a customer, it wants to shop around for the best, cheapest product. (This is America, dammit!) But Nevada does not have the legal or regulatory groundwork in place to accommodate that. PUCN staff characterize Switch's attempt to use NRS 704B in this novel way "as potentially destructive by opening the door to electric service competition without any of the legal framework and consumer protections in place." The Nevada Bureau of Consumer Protection said, "It would be much better if [NV Energy] had a framework that really laid out how competition is going to be good for all customers, not just a few customers that are going to take advantage of excess capacity that happens to exist in the market today."

And that's true: it would be better if Nevada had "any of the legal framework and consumer protections in place." But it doesn't. Few states do.

But tech is developing quickly. Costs are falling quickly. Consumers are quickly coming to view energy not as a utility commodity like tap water but as a differentiated collection of products and services, a bazaar at which they should be allowed to shop.

In short, electricity customers are ready for electricity markets. But the US utility sector is burdened with a century-old business model, decades of sunk costs, and layers of bureaucracy that make change torturously slow.

That mismatch between customer expectations and utility practices is only going to grow wider. And this contretemps between Switch and NV Energy is only a preview, probably a fairly mild one, of the heated battles likely in coming years.