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The simple reason most power utilities suck

electricity substation (Shutterstock)

Most people are at least vaguely aware at this point that power utilities are the Bad Guys in the story of renewable energy — fighting rooftop solar, clinging to old coal plants, and generally slow-walking the work of cleaning up the grid.

But the role of utilities is often badly misconstrued, read as a tale of greed or animus.

While there’s plenty of greed and animus to go around, the fact is, utilities are just doing what they’ve been designed to do. The design is the problem.

I realize most people have limited patience for discussion of utility regulation — it pains me, but I realize it — so I’ll keep this short. I’m condensing from a great two-paper series by America’s Power Plan: Part one is about how utilities make money; part two is about how those incentives can change.

The simple problem with utilities

There is one key fact about utilities that average people need to know in order to understand their current dysfunction.

It is this: US power utilities almost universally operate under what is called cost-of-service regulation (COSR). In a nutshell, they make money by building stuff.

The thinking behind COSR is pretty simple. Utilities are state-protected monopolies, so we can’t have them profiting off their main product. By law, they have to sell power to ratepayers without any markup.

Yet to provide service to their customers, they need investment money to build out new substations, transformers, meters, and power lines. How can we induce private investors to put up money for public capital investments? We offer them — utility shareholders — a safe and predictable rate of return on those investments.

All "prudent" capital investments by utilities are guaranteed the same rate of return; that’s how shareholders make money. The "prudent" part is supposed to be enforced by public utility commissions (PUCs), but in practice, in "prudence reviews," there’s an information asymmetry (utilities know more than PUCs or outside advocacy groups) and PUCs are often cozy with utilities anyway.

In short, investor owned utilities (IOUs) have every incentive to build more stuff. In fact, since it is their legal obligation to act in the interests of shareholders, it is their legal obligation to build as much stuff as possible (and, ahem, prudent). And PUCs have limited ability to restrain them.

As long as the US was rapidly expanding electricity service to areas that had none, utility shareholder interests and the public interest were aligned. We needed more stuff.

But these days, things have changed; building more stuff does not always produce more social value. More and more frequently, utility shareholder interests and the public interest have come out of alignment. That’s a problem.

Building more stuff is not always the right answer

Electricity service has largely saturated the US. The challenge facing the power sector now is not expansion, but making its services greener and smarter (which often amount to the same thing).

Utilities have traditionally been guided by two values: reliability and low cost. Today, however, customers and regulators want more than just reliable power. They want lower carbon and air pollution; they want resilience and equity; they want consumer choice and local control. They want a fuller picture of the total societal value of power.

In these circumstances, building out new infrastructure is not always the best response to grid challenges. There are two increasingly powerful, overlapping alternatives open to utilities today:

  • non-infrastructure solutions, which include software, data analytics, and small-scale distributed energy resources (DERs) like solar panels and batteries;
  • non-utility-owned solutions, which include third parties like private aggregators who link together dozens or hundreds of DERs.

While these alternatives can create value for customers, under COSR they represent limited upside and potentially large downside to utility shareholders. They require investments in operations, upon which shareholders get no rate of return, instead of capital-intensive investments, upon which they do.

To put it more bluntly: utilities’ strong preference for capital investments puts them intrinsically at odds with smarter grids and privately owned DERs. Smarter grids and privately owned DERs have the effect of reducing demand for grid power and grid infrastructure — that’s good for customers, but it reduces utility shareholder profit.

In the second paper from America’s Power Plan, authors Dan Aas and Michael O’Boyle summarize thusly:

1) Cost of Service Regulation (COSR) rewards utilities for infrastructure investments, but new technologies and grid management tools offer non-infrastructure approaches that are potentially less costly and better-aligned with outcomes society seeks.

2) The main tool for cost-containment is the prudence review, but regulators face substantial technical and resource asymmetries when evaluating utility expenditures.

3) These two features of COSR limit regulators’ ability to respond to present and future industry trends and challenges.

Some examples where infrastructure isn’t the right answer

Aas and O’Boyle offer three examples of utilities facing grid challenges, and in each case, they run simplified financial models for a range of solutions. Then they examine which of several regulatory options could induce the solution with the greatest total social value.

I won’t take you through the whole exercise, but a quick look is instructive. The first example is a distribution grid that faces rising demand (load). The second example is a distribution grid facing the need for modernization. And the third is a looming regional shortfall in capacity due to the closing of a large power plant.

In each case, Aas and O’Boyle model a range of scenarios, from traditional infrastructure investments to investments in utility-owned DERs (which allow shareholders to receive a rate of return on them) to third-party-owned DER and smart-grid solutions.

Long story short, in every case, third-party-owned, distributed solutions posed the lowest total cost for the highest total societal benefit. But, crucially, those solutions never made financial sense under COSR. Current utility shareholder interests are misaligned with the public interest.

Realigning them requires different regulatory tools.

There are ways to make utilities not suck

So what are these regulatory tools that induce optimal societal outcomes?

Aas and O’Boyle look closely at two: performance incentive mechanisms (PIMs), which tie (some) utility revenue to performance against social metrics, and revenue caps, which limit the total amount of revenue utilities can receive over a given period of time.

The details of how these tools perform are interesting, but I’m going to leave the subject of optimal utility regulatory and rate design — a thorny, complicated, and perilously boring subject in its own right — aside for another day, another post. I suspect I’ve exhausted your patience for utility regulation for today.

The take-home here is simple: Socially, we need to shift to greener, smarter grids built around aggregated, coordinated DERs, but the regulatory regime under which utilities operate puts them inherently at odds with that shift.

Utilities do not have to suck. They have been designed to suck. They can be designed differently.