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The growing consensus is that the U.S. electric industry is undergoing a transformation over the next several years. Major developments in technology and energy policy point to important changes in the electric industry. While even this favored policy narrative among experts is no guarantee of the future, it is dictating the ongoing dialogue across the country about possible new actions at both the state and federal levels. This paper does not predict that transformation of the electric industry will occur on a broad scale. In fact, it projects that the degree of transformation will vary across states, just as the electric industry saw a diversity of state responses toward retail and wholesale restructuring in the 1990s.
This paper outlines the topics and issues that state utility regulators should examine in line with a changing electric industry. It does not delve deeply into the myriad topics that utilities and regulators will need to address in contemplating a transformed electric industry. Assuming interest from state regulators, NRRI proposes conducting more in-depth analyses of individual topics in future papers. We have seen initial and sometimes heated dialogue on these topics and expect it to continue over the next several years. What NRRI offers in this dialogue is a public-interest perspective that is fundamental for good public policymaking.
This paper starts off by listing the salient features of the electric industry. It discusses, for example, how the industry has a large footprint on society, playing a vital role in economic growth and the environment, among other things. This wide influence makes the electric industry susceptible to interest-group politics and serious disagreement over its future direction.
The paper then lays out a vision of the future electric industry that is compatible with the views expressed by many industry experts. This vision includes the marked growth of new, and what some observers call disruptive, technologies, such as distributed generation, the smart grid, storage, electric vehicles, the slowing of demand growth, rising costs, the increased penetration of renewable energy, an aging infrastructure and rising physical and cyber threats. Along with policy mandates that will increase their costs, electric utilities are likely to face daunting challenges in the years ahead. How they will fare in securing needed investment capital and maintaining shareholder interest, in addition to advancing their customers’ welfare and broader societal objectives, hinges to an important extent on state utility regulation.
This paper addresses two fundamental questions about a transformed electric industry: (1) What roles should utilities play? and (2) How should state utility commissions regulate utilities fulfilling those roles? Many experts believe that utilities will have to operate under new business models to prosper, and even survive, in the new market environment. The new business models should converge on achieving maximum value of the central grid to electricity consumers, which includes both core and distributed generation (DG) utility customers. The result might be a reconfiguration of the utility distribution system as a platform for efficiently and fairly integrating distributed resources and centralized resources. Fairness would involve creating fair opportunities for all generation resources. The business model along with reformed ratemaking could create incentives for steering utility efforts toward predetermined social goals.
The business model, whether fundamentally different from the existing one or only changed by a few minor tweaks, will dictate the goals and scope of regulation.
One question is whether policymakers (e.g., state legislatures and utility regulators) should shape the utility business model. The alternative is for the market to dictate the model with minimal outside intervention. The business model spells out the role of the utility, which can range from a wires provider or a facilitator to an energy-service provider. It should have the primary goal of maximizing long-term customer welfare while keeping prudent utilities financially viable. In a transformed electric industry, this goal requires customer empowerment, with utilities offering value-added services, customers making well-informed decisions about their use of utility facilities and resources, and new technologies enabling customers to minimize their associated transaction costs.
The main part of this paper focuses on the challenges facing state utility regulators in adapting to a transformed electric industry. Many observers contend that the status quo or traditional regulation is not compatible in an environment in which distributed resources, the smart grid, rising average costs, high investment requirements, and energy storage prevail. Under a reshaped utility business model, regulators might want to consider a new ratemaking paradigm that, first, rewards exceptional performance and, second, gives utilities incentives to promote customer and societal interests. In arriving at a final resolution, regulation will likely need adjusting, so that it corresponds with the business model under which utilities will operate.
A basic question is what posture state public utility commissions will take: Will they lead, follow or rationally resist change? Commissions may have to revisit their interpretation of “just and reasonable” rates and redefine the public interest. They may have to grapple with advancing additional objectives, either mandated by the outside or self-imposed. In serving the public interest, smart regulation would achieve these objectives, some of which are conflicting, at the lowest total cost to and engendering the greatest total benefits for society.
In considering reforms, commissions should ask four basic questions:
1. What functions do electric utilities serve in advancing society’s interest and which, if any, of those functions possess the essential characteristics of natural monopolies?
2. What specific actions should utilities take to perform those functions?
3. What incentives or protections should regulation provide?
4. How should regulators reform or change their present policies and practices?
The sphere of electric utilities responsibilities has expanded beyond providing reliable service at “just and reasonable” prices. Increasingly, policymakers require utilities to expand their sphere beyond a for-profit business by assisting low-income households, accommodating, facilitating and even subsidizing their competitors (e.g., distribution generation) and renewable energy, adopting non-profitable new technologies, promoting energy efficiency, achieving clean-air targets beyond federal and local mandates, and empowering their customers to make more economical decisions. A major topic in the policy debate is the extent to which utilities should broaden their functions to address society's needs. No unambiguous answer exists at this time. The vague answer is that it depends on what functions policymakers assign to utilities. An expansive role for utilities could place upward pressure on electricity prices, at least in the near term, and potentially conflict with traditional regulatory objectives (e.g., cost-based rates, consumer protection, least-cost utility operations, adequate service reliability).
One of the most serious challenges for regulators in a transformed electric industry is to provide utilities with financial incentives to achieve cost-effectively both utility financial stability and society’s broader policy goals. Constructing regulatory incentives that are compatible with achieving the goals assigned to utilities has always challenged regulators. Attempts have sometimes led to unintended, counterproductive outcomes. Without financial inducements, however, regulators would have to take an alternate, heavy-handed path of closely monitoring utilities to ensure that their performance coincides with societal goals.
Regulators will also need to address whether to engage in any major reinventing, or a much more modest incremental reshaping. For example, will performance-based regulation, new rate designs, and modest expansions of the utility’s role in a revamped industry satisfactorily accomplish regulatory goals? Will regulators, instead, have to resort to more drastic steps? It is not too soon to think about how the electric industry will evolve and how regulation will have to adapt. Regulators, operating under the assumption that the future electric industry will change fundamentally, should begin to study innovative regulatory approaches.
The last part of this paper raises the question of how likely is it that the radical changes predicted by many industry observers will actually transpire. Some of these predictions reflect less of objective assessments of the future and more of self-serving scenarios, a quasi-religious mission, and parochial wishful thinking. It is easy to imagine that that the future will actually turn out differently from what many observers are now projecting; after all experience demonstrates that predictions often miss the mark. Planning today based solely on a single future scenario, even one that represents a best guess given the information presently available, is risky. If that scenario fails to materialize as imagined, society could suffer large adverse consequences, from well-meaning actions that turn out to have been misguided. Put simply, today’s popular policies may take us down a primrose path to arduous transitional problems, inefficient and unreliable utility service, and excessive electricity prices.
This paper also recognizes the inherent conflict between regulators obligating electric utilities to advance an expanding number of social objectives while simultaneously expecting investor-owned utilities to carry out their fiduciary responsibilities to shareholders. More than almost any other private entities, society expects electric utilities to integrate social goals into their decision-making process. Regulators themselves face the difficulty of balancing the objectives of keeping prudent utilities financially healthy while achieving a broadened social agenda. One can reasonably ask whether electric utilities more resemble public agencies than private entities driven to serving only their shareholders and customers. One can also question whether funding each specific social mandate through utility rates is in the best interest of electricity customers. This paper recommends that regulators as well as other policymakers do a thorough reality check when contemplating the proper roles for electric utilities.
This paper ends by observing that policymakers might be slighting the capability of the free market to direct the future path of the electric industry. In an ideal market, for example, clean energy technologies would compete with one another and with the technologies they seek to replace, not for government handouts or regulatory or legislative favors that effectively function as inefficient, rent-seeking actions. In addition to minimal subsidies, essential conditions for well-functioning markets include consumer empowerment, robust incentives for innovation and economically rational pricing.