NRRI 16-05 R&D in Energy Utility Sector

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For both an industry and the general economy, technological change is a key ingredient for growth and long-term prosperity. It can spawn new products or improvement of existing products or higher efficiency of production processes. Economists generally agree that technological change is a prerequisite for economic growth.
A precursor to technological change is investments in research and development (R&D). A major purpose of R&D is to advance the current state of technology.
R&D has three distinct stages: Basic research attempts to create new knowledge that will lead ultimately to profitable commercial applications of new technologies. Applied research and development uses the new knowledge created by basic research and applies it to products or services that society values. Demonstration helps to determine the commercial feasibility (e.g. feasibility at scale) of a new technology. In other words, basic research provides the theoretical foundation for new technological innovations, while applied research, development and demonstration focuses on the feasibility of new technologies for practical and commercial applications.
The inherent features of R&D pose challenges for a private for-profit company. It is expensive, for example, with costs commonly incurred several years before a company can reap profits or other benefits. R&D by nature is risky and success is difficult to predict. Innovations originating with R&D often require long lead times between basic science and commercial deployment. External parties, e.g., competing companies, can also appropriate the benefits. New knowledge is especially appropriable, unless one has acquired patent protection. These features of R&D imply two things. First, companies are unlikely to innovate unless the payoff from successful innovation is substantial. Second, the market may under-allocate resources to R&D, providing a rationale for government funding.
The public sector complements R&D by the private sector, which rationally disregards R&D that would be in society’s interest but not profitable for a company. Sources of this market failure include (1) public goods (e.g., national security and less dependence on foreign oil), (2) externalities (e.g., unpriced and unregulated environmental effects), (3) economic factors (e.g., less than full appropriability of the research results, the size of the risk, and (4) the length of the time horizon before potential gains translate into profits.
Concerns over R&D in the energy/utility sector
The U.S. has seen a decline over the past several years in the level of R&D funding (in real dollars) in the energy industries by both government and the private sector. Private firms have also shifted their R&D dollars toward short-term projects with an expected rapid payback. Many prominent observers have warned that the downward trend in R&D could have a high social cost; for example, the slowing down of the economy’s long-term productivity and growth, since technological change is the engine of economic growth. For non-regulated firms, technological change is the key element for long-term financial sustainability. For regulated utilities, technological change is critical for advancing long-term regulatory and public-policy objectives, like safety, reliability, cheaper energy, increased energy efficiency and a cleaner environment. As the case study for this paper, the natural gas sector has encountered drastic cuts in R&D investments largely because of the combination of industry restructuring, loss of funding for collaborative industry R&D and the decline in government funding for R&D. These factors taken together have caused a sharp drop in R&D investments over the past two decades. The lost opportunities from the potentially high returns from R&D investments, ultimately, deprive benefits to utility customers and shareholders, the environment and society at large. One indicator of this concern is the small size of R&D expenditures (as a percentage of industry revenues) and the potentially high gains from well-defined, cost-effective R&D projects. It is a topic that has received scant attention in regulatory circles.
Addressing these concerns involves state utility regulation. Declines in R&D in the energy utility industries mirror the energy sector as a whole. A number of studies have warned that this trend will slow down the pace of new technologies to achieve public-policy goals such as clean air, economic growth and the competitiveness of the U.S. in the world market.
The role of public utility regulation
Various features of public utility regulation affect how much and how utilities conduct R&D. They include the tightness of regulation, regulatory commitment, degree of information symmetry, cost recovery, allocation of the benefits, and risk incidence. For example, depreciation policy can help to ensure recovery of invested funds over the economic life of the physical capital. When depreciation rates are too low, with depreciation stretched out over too many years, a utility may find it uneconomical to replace old equipment will new equipment. The costs would be particularly high in a dynamic environment in which new technologies offer significant benefits to society. Allowed deprecation rates can therefore have a significant effect on R&D and technological progress.
As another example, a regulatory practice of splitting the benefits of a new technology between utility customers and shareholders can boos the efforts of utilities to invest in R&D. A third example is the regulatory commitment to R&D, reflected in guidelines, rules or individual rate-case decisions, can lower the risk to the utility, thereby making R&D more attractive.
The economics literature has devoted relatively little attention to regulated firms’ incentive to engage in R&D, and develop and adopt new technologies. Nevertheless, the standard narrative is that regulation causes utilities to be cautious about innovating and taking risks. The common thinking is therefore that utilities fall short in their R&D activities and deployment of new technologies. Utilities would tend to underinvest in R&D and new technologies that have public benefits or threaten their monopoly status. For the latter reason in particular, regulators need to be vigilant that utilities do not “squash” those technologies that threaten their financial health but are in the interest of their customers. This paper emphasizes the need for regulators to evaluate the effectiveness of R&D funded by utility customers: Are customers getting bang for their buck? How can utilities improve the net benefits of R&D funds? Regulators should be vigilant about utility R&D activities, both with regard to the level of funding and the allocation of funds. After all, R&D involves utility expenditures that, similar to others, require regulators to oversee their prudence.
Scope of the paper
This paper covers a wide range of topics relating to R&D that are pertinent to state utility regulators. Its primary purpose is to educate regulators on the various aspects of R&D. The topics include the following:
(1) The meaning of R&D and its importance to private firms and the general economy;
(2) The economic factors driving firms to invest in R&D;
(3) Market and regulatory barriers to R&D;
(4) The role of government in supporting R&D;
(5) The effect of state utility regulation on R&D, not only the level but also the kinds of projects undertaken; for example, regulatory incentives for R&D activities;
(6) An overview of R&D in gas distribution;
(7) Likely obstacles to R&D by utilities; and
(8) Special actions that state utility regulators can take to stimulate R&D.
This paper does not definitely answer the question of whether public utilities are spending too little on R&D. After all, coming to such a conclusion would require more information than what this paper could provide. For example, it would require not only a complex technical assessment on an individual utility level, but also a value judgment about the social desirability of both private and public R&D initiatives. It may well be true that some utilities are undertaking adequate R&D while others are not. Looking across all utilities, however, based on the trends and other evidence, one could conjecture whether or not utilities are spending enough on R&D. Overall, the evidence suggests that speedier action on a larger scale would be in the public interest.
The goal of this paper is to leave the reader with three thoughts. First, R&D plays a vital role in society that is often overlooked by policymakers. Second, the concern that the U.S. is spending too little on energy R&D seems very real. R&D is a hard sell to both the private sector and government, particularly as our society has become more myopic and less patient for benefits farther out than immediate or short term. Third, utility regulators should revisit their practices for providing utilities with incentives to encourage innovation and R&D. One broad approach under the control of state utility regulators is to change the risk-reward relationship so that utilities have greater motivation to innovate. As the electric industry transforms, a potentially significant benefit can come from utilities optimally integrating new technologies into their distribution system. This integration will likely require ingenuity and innovation, bolstered by robust regulatory incentives.

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