The utility business model is a bit unusual, given that power companies own a natural monopoly in the areas in which they operate. But just as the energy transition has upended a bunch of other industry models, it's doing something similar in the staid power industry.
Paul digs into the existing Cost of Service model most utilities employ today, as well as discussing the evolving role that decoupling and Performance Based Ratemaking play in aligning utility incentives with those of states and consumers.
The utility business model is a bit unusual, given that power companies own a natural monopoly in the areas in which they operate. But just as the energy transition has upended a bunch of other industry models, it's doing something similar in the staid power industry.
Paul digs into the existing Cost of Service model most utilities employ today, as well as discussing the evolving role that decoupling and Performance Based Ratemaking play in aligning utility incentives with those of states and consumers.
This is 8 minutes a podcast helping you understand the energy and climate challenge. In just a few minutes I'm your host, paul Schuster. Electric utilities are an interesting industry. They effectively are a monopoly in their given markets and in many ways answer to regulators more so than they do to their electricity consumers. The business model is a bit obtuse as well, and it can be confusing as to how these companies even make their money, especially when certain states actually incentivize their power utilities to reduce the amount of electricity that their customers are using, selling less power through energy efficiency and other programs. So let's spend today discussing the utility business model in general, some of the key legislation that has opened up a more distributed power grid, and how states and regulators are maneuvering to ensure the power companies are engaging in energy reduction as part of the plan to limit greenhouse gas emissions. 8 minutes it's how long it takes to suns race hitters, or about how long I suspect it will last in this year's annual Turkey Trot. Hey, I'll give it a go, but exercising on Thanksgiving, let's get it on.
Speaker 1:
Utilities enjoy a privileged position in industry Because of the design of our power system and the vital role that power plays for society. Our power companies enjoy a natural monopoly in the regions in which they serve, and to ensure that that monopolistic position isn't abused, regulators at the state and federal level step in to approve power prices and the capital plans for these utilities. At its core, the business model for utilities isn't too complicated. It's called a cost of service model and, frankly, the more power that the utility sells, the more money it makes. The regulator sets the price that can be charged, but the utility has an incentive to keep its own costs low and to sell more electricity if it can. There are a couple elements to understand within that model. First is the role of regulators in setting the price of electricity. In general, that price is based on the amount of investment that the utility is putting into the power grid in the first place. The utility asks the regulator for approval on infrastructure upgrades and reliability improvements, and the regulator agrees to that investment. The price for electricity is then basically set so that the utility can receive a reasonable profit on the amount of investment that they are making. Which brings me to the second point of how the utility model works, as power companies have dual incentives to increase their profits. One is by selling more electrons, but the other is by getting the regulator to agree to more internal investment. More investment equals more profit, but that model also leads to some funky disconnects with what customers want. For instance, what about rooftop solar installations? Under the traditional business model, these systems would be just about the worst thing to happen to a utility. Not only do they decrease the amount of power that's being sold to a customer, but because those systems are being invested in by the customer and not the utility, the power company can't even claim them as a capital expenditure.
Speaker 1:
Back in the 1970s, the power company owned the entire vertical value chain for electricity, from generation to transmission to distribution. Utilities managed it all, but the energy crisis of the 70s prompted federal regulators to reconsider whether there were more effective and cost-efficient ways to manage the power grid. What came out of that decade was something called the Public Utility Regulatory Policies Act, or PERPA, and what PERPA did was start the process to disconnect generation from the utility value stack. It essentially required utilities to purchase power from the least cost source of generation, and if that generator happened to be a third party and not part of the utility, well, that was kind of the point. Perpa ushered in an era of competitive generation, competing to supply power to utilities and created the foundation for the surge in new renewables projects throughout the 1990s and 2000s. That it contributed to wind and solar projects today being some of the lowest cost generation on the grid. And PERPA had other impacts as well, namely on energy efficiency, for some regulators recognize that investing in energy-efficient insulation or light bulbs would be a better return on the dollar than simply adding more generation to the grid.
Speaker 1:
But what to do about the utility in that case? I mean the utility was still incentivized to do the exact opposite In more generation, sell more electrons. The solution was to disconnect the sale of electrons from the profit being made by the utility, a market mechanism known as decoupling. Here the regulator and utility agree on a base case amount of electrons that they think would be sold under normal business as usual situations and the utilities provided a return on that base case. If the amount of power sold goes down, the utility adds a surcharge to future bills to make up the difference, and if the power goes up, the utility adds a discount. The result is that utilities are now encouraged to invest in energy efficiency projects because it no longer matters how much power they sell. It only matters in how much money they invest, and those investment dollars can be into energy efficiency projects.
Speaker 1:
De-coupling was an early effort by regulators to align utility incentives with those of a state, and 18 states eventually would adopt a decoupling of their power markets and, for that matter, 26 states would also do so for their gas distribution utilities. De-coupling has its challenges. For one thing, consumer advocacy groups argue that the reduced risk that the mechanism gives to utilities should be reflected in a risk adjusted, lower profit number and that those savings should be passed along to consumers. And you can see how decoupling helps to create a market for customer owned solar where the utility is essentially indifferent as to whether the customer is getting their electrons from an onsite away or from the utility the utility is going to get paid either way. The success of decoupling has led regulators to continue to try to find ways to better connect to utilities incentives with those of its constituents. In California, for example, the state has something called decoupling plus, which actually pays the utility more for energy efficiency projects than for new generation. And this is leading towards the emergence of a new utility business model called performance based rate making. The idea here is to tie utilities profit to meeting certain performance metrics on key indicators such as customer service, greenhouse gas emissions, reliability.
Speaker 1:
The old cost of service model, based solely on how much capital is invested and how many electrons are being sold, seems very dated these days. As the economy further electrifies and the power grid becomes cleaner, though, even today's rate making mechanisms may not be fully sufficient. How should utilities think about increasing power demand in a business model where they aren't paid by volume? How should regulators consider the impact on low and moderate income customers as wealthier homeowners switch to solar or more energy efficient houses, and that would ship the burden of that guaranteed return onto the more disadvantaged consumers? Just like everything else in the energy transition, the regulator market, too, is going through a bold series of innovations, trying to keep up. I'm Paul Schuster, and this has been your 8 Minutes.