I was first introduced to the strange and complex world of utility economics when a friend called me in 1977 with the idea of acquiring a hydroelectric project in Vermont. He had recently begun working at the Federal Energy Regulatory Commission (FERC) and Central Vermont Power had just filed paperwork to retire their license for the plant. He explained to me that, due to a strange quirk in how utility companies’ evaluated expenditures and investments, it was more cost-effective (i.e., profitable) for them to retire the plant and build a new fossil-fueled plant than to perform the refurbishment the plant required.
He explained to me that refurbishment would be considered an operating expense but a new power plant would be considered a capital investment in new power, which would qualify for the guaranteed rate of return on capital expenditures authorized by the Vermont Public Utilities Board. It would be factored into their rate base as “new generation,” as would be the ongoing cost for fuel. Bottom line: Building a new fossil fuel plant would be more profitable for them than refurbishing the hydro plant.
With the energy/oil crisis of the early 1970s fresh in my mind, it didn’t make a lot of sense to me to scrap a power plant that took no fuel to operate for one that required fuel.
The current utility model encourages utilities to spend money by rewarding them with guaranteed rates of return on any investments they make to their infrastructure, sometimes to the detriment of the rate payer.
A Brief History of Public Utilities
The current monopolistic economic model of the regulated public utility has deep historical roots going back to the late 1800s and early 1900s. The objective was to encourage investment in a reliable, nationwide infrastructure that would provide rail service, gas, water, telegraph, telephone and electricity to the general public. Both Federal and State governments wanted to avoid the confusion and inefficiencies of having redundant and competing services in a particular geographic area (this was particularly true for the development of the railroads).
The laissez faire attitude toward the free market initially prevailed for non-railroad utilities. In New York City in 1880, there were six natural gas companies competing for customers. By the 1900s, there were over 30 electric utilities competing to provide electricity (and offering both AC and DC technology), with many of these electric grids having overlapping territories or franchises. By the turn of the century, there were over 45 competing electric utilities in Chicago alone.
It was initially believed that this competition would result in lower rates for the consumer. What actually happened was pandemonium. Competing utilities (both gas and electric) often sabotaged one another’s conveyances, streets were continually dug up as each respective utility either installed or repaired their lines. As is inevitable in such a free market system, the competition resulted in winners and losers and, by 1907, in both New York City and Chicago, mergers and acquisitions amongst the competing utility companies resulted in one dominant player in each of the markets. In NYC, the surviving entity became Consolidated Edison, and in Chicago, it became Commonwealth Edison. The inevitable result of these de facto monopolies is, prices went up.
This was the era of the robber barons. The monopolies – creating and abusing what were deemed necessary services to the public – were coming under scrutiny, and both politicians and the public were demanding regulation. The first states to take this step were New York and Wisconsin (both in 1905), which regulated the railroads, interurban street cars and freight line companies. Wisconsin took this one step further in 1907, and passed the Public Service Commission Law, which brought under commission regulation all utilities, telephone, telegraph, gas, electric light, water and power companies, as well as urban street car companies. It also set the precedent for how modern utility regulation was to be implemented.
Quoting from a 1907 paper authored by the Honorable George B. Hudnall, State Senator from Superior Wisconsin,
“…The commission cannot make a rate so low that the utility cannot receive a return of at least legal interest (6 per cent) upon the value of the utility…Under the act of 1907, the commission is to value only such property of the utility as is ‘actually used and useful for the convenience of the public…. In Wisconsin it is provided that all utilities shall furnish adequate service at reasonable rates…. So long as a utility furnishes adequate service at reasonable rates, it should have not only the privilege of continuing in business indeterminately, but should also continue in business without competition, and the act provides not only that these permits should be indeterminate, but that no other license, permit or franchise shall be granted in any municipality where there is in operation, a public utility engaged in a similar service…”
What Is a Fair and Equitable Return?
There have been many scholarly papers and studies written over the years analyzing the private/public business model of regulated utilities, its societal benefits and rationale for the model and formulas used to determine fair and appropriate rate-based pricing. Regulatory hearings relating to utility rates are complex and lengthy, with a multitude of interveners.
Determining what is a fair and reasonable rate of return for the utility, and what is a legitimate expense qualified to be put into the rate base, is more often than not a contentious and litigious process. Is advertising a legitimate rate base expense of the utility? This depends upon what they are promoting. Is lobbying Congress or a state legislature? A Public Utilities Commission (PUC) in its regulatory capacity has the balancing act of protecting the public good, ensuring a reliable source of electricity (or water, gas, etc.) for the consumer at a reasonable cost, and ensuring that the utility is reasonably compensated for providing this service, and that the utility is sufficient profitability to attract capital and service debt.
PUCs are tasked with determining an appropriate rate of return on equity for a utility, which has typically ranged from six percent to over 10 percent, varying utility to utility and state to state. A 2013 article in the Wall Street Journal cited a study by Regulatory Research Associates of 92 PUC decisions where the average rate of return authorized by PUCs was 10 percent. How this rate is arrived at can sometimes be extremely convoluted and opaque, as evidenced in recent hearings on Alabama Power’s rate of return, which is set at between 13.5 to 14 percent. A study done by the Institute for Energy Economics and Financial Analysis, took issue with the State of Alabama’s process. No doubt many of Alabama Power’s rate payers would be pleased to get even half that rate of return on their savings accounts.
For the private sector, a 10 percent rate of return may not seem terribly high, but put in context, most companies do not enjoy a sanctioned and protected monopoly for their product and services, and, unlike in the private sector, should they operate inefficiently, they generally do not suffer financially, since they are able to petition the PUC to raise their rates to make up shortfalls on their rate of return, with little worry about alienating a customer to the extent that they look for another provider – though this is beginning to be an option in areas of the country where Community Choice Aggregation (CCA) programs exist, or where direct access is allowed. Because of this monopolistic market position and guaranteed rate of return, investments in utilities have traditionally been considered safe havens for pension funds and risk adverse investors. Utilities have a history for reliably paying dividends year in and year out. This may be about to change if the utilities fail to address the changing environment in which they operate.
Increasingly, the utilities are facing competition within one of their traditional roles, as electrical power generators. Though competition in this segment of the utility sector began in the late 1970s with the passage of the Public Utilities Regulator Policy Act (PURPA) in 1978, which opened the market to independent power producers, the utilities for the most part adjusted and some were happy to be rid of the business of generating power. Being relegated to distributing and reselling electrical power was not out of the ordinary for their business models. They were used to purchasing power from such governmental agencies as the Tennessee Valley Authority (TVA), the Western Area Power Authority (WAPA), Bonneville Power Authority (BPA), Southwestern Power Authority (SWPA), and the Southeastern Power Authority (SEPA).
Though many utilities saw PURPA as an existential threat to their traditional business model, it turned out not to be the Trojan horse many of them warned of. Now, once again, they see an existential threat to their traditional business model, and it is distributed power, best represented by rooftop solar. Increasingly, utilities are seeing customers generating their own power as a major threat to their current economic model. As more and more customers embrace energy conservation measures and install solar, the utilities are selling fewer and fewer kWh. They are having to rely more on their distribution services as a revenue source, and they are seeing their profitability erode.
The utilities are fighting back by petitioning their regulators to increase the fixed charges they charge customers. Wisconsin’s Madison Gas and Electric has proposed an increase of this charge from $10 to $68 over a three year period. Kansas City Power & Light has proposed an increase from $9 to $25. Numerous utilities are petitioning to change the way net metering is compensated for. There is a movement afoot to discourage self-generation by not just the utilities but a number of conservative political organizations, such as American Legislative Exchange Council (ALEC) and the Koch brothers’ backed Americans for Prosperity have financed various state initiatives to undermine the attractiveness of self-generation. In Florida, they are backing Consumer’s for Smart Solar, an organization that is pushing a constitutional ballot initiative that would prohibit third-party generators from selling directly to customers (this initiative is also backed by all four Florida utilities). Think Solar City business model. Somewhat ironically, on the opposing side, wanting to change the Florida constitution to allow third party sellers of electricity, with their own ballot initiative, Floridians for Solar Choice is an unlikely coalition of Tea Party, Evangelical and Libertarian organizations, and liberal leaning organization such as the Sierra Club and the Environmental Defense Fund.
In light of new technologies and business models being introduced into the marketplace – fulfilling in many cases the traditional role of the public utility – on a more economic and sustainable basis, it appears time to revisit the traditional role and business model of the public utility.
Rethinking the Electric Utility Model Series: