Is There an Incentive to Innovate?

Remarks to the FTC about State Utility Regulation and Rooftop Solar

Investor-owned utilities’ century-old technology and business model for electricity distribution is being fundamentally challenged. Decentralized technologies and services owned and provided by ratepayers and third-parties allow consumers to buy less power from their local monopoly utility and may effectively compete with the utility for capital investments.

State regulation plays a vital role in how investor-owned utilities have responded to this threat. Investor-owned utilities can, and indeed are, using the regulatory system to maintain the status quo of a top-down utility system. However, to varying degrees, regulators in some states are taking steps to enable an innovative environment where decentralized third-party providers of technologies and services can compete and flourish.

State regulation is about protection. Utilities received protection when states initially passed laws in the early 20th century that tasked public utility commissions with regulating electric companies. State regulation effectively insulated utilities from competitive market pressures, providing them with de facto monopolies over electricity distribution in a geographic region.

Ratepayers receive ongoing protection from state regulation. By law, utility rates must be approved by regulators and must typically be just and reasonable and not unduly discriminatory.

70 years ago, the Supreme Court concluded that just and reasonable rates must balance consumer and utility investor interests. In practice, rates reimburse utilities for operating expenses and allow them to earn a rate of return on capital investments, while preventing monopoly profits. The just and reasonable price is intended to mimic the price of a competitive commodity market.

The prohibition on undue discrimination prevents a utility from playing favorites among ratepayers by charging different rates for the same service. Another formulation of the prohibition is that rates should adhere to the cost causation principle. Again, like just and reasonable, undue discrimination connects utility rates to utility costs.

There are essentially two steps to ratemaking: 1) setting the revenue requirement, which is the total amount of money the utility can expect to earn from ratepayers; and then 2) establishing the rate design, which allocates that amount among different classes of ratepayers and sets volumetric rates and fixed and other charges.

This is a highly technical and contested process, involving engineers, economists, and lawyers. Although parties often speak in neutral terms, emphasizing that their preferred rate structure is based on cost causation, economic efficiency, and sound engineering, choosing a rate structure involves a subjective balancing of interests.

State courts reviewing utility commission rate decisions are deferential to the commission on both aspects, but particularly so on rate design. Many state courts have said that while cost causation ought to be a consideration in rate design, it is only one factor. As long as the Commission bases its decision on the record, state courts are very unlikely to overturn a rate design decision. Effectively, regulators have the final say on rate design.

This regulatory model was created 100 years ago, when it was clearly in the public interest to expand access to electricity and enable more per-capita consumption. The basic ratemaking formula incentivized utilities to invest capital and sell more kilowatt-hours. Growth was the key ingredient that aligned the public interest with private profits.

Today, total volumetric sales in the US have been flat for nearly a decade, which is unprecedented. Rooftop solar likely played only a small role in enabling this trend, but the prospect for dramatic expansion of rooftop solar, along with other complementary technologies, raises the possibility that utility sales could decline.

To delay this decline and blunt the effects of flat sales on their revenues, utilities across the country have sought permission to change rate designs. Two widespread utility proposals are to increase fixed fees on all ratepayers and reduce the net metering rate.

Utilities rationalize these changes by appealing to the cost causation principle. They argue that because they recover most costs through volumetric rates, and the costs of distribution are largely fixed, they must increase fixed fees to account for no volumetric growth. On net metering, they similarly argue that net metered consumers reduce the volume of their purchases and are therefore underpaying for the fixed costs of distribution service. The result, according to utilities, is that net metered consumers are being subsidized by other ratepayers.

These rationales, and the underlying relevant facts, are hotly debated at state public utility commissions, and I won’t get into that debate here. However, I will highlight that cross-subsidies (or cost shifts) between individual ratepayers are a feature, and not a flaw, of utility rates. There are numerous such cross-subsidies, and utilities and regulators typically ignore differences between individual consumers in the same class. Historically, when utilities have offered specific incentives to individual ratepayers to increase or decrease consumption, regulators have typically looked at the aggregate effect on the utility system. So long as they found that the utility system benefited, regulators often allowed incentives that directly benefited only a few ratepayers, such as incentives offered in many states today for investments in energy efficiency.

To the extent that regulators today think that they must chase economically efficient pricing to the exclusion of other goals, there are places to start other than targeting ratepayers who buy less energy from their utility.

Apart from rate designs and any specific policies, such as interconnection procedures, that could be used to slow the growth of solar, there are deeper features of the state regulatory system that put utilities at odds with distributed solar.

Although rapid per-capita growth in electricity consumption may no longer be in the public interest, one could nonetheless argue that the industry needs major capital investment. Today, ratepayers, independent power producers, third-party service providers, and others, rather than the utility, could make those investments. But, under the traditional ratemaking formula, utilities profit from investing their own capital. Utilities also have an incentive to rely on capital-intensive solutions, rather than operational solutions, to maintain the grid.

The architecture and ownership of the electric grid are additional factors that put investor-owned utilities at odds with distributed resources. Nearly all power is generated at thousands of large central power plants that are interconnected by nearly 650,000 miles of high-voltage transmission lines. Investor-owned utilities own approximately two-thirds of all high-voltage lines in the continental US, and in approximately 35 states, utilities that distribute power also own the vast majority of generating capacity. If the electricity system becomes more decentralized, capital deployed by ratepayers and third parties on the distribution grid may directly compete with utility investments on the bulk power system. The Brooklyn-Queens Demand Management Program is the paradigmatic example of this competition.

Then there are utility holding companies that own generation and also own distribution utilities that do not themselves own generation. Take the case of Exelon, one of the largest generating companies, that also owns distribution-only utilities in five states and DC. Last year, two utility commissioners in Maryland dissented from a state Commission order that authorized Exelon to purchase two distribution utilities. The dissent wrote, “Exelon’s economic interests to shield [its] generating fleet from emerging distributed energy technologies and other competitive threats are inherently misaligned with the interests of the customers” of the distribution utilities it is purchasing.

A decentralized architecture is a fundamental change to the physical electric grid. It also raises the possibility that rather than paying uniform rates, each ratepayer could have a unique economic profile based on the ratepayer’s own ability to deliver energy and services to the grid on an hourly. And rather than compensating a handful of large-scale generators and transmission owners, utilities could be transacting with tens of thousands of entities.

This vision is a dramatic departure from the industry’s 100-year old model. This sort of fundamental transformation is very difficult, and the incentives created by the regulatory system appear weighted toward maintaining the status quo, even if decentralized technologies can benefit ratepayers.

Using regulation to insulate a monopoly from the effects of industry trends and technological development, such as by increasing fixed fees, seems unlikely to facilitate innovation. In fact, high fixed fees appear to be designed to maintain the status quo. The nature of regulation of this industry means that innovation must be a shared endeavor among regulators, utilities, ratepayers, and third-party providers. Enabling competition changes the role of regulation, but it does not diminish its importance.

Regulators in some states are moving forward. Many states have rejected utility requests for high fixed fees, fees for solar, or reduced net metering rates. A few states, with New York as the leading example, are not just reacting to utility proposals but are taking a broader approach and are changing utility incentives to enable the deployment of decentralized technologies and services.

As regulators examine whether and how to open up the distribution system, one tool at their disposal is the prohibition on undue discrimination. This prohibition is rooted in concerns about anti-competitive behavior. The connection between discrimination and the economic self-interests of monopolists was a key component of FERC’s argument to advance competition in wholesale generation in the 1990s. FERC concluded that “the incentive [for utilities] to engage in [discriminatory] practices is increasing significantly as competitive pressures grow in the industry.”

FERC was talking about the very same companies that today are facing competitive pressures on the distribution grid.

Depending on state law, at the very least regulators may be able to use this authority to ensure fair procedures that allow new market entrants to participate and that are not biased in favor of incumbents.

For a deeper discussion of these and related issues, please see Unjust, Unreasonable, and Unduly Discriminatory: Electric Utility Rates and the Campaign against Rooftop Solar, Texas Journal of Oil, Gas, and Energy Law (2016).