By Ron Lehr and Bentham Paulos
The basic business approach used by much of America’s electric power sector has changed little over the past 100 years. Electric utilities operated state granted monopolies on electric sales, but were regulated by state utility commissions. They invested in large capital-intensive equipment, mostly generators, and got a return on their investment. The business model has been “invest in equipment, turn the customers’ meters, earn a steady profit.”
But the industry now faces an unfamiliar and uncertain future. Pressures are building that will force fundamental changes in the way that the electric utilities plan, do business, and serve their customers. Many customers are using new technology to save or produce their own power. Consumers are demanding new relationships with the energy they use, and new technologies are proliferating to meet those demands. Our existing fleet of power plants is aging, and facing expensive upgrades to meet federal environmental rules. At the same time, innovative energy service suppliers have come on the scene, disrupting relationships between traditional utilities, regulators, and customers.
In response to these challenges, “new business models” has become the new meme for utility thinkers. Next Tuesday, the California energy agencies (PUC, CEC, and ISO) will convene a joint “en banc” hearing to explore “the nature of the impact of new technologies and services on the traditional electric utility model.”
Peter Kind, in Disruptive Challenges, a paper for the Edison Electric Institute, drew on parallels with the telecom industry to evoke a “vicious cycle” triggered by solar power and net metering that would undermine utility profits. “The threat to the centralized utility service model is likely to come from new technologies or customer behavioral changes that reduce load,” he wrote. As customers depart from utility service and provide their own power, the departing customers’ share of utility costs fall on fewer customers, raising their rates, so more of them depart, and the cycle results in a “death spiral” for utilities.
Peter Fox-Penner had raised the issue earlier in his book Smart Power where he argued that “the Smart Grid will mark a total transformation of the industry’s operating model.”
“Technology, economics and environmental considerations have rendered the foundations of [traditional] business models obsolete,” he wrote. “The new electric power industry will have to be designed with three objectives in mind—creating a decentralized control paradigm, retooling the system for low-carbon supplies, and finding a business model that promotes much more efficiency.”
Others have confirmed the trend. The Deloitte Center for Energy Solutions in Beyond the Math argues “The time is ripe for significant transformation because the potential for dramatic disruption to the existing electricity operating model is coming not from one direction, but from many—demand, technology, regulation, new products, and new competitors.”
Circle the wagons, or a new treaty?
While Kind urges utilities to circle the wagons, by making changes that would undermine distributed technologies and keep customer dollars flowing to utilities, we believe this approach is doomed to failure, and decidedly not in the public interest. Instead, the public interest—as expressed by both government policy and consumer preferences—demands that distributed generation and energy efficiency should be encouraged, not stifled.
But Kind is right that changes are needed to the “regulatory compact” that has guided utility behavior for decades. The current system penalizes utilities with lost profits for every kilowatt-hour not used, for every generator put on the customer side of the meter, and for every contract they sign with an independent renewable power producer. Our century-old legal, economic and regulatory structures are thwarting innovation.
If electric utilities are to remain healthy contributors to America’s clean energy future, their business models must be allowed and encouraged to evolve. This agenda has implications not only for companies themselves, but also for the legal and regulatory structures and markets in which they operate. A new social compact is needed among utilities, their regulators, and their customers and suppliers.
To start a dialogue about changes in the power sector across the wide variety of ownership, market, regulatory, and policy settings in which U.S. utilities do business, the Energy Foundation commissioned America’s Power Plan, a policy roadmap crafted by a team of experts with input from over 100 thought leaders. One part of the Plan is to analyze changes needed to utility business models.
The power sector is heavily affected by policy. Whether in regulated vertically-integrated monopoly and monopsony (single buyer in a market) settings, or in competitive ecosystems, policy sets the rules. Policy makers must define societal outcomes, determine legal and market structures under which companies operate, develop and implement the proper market and regulatory incentives, and follow up to make sure that policies are being achieved.
Policy makers and power companies around the country are experimenting with different responses to changes in the power sector, creating a range of new utility business models, and a diversity of regulatory structures that support them.
On the minimalist end of the spectrum, the utility can be limited to a role as a “wires company,” maintaining the part of the grid that is a physical monopoly – the wires and poles – while competitive providers supply the rest. At the other extreme is the “energy services utility,” which owns and operates all necessary systems to deliver energy services to consumers. Between these two, a “smart integrator” or “orchestrator” role involves utilities partnering with innovative firms to coordinate and integrate energy and related products and services without utilities necessarily delivering all of them.
Three models to emulate
We have identified three good regulatory models for fostering change and aligning utility operations with the public interest.
First, the UK’s new “RIIO” model is an example of regulation based on a broad-scale performance-based incentives with revenue caps. Utilities file business models to achieve RIIO’s goals: “Regulation for Incentives, Innovation, and Outcomes.” New utility business models, recently filed with the regulator, show how utilities will accomplish a range of public policy outcomes, provide customers “value for money” and measure performance to support incentives. RIIO aims to pay utilities to deliver what society wants going forward, while U. S. regulation tends to focus more on whether society paid the correct amount for what it got in the past.
Second, the “Iowa model” describes a series of settlements entered into by parties and approved by regulators that led to electricity prices in Iowa that did not change for 17 years, even as wind power rose to 25 percent of the generation mix, fuel costs fluctuated, and customer loads grew and changed. The Iowa model shows that stakeholders can negotiate for and settle on a regulatory bargain that works for them to keeps rates stable, and provides for shared earnings and utility profits in a less adversarial process than most. The largest Iowa utility, MidAmerican Energy has announced plans to get to 39 percent wind by 2017, so the approach appears to encourage outstanding movement toward clean energy as well.
The final regulatory model we call the “grand bargain,” which combines elements of the RIIO and Iowa models. Most commissions are trapped in solving particular regulatory issues without any opportunity to look across all the issues and work toward comprehensive and coordinated outcomes. This results in what we term “this for that” regulation and can result in confusing and contradictory outcomes. Each issue eventually comes to resolution, but the whole of the resolved set of issues is less than the sum of the parts. In a “grand bargain” model, a commission would encourage utilities and stakeholders, including commission staff, to negotiate a comprehensive settlement to a range of desired outcomes.
The common thread for all three of these models is that they clearly define the goals and the parameters, call utilities to new and improved levels of performance, and grant the companies the flexibility to achieve them. All three require unprecedented new levels of communication and cooperation, based on recognition that utility and regulatory “business as usual” will not be sufficient to reach solutions for the challenges we now face. Companies and regulators need to experiment and find agreement, outside the traditional adversarial venues of utility regulation.
Utility leaders agree. “I think utilities need to be given a little more flexibility to try new products or new programs in order to take advantage of changes in the marketplace, be it charging electric vehicles, distributed generation or the like,“ says Jonathan Weisgall, VP of Legislative and Regulatory Affairs for MidAmerican Holding Company.
Among the nation’s 3,000 or so electric utilities across 50 states, there are many variations but a fundamental truth: current business models were developed for a different time. A modern electricity grid will require a new social compact between utilities, regulators and the public.
Ron Lehr is an attorney and consultant with energy sector clients, and former chair of the Colorado Public Utility Commission. He wrote Utility and Regulatory Models for the Modern Era for America’s Power Plan. Bentham Paulos is the project manager for America’s Power Plan.