Tong and Wellinghoff: Are fixed charges a curse in disguise for investor-owned utilities?

The push for fixed charges won't benefit shareholders in the end.

Editor's Note: The following is a guest post written by Jon Wellinghoff and James Tong. Wellinghoff is the former chairman of the Federal Energy Regulatory Commission and is currently a partner at law firm Stoel Rives LLP. Tong is the vice president of strategy and government affairs for Clean Power Finance, a financial services and software firm in the residential solar market.

Let’s dispel a common myth: investor-owned utilities (IOUs) are not guaranteed any rate of return. 

As Scott Hempling, a respected regulatory attorney and scholar, notes, regulation does not even “guarantee profit (except in very, very rare situations).” The Edison Electric Institute (EEI), the trade association representing investor-owned utilities, seems to agree: “…a utility should have a reasonable opportunity to earn its allowed rate of return if it operates efficiently.” The key words are “opportunity” and “operates efficiently." There is no promise. And returns are contingent on performance. They must be earned — not given.

Media attention has focused on potential cost-shifting between solar and non-solar customers. Almost no attention is given to the potential of a much larger cost-shift from utility shareholders to all ratepayers – solar and non-solar, rich and poor, black and white, old and young. Lately, we’ve been hearing, “How do we fairly divide fixed costs among different ratepayers?” Almost never do we hear, “To what extent should utilities bear the risk of insufficient cost-recovery?”

IOUs, their critics, and even some regulators often misunderstand or overlook that profit expectations are not iron-clad. We see this when critics claim utilities don’t understand competition because they are guaranteed profits. More disturbingly, we see this in utilities’ current push for fixed charges [1], which presupposes that utilities are entitled to full fixed-cost recovery. The popular meme that “fixed charges should cover fixed costs” implies that grid investments by utilities should be risk-free.

But utilities are paid to assume some level of investment risks. (For those less familiar with corporate finance, we suggest reading the basic primer here.) That’s why shareholders, the owners of utilities, are given the opportunity to earn an authorized return on equity (ROE). That ROE reflects comparable returns of competitive players facing similar risks. Competitive players are not shielded from poor investment decisions and business risks; utilities shouldn’t be either. This is not our opinion, but rather the opinion of the Supreme Court of the United States: 

"The due process clause has been applied to prevent governmental destruction of existing economic values. It has not and cannot be applied to insure values or to restore values that have been lost by the operation of economic forces."[2]

The push for fixed charges seeks to redefine the risk-reward formula by reducing only the risk, and not the rewards. A utility’s authorized ROE is a component of its fixed costs. Guaranteed fixed-cost recovery would mean guaranteed profits, and suggests that ratepayers must assume all of a utility’s investment risks. 

While more fixed charges can literally pay dividends to shareholders in the short run, they will very likely hurt them down the road. Offloading risks to ratepayers offloads both accountability and responsibility for investment risks. Less accountability can lead to a waste spiral. Less responsibility can spiral towards irrelevance. 

[1] We are referring to fixed customer charges – fees that cannot not be avoided or reduced in any way – and not demand charges. All recent proposals for fixed charges seek higher customer charges, and only a few combined them with demand charges.

[2] Market Street Railway Co. v. Railroad Commission of California

From death spiral to waste spiral…

As with any other business, utilities’ investment decisions are governed by risk-reward calculations. Risk-taking is rewarded by rates of return; the higher the risk, the greater the potential for returns. The possibility that companies (monopolies or competitive players) can lose money on investments serves as a check against wasteful investments. 

Since IOUs grow their profit base by deploying capital, they have a natural bias towards making capital investments over actions that minimize total costs for customers. This is known as the Averch-Johnson effect. Using fixed charges to reduce utilities’ risks without a comparable downward adjustment on the rate of return will lead to wasteful investments and higher costs. This waste, along with utilities’ authorized returns on that waste, will get absorbed as fixed costs. The resulting higher fixed costs will invite calls for more fixed charges. Thus, we see the beginnings of a waste spiral. In fact, it may already be happening. 

As we discussed separately, excess or wasted capacity in grid infrastructure is at unprecedented levels. A possible explanation is that IOUs may be receiving too high an authorized ROE. An independent analysis found that the “…cost of equity for electric utilities in today’s capital market ranges from 8.5% to 9.5%, with a mid-point of 9.00%.” However, IOUs are being awarded an average ROE of about 10%. Similarly, another analysis finds evidence indicating that decoupling in California, which has insulated IOUs from cost-recovery risk, has encouraged an IOU to consistently over-forecast demand to justify new distribution investments that probably aren’t needed.

A waste spiral would be a boon to IOUs and their shareholders in the short-term. But it also would represent a house of cards. More wasteful investments increase the risk of stranded assets (i.e., investments that are sunk and no longer useful, but still need to be paid for); these risks are already high given current excess capacity, increasing deployment of distributed energy resources (DER), advances in energy efficiency technology, and growing calls for reduction in carbon emissions. At some point, the cards will collapse. [3]

A similar story has already played out with California’s botched “deregulation." The energy economists Severin Borenstein and James Bushnell found that “the motivations for restructuring were driven more by a desire by some groups to avoid paying for stranded assets (like nuclear and coal plants which looked like white elephants in the late 1990s) than by a belief that restructuring would reap massive efficiency gains.”

Not fully respecting market principles, policymakers designed retail electric rates to ensure recovery of stranded costs and spread those costs among ratepayers in a way that would minimize complaints. Ultimately, the plan backfired. The flawed market structure led to rolling blackouts, and cost residents in California and Nevada a total of over $40 billion. The IOUs did not escape harm: PG&E declared bankruptcy; SCE narrowly escaped it; and SDG&E and Nevada Power both lost over $400M in unrecovered power cost and share prices of the latter tumbled by 70%.

Borenstein and Bushnell warned in a working paper published last year that current trends in utility regulation are following a similar path.

[3] We do not suggest that all investments would be wasteful. Two areas where distribution utilities are making significant investments are in “smart grid” upgrades and in infrastructure to enhance cyber and physical security. Nevertheless, measurable benefits and strong cost controls are still essential.

…or the spiral of irrelevance

To avert the waste spiral, regulators and the public may force a different route. Instead of accepting more fixed charges, they may ask: “Why are we rewarding utilities with such a high ROE?”

Following that line of reasoning, the question becomes, “If utilities want to avoid responsibility for investment risk, why not make their authorized ROE equal to their cost of debt?” At which point, people may even ask, “Why have IOUs at all?”

All things being equal, government ownership of the distribution grid would reduce customer cost by being able to leverage tax-exempt financing and eliminate the need for authorized ROEs and income taxes on profits. Let us be perfectly clear: we do not recommend this course of action. But shifting risks to ratepayers through more fixed charges will likely invite these uncomfortable, albeit reasonable, questions. 

In fact, people are already asking the questions. A recent survey by UBS sees “ROE risk as back on the table for rate cases.” Additionally, cities across the country have shown increasing interest in taking control from IOUs and “municipalizing” their utility. As the New York Times writes, “municipal utilities over all offer cheaper residential electricity than private ones.”

Others are looking to implement community choice aggregation (CCA), whereby local or regional jurisdictions assume responsibility of buying and selling power, but, unlike municipalization, leave grid operation, maintenance, and billing to IOUs. Six states have already adopted CCA, and New York is looking to be the seventh. 

Increasing fixed charges can encourage grid defection, where customers use distributed generation and storage to withdraw from the grid entirely. [4] Others discount the risks, insisting that sufficient storage will remain cost-prohibitive for the foreseeable future. However, both sides miss a critical point: customers will defect not just to lower costs, but to also achieve greater value. In this regard, both misunderstand the risks of defection and how it has already begun. 

Municipalization is a form of grid defection – as is CCA. A large motivation for both movements is to provide constituents cheaper energy or more local control (e.g., the ability to choose cleaner energy) or both. Big tech companies are also defecting from the grid. Microsoft’s new data center in Wyoming never “cut the cord” with the grid – it never even had a cord to begin with. Similarly, Facebook built its data center in Sweden, where its specific energy needs can best be met. 

One way or another, the general trend of shifting risks to ratepayers will end. How shareholders will fare is up to the managers of utilities.

[4] Grid defection has in fact occurred in some instances in Hawaii, but mostly as a result of high volumetric charges.

What next?

That IOUs seek to maximize returns at minimal risks for their shareholders is not necessarily shameful or corrupt. After all, this is the goal of every company and the foundation of our market economy. However, since electric utilities, by definition, are monopolies that provide an essential service for all of us, their calls for more fixed charges to reduce risk deserve more scrutiny.

The issue at hand is not simply a matter of what solar and non-solar customers should pay. Nor is it just a matter of how to align rates with costs. We must ask instead: How will IOUs best serve the public? What risks should they assume? And how do we compensate them for performance? 

Using the regulatory compact to protect shareholders from risks will only hurt shareholders. As Hempling writes: “Utilities often cite the ‘compact’ self-referentially, as if it is their compact, created solely to support their specific revenue needs and their specific business success.”

However, this understanding “… misstates the constitutional relationship between investors and regulators, and between investment and rates. There is no ‘compact’ for a simple legal fact: The constitutional protection of shareholder property is far from airtight.” 

The push for fixed charges merely masks long-term trends for utilities, aptly described in Deloitte’s “The Math Does Not Lie” series. More fixed charges do not solve the math for shareholders. Rather, they entice shareholders to invest even more – to double down when they may be holding a potential bust hand. 

Regulation of monopoly franchises requires that IOUs serve the public, not the other way around. Current discussions about cost-recovery imply that the public must figure out how to pay utilities regardless of their value and prudence. But focusing on cost recovery is actually a dangerous game for IOUs. The topic invites questions utilities might rather not answer. And it opens the debate to people who do not fully understand utility regulation, whose opinions about compensation for prudently incurred sunk costs may vastly differ from those of utilities.

IOUs would be better off focusing less attention on what the public owes them and more attention on how they can best serve the public. IOUs have a great opportunity to redefine their roles, especially as public needs change. Delivering safe, reliable, and low-cost electricity is no longer enough. The public wants more choice, cleaner energy, and a more dynamic and resilient grid. Utilities can play an important role in making this happen. But they must demonstrate value and cost-efficiency in doing so. 

We thus support EEI’s efforts in steering utilities to a more constructive path by acknowledging the potential public benefit for more electrical vehicles (EVs) and how utilities can facilitate their deployment. EVs can reduce oil dependency, improve grid stability, and provide cleaner transportation, which comprises the largest source of carbon emissions in the U.S. after the electricity industry. 

Total U.S. greenhouse gas emissions by economic sector in 2012

More fixed charges don’t create more market incentives for EVs, however. On the contrary, they can reduce the pricing signals of variable energy and demand charges or depress the need for time-varying rates, from which EV owners can greatly benefit. And EVs are but one example of myriad distributed energy resource technologies with similar promise and benefit to the grid at large. 

We recognize utilities are entitled to fair compensation and that some level of investment waste is inevitable and reasonable – even for efficient businesses. We also acknowledge that cost-shifting should not be ignored. But one-sided discussions that insist that ratepayers are solely responsible for fixed costs are counterproductive. They will hurt the public, hurt innovation, and ultimately hurt utilities’ shareholders.

Editor's Note: This article is the third in a series from Tong and Wellinghoff looking at issues surrounding utilities, distributed energy resources, and the grid. The first piece addresses the common confusion over "cost-shifting" and "not paying your fair share"; the second piece argues that fixed charges are a "false fix" to industry challenges.

The series has sparked a dialogue over utility-solar issues in Utility Dive's opinion pages. Edwin Overcast, a director with Black & Veatch's management consulting business, issued a response to Wellinghoff and Tong, explaining why fixed charges are a good solution to the solar challenge. Ashley Brown, the executive director of the Harvard Electricity Policy Group, issued another response to Wellinghoff and Tong, arguing that solar should not be net metered at the retail rate. Tyler Huebner and Brad Klein, the executive director of RENEW Wisconsin and a senior attorney at the Environmental Law & Policy Center, respectively, gave their opinion on utility fixed charges in Wisconsin — and why data is the key to determining solar's real value. 

If you are interested in joining the ongoing dialogue and submitting an opinion piece, please email us at [email protected].

Filed Under: Solar & Renewables Distributed Energy Regulation & Policy