Not since Billy the Kid’s gang was named “The Regulators” has regulation of any sort seemed exciting, but a new book about the governance of the electric power industry gets surprisingly close.
More than a typical textbook, the second edition of “Electricity Regulation In the US: A Guide” from the Regulatory Assistance Project (RAP) matches Utility Dive’s daily effort to make the complicated subject of electricity as interesting and straightforward as other important daily news stories.
That's why the book is required reading for Pace Energy and Climate Center interns and energy law students at the Elisabeth Haub School of Law, Executive Director Karl Rabago told Utility Dive.
The traditional approach to law is having students read case decisions and discern how law and legal logic informed them, Rabago said. “The [RAP] book shows how specific regulatory questions interact with the law in real world situations.”
Lead author Jim Lazar and the staff of the Regulatory Assistance Project “have taken an extremely complex topic and broken it into reasonable and bite-size chunks and explained them clearly,” said Rabago, a former regulator with the Public Utilities Commission of Texas.
Energy law requires an understanding of law, policy, and economics and “it would be a fool’s errand to try to teach electricity regulation without covering all three,” Rabago said. “This is a tool that allows me to introduce my students to basic economic and regulatory concepts and how they are applied in administrative law. The result is practice-ready lawyers.”
With climate and energy growing in importance, the book is also timely, Rabago added, “and it is clear Lazar knows his stuff.”
For anyone — industry veterans and curious consumers alike — seeking to understand the intricacies of electricity regulation and how it affects society, the book delivers authoritative answers in clear, digestible language.
The big picture: what regulation is and why it's needed
Lazar’s text appropriately opens with an explanation of why utilities need to be regulated.
They provide “essential services for the wellbeing of society” but utilities' unique “technological and economic features” limit competition among them, he writes.
“A single provider is often able to serve the overall demand at a lower total cost than any combination of smaller entities” and “eventually, all firms but one will exit the market or fail,” the book goes on. The surviving providers are “natural monopolies” and could “restrict output and set prices at levels higher than are economically justified.”
Regulation, the book explains, “is the explicit public or governmental intervention into a market that is necessary to achieve public benefits that the market fails to achieve on its own.”
The book is equally clear on the “complex” role of the regulator.
“Ensuring reliable service at reasonable cost while meeting societal goals involves balancing the interests of utility investors, energy consumers, and the entire economy,” Lazar writes.
Because “lowest possible cost” can conflict with “public goals,” regulation is managing “the environmental impacts of the utility system while also assuring reasonable prices, reliability, and safety.”
By imposing “net benefits,” regulators may leave some better off but some worse off. Facilitating new opportunities with new technologies can also introduce new challenges.
To cope with the complexity, regulators must educate themselves on technical issues and policy. Public involvement should be invited and inexperienced participants should be tolerated. But regulators should also “expect respect” for regulatory principles, and a “dignified process,” “facts,” and “reason,” according to Lazar.
Regulators should work to set a clear understanding of a major proceeding’s objectives at the outset, the book recommends. Regulators should also recognize the value of moving some issues out of “the contested rate case framework and into more collaborative approaches."
The goal is “a problem-solving and constructive working relationship among the various participants, and an efficient, thorough, open, and complete resolution of important issues,” the book adds.
Traditional regulation: Strengths, weaknesses and fixes
Many of the key tensions regulators now face involve reconciling traditional “cost-plus” regulation with climate goals and the complicated economics of emerging distributed energy resource (DER) technologies.
That is a big part of why the book is resource material for work being done by graduate students at the University of Texas Energy Institute supervised by Research Fellow Roger Duncan, a former Austin Energy General Manager.
The students are taking a "comprehensive look at electricity business models" as part of a larger study on "the full cost of electricity," Duncan told Utility Dive. The Lazar book is both detailed and comprehensive and offers “overall guiding principles” for his students, he added.
“The book covers all the rate issues I know of that are now being considered in regulatory and legislative proceedings around the county,” Duncan said. It also “drills down to the core points of contention.”
And, he added, the book “broadens the rate design principles that were developed decades ago with new perspectives that fit the new technologies we are dealing with today.”
Its chapter on cost-plus regulation, and the alternatives to it, is an example of the qualities Duncan described in the book.
Cost-plus regulation allows regulators to grant utilities revenue recovery through “just and reasonable rates” for “prudently incurred costs associated with used and useful investments and expenses,” the book reports.
In regulatory proceedings, DER advocates echo the argument famously made by Averch and Johnson that “utilities will spend too much on capital investments because their allowed return is a function of their investment,” it explains.
Averch and Johnson are right that cost-plus regulation encourages utilities to “gold-plate” their systems with over-investment in infrastructure, Lazar writes, while obstructing non-capital expense opportunities.
Cost-plus regulation inclines utilities to prefer capital expenditures they can prove are “used and useful,” and disinclines them to innovate for fear of being unable to justify the costs to regulators.
“Creative change involves risk, and if the only potential ‘upside’ is cost recovery, while the potential ‘downside’ is a disallowance, utilities may be hesitant,” Lazar writes.
The “Averch-Johnson effect” is also an incentive to utilities to drive more electricity use by customers. Profits come from returns on infrastructure investments. Electricity sales justify infrastructure investments. This works against public goals to reduce consumption through support for DER.
Increased sales of “lowest cost” generation can also add to utility profits under cost-plus regulation. This too can go against public goals that are often met with higher cost new technologies, the book adds.
Finally, utilities may benefit from the “regulatory lag” that comes with cost-plus regulation. If costs rise faster than approved rate increases, "expense reconciliation mechanisms" can alleviate utility revenue shortfalls, it explains. But if costs rise or sales increase between rate cases, utilities' profits may rise without a rate increase.
Regulators, faced with the need to “encourage innovation while protecting consumers” from inappropriate utility investments, will find their options well cataloged in the book's full range of evolving rate structures.
Fixes: Decoupling, PBR and more
Decoupling, or revenue regulation, “is a slight but meaningful variation on traditional regulation,” Lazar writes. It is intended “to remove a disincentive for utilities to embrace energy efficiency or other measures that reduce consumer usage levels.”
With decoupling, the general rate case process is unchanged but, after is it settled, rates can be “adjusted periodically,” the book explains. If sales rise or fall from the levels assumed in the GRC proceeding, rates increase or decrease to the maintain utilities revenues. The decoupling mechanism can also include revenue adjustments for pre-defined factors like growth in the number of consumers, the book adds.
Performance-based regulation (PBR), more of a departure from traditional cost regulation, provides utilities with opportunities to increase their profits “by constraining costs rather than increasing sales.”
Multiyear rate plans are established with pre-approved regular rate increases tied to inflation, productivity, or other predictable changes in costs. “If the utility invests in expensive new facilities, its costs will grow faster than its revenues, so it has an incentive to constrain expenditures,” the book explains.
“Commissions have learned to establish strict service quality standards when approving multiyear PBR mechanisms, because experience showed that some utilities took actions to improve earnings at the expense of reliability and customer service quality,” it adds.
Innovative “mechanisms to reward utilities that take specific actions or achieve specific goals” are a way regulators can create "circumstances like those the utility would face if it operated in a competitive market,” the book explains.
Those mechanisms include helping customers manage electric bills, growing customer energy efficiency use, or meeting commission-set reliability goals. Rewards must be “large enough to be meaningful to the utility, but not so large as to create significant rate impacts for consumers,” the book adds. This kind of incentives “are increasingly recognized as sound regulatory practices, for which consumers are well served.”
Lazar and RAP also go into “Competitive Power Supply Procurement,” “Utility Restructuring,” “Prudence and Used-and-Useful Reviews” of utility investments, “Integrated Resource Planning,” and “Integrated Distribution System Planning” in equally thorough terms.
The regulatory compact
Along with outlines of utility regulatory models and innovations, Lazar also includes a number of ponderable passages on the broader foundations and purposes of regulation.
“Regulation constitutes an agreement between a utility and the government,” he writes. “The utility accepts an obligation to serve in return for the government’s promise to approve and allow rates that will compensate the utility fully for the costs it incurs to meet that obligation,”
“This implied agreement,” he writes, “is sometimes called the regulatory compact.”
Every regulation creates limits on what utilities can do, Lazar acknowledges, but regulators also have the power to use utilities’ profit incentive to create societally optimal outcomes.
“[E]very regulation also gives the utility incentives to act in ways (driven generally by the desire to maximize net income, or earnings) that may or may not promote the public interest,” he writes. “Given any set of regulations, utilities will take those actions that most benefit their principal constituencies — shareholders and management —while meeting the requirements of the regulations.”