Utility regulation in the Anthropocene
Energy Innovation's Sonia Aggarwal on how regulators can guide the power sector to a sustainable future
Editor's Note: The following is a guest post from Sonia Aggarwal, vice president at the research firm Energy Innovation. This paper was written as background to aid a discussion about the future of utility regulation among the leaders from around the world. It describes goals for the sector, goals for regulators, and specific actions that can help achieve these goals.
The electric utility is going through a rapid and profound transformation.
Reliability was once one of two main concerns for the utility, but in the face of extreme weather events and security threats, the focus must increasingly move toward resilience—the ability to self-heal and take advantage of the statistical stability of a diverse portfolio of resources.
Cost was once the other principal concern, but affordability becomes a new challenge as the revenue engine of load growth slows even as grid investment is needed to modernize—affordability becomes about keeping bills low by giving customers choices to pay for what they really value.
Environmental performance has now risen to the same level of importance as those original utility goals, as we witness the impacts of our power systems on public health and disadvantaged communities and we scream toward the precipice marked by our global carbon budget.
Finally, monopoly utilities once considered “ratepayers” captive, but with increasing options available to customers from third parties, utilities in developed economies face a choice between customers leaving the grid en masse, or an internal revolution in utility culture to become true customer service providers.
The challenge of deep decarbonization magnifies and complicates these fundamental imperatives, but may also offer opportunities for utilities. Extreme weather spells system stress, and utilities can choose to respond to that stress by hardening the grid in traditional ways or they can look to new approaches that take advantage of flexibility to drive toward a more resilient system. Both require investment.
In many developed economies, load growth has stagnated, but deep decarbonization likely involves electrifying vehicles, buildings, and factories to the maximum extent possible. This could be a huge opportunity for utilities, not only in terms of new revenue associated with new investment and load growth, but also in terms of creating a vast resource of controllable demand that can be used intelligently alongside variable supply.
The role of the regulator
Today’s utility regulators cannot simply preside; they must guide policy. In this period of transformation, regulators have an outsized role in easing the transition from an old view of utility function and grid operations into a wholly new approach.
Not just an outsized role, in fact; this kind of transformational work is an obligation if regulators are to effectively support the public interest. The call of the day is an orderly and affordable transition to a more resilient, clean power system that continues to serve all customers well into the future.
Weathering this transition as a regulator requires internal resilience as well. Some businesses will become unviable, and they will not go quietly into the night. This is to be expected, but requires a watchful eye to minimize mischief in markets and rate cases.
Jobs will be on the table, and it is critical to think about a just transition for the workers who hung their hats on the industries that helped our nations grow into economic powerhouses. Large institutions that have focused closely on reliability for decades are often constitutionally resistant to change. So they will need clear, persistent signals from regulators to innovate, or they will fail.
But there will also be vast opportunities. Healthier kids in our communities will enjoy breathing cleaner air. Smart technologies can help balance variable supply and dispatchable demand in a way that delivers the same or better customer comfort. New clean energy industries will grow, creating jobs in places that desperately need them. And with careful regulation, utilities can continue to thrive even as customers get the services they want.
How regulation can lead us to the future
The principal way to lead toward this future is to approach each decision with an eye on the top goals for the utility sector: resilience, affordability, environmental performance, and customer service. Each decision an electric utility regulator makes will bear on these goals. For example, decisions about how to count capacity value of different generation resources or how grid services are defined in an auction can have profound implications for whether new kinds of resources have a fair chance to compete to provide energy services.
Regulators can take three primary steps to set the electricity system up for success, and then consider additional actions to create an enabling environment for the power system of the future:
Several regions have already adopted some form of performance-based regulation, and this structure is providing new opportunities for innovation in the utility sector.
Traditional cost-of-service regulation allows utilities to earn a rate of return on all capital investments, and to pass through most operational expenses. Performance-based regulation shifts some of the utility’s profit incentives toward achievement of top goals.
For example, a 200 basis point adder could be available to utilities if they meet quantitative targets like CO2/capita, and a symmetrical penalty assessed if they fail. This kind of mechanism can be used to shift an appropriate amount of risk onto the utility for meeting important societal goals, enabling them to use their role as market makers to drive outcomes in the public interest.
Performance-based regulation can (and should) be designed with customer affordability in mind, via normalized revenue caps with “productivity factors,” for example. This structure contains costs and makes utilities most profitable when they serve as a platform for customers to access clean energy and demand management services. As former Colorado regulators Ron Binz and Ron Lehr say: performance-based regulation shifts the central question from “Did I pay the right amount for what I got?” to “Am I paying for what I want?”
A financial structure that pays utilities for outcomes can set the table for innovation in a historically staid industry. Well-designed performance-based regulation aligns utility decision-making to accomplish a clearly-defined goal, opening up opportunities to try new things that may produce some good surprises.
Fairer wholesale markets
Competitive power markets were designed at a time when large power plants dominated the power mix and minimizing costs meant running the big ones as often as possible and then dispatching flexible resources to meet uncontrollable demand around the edges. We are entering an era that flips this paradigm. Low-cost generation is becoming more variable at the same time as demand becomes more dispatchable. In order to take advantage of new, cleaner, low-cost technologies, the grid must be managed in a much more dynamic and flexible way.
Wholesale power markets need to catch up by updating their rules and product definitions to expose the value latent in today’s power system, and to incent the new capabilities—like flexibility—that will become more valuable as our generation mix evolves.
The interface between transmission and distribution grids demands special care if resources at the distribution scale are to provide their full value to the integrated grid. Regulators can also begin to think about the long-term changes that will be required if the power system is to operate cost-effectively with a high share of low- or zero marginal cost resources.
Handling 'stranded assets'
As the power system turns over to become cleaner and more resilient, regulators must pay attention to claims about stranded assets. In vertically-integrated regions, the choices utilities and their regulators make about these stranded assets can have major implications for customer affordability.
Once a power plant is built, there is a certain inertia created around it (pun intended). Analysis by the Climate Policy Initiative (confirmed by Moody’s) in the U.S. finds about half of the nation’s coal plants are uneconomic on a marginal cost basis compared to the all-in capital and operational costs of a new wind facility in a nearby region. But investment inertia is keeping many of these plants operating. Enabling utilities to securitize the undepreciated balance in an old, uneconomic facility can enable it to recycle that capital into more productive, cleaner alternatives at a savings to customers.
One other important note here is that it is not the network regulator’s job to manage stranded generation assets in restructured regions with competitive generation. Private owners of generation took on the risk that their facilities may one day not be able to compete in exchange for the opportunity to earn higher returns in the interim. Today, many owners of power plants that are no longer able to compete in markets are going to grid operators to request changes to capacity market rules to cover their costs, but capacity markets were designed to signal the need for new investment, not keep uneconomic assets around. A well-functioning capacity (or energy) market will send the appropriate price signals to bring the system back into equilibrium as old plants retire.
The enabling environment
Beyond these three steps, regulators can also help ease the transition to a cleaner, more resilient and affordable grid by using their power to create the enabling environment.
Wind and solar are growing like gangbusters, largely because they have come down in price much faster than almost anyone thought possible. But relying on wind and solar will require a flexible and dynamic electricity system. Luckily, there are many sources of flexibility available to grid operators: transmission and balancing over a more diverse portfolio of resources, aggregated demand-response, managed charging of electric vehicles or other dispatchable load, fast-ramping natural gas running a minimum number of hours to provide ramping and storage. Modern IT and grid management systems can optimize these resources in real-time, and fairer wholesale markets can propagate the right price signals for flexibility. Regulators can support all of these options.
The opportunity for electrifying more of the economy can offer tremendous help through this transition. The electric grid can help decarbonize vehicles, buildings, and parts of industry at the same time as it takes advantage of each to drive growth, investment, and new sources of flexible demand. Utilities can be engines for electrification and system optimization.
It is the responsibility of the regulator to serve the public interest. This responsibility brings with it a new and expanded role during today’s transformation of the global power system. Regulators must take an active role, since foresight and careful management are required to facilitate this deep transition with appropriate speed, all the while maintaining order. But a great victory is within reach: we have the tools and the technology to operate a resilient, affordable, clean grid with high quality electric service for all.
 Chung, Jairo et al. Rate-Basing Wind Generation Adds Momentum to Renewables. Moody’s Sector In-Depth: US Power and Utilities. 15 March 2017.