Utility Regulation, Old and New

God forbid that you have a job that requires you to read the orders issued by public utility commissions (PUCs). As a regulator, I not only have to read them—I have to write them. And even I marvel at the arcane, trial-like proceedings of PUCs and the orders that emerge from them, which are the basis for most of the revenues earned by U.S. electric utilities. As much as it is my job to set rates, it’s also my job to demystify the process PUCs use in making those decisions.

In the “Good Old Days…”

The basic regulatory model of the past was relatively uncomplicated. A company began offering electric service in a densely populated area, persuaded the local government or legislature to give it exclusive franchise, and in return the prices it was able to charge consumers were regulated by a PUC.

The utility was the monolith, providing all the services. In telecom, Ma Bell owned everything—from the central office switch to the telephone you used. Electric utilities marketed appliances, but eventually settled down in a model of owning all equipment from the power plant up to the customer’s meter.

How did regulators establish prices? Not the way a competitive market would. Unregulated firms will, of course, sell to customers at as high a price as they are willing to pay. Competition between those firms drives prices down, toward the marginal cost of producing the next unit a company wants to sell its customer. Monopoly utility regulation modifies that proposition, holding that a price should be equal to a utility’s reasonable costs.

This “cost-of-service regulation” sounds simple. It isn’t. First, a regulator must divine whether all of a utility’s costs are reasonable—how big should the total pie be? Second, how should the pie be divided, or allocated, to particular types of customers? Third, the complicated division problem central to it all: how to take the particular lump sum of revenue that should be collected from a group of customers and break it apart into particular rates (per kWh of energy or per kW of demand) based on expected sales volumes.

Let’s focus not on the first element of that work but on the second and third. This work—cost allocation and rate design—is undertaken at PUCs by people who used to be called “rate engineers.” (Now, drearily, they are usually just “analysts.”) Their job is to divide an integrated network into its various functions and assign the attendant costs to groups of customers on the basis of energy, demand, customer count, and other factors. A high load factor customer may use more energy than 1,000 residential customers, but far less of the system’s capacity at its peak than those residential customers at theirs. How, in that example, should a coal plant be paid for? A simple cycle combustion turbine? A new substation? A transmission line?

New Regulatory Realities

When Ma Bell was finally exploded by anti-trust litigation, it quickly became apparent that telecom’s regulatory cost-allocation process was filled with cross-subsidies. It did not actually cost that much to make a long-distance call, but you wouldn’t know that from the regulated rates, where proceeds from long distance subsidized other services. Many people now pay a kind of capacity charge for their cellular service and are not confined to a certain number of phone calls or text messages.

This dynamic is now playing out in the electric sector. When a monopoly utility provides all the services, errors in the cost-allocation process do not often have visible consequences. One customer might be overpaying for energy and another underpaying for capacity, but unless one of those customers—say, a manufacturer—literally cannot make ends meet and closes, hidden subsidies linger.

The big difference between that old utility world and the one of today is the presence of consumers and others who also produce services in competition with the utilities. Under the most typical regulatory scheme to compensate owners of rooftop solar photovoltaic (PV) panels, called net metering, consumer-side PV competes horizontally with the per-kW price of energy a regulator has set. If that price does not actually reflect the cost of distributed energy supply, in the same way a long-distance rate overstated Ma Bell’s actual costs, it means someone (the incumbent or the new producer) is benefitting from a regulatory arbitrage.

Unlike the telecom industry, where multiple networks in competition have seemingly thrived, electric utilities still have the look of natural monopolies, with a few exceptions. Power generation has been made competitive in some markets, allowing regional transmission organizations to run auctions for the products generators provide. But that isn’t the case everywhere, and it isn’t the case anywhere for most transmission and distribution services. That means regulators won’t be getting out of the price-setting business anytime soon.

Even More Regulation?

Ironically, regulation may even increase with these new competitors. We may be moving away from the command-and-control regulation that was used to oversee monopolies that owned it all, to a type of regulation that specifies products and designs markets that those products are traded within. That’s a less-blunt, but more-complex form of regulation.

Regulation is evolving, and it’ll probably have as many variations as there are states. Stay tuned. And try reading a PUC order once in a while. ■

—Travis Kavulla ([email protected]), the vice-chairman of the Montana Public Service Commission, is the outgoing president of the National Association of Regulatory Utility Commissioners.