Renewable sources of power generation, such as solar, wind, and batteries, are displacing fossil fired power generation. The reason? Price. They produce power more cheaply. This is also a little more complicated because this is also a technology transition away from fossil fuels, and its assimilation rate throughout the economy is accelerating. But when competing businesses, which produce the identical commodity, such as electricity, begin to diverge radically in terms of their underlying cost structures, winners and losers emerge.
One of the collateral victims of increasing renewables penetration may be our state and federal public utility commission regulatory framework. The specifics here are complicated, and we’ll address them later. But the underlying reason for inevitable regulatory failure is simple. Regulators today are like the proverbial one trick pony. All they can do is decide to raise customer rates (and by how much). That’s why we hear so much from critics about the supposedly inevitable utility death spiral where commission authorized rate increases lead to a cycle of customer (and revenue) losses which are offset by further rate increases until financial distress occurs. We’re not big fans of this hypothesis although we would watch whether large C&I customers could be bid away from the utility by renewables providers. There is way too much growth in power demand right now for defections from the utility to be an immediate problem. But we still argue that regulatory weakness is embedded in the nature of the institutions and is thus incurable.
lated: Little-Known US Company Lands Important Pentagon Contract in Rare Earth Race
The first state public utility commissions appeared in the US in 1907, just as central station power was making extraordinary gains in efficiency.. The first fifty years of utility regulation involved overseeing an almost unprecedented industry expansion that began as a modest urban enterprise and ended with the concept of universal service. The regulators had to balance one problem: How do we finance utility system growth and avoid exploiting captive customers? Our argument about where we go from here is simple. These are not administrative agencies that are even remotely capable of running in reverse. And not because of concerns about agency “capture” by the industry, which may or may not be valid. They can’t because of the interesting idiosyncrasies of the utility business.
There are two kinds of expenses for utilities, fixed and variable costs. Fixed costs represent the hard assets of the business (generation, transmission, and distribution), while the biggest variable expense is fuel. The main focus of early ratemaking until the price chaos and inflation of the 1970s was mainly on the fixed cost side, plant and equipment. The entire edifice of cost of service ratemaking, the essence of utility ratemaking, basically asks the corporation two questions: 1) How much did you spend on plant and equipment to serve the public? and 2) what is the appropriate capital structure (the % of equity versus debt) and the appropriate return on shareholders’ equity that should be used to determine rates. They could do so safely because the utilities steadily reduced operating costs, which redounded to the benefit of consumers.
Related: How China’s Rare Earth Ban Backfired into a U.S. Tech Breakthrough
And this is where the nasty business of technology transitions rears its ugly head for incumbent utilities. If regulators were to ask the renewables providers the same cost of service question as the current utility incumbents, how much did you spend to provide electricity to the service area, their answer would be, “a heckuva lot less than legacy utilities because we have no fuel costs. Oh, and we don’t need all that expensive equity in our capitalization structures either. Low-cost corporate debt rates are fine with us.” A corporate balance sheet consists of assets (what does the corporation own) and liabilities (how did they pay for those assets). The renewable providers address both sides of the balance sheet in a financially superior way. Their production costs are lower (zero fuel expenses), and their financing costs are also lower (less equity). They can tolerate much higher debt levels because their business risk is much lower. (For example, solar companies did not see a dramatic spike in fuel expenses as a result of the Iran war.) At a fundamental level, there is no true response to a competitive disadvantage this profound short of capitulation. It’s not that regulators can’t try to help existing utilities. They will. It’s that they simply don’t have effective tools.
These issues never occur in a political vacuum. Affordability of electricity is front and center in the public’s imagination, thanks to rapidly rising electricity prices and a considerable amount of press. Election of regulatory officials, typically a low key affair, is also gaining more popular attention. And remember, the public utility commissions can’t really lower prices. Fuel costs are what they are and the utilities are simply price takers. These expenses are a direct pass through to customers. And the assets to serve the public are fixed and their costs grow at least at the rate of inflation, if not more just to maintain a steady state.
We believe we are witnessing the twilight of utility regulation as we know it due to the emergence of cheap renewables displacing fossil fired power generation. But we don’t think the existing regulatory apparatus will give up without a fight. We expect two very distinct efforts at regulatory reform, both of which are doomed because they refuse to acknowledge the technology transition underway, which creates winners and losers. Rate design will be pursued first because, in a way, it’s easier. This is about fixed charges versus volumetric rates and how to make rate design more fair for all customers. While producing a more equitable rate design, this ignores the competitive challenges faced by utility incumbents. The second reform effort, aided in part by the current municipalization movement, is to rein in utility returns on equity, essentially claiming that utilities are earning excessive profits. While we are sympathetic to this effort, our problem here is that, from a utility balance sheet perspective, they are proposing a liability side solution to an asset side problem. If the utility’s assets are ultimately uncompetitive versus renewables it does not matter how they are financed and if that financing rate is excessive.
Finally, we believe that the role of regulators in the next few years will be essentially palliative. We think their role will be to provide an air of normalcy to a utility industry undoing a dramatic technology transition away from expensive fossil fuels usage. To us regulators resemble one of those formidable Antarctic ice shelves gradually being undermined by climate change induced warm water. To the inexperienced observer, these ice giants look as if they will be around forever. And then they’re gone.
By Leonard Hyman and William Tilles for Oilprice.com