Nudging Utilities Into the Future

by Joseph Tomain

Two of the most important aspects of the Clean Power Plan (CPP) are the flexibility afforded states as they design compliance strategies and the plan’s openness to all energy resources. A state can satisfy its emission-reduction targets through the use of cleaner or more efficient coal-fired generation, natural gas or nuclear power as well as through increased use of renewable resources and energy efficiency. Regardless of this flexibility and openness, investor-owned utilities (IOUs), which have dominated the electricity market for more than a century, tend to resist the imposition of additional environmental regulations. Some resistance is predictable as utilities have sunk trillions of dollars of investments into the construction of generation, transportation and distribution networks..

While this resistance may be understandable, there are two significant rebuttal arguments to it. First, utilities have demonstrated remarkable resilience, particularly over the last three or more decades, to dramatic challenges to the traditional electricity industry. Second, public policy and state regulation have, for almost as long, promoted a clean energy economy. The CPP continues developing that clean economy and utilities have a role to play in a cleaner energy future. Let’s look at both of these points more closely.             

Challenging the Electric Industry

The electricity industry has been roiling for three or more decades.[1] For the first two thirds of the 20th century, the industry continued to realize growth and, with it, increasing sales and profits. By the mid- to late 1960s, however, things began to change: A national electricity infrastructure was completed; electric generation plants reached a technological plateau; and, the cost of electricity from traditionally structured electric utilities began to rise. These events, among others, shook the industry from its complacency. And, while it may be fair to say that the CPP presents a challenge to traditionally structured IOUs of the sort that they have not encountered before, it is a reality that the industry has successfully confronted dramatic challenges in the past. Three such challenges are notable.

Increased Prices. The first challenge began in the mid-1960s as electricity prices rose. Price increases were inevitable because regulations encouraged IOUs to continue to build more plant even to the point of excess capacity.[2] In short, IOUs were compensated for all of their prudently incurred expenses on a dollar-for-dollar basis. Then, in order to attract funds, IOUs could receive a reasonable rate of return on their capital investments. As a result, this pricing method encouraged utilities to continue to invest in and build more plant. The problem with increased construction was that once demand flattened, utilities then had excess generating capacity and the cost of electricity began to rise.[3]

The price rise from IOUs suggested that a profound change in the industry was afoot. More specifically, it indicated that electricity from IOUs might be overpriced and that other electricity providers might be able to produce electricity more cheaply. The potential availability of cheaper electricity turned out to be a reality because of an increase in the number of non-utility power producers, and because regulators were indeed interested in getting cheaper electricity to market through restructuring electricity regulation.

Industry Deregulation. The second challenge came with efforts to deregulate the electric industry and, when that failed, to restructure it. During the 1980s through the 1990s, regulators attempted to deregulate wholesale and retail electricity markets. Those deregulatory efforts, however, were only partially successful for wholesale sales and much less so for retail sales. At the wholesale level, deregulation looked promising and was successful to a significant degree. At the retail level, however, the continued natural monopoly characteristics of the distribution and transmission segments prevented full deregulation from occurring.[4] Many states, however, did attempt retail deregulation, but California’s notable failure threw two major utilities into insolvency with Pacific Gas & Electric declaring bankruptcy.[5] With the failed California experiment, restructuring effectively ended but left IOUs with huge financial bills that they incurred in trying to comply with restructuring regulations.[6]

Nuclear Failure. The third challenge came from the failed nuclear experiment. Nuclear power was not, as promised, “too cheap to meter,” instead, it was too expensive to produce. From the mid-1970s into the 1980s, the nuclear industry collapsed with significant repercussions for both shareholders and ratepayers. Utilities that had invested in nuclear power found themselves with excess capacity, canceled plants, or the conversion of nuclear plants to coal-fired plants – all at great expense. These nuclear investments ran into the billions of dollars, leaving federal and state regulators to apportion costs between ratepayers and shareholders, which they did through a variety of mechanisms.[7] In brief, the regulatory response to the nuclear crisis was to protect some of an IOU’s investment and to maintain their financial stability while not overburdening consumers.

IOUs and regulators were able to respond to those three challenges through various adaptations of traditional cost-of-service ratemaking.[8] In brief, there was enough flexibility in the traditional formula to address those challenges and IOUs weathered each of those financial storms. Such success indicates that IOUs will also weather the CPP.

A Clean Energy Future

It is also noteworthy that even as IOUs responded to the challenges above, the electric industry was changing. Prior to 1978, IOUs generated about 70 percent of U.S. electricity.[9] Today, privately owned IOUs continue to generate 42 percent of the electricity with another 42 percent generated by private non-IOU firms, and the remainder provided by various local and federal power sources.[10] While a significant portion of that drop in IOU market share can be attributed to industry restructuring, the reality is that the industry is more competitive today than it has been the past. Not only must IOUs compete with other power providers, they must compete with reduced demand, energy efficiency, and customer-generated electricity products such as roof-top solar. Today, not only is the emerging electricity market more competitive; it is cleaner.

The CPP is consistent with the changes that have been evolving over the last few decades. States have been promoting renewable resources, energy efficiency and conservation through a variety of regulations including renewable portfolio standards, feed-in tariffs, energy efficiency standards and the like. For decades now, public policymakers and state regulators have been promoting the idea of a clean energy future with two central arguments.[11] First, environmental sensitivity and sensitivity to the risks associated with climate change necessitate that attention be paid to greenhouse gas emissions. Second, a clean energy future, particularly one that incorporates conservation and energy efficiency, is an economically attractive future.

IOUs, in turn, have been complying with those regulations and in the process they are rethinking their business models. The CPP, because it is consistent with those state regulations promoting a clean energy future, simply provides an added impetus for IOUs to adapt. The CPP nudges utilities to reconfigure themselves from firms that sell only electricity to firms that will provide a variety of energy products and services. The utility of the future will sell clean power; promote renewable resources; “sell” efficiency; help finance consumer adoption of energy savings appliances and controls; engage in two-way information and energy sales between consumers itself; and, pay attention not only to its public obligation to provide affordable and reliable electricity, but to its obligation to the public to work toward a a clean environment.

The CPP is far from a radical challenge for IOUs. Instead, it is consistent with the direction the industry has been going for decades now; it simply confirms the need for a clean energy future and provides reasons and tools for IOUs to satisfy those obligations as they transform into the utility of the future.


[1] Karl McDermott, Edison Elec. Inst., Cost of Service Regulation in the Investor-Owned Electric Utility Industry: A History of Adaptation 17 (2012); Peter Kind, Energy Infrastructure Advocates, Disruptive Challenges: Financial Implications and Strategic Responses to a Changing Retail Electric Business 1 (2013).

[2] Harvey Averch & Leland L. Johnson, Behavior of the Firm Under Regulatory Constraint, 52 Am. Econ. Rev. 1052 (1962); Joseph P. Tomain & Richard D. Cudahy, Energy law in a Nutshell ch. 4 (2d ed. 2011).

[3] Leonard S Hyman at 164 (Table 19-1) 170 (Table 19-6) and 188 (Table 20-7).

[4] Joseph P. Tomain, Whither Natural Monopoly?: The Case of Electricity in Peter Z. Grossman & Daniel H. Cole (eds.), The End of a Natural Monopoly: Deregulation and Competition in the Electric Power Industry 111 (2003).

[5] Laura M. Holson, California’s Largest Utility Files for Bankruptcy, N.Y. Times (April 7, 2001)..

[6] Sidney A. Shapiro & Joseph P. Tomain, Rethinking Reform of Electricity Markets, 40 Wake Forest L. Rev. 497 (2005); Joseph P. Tomain & Richard D. Cudahy, Energy law in a Nutshell 408-22 (2d ed. 2011).

[7] Joseph P. Tomain, Nuclear Power Transformation (1987); Richard J. Pierce, Jr., The Regulatory Treatment of Mistakes in Retrospect: Cancelled Plants and Excess Capacity, 132 U. Pa. L. Rev. 497 (1984).

[8] See e.g. Karl McDermott, Cost of Service Regulation in the Investor-Owned Electric Utility Industry: A History of Adaptation viii-x and 17-40 (June 2012) (a report for the Edison Electric Institute). In addition to nuclear power and restructuring , McDermott notes other periods of stress including the rise of inflation during the 1970s, excess capacity in the 1980s, and a current challenge to restore customer and investor confidence in the industry.

[9] Hyman at 157(Table 18-7) (8th ed.2005).

[10] U.S. Energy Information Administration, Electric Power Industry Overview 2007 available at http://www.eia.gov/electricity/archive/primer/;Hyman at 217 (Table 21-7).

[11] Joseph P. Tomain, Ending Dirty Energy Policy: Prelude to Climate Change chs. 3 & 4 (2011).

 



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