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MN2020 - Modernizing the Utility (and Public Policy) Model
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Modernizing the Utility (and Public Policy) Model

February 19, 2014 By Maria Brun, Graduate Research Fellow

Historically, Thomas Edison and George Westinghouse are most often associated with bringing the modern day electrical grid to life. Modern is a fairly correct usage in this case because, despite technological changes over time, our electricity system as a whole has not fundamentally changed much since the 1800s. What has also changed very little is the electric utility business model whose creation can be credited to Samuel Insull.

Once electricity became a commodity that could be sold and distributed, Insull realized that the only viable way at the time to make the operation profitable would be to spread the high fixed costs of generation plants and support infrastructure across the widest customer base possible. To achieve a high customer base, balanced loads, and minimal transmission losses across distances, he also realized that a large, centralized system of electricity generation and distribution with only one provider would be the most efficient strategy.

From his insights and lobbying efforts, the highly centralized regulated monopoly system of utilities selling electricity as a commodity good was born.

Though some states have undergone deregulation in the last few decades, this utility business model still survives in a similar form today. But for anyone following the news, lately that business model has come under threat as more states and individuals embrace distributed (decentralized), clean energy technologies, energy efficiency, and conservation.

These “disruptive forces” as they are considered by many in the energy industry, are not just new technologies and behaviors that are changing the energy market, but, according to a report by the Edison Electric Institute, are wholly at odds with the utility business model. There is one core piece of this business model driving this conflict and, as a result, put the utilities wholly at odds with the public interest – its focus on selling energy as a commodity.

From a business perspective, this doesn’t seem like an unreasonable model. But there is a better model, both for utilities and for public interest that is well illustrated by the dilemma of energy efficiency and conservation.

On average in the U.S., it takes about 3 kilowatt hours of energy to produce 1 kilowat hour of electricity used by a consumer. Given this ratio, from both a financial and environmental standpoint, the most impactful savings to be had are the kilowatt hours not produced. Energy efficiency alone poses an estimated savings of $700 billion in costs, 1.1 gigatons of CO2, and could support a significant amount of new jobs by 2020. It’s also the cheapest way by far to meet electricity demand in the long run. So why are utilities at odds with such a win-win scenario?

Under standard regulatory process, the utility’s fixed and operational costs and a reasonable rate of return for investors is calculated and divided by the expected amount of demand for electricity, creating a rate per kilowatt hour. If a utility sells more electricity than estimated, it’s extra profits for the utility; if less, the utilities lose out but can recover costs per regulatory laws in the relevant state. Either way, for utilities, helping customers reduce their energy usage reduces their ability to cover costs and provide a return to their investors.

If not selling energy as a commodity, what’s left? One solution, already adopted for gas utilities in Minnesota, is decoupling. Decoupling removes the “throughput” incentive – the more they sell, the more they profit – the utilities currently have by changing the regulatory mechanism. Under decoupling, instead of setting a fixed rate based on projected sales, rates are adjusted periodically to match a utility’s revenues to those authorized to cover fixed costs.

The result: the utility business model shifts away from selling energy to providing energy as a service. This distinction may seem small, but it could make a big difference for efficiency and energy conservation.

On the flip side, public policy is guilty in some cases of exacerbating the situation by threatening the ability of utilities to recoup their fixed costs of operation. Aggressive net metering laws for distributed, clean energy generation, particularly for rooftop solar, are a prime example.

Though the electricity generated from household solar panels helps utilities avoid the cost of generating power on their own, these small systems also use utility infrastructure to distribute excess energy produced, often without paying for the use of the infrastructure. Net metering laws in some states are written such that utilities pay customers for the electricity generated at a rate higher than the avoided cost, incentivizing solar development but further interfering with a utility’s ability to cover its basic fixed costs of operating the grid.

Though some utilities have moved toward entering the rooftop solar business as a way to adjust and capture the market, most are in what Forbes labeled the denial stage in their end-of-life, spending more effort on battling net metering laws and lobbying for regulations that make it harder for households to go, at least partially, off-grid. Here again, not setting rates to cover fixed costs and valuing energy as a commodity is putting utilities squarely in conflict with the public interest. This time, however, public policy interacting with the old utility business model is to blame.

The Minnesota Value of Solar Methodology, due to be finalized soon, is an attempt to correct this by setting the rate paid to customers generating solar power as a function of the value of the energy, generation and transmission capacity, associated losses, and environmental benefits. Moreoever, it separates this value paid to the customer for generating solar power from their usage charges. By separating the usage and production transactions, utilities should be able to recover of the cost associated with serving those who generate solar power while the generators get fair compensation for the power they put into the grid.

Though piecemeal decoupling in the energy sector is moving forward and the Value of Solar Methodology is an example of public policy working with utilities, the bottom line is that it’s time for a change.

The utility business model first designed in the nineteenth century by Insull is not compatible with the needs and challenges of the twenty-first. At the same time, public policy should shy away from pursuing the public interest at the expense of the utilities. To meet our future energy needs in the most economically and environmentally sound way, regulators, policy makers, and the utilities need to work together to make fundamental changes to bring the system, the utilities, and the public interest into alignment rather than into conflict.

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