Utilities come under fire as a recent ruling by a federal judge agreed that the amount that electric transmission companies charge ratepayers for their infrastructure investments is too high. The current regulatory system caps utilities’ profit margins and then sets electric rates at levels that generate enough revenue to cover their costs. Currently utilities’ acceptable profit is capped at 10.57% of shareholders equity. This means that when utilities spend more money on infrastructure, by building pipelines and transmission lines, they actually boost their bottom line.
The decision by Administrative Law Judge Steve L. Sterner would reduce the return on equity (ROE) transmission companies are able to earn on their investments from 10.57% to 9.59% for for rates that were in effect between January 2013 and April 2014. It would also ensure that ROE in effect from July 2014 through October 2015 be no higher than 10.9 percent. Cumulatively the decision would result in a refund to customers of $234 million. This action is the result of ongoing litigation before the Federal Energy Regulatory Commission (FERC) initiated by the Massachusetts Attorney General’s Office in 2011. It is still up to FERC to approve the judge’s decision.
In most industries, companies generate revenue, deduct their costs, and are left with their profits. Regulated utilities work differently.
Under the regulated utility model, Public Utility Commissions (PUCs) serve as a replacement for the competitive market by determining how much utility companies invest and what their profit margin can be. This is historically known as the “regulatory compact,” laid out in the Binghamton Bridge Supreme Court case of 1865. PUCs, thus, determine a utility’s total revenue requirement, also known as a rate case, based on a number of factors, according to this equation:
Rate Case = (Rate Base x Allowed Rate of Return) + Operating Expenses
The rate base refers to the gross value of a utility’s assets on which they are able to earn a rate of return. The allowed rate of return, a percentage of the rate base, is a combination of the return on debt (ROD) and the return on equity (ROE). The ROE is the portion of the revenue requirement that a utility ultimately keeps as profit. Utilities are allowed the opportunity to earn the set return on their investments through the rates they charge their customers. If a utility expects to earn less than its allowed rate of return, it may file a rate increase. Capital spending has climbed for utilities across the country, and so have electricity rates.
Although electric utilities are regulated with the intent to protect the interests of ratepayers, rate of return regulations do not effectively motivate utilities to function efficiently and reduce their operating costs. With a set rate of return, utilities are actually incentivized to make unnecessary capital investments in order to increase their rate base and therefore, their profits – historically known as the Averch-Johnson effect.
Put simply, utilities build pipelines and transmission lines because that’s where the money is. Massachusetts utility companies have been advocating for the purchase of new natural gas pipeline capacity and hydroelectricity, at the expense of renewable projects like wind and solar. The position of Eversource and National Grid on what’s best for ratepayers is heavily influenced by their business interests. Under the current energy system, the companies receive a higher rate of return on capital investments in power lines and pipelines than they do for implementing energy efficient projects. It comes as no surprise, then, that the major utility companies have added fuel to the fire in the debate over solar, pushing lawmakers to reduce solar incentives.
Until we change the incentive structure, or at the very least reduce the rate of return, utilities will continue to seek out costly infrastructure developments such as pipelines. Some states have already taken the lead in changing their current model. In New York, a strategy developed by Gov. Andrew Cuomo and the Public Service Commission seeks to alter regulatory, tariff, and market designs and incentive structures to better align utility interests with overarching state policy objectives. The Reforming the Energy Vision (REV) Initiative would require utilities to coordinate and partner with other companies to provide local, clean energy solutions.
The conditions driving innovation in New York apply to many other states as climate change impacts outrun traditional forecasting and risk assessment methodologies. But factors driving this innovation extend beyond climate change. Like New York, states across the country are faced with an aging utility infrastructure. In Massachusetts too, the natural gas pipeline infrastructure is showing signs of age. Nearly 25,000 gas leaks have been identified as of March 2015, contributing to continued methane emissions and a displaced cost of $38.8 annually. There is a growing need to fix our aging infrastructure, while also securing future energy security with local, renewable sources. Customers and businesses demand greater control over their energy supply, and both global and national climate change initiatives require large-scale investment in renewable resources and demand reduction measures.
While large-scale change can be difficult to imagine, a low-carbon, modernized system of electricity generation and distribution in Massachusetts is very much within our grasp. Solving these problems requires a transformation of conventional industry and regulatory institutions and requires strong commitment from lawmakers. We cannot reach out emissions reduction targets by incrementally adding renewable energy resources at the current rate of 1% per year.
The current energy debate is not about the cost or capacity of large-scale deployment of renewable energy, since costs continue to sharply decrease. The principal issue is our outdated regulatory structure providing perverse incentives for utilities to increase profits by building fossil fuel infrastructure. As we continue to advocate for solar, wind, and energy efficiency measures in Massachusetts, we also have to reform the underlying structure of the regulatory system opposing progress.