Renewable sources of power generation, such as solar, wind, and batteries, are displacing fossil-fueled power generation. The reason? the price They generate cheap electricity. It is also somewhat more complex because it is also a technology transfer away from fossil fuels, and its rate of absorption throughout the economy is rapid. But when competing businesses, which produce similar goods, such as electricity, begin to differ fundamentally in terms of their underlying cost structures, winners and losers emerge.
One of the surest casualties of renewable penetration may be the regulatory framework of our state and federal Public Utilities Commission. The specifics here are complicated, and we’ll address them later. But the root cause of essential organizational failure is simple. Organizers today are proverbial. All they can do is decide to raise customer rates (and how much), which is why we hear so much from critics about a potentially inevitable utility death spiral where commission-authorized rate increases lead to a cycle of customer (and revenue) losses that lead to further rate increases until a financial crisis occurs. We’re not big fans of this hypothesis though so we’ll see if the big C&I customers can be bid away from being leveraged by renewable providers. Currently there is too much growth in electricity demand to divert utility from being an immediate problem. But we still argue that organizational weakness is embedded in the nature of institutions and therefore cannot be cured.
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Public utility commissions first appeared in the United States in 1907, just as extraordinary gains were made in the efficiency of central station electricity. The first fifty years of utility regulation involved overseeing the development of an almost unprecedented industry that began as a modest urban enterprise and ended with the concept of universal service. Regulators must balance a problem: how do we finance the growth of the employment system and avoid the exploitation of captive buyers? Our argument is about where we go from here. These institutions are not even remotely capable of doing the opposite. Nor because of concerns about agency “capture” by industry, which may or may not be valid. They can’t because of the interesting idiosyncrasies of the utility business.
There are two types of utility costs, fixed and variable costs. Fixed costs represent the hard assets of the business (production, transportation, and distribution), while the largest variable cost is fuel. Until the price chaos and inflation of the 1970s, the main focus of early pricing was mainly on the fixed cost side, plant and equipment. The whole building block of cost of service pricing, the essence of profitability pricing, basically asks the company two questions: 1) How much did you spend on plant and equipment to serve people? and 2) what is the appropriate capital structure (% debt vs. equity) and appropriate return on shareholders’ equity that should be used to determine the price. They can do this safely because utilities consistently reduce operating costs, which in turn benefit consumers.
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And this is where the nasty business of technology transfer rears its ugly head for existing utilities. If regulators were to ask renewable providers the same cost of service as current utility officials, how much did you spend to provide power to the service area, their response would be, “Much lower than legacy utilities because we don’t have the cost of fuel. Oh, and we don’t have to have low rates of debt in our investment debt structures.” A corporate balance sheet consists of assets (what the company owns) and liabilities (how they paid for those assets). Renewable providers address both sides of the balance sheet financially. Their production costs are low (zero fuel costs), and their financing costs are also low (low equity). They can afford high levels of debt because their business risk is very low. (For example, solar companies have not seen dramatic increases in oil costs as a result of the Iran war.) At a fundamental level, there is no real response to competitive disadvantage. It is not that the organizers cannot help with the existing facilities. They will It is that they simply do not have effective tools.
These issues never happen in a political vacuum. The affordability of electricity is front and center in the public imagination, thanks to rapidly rising electricity prices and significant press. The appointment of regulatory officials, usually a low-key issue, also attracts public attention. And remember, utility commissions can’t actually lower rates. Fuel costs are what they are and utilities are simply price takers. These costs are passed on directly to customers. And assets to serve the public are fixed and costs are rising at least at the rate of inflation, if not 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 that are displacing fossil-fueled power generation. But we don’t think the existing regulatory apparatus will go down without a fight. We expect two very different attempts at regulatory reform, both of which are doomed because they refuse to acknowledge technology transfer, which creates winners and losers. Price design will be followed first because in a way, it is easy. It’s about fixed costs versus volumetric pricing and how to make pricing more fair for all customers. While producing a more equitable pricing design, it ignores the competitive challenges facing utility operators. A second reform effort, aided in part by the current municipal movement, is to reverse leverage on equity, essentially claiming that utilities earn more profits. While we sympathize with this effort, our problem here is that from a utility balance sheet perspective, they offer a liability-side solution to an asset-side problem. If utility assets are ultimately uncompetitive against renewables it does not matter how they are financed and if the level of financing is high.
Ultimately, we believe that the role of regulators will inevitably be disruptive in the next few years. We think their role will be to provide the utility industry with a climate that prevents a dramatic technology transfer away from the use of expensive fossil fuels. Regulators for us resemble one of those mighty Antarctic ice shelves that are gradually being eroded by climate change-induced warming. To the inexperienced observer, these ice giants look like they will last forever. And then they left.
By Leonard Hyman and William Tells for Oilprice.com
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