The Regulatory Compact and Its Consequences for Innovation

Lynne Kiesling

The regulatory policies of the past century in the electricity industry have enshrined the regulatory compact: in return for being granted a monopoly franchise with legal entry barriers, the regulated utility assumed an obligation to serve all customers in their service territory who desired service. The compensation received for this bargain is an estimated normal rate of return based on costs incurred to provide the energy and the service (i.e., the rate base). The costs (rate base) plus the return on those costs from the basis of the retail rate structure, which divides this “revenue requirement” among three customer classes (residential, commercial, industrial) to determine the retail price, or rate, that each type of customer will pay for the service.

As a consequence of the regulatory compact, utilities focus narrowly and conservatively on investments and business strategies that they can be sure regulators will include in their rate base; this approach reinforces the construction of the types of physical assets used over the last century – generation capacity, wires, and mechanical substations, for example. The cost recovery basis of the regulatory compact, coupled with ex post prudence review by regulators, has stifled utility incentives to explore and invest in other types of assets, including distributed digital technology that could enhance the resilience of the physical grid, reduce operating costs and increase the ability to identify faults proactively, and enable the development and sale of differentiated products and services to end-use consumers.

From the perspective of consumers, the regulatory compact was intended to protect consumers, particularly the residential consumers who are also voters. It has done so by creating a policy environment in which the sole value proposition that regulators recognize as being “in the public interest” is one of keeping prices (rates) low and stable. In other words, a consequence of the regulatory compact is that the concept of consumer benefit in the electricity industry is narrower than in any other industry. By regulatory fiat, consumers only benefit from low, stable rates. The regulatory compact rigidifies the definition of consumer benefit, despite the fact that in many other industries, technological change and economic growth have created consumer benefit through innovation, new products and services, and product differentiation. As long as the regulatory compact has retained the idea that consumer benefit in this industry derives only from low, stable rates, it prevents electricity consumers from having access to potentially valuable new products and services associated with electricity consumption, because it stifles innovation.

So here’s a question: what purpose does the regulatory compact still serve? If its negative effects are outweighing its positive effects, but if there are influential parties who like the status quo and want to retain the regulatory compact, how do we modify or eliminate the regulatory compact?

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