Another reason why retail regulation is obsolete: atrocious incentives

Lynne Kiesling

While I am musing on the problems with the traditional regulatory model in electricity, as in my prior renewables feed-in reverse auction post, I am going to pile on (yes, it is like shooting fish in a barrel, but it’s the first day after a long holiday weekend, so cut me some slack, OK?). I was simultaneously excited and appalled on Friday when I read this Financial Times article about how consumers are changing their electricity consumption. More and more people are investing in energy efficiency upgrades to houses and buildings, replacing devices and appliances with ones that deliver the same functionality while using less electricity, and consequently reducing their electricity consumption. Increases economic efficiency, good for the longevity of the planet, individuals save money and feel good about themselves and how they are choosing to live their lives. So far, so good.

But here’s the meat of the article:

Wholesale power demand was down 15.3 per cent in the second quarter compared to last year, according to data compiled by Credit Suisse Securities. Total retail demand was down 5.4 per cent, with industrial demand plunging 14.7 per cent, commercial demand falling 3.5 per cent and residential demand dropping 1.7 per cent. …

“There is a mindset change in consumers,” said John Berger, chief executive of Standard Renewable Energy, which sells energy audits and solar energy. Those who follow the advice in energy audits typically reduce power demand 20-30 per cent. “The demand for that service is going up exponentially,” he said.

The company’s energy efficiency and solar businesses have both grown about 20 per cent per month in the past six months.

The impact on utilities’ bottom lines has led to talk about forcing consumers to pay a flat fee for electricity, so utilities will be profitable even if power demand continues to drop.

“It’s desperate behaviour,” Mr Berger said.

Let me just pull that out and emphasize it, in case you missed it because it’s the first day back after a long holiday weekend:

The impact on utilities’ bottom lines has led to talk about forcing consumers to pay a flat fee for electricity, so utilities will be profitable even if power demand continues to drop.

Yes, you read that right. Price signals and other intrinsic motivators are leading individuals to increase their energy efficiency, conserve, and (if they are fortunate enough to be able to choose a dynamic pricing contract) shift their consumption from peak hours to off-peak hours. And what’s the regulated retail utility response to this salutary change? Force consumers to pay even if they don’t buy their services. Furthermore, if they force (force!) consumers to pay a flat fee, do you think they are still going to have these incentives to invest in energy-efficient technologies? That’s only the case for consumers who have very, very strong intrinsic motivation because they want deeply to reduce resource use and environmental distress.

If you don’t realize that retail economic regulation of electricity service is pernicious and counter-productive, you have not been paying attention.

At its core, this atrocious incentive problem is a direct, predictable consequence of cost-recovery-based retail rate regulation. Regulated utilities are legally entitled to recover all of the costs that the regulators allow, plus a markup for their regulated rate of return. They are guaranteed that by law. That guarantee means that their business model is rigid, inflexible, and maladaptive in the face of the kinds of changes described in the FT article that we are all seeing around us and engaging in ourselves. And instead of using this fall in profits as a signal, as a way for them to learn that they should do.things.differently, they want to resort to the old, traditional, top-down regulate-and-control model to force consumers to pay them, even if they don’t continue to consume as much of their service.

Not only is this economically inefficient and environmentally deleterious, it’s a disgusting demonstration of the corrupting effects of political processes. Retail electricity regulation based on cost recovery: EPIC FAIL.


8 thoughts on “Another reason why retail regulation is obsolete: atrocious incentives

  1. Lynne: Interesting and thought-provoking post.
    Just to add my 2 cents … the industry’s incentives aren’t controlled ONLY by its political and institutional inertia. Common stockholders also want utilities to remain annuity-like in their return characteristics. To the degree removing retail regulation upsets that financial status quo, I suspect Wall Street will vehemently oppose retail deregulation — particularly now, as utility stocks provide a relative safe haven in a world of turmoil.
    OTOH, in deregulated states, wires-management companies remain rate regulated and continue providing predictable returns for investors. A pure economist would argue that this is a better investment paradigm anyway, allowing investors to better control their exposure to market forces and geography. But so far I don’t see Wall Street pushing for retail deregulation and industry restructuring generally. Is it a matter of time, or is it a matter of politics and institutional history smothering this trend before it can get out of the pram?

  2. I would counter that utilities are guaranteed an *opportunity* to earn their allowed rates of return. That legal guarantee generally does not insulate shareholders from normal business risks, although some utilities can achieve high returns while minimizing risk through regulatory capture. I realize this is beside your point, though.

  3. Lynne,

    Are utilities able to provide such service as to enable maximun social welfare? Can retail regulation provide it? Is power system demand larger than necessary because of perverse incentives since EPAct 92?

    If the paradigm under which utilies as we know them is unable to provide maximum social welfare and a new paradigm is able to do it, what is keeping society stuck on an obsolete paradigm? When will the paradigm shift.

    Notice that the new new paradigm is not retail deregulation as practiced under the flawed wholesale organized markets, where the policy economics first, system performance second ruled.

    It is under the EWPC basic innovation paradigm, under the policy system performace first, economy second, where retail and wholesale markets mutually reinforce each other, with unregulated retail being the driver.

  4. So you’re against decoupling of rates? Any sane person would be.

    What D.O.U.G. said about the “opportunity to earn” is correct, and not beside the point.

    These statements:
    “Regulated utilities are legally entitled to recover all of the costs that the regulators allow, plus a markup for their regulated rate of return. They are guaranteed that by law.”

    are way, way off. Surprising.

    The point I get from the data/article is that people can actually respond to rates–whatever and however they are set–without all the doodads of smartgrid, real-time prices, etc.–all the RTP behaviour paradigm shifts that you tout. Do you really think people want to manage their usage on a minute-by-minute basis? A small minority, yes; the majority, no.

  5. Larry,

    There are two ways to decouple: artificial and natural. To extend the obsolete Investor Owned Utilities Architecture Framework (IOUs-AF) and its incremantal extensions way beyond its useful life, artificial decoupling is one of the key incremental extensions.

    Natural decoupling arrives with the EWPC Architecture Framework (EWPC-AF) paradigm shift, in which customers choose the Second generation Retailer (2GR) that best fulfills his needs. 2GRs develop competitive business models that replace IOUs-AF obsolete monopoly business model.

    As we get deep into a world that no longer guarantees low energy costs (a key assumption of the IOUs-AF), while increasingly providing lower and lower information costs, pre-programed arrangements designed and implemented by 2GRs that take care the management of the usage needs of customers, which need not worry. That is how the EWPC-AF leads to maximun social welfare.

  6. It is extremely important to note, in this context, that the price of electricity has two fundamental components: fixed and variable. Much of the angst regarding electricity prices is the result of the fact that typical regulated rates do not separate the components properly. Rather, the regulated rate includes a monthly service charge which recovers a portion of the utility’s fixed costs, while the remainder of the fixed costs are recovered through the variable portion of the rate. This clear violation of traditional cost accounting principles is nearly universal in state utility regulation.

    The electricity grid is, in some ways, analogous to the driveway at your home. You contract, or someone contracted previously or on your behalf, for the installation of a driveway two cars wide, the fact that you choose to own only one car does not entitle you to a refund for the half of the driveway that you choose not to use. Similarly, if you choose to rent a home with a two car wide driveway, your decision at a later time to own only one car does not entitle you to a reduction in your rent. The investment in the driveway is sunk and its cost is part of your cost.

    The decision to install electric service to a structure triggers a requirement on the utility, not only to provide the connection to the grid, but also to assure that the grid is capable of supplying the required power to the new connection to the grid. Depending on the nature of the regulatory environment, however, the establishment of a connection to the grid may or may not impose an obligation on the utility to assure that adequate power is available to flow through the grid and the connection to the customer’s loads.

    It is entirely reasonable that the utility should have the ability to recover its fixed investment to provide service to a customer, as long as the customer contracts for service. It is not unreasonable that the utility not have the ability to recover if the customer elects to disconnect from the grid; however, it is also not unreasonable that the utility no longer have the obligation to assure that the grid is capable of supplying the power which was previously required by the customer which has now elected to disconnect from the grid.

    If there is a desire to revamp the “utility compact”, or to completely eliminate it, then step one in the process is for the customer to purchase from the utility the ownership of the physical investment in the facilities which are necessary to provide the customer’s desired level of service and to take responsibility for its maintenance. Somehow, I suspect that that would be a relatively undesirable prospect.

  7. Well said, Ed. If I can piggy back on that… Even regulated utilities can get the message to do something different in response to changes in demand. Their problem may be one of recovery of fixed cost in the short term while the system adjusts over the long term. (Whether it ever arrives at an “optimal mix” is a different issue.)

    We know that *regulated* prices are often perverse signals, being high during surplus and lower during scarcity. But the industry will never escape from retail regulation peacefully if it means that we abruptly re-trade the deal under which investments were made, essentially forcing investors in regulated assets to lose their investments. The transition is tricky and political. Hitory provides plenty of examples. [An aside: In the case of public entities there is no way to cancel recovery of cost other than default on debt. Short of going bancarota, customers must pay… eventually.]

    In the meantime, regulated prices can and should do a better job of providing price signals, using rate structures with marginal rates suggestive of avoidable cost. If a utility has low variable cost because it has invested in high fixed-cost plants, then perhaps recovering all of its costs through per-kWh energy rates gives an inappropriate price signal. But then there is the problem of how to allocate the fixed costs fairly. Granted, prices in a market would deal with these problems efficiently, but the *transition* to a market presents huge problems of its own.

    In my mind the FT article was not written in enough detail to know whether the writer really understood what was being implied by his words “fixed fee.” I thought he was just talking about decoupling in too-strong language.

  8. The assumption “It is extremely important to note, in this context, that the price of electricity has two fundamental components: fixed and variable” is clearly an integral part of the IOUs-AF, in which long run marginal costs were used because information costs were prohibited.

    The above assumption does not hold under the EWPC basic innovation, where information is more than affordable to allow for short run marginal costs of supply security to replace long run marginal costs of power demand, which by the way is next to impossible to predict in this highly uncertain world.

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