What the Maryland PSC’s rejection of BG&E’s smart grid proposal reveals about regulation

Lynne Kiesling

Last week the Maryland Public Service Commission rejected Baltimore Gas & Electric’s proposed project to install over 2 million digital electric or gas meters, change the retail electricity rate structure to incorporate time-of-use pricing and peak-time rebates, and recover the meter capital costs through a surcharge on residential retail bills. BG&E’s ambitious and thoughtful project had undergone extensive pilot project testing and had generated economic and physical results similar to those seen in other such projects (customer savings, reduction in peak energy use and in peak strain on system infrastructure, reduction in peak wholesale prices due to the transmission of retail price signals). Their recommended technology and rate designs are not unusual relative to evolving practice in other states (although they are much, much less than I personally would like to see). Despite those promising results, the Maryland PSC rejected BG&E’s business case for structuring their cost recovery from the project as they did.

Although I am pretty familiar with the BG&E pilot, I am not sufficiently informed or expert in rate case matters to have an intelligent opinion on whether the PSC took the correct position. Their position, though, reveals some of the most important and pressing reasons why traditional economic regulation is incompatible with economic dynamism, with technological change, with innovation, and ultimately incompatible with widespread consumer well-being.

1. Traditional economic regulation is based on cost recovery, not on expected value creation, and therefore does a poor job of “standing in for the market” as it is (incorrectly) supposed to do in theory. Whether it’s enshrined in the legislation giving the regulatory agency its mission or in the deeply-embedded Populist culture and history of regulation, traditional regulatory procedures focus regulators and the regulated on providing a narrowly-defined, generic, highly reliable service at the lowest possible long-term cost. As long as you’re in a static environment, the static model from which this theory and culture emanate will do a decent job of providing that generic service. That’s the context in which regulators have developed a norm and a culture of ignoring value creation — focusing narrowly on the provision of generic electricity service and scoping your efforts accordingly fits with that static world. But regulatory models premised on cost recovery fail miserably in a more dynamic context, with pervasive economic and technological change and Schumpeterian creative destruction. That dynamism characterizes the economic and technological context of the early 21st century, and the reason that dynamism and creative destruction become so pervasive in human society is that they create value — value for consumers, variety for consumers, product differentiation for consumers, and value for the risk-taking and opportunity-seeking entrepreneurs who risk private capital to create that value.

If the regulatory institutions and the regulatory culture constrain the electricity value proposition to the provision of generic service to the exclusion of other product/service/pricing bundles, and if they constrain the business model to one of cost recovery instead of value creation, then the regulators will reject the types of projects that are most likely to create value for consumers and entrepreneurial producers. This rejection shows precisely why regulation cannot “stand in for markets”, because the most important function that market processes perform is the pathways for this new value creation. The static, price-determining, resource allocation function of markets is not the most important function of markets, and the formulators of static natural monopoly theory at the end of the 19th century got that wrong. Our current regulatory institutions are built on that incorrect, static natural monopoly theory.

2. Traditional economic regulation stipulates that the regulatory agency controls price determination on behalf of consumers, and regulators are loath to relinquish such power once they have had it for a century. This point is a political economy corollary to the first point. Legislation requires regulators to represent the interests of consumers, and they do so through administrative procedures to control both costs and prices, as well as controlling the profits that the regulated firms are allowed to earn. Control, control, control. Take, for example, this quote from the New York Times/Climatewire story linked above:

The Maryland commission took a fists-up stance toward its powers and prerogatives to rule on utility rates. “For one hundred years, since this Commission was created by the General Assembly in 1910, one of our primary functions has been to establish the rates that public service companies can charge their customers,” the commission said. Currently, it faces a growing trend by regulated companies to cover costs in advance through surcharges rather than subjecting costs to review after they have been incurred.

While it has approved such surcharges in some limited cases, it drew the line on BG&E’s current proposal, it said. “Surcharges guarantee dollar-for-dollar recovery of specific costs, diminish the Company’s incentive to control those costs,” and put those costs outside the commission’s reach, the commission said.

Ironically, Maryland is at least nominally a state that has retail competition and retail choice available for its residential consumers. If they were actually serious about competition and were willing to relinquish this control over prices and costs, then the regulation of prices and costs would occur through the decentralized market processes of firms making retail product/service bundle offerings to consumers, and consumers using their choice and autonomy to say NO. But if you are deeply steeped in regulatory culture, you do not believe that this decentralized process can work effectively for consumers, even though it does so in other markets and industries … even ones that have high infrastructure costs and are considered essential to daily life! You, therefore, believe that your power to control is a salutary intervention, even though the dynamism of economic and technological change are proving you wrong on a daily basis. So you make decisions that reinforce your power and control, believing them to be in the best interest of consumers while you deprive those same consumers of the opportunity to make their own autonomous choices.

3. Traditional economic regulation entrenches the political and economic power of easily identifiable, politically active special interests. Which leads us to the third lesson from this episode for the political economy of regulation. The legislative mandate for regulation, and the stated mission of every regulatory agency, is to control prices and allow the firm to recover costs for the provision of a generic service at a highly reliable level in a way that benefits all consumers. But in the time that I have been involved in regulation, and in debates over smart grid investments and policy, it is abundantly clear that Mancur Olson was correct, and that regulation actually represents the interests of easily identifiable, politically active interests, not the interests of consumers as a whole. On the consumer side, this means that decisions get made frequently based on the organized, coordinated political actions of so-called consumer advocates (who really represent low-income consumers, not all consumers) and groups like the AARP, who perceive their interests as being best served by the perpetuation of the traditional regulatory model — generic service provided at high reliability, controlling price through strict cost recovery.

Take, for example, this quote from the excellent Ahmad Faruqui in the New York Times/Climatewire story above:

While some state utility commissions are willing to back smart meter deployment, they are reluctant to approve new “dynamic” electricity rate plans that allow prices to rise during the day when power demand peaks and fall when demand is slack. Such real-time pricing plans are essential to prompt customers to shift energy usage to slack times and reduce overall consumption, he said.

“There is no doubt in my mind that without state commissions approving the business cases for advanced meters and the smart grid, this is not going anywhere. They control the dollars; they set the rates for the customers,” said Faruqui, an economist and principal with the Brattle Group. Faruqui testified before the Maryland commission in support of the BG&E plan and declined to comment on the commission’s decision in that case.

But he said that around the county, commissions are heeding warnings from state consumer advocates and retiree organizations about possible cost impacts on customers if electricity rates are linked to actual generation costs, hour by hour.

“Most of the state commissions are frozen in time. They are being subjected to these very, very pessimistic, worst-case arguments,” he said.

What’s missed in that calculation is the unseen, lost value that could be created for both these vulnerable groups and for other consumers by moving away from that model. When regulators are already predisposed, by legislation and by culture, to constrain the value proposition of the regulated firm and focus on a generic service and cost recovery, the political action of those who seem to visibly benefit from that constraint will find a big foothold. In that environment, the value proposition based on the idea of better service provision (such as, for example, bundling home health care monitoring services in with a “senior care” electric service contract for the AARP constituency) is going to fight an uphill battle. In open markets with low entry barriers, that type of service bundle would be able to compete, and would sink or swim, fail or profit according to the value it creates for consumers and the ability of the provider to control costs.

In brief, traditional economic regulation is incompatible with economic dynamism, with technological change, with innovation, and ultimately incompatible with widespread consumer well-being because of the enormous extent to which traditional economic regulation stifles experimentation. The really valuable function that market processes provide is this ability for consumers and producers to experiment. Traditional economic regulation is almost reflexively anti-experimentation, and that reflex is the source of lost value creation opportunities from smart grid technologies.

A historical example illustrates why I think these points are important. In the medieval period, China was one of the most forward-looking, open, technologically creative and vibrant societies in the world. Chinese inventions became the foundation of many important technologies, machines, and industries. Yet by 1600, China’s backwardness was obvious to all observers; China had closed herself off from knowledge, had become technologically stagnant. Western Europe and then the young United States surged ahead of China in technology, in economic productivity, in per-capita income, and in living standards for most of the population (China’s elite, of course, continued to enjoy luxury). Economic historians credit this stagnation (or, what Needham argues was “homeostasis”, not stagnation) and worsening of living standards for most of the Chinese population to conscious technocratic policy decisions in China to look inward (growing through population growth and increasing intensification of agriculture), to be backward-looking, and to make strong top-down rules based on status quo bias. Writ large, the dynamic driving the stultification of China had at its core many of the same policy drivers and incentives as we seen in play in electricity regulation in the 21st century.


7 thoughts on “What the Maryland PSC’s rejection of BG&E’s smart grid proposal reveals about regulation

  1. Your point on political economy is a keen one; even the most forward thinking utility regulators I have met (and there are quite a few of them out there) are not especially capable contemplating a world in which their job is superfluous. Given the paramount importance of pricing in the regulated utility model, shifting to dynamic/market-set rates either forces them to think (or inadvertently assume impossible) the unthinkable. Perhaps unsurprisingly, their thinking in that regard tends to be a bit muddy…

  2. Hi Lynne and Sean,

    I find the article well though out and almost impeccable. The only thing that I am concerned is with an apparent endorsement on Faruqui’s quote that says “There is no doubt in my mind that without state commissions approving the business cases for advanced meters and the smart grid, this is not going anywhere. They control the dollars; they set the rates for the customers.” I think that was to be expected based that “In brief, traditional economic regulation is incompatible with economic dynamism, with technological change, with innovation, and ultimately incompatible with widespread consumer well-being because of the enormous extent to which traditional economic regulation stifles experimentation.”

    Maybe the regulatory approach is not going anywhere, which means regulators need a new mandate, as it is suggested in the the EWPC article “Forget the Customer Engagement Debate; Think Risk Taking Suppliers ( http://bit.ly/EWPC08 ),” which offer a proposal for a new approach to the simple and holistic smart power service.

    Its summary says “The outstanding Maryland PSC’s leadership decision is a potential precedent, which will help utilities and state governments accept the fact that the utility partnership with a regulator run out of steam. Instead of a predictive customer engagement debate to extend the obsolete indirect regulated risk free business model, for example on utilities AMIs, we need a new bargain in the power industry to facilitate a customer partnership with one of several suppliers having an emerging direct competitive risk taking business model.”

    Best regards,

    José Antonio

  3. Dr. Kiesling:

    I admire your optimism and you advocacy for this cause. But, as long as the electric business is highly politicized, and regulated by politicians, I am not willing to see their power over my day to day life increased. I am only only willing to accept a system under which is is physically and economically impossible for the socialist state to use it as a vector of social control. If the regulators persist in seeing the smart grid as a problem for them and not an opportunity for social control, I am thankful when my enemies screw up.

    “the organized, coordinated political actions of so-called consumer advocates (who really represent low-income consumers, not all consumers) and groups like the AARP,”

    Consumer groups seldom “represent” anyone other than their upper class selves. Recently, the veil has been striped from ACORN, which is in fact a tiny group of professional “community organizers” conspiring with public employee unions. AARP, is an insurance marketing scam with a hard left political arm.

    Your point about China is well taken. We can see the actions of our own mandarins having the same effect on our lives. We just call them “environmentalists”.

  4. Very thoughtful analysis, Lynne. I wonder what precedents exist, if any, for transitioning from the current regulatory framework that emphasizes entrenched political interests to a more dynamic system that allows/enables/encourages innovation and experimentation in the power sector.

  5. Great Article. I was really surprised by this decision because I thought that utilities had captured state regulators enough to get this through.

    I’m not totally convinced about your thesis on regulators being afraid of risk-taking and innovation. These same commissions had no problem approving very risky nuclear projects in the 70s and even some economically risky clean coal projects more recently.

    A multi-billion dollar power plant has many forces pushing the project forward, including a plethora of ancillary interests, like local unions and construction firms. There can be a lot of economic activity generated by some of these projects.

    OTOH, smart-grid projects can have a tough time identifying and aligning the economic interests. It’s partly due to the uncertainty around which consumers will benefit and IMO mostly to do with the local political power of the firms doing the work.

    Jim

  6. Lynne and Jim,

    Jim: times are a changing!

    Lynne, for great input check the article “Could We Lock in the Past?” at http://bit.ly/b7PLMm

    Whether they are aware or not, my guess is that the Md.’ PSC made a great move. As can be seen in the post “The Potential Setback of the Smart Grid that is Being Pushed” http://bit.ly/EWPC09 :

    The Order No. 83410 is sending the very clear message to the general public that the Maryland PSC needs to fulfill its legal duties on a problem they seem unable to handle. That Order may involve a very smart move as (using your words) “the utility has been invited to re-submit its proposal in a way that shares risk between the utility and its consumers.” Thank you also for writing “…that other utilities looking to begin or expand smart grid implementations must take this into account.” The Order is in fact shifting that problem to BGE and utilities with a potential setback for the smart grid that is being pushed.

  7. “What’s missed in that calculation is the unseen, lost value that could be created for both these vulnerable groups and for other consumers by moving away from that model. When regulators are already predisposed, by legislation and by culture, to constrain the value proposition of the regulated firm and focus on a generic service and cost recovery, the political action of those who seem to visibly benefit from that constraint will find a big foothold. In that environment, the value proposition based on the idea of better service provision (such as, for example, bundling home health care monitoring services in with a “senior care” electric service contract for the AARP constituency) is going to fight an uphill battle. In open markets with low entry barriers, that type of service bundle would be able to compete, and would sink or swim, fail or profit according to the value it creates for consumers and the ability of the provider to control costs.” This is true, but your conclusion after is basically nonsense. There was no resistance to the “smart grid” technology as such nor with moving to high on-peak pricing, even mandatory pricing, as long as there was a sane plan to prepare the customer for this. There was simply no such plan in this proposal of BG&E’s, it was incomplete and incompetent.

    The Maryland decision was quite clear about what its problems were:

    1. Higher distribution rates per kilowatt rather than fixed charges on bills should pay for these upgrades – effectively meaning heavy users subsidize light ones which seems entirely fair and reasonable to me. BG&E would have been entirely insulated from the risk of deploying for instance bad proprietary non-IPv6 based meters, etc., and having to replace them sooner than scheduled. Why not force them to do it right and use something robust that actually meets the IPv6-based “smart grid” standards?

    2. Residential home-area-network (HAN) networks based on Zigbee and other powerline networking standards must be deployed and perhaps financed by the distributor before implementing any mandatory time-of-use or dynamic pricing scheme. This lets the customer adjust to a world of expensive peak and cheaper off-peak power. Also seems very fair. BG&E’s proposal notably did not include in-home meters and guarantees of interoperability with third party conservation service providers (goal 6 of the US National Broadband Plan, read it!).

    3. Distributors are simply not allowed to hand-wave away the question of backhaul (communications between the meters, other secure devices on that network, whatever carrier/ISP gets the data for billing to the distributor and for demand-response to a third party). They can’t, for instance, blame satellite connections in a rural area or frequent outages on a cable network, for bad electric demand decisions. This strongly suggests distributors are being gently urged to set up their own secure networks, which in practice will either use 802.15.4 (suites like Arch Rock sells), 802.11abgn (the “Wi-Fi” standard) or powerline networking (a perfect match for HANs in the home and ITU G.hn networking when it arrives) or all of the above (perhaps the powerline networking primarily and the wireless for failover).

    This in combination with Prop 16’s failure in California means that communities are keeping the power to deploy their own power-and-data unified utility/distributor and telling incumbent monopolies to go hang. Good idea. Given the robust standards the IEEE, ITU and NIST and FERC are working out, probably any Mom-and-Pop ISP would make a better power company than these mindless horrors mostly focused on generation. 😉

    Since when does economics favor entrenched monopolies trying to hive off all risk of deployments (including future mistaken relationships with data providers) of tech the customer does not understand, onto those customers rather than bear it, itself?

    Please learn something of the field you are commenting on before commenting. More:
    http://www.smartgridnews.com/artman/publish/Business_Policy_Regulation_News/Uh-Oh-Maryland-PSC-Dumps-BG-E-s-Smart-Grid-Metering-Project-Utility-Exec-Dumbfounded-2549.html#blogcomments

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