The regulation of public utilities is an arcane art practiced in the U.S. at the state and federal government levels. Public utilities, also called public service companies, include such vital infrastructure industries as electricity, natural gas distribution and water. These private companies are granted monopoly franchises to serve specified communities. In return for the monopoly status the public utility is regulated as to services, investment and prices by a government agency. In setting prices for services the regulators review and approve: investments in assets, depreciation policies and control of profit levels. It is the control of these aspects where regulators can stifle or delay innovation.
The regulation of electricity is of particular importance as state and federal policies have been advancing policies leading to increased “electrification” of the economy. This means the substitution of fossil fuels by electricity in transportation and home and commercial space heating and cooking. In the future generation of electricity may come predominately from renewable or nuclear energy sources replacing most fossil fuel in generation. My estimates are the complete electrification in the U.S. would require the construction of new generation able to produce five times the annual electricity generated today.
The state and federal regulators can negatively impact the introduction of innovation through new technologies in three ways:
- Rate base: by rejecting new investments in innovative technologies
- Depreciation: by failing to timely recognize obsolescence in existing technologies in depreciation rates
- Return on investment: by failure to allow innovative utilities a higher return on innovation investments
The most common technique to reject or delay investment in new technologies is to insist on company specific “pilot studies.” Regulators are reluctant to be the first to approve new technologies. Thus, they require “pilot studies” even when the results of such studies are available from other companies or other jurisdictions. Someone, however, must go first. For this reason, utility executives are reluctant to be the first to propose investments in new technologies. One wag suggested that America’s regulated utilities aim to be “the first to be the second in introduction of new technologies!”
It’s only because we have had progressive regulators in a few states, for example, who were the first to approve aero-derivative gas turbine technology. Gas turbines have been the most efficient fossil fuel plants and are now required to back up the growing fleet of solar and wind installations.
Depreciation policy is among the least understood aspects of public utility regulation. The annual depreciation expense is based on a annual depreciation rate (%/year) applied to the investment dollars. The depreciation rate is developed by an expert estimate of the economic service life and net salvage of each asset of asset class at time of retirement.
The introduction of new technologies generally makes an existing technology obsolete either because the old technology does not provide all the services of the new technology or because the new technology is more efficient and cost effective. The economic life of old technology short be adjusted downwards at the time the new technology becomes available in the industry in advance of the acquisition of the new technology! This is a tough call for the regulator as shorter economic service lives mean higher depreciation expense levels leading to higher rates.
The rate of return used in utility regulation is the weighted average cost of capital of a utility company. The regulator approves both the capital structure (amount of debt and equity) and the cost of debt and return on equity (ROE).
Judge Richard Posner recognized that regulation may inhibit innovation. In Natural Monopoly and its Regulation (1969) he explained that innovative firms in competitive markets, firms which produce patents, should earn a higher return based on their exclusive right to use the patented technology. Regulated utilities, Posner observed, run the risk that regulators will ignore that the higher profits came from innovation and not from their monopoly position. Thus, regulators can remove the incentive for innovation.
Looking back at the period at a period in the 1970s and 1980s when regulators of the telephone utilities were observing digital electronics replace analog equipment, New York Public Service Commission member Charles A. Zielinski observed “And those (regulators) with a broad sense of fairness might also want to see whether the old technology was under-depreciated because of their past refusals to accelerate depreciation: or whether they allowed sufficiently high rates of return to reflect this particular risk they would, in effect, assign to shareholders” (Proceedings of the Iowa State Conference 1981)
The National Electricity Reliability Corporation has expressed concern about the increased demand for electricity to accommodate the boom in the construction of data centers. New centers are being built to handle the demand for additional computer power to accommodate access to Artificial Intelligence. This increased demand is in addition to the future requirements for “electrification” of the economy. America’s future electricity demand cannot be met with current technology but will need new and innovative technologies in generation, transmission, distribution, storage and efficient end use of electricity. To meet the unprecedented energy need, America’s public utility regulators will need to factor in innovation incentives in their regulatory policies and look for ways to stimulate and not stifle innovation.
About the Author
The Honorable Branko Terzic is a former Commissioner on the Federal Energy Regulatory Commission and the State of Wisconsin Public Service Commission. He was also the Chairman, President and CEO of Yankee Energy Systems, Inc. Dr. Terzic is a founding member of the Society of Depreciation Professionals.
