From American Affairs Journal:
Electricity is an input in virtually everything we do as a modern society. Few Americans remember what it was like to live without it and its attendant benefits on quality of life, labor productivity, and human health. Electricity is today largely taken for granted, yet for middle-class and older Americans utility bills often constitute a significant share of household expenses. In the manufacture of everything from aluminum to silicon to chemicals, electricity is usually the largest operating expense; for many other manufactured goods, it is second only to labor.
The trade in electricity exists at the intersection of society’s demand for the product’s affordability and constant availability. Obtaining one of these two inverse variables means trading off the other. Yet the electric sector has become still more complicated in recent decades, with the addition of environmental and social considerations from emissions and land use to employment at power plants and mines. These demands do not coexist easily, and they never have.
Conflicting policy demands have meant the heavy involvement of government in this sector, ever since its origin. Electricity has never fit the paradigm of business versus regulation. As has been since the case since its earliest days as a commercial product, it is often sold by monopolies at prices fixed by government, both in Washington and at state capitals. The utility sector clamors for government’s involvement in its business decisions, and government is happy to oblige. As a result, few products are regulated in such a command fashion as electricity in our supposedly free market society.
Understanding the sector is not just important because electricity is important; the market for electricity is really a window into the workings of the modern administrative state. The economic regulation of the sector often blurs the line between government and business, turning each into the other’s client. Even in places where competitive features exist, the marketplace is still designed by government and warped by subsidies. Today there is no genuinely free market for electricity. Ironically, many of the ideologically driven, market-oriented reforms of recent decades have precipitated a retrenchment of the monopoly problem they intended to solve. Reforming the market for such a fundamental consumer good is not impossible, however.
The market in electricity is almost hopelessly complicated to the layman. Even experts in certain places, such as New England, profess that they cannot understand the market rules for the product’s trade in, say, California. If knowledge is power, then this type of power is the one scarce attribute of electricity. The shortness of the public’s attention span for headlines dealing with energy does not help matters. A rate hike here, a pipeline there, and Earth Day once a year—beyond this, the public is ill-equipped to judge a sector that is more opaque than even finance or telecommunications. So a primer on the basics of this business, as well as a diagnosis of its systemic flaws, should precede any policy proposals to reform the government’s nearly all-encompassing relationship with the trade in electric power.
Spend More, Make More
While the story of Thomas Edison is usually depicted as a triumph of innovation, it is even more importantly a story of how a transformative invention became quickly attached to the apparatus of the state. Innovation was its kernel, but it was at full blossom only by recourse to state power. Histories such as Jill Jonnes’s Empires of Light (Random House, 2003) and novels such as Graham Moore’s The Last Days of Night (Random House, 2016) tell the same story: Edison and Westinghouse jockeyed in a technological battle over the proper electrical current to supply consumers (direct versus alternating) and over the design of appliances that would use each current. Although AC would eventually become the dominant delivery method of electricity, Edison won the early victories and today wears the laurels of the “Father of Electrification.” He did this by waging a battle of public opinion designed to impel political action, rather than by selling a superior product. For example, he dispatched lieutenants to perform grim demonstrations of the supposed danger of the rival technology (a golden retriever and other animals were electrocuted as part of a traveling public spectacle) and then, building on the perception of a technology spinning out of control, convinced policymakers to endorse the “safer” alternative: his own. Elsewhere, Edison turned litigiousness into an art form, driving competing technologies out of business on frivolous patent claims.
From the beginning, the business wanted to be regulated. Samuel Insull, Edison’s one-time employee, laid the groundwork for electrical monopoly. When Insull arrived in Chicago from Edison’s New York, there were “almost 500 self-contained systems” powering the growing city’s hundreds of thousands of lights, according to Jeremiah Lambert’s The Power Brokers (MIT Press, 2015). It was a bonanza, and to Insull it had the look of ruinous competition: an industry with high fixed costs failing to exploit its natural economies of scale. But it was impossible, as a legal matter, to prevent new or smaller firms from skimming the cream of the customer base, making deals with manufacturing plants or large commercial properties like hotels while leaving residential customers without service. Insull first bought out rivals, but this was not enough. He and his contemporaries eventually cut a deal that would later be replicated across every single state in the union: exclusive franchise for the new monopoly utility, in return for the regulation of rates and the provision of service by the government. It is an odd story, but one that sounds paradoxical only given the current dichotomous portrayal of regulation and business interests.
With few exceptions, the way these companies earn revenue has not changed for a century. The basic formula is the same everywhere, and it seals the relationship between regulation and corporate revenue.
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The regulator reviews the reasonableness of the utility’s operating expenses, usually allowing virtually all of them to flow into consumer rates. The regulator ascertains a total value of capital investment, or rate base, usually based on its original cost less depreciation, and fixes a lifespan for those assets, allowing a return of the capital investment over that time. Finally, and perhaps most importantly, the regulator ordains a percentage return on investment; this is usually about 7 to 9 percent in the current environment, applied to the undepreciated amount of capital the utility’s debt and equity investors have contributed.
The sum of these costs is the “revenue requirement,” which can be thought of as a pie that is subsequently apportioned into individual slices—the rates a customer pays for kilowatt-hours of electricity or dekatherms of natural gas, which should earn the company the “revenue requirement” based on projected customer consumption. These rates then remain fixed until the regulator changes the rates. The expenses and sales volumes incorporated into rate regulation do not reconcile to the company’s actual expenses and sales volumes. Indeed, it is this lack of reconciliation that is the source of essentially the sole businesslike incentive present in the revenue model. It provides a narrow band for the utility to earn potentially more (or less) than its regulatory “revenue requirement” by reducing costs or providing more of its service.
Boring as this detail may seem, it is the key to understanding the electrical market. This so-called cost-of-service regulation suggests to the utility that it should spend as much as possible, even when less might do. The barometer for whether an investment is wise for a utility is not capital productivity, but whether expenditures will be disallowed by the regulator. This seldom occurs. Indeed, the legal presumption that governs the arcane, trial-like proceedings of utility commissions is that all utility spending is prudent. A utility earns a return even on the cost of decorating the C-suite.
Investment funds understand this dynamic perfectly. Their analysis often simply celebrates more and more capital investment (“ratebase” or “capex” in industry lingo), with little attention to the underlying value it delivers to customers. One recent investor note by UBS on the New Jersey utility PSEG was titled “More Ratebase Please.” PSEG advertised its ever-increasing “spend” to its investors, optimistically presenting a case that it would add more to “ratebase” than even its prior projection. This is the thinking of an industry that has come to expect that every dollar will attract the standard regulated return. Utilities often boast that they are “100% regulated,” as one utility from Montana recently told its investors. Regulation, in their eyes as in Insull’s, is a profitable enterprise.
In recent decades, utilities have tended to ask regulators for pre-approval of investments or to update rates monthly or yearly to true-up to actual expenses, two modifications to the traditional revenue model that allow the monopoly to escape ever more of the business risk that any other enterprise would face in the course of its ordinary dealings. Consumers are increasingly on the hook if a power plant a company builds proves to be uneconomical or if a utility’s procurement practices are sloppy. Meanwhile, regulators, like much of officialdom, cherish the thought of being in the mix. They like approving shiny new things, even if it means stepping into the managerial prerogative of business—in this case a business willing to surrender its prerogative, so long as it produces income from a captive set of consumers.....MUCH MORE
This mode of utility regulation perversely causes a utility to be hostile to assets that are still productive, yet fully depreciated per the company’s books. This hostility to depreciated assets emerges because, when a utility’s capital investment is returned to it through regulated rates, it earns nothing on an asset’s continued productivity. This attitude is opposite that of most businesses, which lose money on new assets in the first year of ownership only to grow their earnings in the outer years as the asset’s financing is repaid. A silver lining, one might assume, is that this impulse toward new capital investment would incentivize innovation. Yet it only sometimes does. Innovative products often make the old ways of doing things cheaper, reducing a utility’s capital spending and thus its regulated earnings. Innovation and the utility’s profit motive are frequently misaligned....
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