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Time to Change the Rules of Electric Utility Business

Power utilities are designed to provide universal access of electricity by keeping them profitable for investors. Rapid changes in power industry, like distributed generation, transportation electrification, energy storage and others, has brought up many challenges to the traditional business models. Let us have a look how the marketplace is likely to evolve & map out the risks and opportunities for both utilities and policy makers.

Conventional Business Model:

Cost of Service (COS) model was devised by Samuel Insull in the late nineteenth century. This business model allows the utility provider to enjoy a fair and fixed rate of return on investment. Whether it’s regulatory environment or deregulated market structure the rate making is done in line with COS model most of the times.

James Bonbright laid down seven principles of rate design in his work Principles of public utility rates. These principles are widely followed by utility managers and policy makers as criteria for rate designs. These principles can be summarized as:

  • Rates should yield revenues sufficient to recover utility costs
  •  Rates should be designed so that costs are fairly apportioned among different customers without any discrimination 
  • Rates should provide efficient price signals and discourage wasteful usage
  •  Rates should be relatively stable, predictable, simple, and easily understandable

COS rate making generally follows these principles. Under this model, the regulators allow the investor-owned and public utilities to recover revenue that matches their cost of providing services plus a rate of return as an incentive for taking risk of investment in capital. Generally, excessive revenues are returned to consumers via claw-back initiatives & are either rebated in future bills or are invested in non-utility public initiatives of social welfare. The revenue requirement is generally formulized as,

Revenue Requirement = Operating Costs + Depreciation Costs + Taxes + (Rate Base x Rate of Return)

In this equation rate base plays a key role in determining the revenue requirements. Utilities drive their decision of investing in long term assets by keeping in view the type of capital intensive investment falls under the rate base. 

Most of the times, the revenue requirement is determined based on a test year and then revisited during a rate case. Rate cases usually occur on the request of utilities when they invest in capital, so that their rate base is adjusted to match their capital expenditure. Between rate cases, cost trackers and rate riders are applied to adjust the changes in cost that are beyond the control of utilities like fuel cost adjustments and others.

Utilities cover their fix and variable costs through combinations of different charging mechanisms in the retail bills. Some of the commonly used methods of charging are:

  • Fixed Charges: Fixed charges provide revenue for utilities independent of the usage. They are used as a mean to cover the cost of services.
  • Minimum Bills: A minimum bill ensures that utility receives sufficient revenue from each consumer. The mechanism of charging varies across the globe. Some utilities apply minimum charges if a consumer uses less than a certain amount of power. While on the other hand, for some utilities minimum bill includes the costs of metering, billing, and payment processing.
  • Demand Charges: Demand charges are considered as an effective way of meeting up T&D system cost and cost associated with being able to meet peak demand. These charges are generally applied to commercial & industrial consumers.
  • Time-Varying Rates: These type of rates are also referred to as Time of Use (ToU) and Time of Day (ToD) rates. They are generally favoured for addressing peak demand by encouraging the consumers to reduce their demand in peak hours.
  • Tiered Charges: Tiered (block) charges are volumetric charges and are often in inclining blocks, meaning higher users pay more per kWh. This helps to reduce burden on low income customers who uses less electricity and it also helps to encourage efficient use of energy through price signal.
  • Revenue Decoupling: This rate making mechanism separate utilities' sales from their revenues and profits. This is used to reduce the stress form the utility in the time of crisis or low demand growth.
  • Formula-Rate Plans: This is a ratemaking method in which the utility adjusts its base rates outside of a general rate case. These plans discourage utility efficiency.
  • Lost Revenue Adjustment Mechanism: A rate adjustment mechanism that allows a utility to recover revenues that are reduced specifically as a result of energy efficiency programs.

Market Disruptors:

The profitability for utilities in traditional COS business model is linked with increase in sales and continuous investment in capital. It has been effective model since its inception but the distributed generation and demand side management through energy efficient devices has disrupted the model.

Electric Load Growth in Decline:

Electricity demand is highly correlated to economic growth and macro-economic factors. Utilities serving a certain geographical area face this challenge as the demand growth is beyond the control of utilities and the load growth in these cases is generally negative.

Energy Efficiency:

One of the main player bringing down the load growth is energy efficiency. High energy efficiency standards particularly in lighting and other appliances has reduced the amount of energy sold by utilities resulting in shrinking utility revenues. IEA claims the overall reduction in global energy demand by 12% since 2000 because of energy efficient equipment.

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Distributed Generation (DG):

Distributed generation is an onsite and small scale generation near to the consumer. It can be generated from solar to wind to hybrid electric vehicles. Consumers solar panels, as called PV, are a very common source of distributed generation. According to New York University all but 90% of distributed generation is currently being done by solar panels in USA. This increase in distributed generation impacts utility negatively. For instance, if a utility sold less MWh than it had expected due to an unforeseen switch to rooftop solar by some residents, its total revenues at the end of the year would be less than the revenue requirement. Consequently, said utility might request a rate case to address its revenue attrition by increasing customer rates. However, this rate increase might make rooftop solar more financially attractive to customers, further decreasing sales and necessitating additional rate increases. This cycle is known as the “utility death spiral”.

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Energy Storage:

Energy storage is gaining popularity. Intensive commercial research is being done in this domain to get maximum out of renewable energy sources. In near future it is going to reshape the way grid operates. Power generated by renewable energy resources would be readily available for dispatch on demand. It may also insulate the consumption of electricity form the generation and it would not be necessary to consume electricity at the very time of its generation. Electrical Vehicles (EVs) can also be categorized as energy storage systems. Energy storage systems can be taken as a complementary product of DG and complicates the challenges face by utilities on technical & commercial fronts.

Challenges & Opportunities:

These transitions in electrical power system brings both opportunities and challenges that utilities must manage. For example, the high penetration of PVs threatens traditional business model while other developments open window of opportunity for utilities, like the rise of electric vehicles provides a chance to set up charging stations and increase revenues. Overall, utilities have to face serious challenges in future.

The policy makers need to consider the best way to incorporate distributed energy resources and reach a balanced trade-off for both rate payers and utilities. Distributed energy resources' valuation and revenue generation from them is a complex undertaking. For example, a California economic study concluded 30% penetration of distributed PV generation might be 65% less valuable than PV penetration at only 5% because the combination of PV penetration at 30% and baseload generation could strain the grid. In this case, the utilities paying for distributed energy resources via net-metering mechanism would be asked to pay for the full value under COS model resulting in giving out more money than their avoided cost.

Rate making mechanisms are also needed to be revisited to avoid ‘death spiral’ situations and to shift the focus of utilities, in terms of revenue generation, from increase in sales to performance based incentives.

Rapid commercial acceptability of advance technologies and the challenge of climate change is forcing the utilities and regulators to change the rules of the games in order to meet diverse market needs. May be its time to bring agile approach in the future utility business models.

Basit Lashari's picture

Thank Basit for the Post!

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Matt Chester's picture
Matt Chester on Aug 23, 2019 6:52 pm GMT

Rapid commercial acceptability of advance technologies and the challenge of climate change is forcing the utilities and regulators to change the rules of the games in order to meet diverse market needs. May be its time to bring agile approach in the future utility business models

What an emphatic point to end on, kudos Basit. For an industry that's traditionally been quite slow to change and intent on moving forward set in its own ways, what level of optimism do you have that the utility sector at a whole will embrace this agile approach moving forward? I'm seeing a lot of reasons to believe they're up to the challenge, but I'm curious your thoughts

Basit Lashari's picture
Basit Lashari on Aug 26, 2019 6:42 pm GMT

In my humble opinion, most of the utilities being regulated acroos the globe, regulators and policy makers will be playing a key role. They need to see how to amend the business rules to make a win-win situtaion  for both rate payers and utilities. 

In addition to this, in a derulated market the network operators may not be that exposed to the risks then the retailers. Retailers need to look for new markets and see how to get growth or extend their product line.

Will Etson's picture
Will Etson on Aug 25, 2019 6:53 pm GMT

I may have missed it in the article but what about performance based rate making, where utilities negotiate innovation and cost reduction targets in exchange for additional revenue opportunity? Performance based rates can create an incentive to reduce operating cost and split the saving between customers and shareholders. In an environment where loads are generally flat and customers are producing more of their own power new models should be considered.

Basit Lashari's picture
Basit Lashari on Aug 26, 2019 6:52 pm GMT

Thank you so much for raising this intertsing point. Yes, I didn't touch this point intentionaly.  I kept my discussion I am working on performance based rate making. If you have already worked on this topic lets join hands to come up with something.

Looking forward to hear from you :) 

Frank Lacey's picture
Frank Lacey on Aug 29, 2019 12:57 pm GMT

What does the utility of the future ("UOF") look like?  In my opinion, the UOF should look like a conductor of an orchestra -- instead of trying to play all of the various instruments, it should be coordinating all of the instruments and its core competency should be a wires owner/operator.  Understanding it's core competencies, it should leave generation (which appears to be a losing proposition economically), customer service, product innovation, design and delivery and other services to the competitive market place. 

I am always shocked when a traditional utility seeks approval to build a big, centralized, fossil fuel plant, and even moreso when the regulators say "OK".  The market is moving to de-centralized, small and renewable generation.  I understand that we may be a long way away from the point in time where renewables are the 100% solution, but every solar array that is rolled out chips away at the ability of the centralized station to earn any "rents" from peak-pricing.  Solar, DR, Storage, Learning thermostats, other DER and EE have already essentially eliminated peak pricing.  The markets used to see consecutive days at $1,000/MWh.  Now, at best, it is an hour or two, and prices usually stop climbing when they hit $200/MWh.  

Also, on a more practical note, how does a regulated utility manage EV charging?  How does it compensate customers with storage resources?  Market prices change every day.  Are we going to allow a monopoly to move its prices every day in a market where all customers are captive?  That is not good public policy.  FERC is driving aggregation of storage resources by third parties.  Presumably, the order on DER more broadly will be coming soon.  All of this spells doom for the current utility model. 

Eventually, the innovation will drive customers away from the utiltiies, whether they are vertically integrated or not.  when that happens, the regulated rates being assessed to the "second movers" will become so high that consumers will push back.   It is going to be a slow and ugly process, but progress will prevail.  It always does.  

Bob Meinetz's picture
Bob Meinetz on Sep 1, 2019 4:19 pm GMT

Basit, thanks for your overview of electricity ratemaking. However, the idea there is a "market" in electricity is reponsible for much of the problems, distortions, and fraud in ratemaking.

Investor-owned utilities (IOUs) are monopolies - there is no competition. Comparing DERs with utility electricity compares two different products -  like considering "pumpkins" competitive with "apples". Though apples might deflate the economy for pumpkins in the U.S., as Thanksgiving draws near and pies are made from both, there is no way to make a pumpkin pie from apples.

Similarly, there is no way to provide a reliable supply of electricity from solar farms, wind farms, or rooftop solar arrays. Though rooftop arrays will continue to be available at consumer discretion, any attempt to use the supply of electricity from DERs to utility ratemaking will be problematic - like trying to make a pumpkin pie from apples.

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