What Utility Regulators Should Ask about New Technologies

Ken Costello* (kcostello@nrri.org)

A primary objective of utility regulation is to have utilities operate at a high level of performance.  One dimension of performance is economic efficiency.  High efficiency translates into lower utility costs.  One component of efficiency is what economists call “dynamic efficiency,” which measures the technical progress of utilities over time.  It has potentially significant benefits compared with gains from short-run cost reductions and efficient pricing.  A major factor in long-run utility productivity growth is technical progress.  Technical progress depends heavily on utility investments in new technologies.  Because of their inherent risks, unregulated firms require a high payoff for successful outcomes from new technologies.

New technologies also can improve a utility’s performance in ways distinct from economic efficiency.  Some new technologies create new services, improve utility reliability and safety, and advance certain social objectives relating to energy efficiency, competition, a clean environment, and diversity of electric generation.  New technologies can also break down the natural-monopoly feature of utility sectors by facilitating competitive entry.  We have especially seen this outcome in the telecommunications industry.

The purpose of this short article is to initiate a dialogue on how utility regulators can best induce utilities to adopt new technologies that are in the public interest.  This dialogue begins with background on the characteristics of new technologies that pose special challenges for utility regulators.  It then asks several questions about what roles the utility, the regulator, and other government entities should play in promoting new technologies.  Finally, it identifies questions for regulators to ask about ratemaking practices and regulatory incentives.

Features of New Technologies

New technologies have several features, some of which distinguish themselves from “old” technologies:

  1. Most often they are exogenous to an individual utility, i.e., their creation occurs either at the industry level (e.g., EPRI, NREL, GTI) or outside the industry (e.g., Westinghouse or General Electric).
  2. They affect either the supply side or demand side of utility operations:  Some new technologies reduce a utility’s costs (i.e., improve long-run cost efficiency) and create new services; others improve utility reliability and safety; yet others advance certain social objectives relating to energy efficiency, competition, the environment, and diversity of electric generation.
  3. Costs and success are difficult to predict, which makes new technologies risky.  They can turn out unsuccessfully in a number of ways, including not used and useful, low operating performance, high cost overruns in construction, and low penetration of new demand-side technologies.  Overall, new technologies carry a high risk, with unforeseeable problems not uncommon.
  4. They often incur substantial costs with revenues typically received after the utility incurs these costs, which imposes a potential cash-flow problem for a utility.

Challenges for Regulators

Utilities can choose among a large number of new technologies to improve their long-run performance.  An important job of regulators is to make sure utilities: (1) review new technologies and (2) choose those that serve the public interest.

Regulators face special challenges when making decisions on new technologies.  They include the following: (1) utilities might lack good incentives to adopt new technologies; (2) regulators have an information disadvantage relative to utilities over the availability, risks, and benefits of new technologies; and (3) regulators have to make trade-offs among different regulatory objectives.[1]

Incentives: Utilities operate in monopoly markets in which they might have little incentive for, or even resistance against, adopting new technologies.  New technologies can erode a utility’s monopoly status, for example, by reducing entry barriers for newcomers—combined-cycle gas turbines are a good example.  Traditional rate-of-return (ROR) ratemaking might not provide utilities with the right environment to adopt new technologies that are in the public interest.  With constraints on competitive entry and profits in addition to cost-based prices, ROR ratemaking eliminates many of the incentives that unregulated firms have for technological improvements.  Its positive feature is that it limits the risk to a utility for unsuccessful new technologies.  In other words, ROR regulation tends to socialize both the benefits and risks of new technologies.[2] In competitive markets, as a comparison, firms shoulder the risks and receive benefits, at least in the short term.[3] (See Table 1.)

Table 1:  Benefits and Risks of New Technologies in Different Markets

Market

Benefits

Risks

Competitive

Firm in the short term, consumers in the long term

Firm

Monopolistic

Firm and consumer sharing

Firm

Oligopolistic

Firm in the short term, consumers in the long term

Firm

Regulated monopolistic with ROR ratemaking

Largely customers

Largely customers

Regulated monopolistic with price caps

Utility in the short term, customers in the long term

Utility

 

Information asymmetry: Another challenge for regulators is that they know less than utilities about the availability, risks, and benefits of new technologies.  Risks relate to construction, operation, and financial consequences.  This asymmetrical relationship can lead to ill-informed decisions that serve utility interests but not the public interest.

Trade-off complexities: A third major challenge for regulators is that, like most other matters, new technologies require them to make tough trade-offs.  Examples of trade-offs are timely utility recovery of costs versus tolerable customer risk, fuel diversity of electric generation versus the lowest possible utility rates, and advancing competitive conditions versus social activities such as funding of low-income assistance.  In the first example, many utilities would argue that the inherent risks of new technologies require timely and guaranteed cost recovery reflecting full regulatory commitment.  Regulators might balk at passing all the risks to customers.  They face the challenge of protecting customers while not discouraging utilities from adopting new technologies because of excessive risk (e.g., possibly serious financial consequences).  Regulators need to balance these concerns in a way that best serves the public interest—a difficult task indeed.

Another question for regulators relates to the role of utilities in developing and deploying new technologies.  According to the late economist Josef Schumpeter, the market penetration of a new technology requires three stages:  invention, innovation, and diffusion.[4] After the invention of a new product or process, innovation involves commercialization.  Diffusion means the wide use of a successful innovation in the marketplace.  Utilities definitely play a role in using a new technology and, mainly through funding, participate in the innovation and, on rarer occasions, in the invention stages.

Questions for Regulators to Ask

Regulators should ask several questions about new technologies.  Answers to them might trigger different ratemaking practices and even a new general regulatory framework for accommodating new technologies.  They might also lead to a regulatory policy on new technologies or new actions that require utilities, for example, to explain why they haven’t adopted a new technology that would seem to benefit their customers.

The most important of these questions are:

A. The role of utilities

  1. Should utilities fund industry-wide research and development (R&D) that could create new products and production processes and techniques for commercialization?  What economic barriers do utilities face in conducting their own R&D?[5]
  2. In addition to investing in new technologies, should utilities assume the roles of market facilitator, educator, coordinator, and leader?
  3. Should utilities devote resources to promoting and marketing demand-side new technologies?  Should they be able to provide incentives to customers to increase the penetration of these new technologies?
  4. Does the adoption of a new technology by one utility mean that other utilities should also adopt the technology?[6] Are “best practices” the same across utilities?

B. The role of utility regulators, state legislatures, and the federal government

  1. Should state legislatures only provide regulators with guidance on new technologies (e.g., the general framework for evaluating demand-side new technologies) or should they prescribe more detailed regulatory actions (e.g., 15 percent of new generation capacity must be renewable energy)?
  2. Should the federal government provide utilities with financial incentives when they are first adopters of a new technology?  First adopters usually face high risks, and often they incur higher costs than later adopters because of “learning.”
  3. In addition to deciding on whether a utility should adopt a specific new technology based on a utility’s proposal, what other functions should regulators assume?
    1. Should they provide utilities with guidelines or parameters for new technologies?
    2. Should they take a proactive leadership role by proposing or requiring that a utility adopt a specific new technology?
  4. What information should regulators have available to make well-informed decisions on new technologies?  How can regulators mitigate the problem of information asymmetry?
  5. On what basis should regulators approve or reject new technologies?  Should they, for example, require modular and flexible plans that reduce the risk of a long-term commitment? [7]
  6. How should regulators identify barriers to utility adoption of new technologies?  Which barriers should they consider lifting?  Some barriers prevent overinvesting in new technologies while others hamper new technologies that are in the public interest.  The former barriers act as protection against excessive risk taking and poor investment choices[8]; the latter barriers are those that regulators should attempt to eliminate.
  7. Should regulators have a policy on new technologies?
    1. If so, what should be included and what would be its objective?
    2. Should regulators set guidelines for new technologies?
    3. Should regulators set parameters and establish a general regulatory framework for evaluating new technologies?
  8. What regulatory forum is best suited for addressing questions relating to new technologies?  Should regulators consider new technologies as part of resource planning, in a general rate case, or in some proceeding?

C. Ratemaking practices and regulatory incentives

  1. Does traditional ROR regulation provide utilities with inadequate incentives to adopt new technologies that are in the public interest?   Does it compensate the utility for bearing the risks inherent in new technologies?
  2. What circumstances could lead utilities to overspend on new technologies and adopt them too quickly? They can include risk-shifting to customers, rate-basing of costs, and government subsidies offered for a limited time.  Risk-shifting can lead to a “moral hazard” situation in which the utility would be willing to take a chance on a new technology only because it would not suffer financially if the technology turns out to be unsuccessful.
  3. Can incentive-based regulation better motivate utilities than ROR regulation to adopt socially beneficial new technologies?  Would a mechanism like price caps allow a utility to receive adequate benefits in relation to the risks?
  4. How can ratemaking be fair to both the utility and its customers while giving utilities good incentives to adopt new technologies?
  5. What commitments should regulators make to new technologies?
    1. Should they preapprove both the utility adoption of a new technology and all its costs?[9]
    2. Should they instead make partial or no commitment?
  6. Who should bear the risks of new technologies?
    1. Who has more control over risk, the utility or its customers?
    2. Who is more likely to capture the benefits?
    3. Who can bear the risk at less cost?
  7. How do depreciation practices affect the utility’s incentive to adopt new technologies?  Does book depreciation, for example, discourage replacement of existing physical assets that are not fully depreciated?[10]
  8. What role does regulatory lag play in stimulating utility investments in new technologies?
  9. Do some new ratemaking mechanisms discourage utility adoption of new technologies?  Revenue decoupling, for example, might discourage demand-increasing technologies because the utility would reap few of the benefits that the utility would otherwise receive from increased revenues.
  10. If regulators allow more timely and certain cost recovery of new technologies, for fairness, should they require that customers receive more of the benefits?  If customers bear most or all of the risks, they should probably enjoy most of the benefits.  Similarly, if all the benefits of new technologies go to customers, they should probably bear all of the risks.  Thus, one factor in determining cost recovery is the allocation of the benefits.
  11. How should regulators treat cost recovery for new technologies that have large “external” benefits?  These benefits accrue mostly to society at large rather than to utility customers.  Should funding for these technologies come from taxpayers rather than from utility customers?
  12. How can regulators make utilities accountable for their actions involving new technologies?  Some suggestions are risk-sharing (e.g., no guaranteed cost recovery), minimum required performance levels (say, for construction and operation), and for demand-side new technologies, customer education and communication.[11]

Conclusion

The ultimate question for regulators is:  How can they balance different objectives to best serve the general public?  Specifically, how can regulators balance the objectives of (a) protecting customers from the risks associated with new technologies and (b) giving utilities adequate incentives to adopt socially desirable new technologies?  Incentives depend on regulatory commitment, risk allocation, and earnings constraints imposed by regulators.

 

* Principal, National Regulatory Research Institute


Notes

[1]  The main features of regulation that affect a utility’s adoption of new technologies are (a) the tightness of regulation in reflecting changed costs in rates (e.g., regulatory lag, sharing of cost savings), (b) regulatory commitment to the investments in a new technology, (c) information asymmetry, (d) cost recovery mechanism, (e) allocation of the benefits, and (f) risk incidence.

[2] Overall, it is not clear whether ROR regulation leads to over- or under-investment in new technologies.  It tends to induce new technologies by passing most of the risks to customers while discouraging new technologies by allocating most of the benefits to customers.  In periods before the late 1960s, when electric utilities had declining costs, the infrequency of rate cases allowed them to retain the benefits of new technologies over several years.  Evidence has shown that new technologies and other innovative activity during this period were prevalent in the electric industry.  (See, for example, Paul Joskow, "Productivity Growth and Technical Change in the Generation of Electricity," The Energy Journal, Vol. 8, No. 1 (1987): 17-38.)

[3] The author found few studies that examined the effects of utility regulation on the adoption of new technologies and other innovative activities.  It seems clear, however, that regulation would affect innovative activities through the allocation of the benefits and risks.  One factor is regulatory lag; if a utility, for example, retains for a longer period the benefits from a cost-reducing technology, it would have more incentive to adopt the technology.  Regulatory lag highlights the conflict between strengthening the incentive for innovation and allocating the benefits to utility customers in the short term.

[4] Josef Schumpeter, Capitalism, Socialism and Democracy (Harper: New York, 1942).

[5] One possible barrier is the sharing of benefits with other utilities while the individual utility alone incurs the costs.

[6] The diffusion of new technologies is a gradual process.  The fraction of potential users that adopts a new technology typically follows an S-shaped path over time, rising only slowly at first, then experiencing rapid growth, followed by a slowdown in growth as the technology reaches maturity and most potential adopters have switched.  One explanation is that potential technology adopters face different conditions so that the economics of a new technology differs across potential users.  Another explanation relates to the inherent risk associated with adopting a new technology; this risk requires a potential user to acquire much information on both the generic features of the new technology and its use in the particular application under consideration.

[7] Modular plans can reduce risk by dividing a single large project into a series of small sequential investments.  This action can allow utilities to respond to new information or unfolding contingencies.  Modularity and flexibility are especially attractive for investments such as new technologies that have a high degree of uncertainty.

[8] One example is uncertainty, which may hamper the penetration of a new technology.  Uncertain outcomes are inherent in new technologies.  Eliminating this uncertainty for a utility, say, through guaranteed cost recovery can cause the utility to take excessive risk with a new technology (i.e., a “moral hazard” outcome).  The problem is that the utility’s customers would bear the consequences of technology failure.

[9] For a more detailed discussion of regulatory pre-approval practices, see Scott Hempling and Scott Strauss, Pre-Approval Commitments: When and Under What Conditions Should Regulators Commit Ratepayer Dollars to Utility-Proposed Capital Projects? NRRI 08-12, November 2008, at http://nrri.org/pubs/electricity/nrri_preapproval_commitments_08-12.pdf.

[10] When economic obsolescence occurs before full book depreciation, replacement of existing physical assets can lead to stranded costs for the utility.  If utility shareholders absorb the burden of undepreciated assets, the utility might be reluctant to replace those assets when it would be economically efficient technology to do so.

[11] A recent report on one new technology -- the “smart grid” -- recommended the following:

As new opportunities for energy management emerge, regulators and policymakers should update and enhance consumer education efforts.  The number of new choices and options may initially prove daunting for some consumers, but to ensure a successful transition to a smarter grid, consumers will need to understand the transition and the new choices they confront.  (Executive Office of the President of the United States, National Science and Technology Council, A Policy Framework for the 21st Century Grid:  Enabling Our Secure Energy Future, June 2011, 38, at http://www.whitehouse.gov/sites/default/files/microsites/ostp/nstc-smart-grid-june2011.pdf.)

 

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