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Devra Wang’s Blog

Modernizing California's Utilities to Build a Clean Energy Future: The Conversation Begins

Devra Wang

Posted October 3, 2013

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The regulators of California’s largest electric utilities will hold a forum next week on the future of those businesses, and while a discussion of utility “business models” might not seem like the most electrifying topic, the direction they take will determine the size of our energy bills, how clean our air is and whether we can stabilize our climate.

That’s because power plants are America’s largest source of climate-changing pollutants, and a major source of the air and toxic pollution that causes smog and increases the chance of heart attacks and strokes. Refocusing utilities away from investing in dirty and expensive power plants and toward an efficient and clean energy future is essential.

Who determines the future utility business model?

You may be wondering why we need Tuesday’s public forum and thinking “Don’t utilities decide what direction to take their businesses?” But utilities are different from “normal” businesses because their profit opportunities are determined primarily by their regulators (in California it’s the Public Utilities Commission). Although it requires a collaborative effort between regulators, utilities, and other stakeholders to determine a future direction, ultimately the regulators create the financial incentives that will lead utilities’ businesses in a new direction.

Why are changes needed? transmission picture.jpg

Around the country, the core regulatory framework guiding utilities’ businesses hasn’t changed much since the dawn of the electric industry over 100 years ago. Then, a key objective was giving everyone access to power, which dramatically improved quality of life and has rightly been called the greatest engineering achievement of the 20th century.

But today’s regulatory framework in most states still strongly encourages a focus on building infrastructure and increasing electricity sales even though it’s leading us to dirtier air, higher energy bills, and a destabilized climate.

What do we want utilities to do?

Any discussion of future utility business models should start with the key societal objectives we want these regulated businesses to advance. We need to modernize our regulatory framework to ensure they provide safe, reliable, affordable and environmentally sensitive energy services that meet California’s air quality and carbon pollution reduction goals.   

What’s wrong with simply focusing on supplying energy at low rates? Much of the answer comes down to differences that may seem subtle, but will have profound implications for how we incentivize utilities.

  • Energy services vs. energy: Utilities should no longer be in the business of providing energy as a commodity, since consumers don’t care about kilowatt-hours but about the services they provide, such as light, heat, and refrigeration.
  • Bills vs. rates: Most consumers only care about the size of their monthly utility bill, not the rate for each kilowatt-hour of electricity.   
  • Long-term vs. short-term: Analyses of the cost of alternatives to dirty resources have typically looked primarily at the next decade, but today’s investments will largely “lock in” the electric system our children and grandchildren inherit, and determine whether we succeed in meeting long-term air quality and pollution reduction goals.  

This is about more than semantics. With my background in engineering, I think about it like this: if you’re solving a complex equation for the wrong variables, of course you’ll get the wrong answer.

How do California’s utilities make money?

To understand whether regulators’ current financial incentives are driving utilities in a direction that helps, or hinders, the state’s ability to achieve its principal goals, we need to understand how utilities earn profits today.

Utilities have a broad set of responsibilities, including helping customers increase energy efficiency and vary consumption to avoid peak periods, increasing the use of renewable resources, building and operating power plants and the grid, purchasing power from privately owned generators, and assembling a diverse portfolio of all these resources. However, they can only earn profits on a narrow subset of these obligations.

In fact, the bulk of the more than $4 billion in annual pre-tax profits that California’s electric and gas utilities averaged over the past five years under California Public Utilities Commission  (CPUC) regulations came from “rate-based” investments in infrastructure -- including power plants, poles, wires, and other equipment making up the electric grid. Moreover, these profits were based on how much they spent, not their performance.  

                                     Trends in California Utility Rate Base

trends in rate base.jpg

                        Source: California Public Utilities Commission

Fortunately, California’s utilities no longer profit simply from selling more electricity in the near-term, unlike in much of the rest of the country, because the state was an early pioneer of “decoupling” that breaks the link between utilities’ ability to recover fixed costs and how much energy they sell. Using small annual true-ups in rates, the commission ensures utilities’ revenues to cover fixed costs match their authorized totals, regardless of whether sales are higher or lower than expected.

In recent years, the utilities have had opportunities to earn a profit (and at times risked a penalty) for energy efficiency. But the earnings have been less than 2 percent of utility pre-tax profits, and less than half of what they could have earned on comparable supply-side investments. That is a small fraction for California’s top priority resource.

As for renewable energy, the state’s second priority, utilities face a penalty if they fail to meet the requirements of the Renewable Portfolio Standard to generate a portion of their power from clean sources like wind and solar, but they don’t have an earnings opportunity on most of their efforts to meet the RPS (they can only earn a profit if they own the renewable generators).  Similarly, utilities have no business opportunity for helping increase distributed renewables like rooftop solar to meet the state’s goals.

What’s next for California?

Thankfully, California has a head start with decoupling and the CPUC’s recent adoption of a new performance-based incentive mechanism for energy efficiency that continue to move the state closer to a regulatory framework aligned with its clean energy objectives. In addition, the commission’s rate redesign proceeding is examining more equitable ways for customers to pay for their use of the system.

But continuing to allow utilities more profits for more spending on infrastructure, with no or only small opportunities to earn from the state’s top priorities like efficiency and renewables, won’t ensure California meets its goals.  

Although Tuesday’s discussion will focus on the investor-owned utilities regulated by the CPUC, the publicly owned utilities’ business models also need modernization. Recent advances include Los Angeles and Glendale adopting decoupling mechanisms that enable them to stay financially healthy while helping their customers improve efficiency and put solar on their roofs. But Sacramento’s utility – a longtime leader on efficiency and clean energy – took two steps backward by adopting high fixed charges that will slow these efforts. However, Sacramento is now engaged in a dialogue with NRDC about better ways to ensure customers equitably share the costs of the grid without creating new barriers to the clean energy future.

Studies show California must dramatically ramp up energy efficiency and renewable Thumbnail image for solar workers NREL.JPGenergy to meet the state’s long-term carbon pollution reduction goals. We urgently need to accelerate the pace of progress.

Tuesday’s forum is the beginning of an important conversation on how to establish a regulatory framework “firing on all cylinders” to drive the utilities’ businesses in the direction of a clean, affordable and reliable energy future.                                             Photo: Dennis Schroeder / NREL

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