Dar & Company

The Need For A New Utility Regulatory Model
(First published on www.SeekingAlpha.com on March 29, 2009)

The current regulatory model for local gas and electric utilities no longer adequately serves public policy needs, meets customer priorities or makes best use of the resources and relationships of the local utility. The model has been static for several decades now even though the regulatory models governing energy supply and gas and electric transmission have been substantially changed and refined to reflect market and business realities and legislative will.

Until recently, the static model provided predictability and profits for the franchised utility and, hence, investor support and management success. Now, however, the static model is becoming increasingly disconnected from the dynamic business environment of the utility. The growing gap between a static regulatory model (which means a static business model) and the business and political reality is a source of expanding risk and margin compression for the utility. The utility must change its business model to adjust to new business and political forces but it cannot materially change the business model until the governing regulatory model changes. The pressure to change is the greatest in the Northeast, the Upper Midwest and California, in that order and least in the South and Southwest. Texas has a unique regulatory status because , as a matter of state policy, it has refused to connect with the regional grid preventing Federal energy regulators from dictating terms and preserving for its state regulatory commission great freedom and power to regulate and guide local utilities. Texas has shown the most regulatory flexibility and innovation of any state and has periodically but incrementally refreshed the utility regulatory model

There are four reasons why the current regulatory model no longer suffices, especially in the economically stagnant parts of the US , particularly the Northeast (which combines obsolete regulation with high costs, a hostile business environment for utilities, low value added for consumers and egregious regulatory mandates):

1.       Globalization, which connects distant events and trends in natural gas, non-energy commodities, and energy equipment supply – demand with the local utility in ways never before experienced and never envisioned by legislators and regulators when the current regulatory model was conceived. The price of natural gas in the U.S. Northeast for example, is now as much a function of events in Indonesia and Australia, Japan and the Persian Gulf as it is of gas production in Texas or degree days in Manhattan. Regulatory fragmentation is colliding with global energy market integration.

Until a few years ago, New York/New England was the world’s premium priced large scale market for natural gas. This is no longer the case. In the future, the region will have to compete with an expanding list of foreign and American buyers capable of and willing to outbid the area’s utilities for gas both on price and non-price terms, while providing a more favorable siting and permitting environment for LNG import facilities. The current regulatory model is not equipped to oversee or evaluate the prudence of global supply procurement and the new realities of supply portfolio management.

The same is true for the market for power generating equipment or transmission systems. The incremental opportunity for power system vendors in the U.S. Northeast and Upper Midwest, for example, is very small compared with opportunities in the U.S. South, Southeast and certainly in the Asia/Pacific markets. Local utilities in the Northeast, once quite significant as customers for these vendors, now are only of minor interest. Local utilities in the Northeast have been relegated to being passive price takes in both commodity supply and vendor markets because of globalization and have no leverage for securing preferential treatment. Local regulatory agencies have yet to accept and internalize this new reality during rate cases or prudence reviews or performance audits. The customers, vendors and suppliers of utilities in the Northeast are adjusting to globalization while its regulators are not.

2.       Demographics: The current regulatory model dates from the late 1930s with minor upgrades and refinements in the 1950s when the demographic profile of the utilities in New York, New England and Upper Midwest was very different. Population and labor force were growing and relatively young, social overhead was still low, the factory dominated the economic structure, the nuclear family was the predominant social unit, and the four-year college education was still confined to a minority of high school graduates. Per capita energy use, especially electricity use, was modest, homes and businesses were underserved by even the basic energy commodity. There was little need for high quality or high reliability energy and almost no need for integrated energy management because prices were low, energy security was high, equipment was analog, and the local utility was both small and truly local.

The regulatory concerns, when the model was conceived, were:

·         Volumetric economics

·         Hook ups and system expansion/build out

·         Providing the lowest common denominator commodity to all who desired and could pay for it within a geographically compact franchise

·         Continued development of and adherence to the utility system of accounting

·         Cost of capital analysis

The demographic profile, economic mix and public policy/voter concerns now are much different from the 1950s; but the regulatory model is not. The current regulations are incapable of being stretched and twisted to accommodate current and projected demographic, economic and public policy priorities and realities. Since the priorities and realities will not give, the model will have to.

3.       Technology: The current regulatory model was formed when utility technology was lumpy, large and centralized. Customer energy technologies were few and robust. The embedded optionality in energy technology was minor; islands of incompatible technology were the rule; response times were slow and technology life cycles were longer. The regulatory model, in fact, looked like (and still looks like) a bulky, slow, engineered artifact with many gears and moving parts. Centralized technology meant centralized decision making, which led to the centralized regulatory model. Most often the prevailing technology shapes the regulations, rarely the other way around.

Once a regulatory model is codified and institutionalized it becomes ossified. Technological change is continual and sometimes makes leaps, causing the regulatory model to lag further and further behind until the regulatory model and technological reality become so separated that they occupy two different realms. This is the case now.

Today, energy technology is characterized by flexibility, modularity, connectivity, decentralization and substantial embedded optionality. The pace of change in consumer energy technology is brisk and in the past five years has exceeded the pace of change in utility energy technology. Analog engineering islands are being absorbed into energy-engineering eco-systems which create possibilities for energy management beyond the ability of the current regulatory model to realize. As a result, utilities and customers alike are unable to capture significant benefits.

4.       Customer Preferences: When the current regulatory model was developed, customer preferences were not a factor. Consumers, especially residential consumers, were content to obtain lowest common denominator commodity services (because even those services were considered a substantial enhancement to the then quality of life) of only modest quality and reliability, pay invoices they did not understand, passively accepted the fact that the utility controlled every aspect of their relationship and interface and were tolerant of outages and high noise levels in electricity since they had few appliances and almost none that where particularly sensitive to swings in frequency or pressure. Outages were an inconvenience but not viewed as major disruptions of life at home or at the small business.

The notion of energy consumer choice hardly existed and retail consumers did not dwell on their preferences because there was no systematic way to make those preferences known and no expectations that if revealed, their preferences would have an influence on the thinking of utilities or regulators. Customers, in the parlance of the day, were accounts, meters and rate payers: an undifferentiated and unknown source of guaranteed revenues. The regulatory model assumed that the customer-utility relationship and communications were passive, one way and infrequent. To the customer, the face of the utility was the meter reader and the representative at the local utility office.

The customer reality now is much changed. The retail consumer in urban, particularly metropolitan, areas is very highly dependent on energy for every aspect of living because of the proliferation and diversity of energy using devices in the home and business and unhappy about this dependence. This unhappy dependence translates into a growing discontent with both the utility and regulator who are viewed as impediments to choice and innovation in efficiency, quality, reliability and environmental management. In great contrast with the retail consumer of 40 to 50 years ago, the consumer today is increasingly vocal and insistent on a two way relationship with the utility. The consumer is:

·         Interested in choice as an end unto itself.

·         Perturbed about the high economic cost of retail energy and deteriorating security of supply.

·         Keen to assert greater control over decision making.

·         Much more willing, in the upper middle and upper class segments, to pay for customized services that meet demographically and ideologically specific needs (e.g., carbon suppression) than for lowest common denominator commodity delivery.

·         Much less trusting of the utility and the regulator.

·         Far less tolerant of outages, frequency drift or service degradation of any kind.


A Summary View

The current regulatory model was developed when retail utilities were truly local, small, single-commodity and generally insulated from distant events. Demand was growing, supply was abundant, prices were not an issue and sustained system build out was ahead. Customers were taken for granted and the ability of consumers to interact with utilities and regulators was very constrained. The model was certainly not designed for: large, multi-franchise, geographically extended and multi-product utilities; integrated energy management; innovation and choice in technology based consumer energy services: and an interactive relationship between utilities and consumers. Neither was it designed to enable consumers to procure the EQR (Efficiency, Quality, Reliability), carbon management bundles customized to address their particular preferences and priorities.

When designed, the regulatory model may have been an enabler; today it is a hindrance.