Disruptive Innovation and the Regulated Utility

How well do regulated systems adapt to unknown and changing conditions?

I’ve just returned from work travel this week, so I’m dipping into the KP archives to something I wrote in 2013, a decade ago (feeling old …), that is even more relevant today than when I wrote it. In the ensuing decade, solar PV and other distributed technologies have had increased efficiency and decreased production costs, adding to their proliferation. This post was written when the system effects of net energy metering had not yet materialized – the duck curve was not yet a thing.

Here I’m making an argument that unbundling both generation and retail from the regulated monopoly (i.e., quarantining the monopoly) and having the regulated footprint correspond to the wires portion of the supply chain would result in more economically valuable solar PV investment.

Electricity Restructuring and the Failure to Quarantine the Monopoly

I’m also arguing that distributed generation (and now in 2023 I’d add storage) will make the wires network contestable, competing with grid-supplied power. I first made that argument in 2003, and this post traces those bread crumbs if you want to explore the contestability theory I summarized when talking about the natural monopoly model.

Economic Foundations: Natural Monopoly Theory II

How much of what I wrote a decade ago is still relevant, or more relevant than before? I’m interested in your thoughts. And for those of you who are new to electricity economics and policy, or are not steeped in these topics, I hope this provides you with an informative summary of the economic effects of innovation and regulation.

From the archives, July 30, 2013:

Over the weekend the New York Times ran a good story about how rooftop solar and regulatory rules allowing net metering are putting pressure on the regulated distribution utility business model:

The struggle over the California incentives is only the most recent and visible dust-up as many utilities cling to their established business, and its centralized distribution of energy, until they can figure out a new way to make money. …

“Net metering right now is the only way for customers to get value for their rooftop solar systems,” said Adam Browning, executive director of the advocacy group Vote Solar.

Mr. Browning and other proponents say that solar customers deserve fair payment not only for the electricity they transmit but for the value that smaller, more dispersed power generators give to utilities. Making more power closer to where it is used, advocates say, can reduce stress on the grid and make it more reliable, as well as save utilities from having to build and maintain more infrastructure and large, centralized generators.

But utility executives say that when solar customers no longer pay for electricity, they also stop paying for the grid, shifting those costs to other customers. Utilities generally make their profits by making investments in infrastructure and designing customer rates to earn that money back with a guaranteed return, set on average at about 10 percent.

In a nutshell, what’s happening is that environmental and global warming policy initiatives are resulting in government subsidies and tax credits for consumer investments in rooftop solar, especially in states like California. As more consumers install rooftop solar they both make less use of the electricity distribution network to receive electricity and can put the excess power generated from their solar panels onto the distribution grid (called net metering). Under net metering they receive a per-kilowatt-hour payment that ranges between the averaged, regulated retail rate and the wholesale price of electricity at that time, depending on the net metering rules that are in operation in that state. From the regulated utility’s perspective, this move creates a double whammy — it reduces the amount of electricity sold and distributed using the wires network, which reduces revenue and the ability of the utility to charge the customer for use of the wires, but since most of the costs for the network are fixed costs and the utility is guaranteed a particular rate of return on those assets, that means increasing rates for other customers who have not installed solar.

Offsetting some of that revenue decrease/fixed cost dilemma is the fact that net metering means that the utility is purchasing power from rooftop solar owners at a price lower than the spot price they would have to pay to purchase power in the wholesale market in that hour (i.e., wholesale price as avoided cost) … except what happens when they have already entered long-term contracts for power and have to pay anyway? And in California, the net metering payment to the customer is the fully-loaded retail rate, not just the energy portion of the rate, so even though the customer is essentially still using the network (to sell excess power to other users via the regulated utility instead of buying it), the utility is not receiving the wires charge portion of the per-kilowatt-hour regulated rate.

Sounds like a mess, right? It sure is. And, as Katie Fehrenbacher pointed out yesterday on Gigaom [note: broken link, but she made a great Schumpeterian analysis], the disruption of the regulated electric utility in the same way that Kodak, Blockbuster, and Borders have been disrupted out of existence is not a new idea. In fact, I made the same argument here at KP back in 2003, building on a paper I co-authored for the International Association of Energy Economics meetings in 2002 (and here are other KP posts that both Mike and I have made on net metering). I summarized that paper in this Reason Foundation column, in which I argued

Many technological and market innovations have reduced the natural monopoly rationale for traditional electric industry regulation. For example, consider distributed generation. Distributed generation (DG) is the use of an energy source (gas turbines, gas engines, fuel cells, for example) to generate electricity close to where it will be used. Technological change in the past decade and deregulation in the natural gas industry have made DG an economically viable alternative to buying electricity from a monopoly utility and receiving it over the utility’s transmission and distribution grid. The potential for this competition to discipline a transmission owner’s prices for transmission services is immense, but it still faces some obstacles. …

Technological change and market dynamics have made the natural monopoly model of electricity regulation obsolete. While technological changes and market innovations that shape the electricity industry’s evolution have received some attention, their roles in making natural monopoly regulation of transmission and distribution obsolete have not received systematic treatment. For that reason, the policy debate has focused on creating regional transmission organizations to rationalize grid construction, but has not dug more deeply into the possible benefits of dramatically rethinking the foundations of natural monopoly regulation.

I may have been a bit ahead of my time in making this argument, but the improvements in energy efficiency and production costs for solar technology and the shale gas revolution have made this point even more important.

Think a bit about how the regulated utilities and regulators have come to this point. They have come to this point by trying to retain much of the physical and legal structure of traditional regulation, and by trying to fold innovation into that structure. The top-down system-level imposition of requirements for the regulated utility to purchase excess solar-generated electricity and to pay a specific, fixed price for it. The attempts of regulated utilities to block such efforts, and to charge high “standby charges” to customers who install distributed generation but want to retain their grid interconnection as an insurance policy. The fact that regulation ensures cost recovery for the wires company and how that implies that a reduction in number of customers means a price increase to those customers staying on the wires network. And adding on top of that the subsidies and tax credits to induce residential customers to purchase and install rooftop solar. I don’t think we could design a worse process and set of institutions if we tried.

You may respond that there’s no real alternative, and I’d say you’re wrong. You can see the hint in my remarks above from 2003 — if these states had robust retail competition, then retailers could offer a variety of different contracts, products, and services associated with distributed generation. Wires companies could essentially charge standard per-unit transportation rates (assuming they would still be regulated). In that market design, much of the pressure on the business model of the wires company from distributed generation gets diluted. The wires company would still have to be forward-looking and think (with the regulators) about what increased penetration of distributed generation would mean for the required distribution capacity of the wires network and how to invest in it and recover the costs. But the wires company would be just that, a wires company, and not the party with the retail relationship with the residential customer, so all of these distortions arising from net metering would diminish. If I were a wires company I would certainly use digital meters and monitors to measure the amount of current flow and the direction of current flow, and I would charge a per-kilowatt-hour wires transportation charge regardless of direction of flow, whether the residential customer is consuming or producing. Digital technology makes that granular observation possible, which makes that revenue model possible.

That’s why states like California have created such an entangled mess for themselves by retaining the traditional regulated utility structure for integrated distribution and retail and trying to both absorb and incentivize disruptive distributed generation innovation in that traditional structure. Not surprisingly, Texas with its more deregulated and dis-integrated structure has escaped this mess — the only regulated entity is the wires (transmission and distribution) company, and retailers are free to offer residential customers compensation for any excess generation from distributed renewable generation sources, at a price mutually agreed upon between the retailer and the customer in their contract. In fact, Green Mountain Energy offers such a contract to residential customers in Texas. See how much easier that is than what is happening in California?