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Razing the Regulatory Compact

Smart-grid technologies will dismantle the regulated utility business model, says economist Lynne Kiesling.

Fortnightly Magazine - September 2007

in creating value and providing customer service.

Fortnightly: How does this transformation enhance shareholder value? If it will break down the IOU business model, is building a smart grid a good way for investors to spend their capital?

Kiesling: Over millennia of human history, technological change has created new ways to gain from trade. In the long run, trying to maintain the status quo in the face of technological change is really problematic. Shareholders and consumers can both benefit from this transition. The question becomes muddied only when we get into a zero-sum mindset, which assumes if you win, I lose.

For utilities, we face a political struggle over who gets how much value from the created benefit. You don’t see that in other industries that are not as heavily regulated. In retail banking, for example, the pace of innovation and new service offerings in the past decade has been staggering. The banking industry didn’t spend time bickering about how to split the gains. They answer is the gains are there, everybody is better off, and we’re going to move forward.

Also, we’ve seen increasing awareness on the part of regulators and legislators that bringing these technologies to market and implementing them can’t happen in a vacuum. It requires a retail environment in which these entrepreneurial solutions can create value for customers.

Fortnightly: The IOU business model is embedded in existing market and regulatory structures. How do we get past that?

Kiesling: Shifting from a centralized-control model to a decentralized model makes people nervous because they haven’t operated in that environment before.

We know from other industries it is very efficient. Examples are the Internet, financial services, and market-trading platforms. But electricity is trickier because of the physical reality of energy, and a century of institutional history. It’s a deeply embedded cultural thing, and the regulatory environment makes us very risk averse.

The core of the utility business model is about cost recovery and rate determinations based on prudence reviews. If you do something innovative and it works out well, the gains don’t necessarily flow to shareholder value. But if it fails, the regulator can say, ex-post facto, it wasn’t a prudent investment and shareholders have to eat the cost. Facing that set of incentives, you are not going to innovate.

As we realize the extent to which digital technologies can and will transform the industry, we will realize our regulatory institutions aren’t necessarily compatible with that vision. We need a regulatory environment that will allow creativity to flower and new products and services to reach the market.

Fortnightly: You seem to be saying the old regulatory compact doesn’t work in the 21st century.

Kiesling: I couldn’t have said it better myself, so I’ll repeat it. The old regulatory compact doesn’t work in the 21st century.

That’s a scary thought for a lot of people, in particular because it means rethinking cost-recovery structures and the obligation to serve. But the world really has changed in the past 100 years.

A century ago, the regulatory compact emerged from a three-fold