Distributed Generation

Deck: 

Disruptive Technology or Regulatory Challenge?

Fortnightly Magazine - August 2015

The U.S. and other developed nations are undergoing unprecedented change in their electric and natural gas systems. One such change - the growth of of distributed generation, including solar, wind, localized turbines, and micro networks (defined collectively here as DG) - is disrupting established market structures within the utility industry. Regulatory incentives have become misaligned. Pricing no longer allows utilities to recover the costs of existing infrastructure. That portends of stranded investment within transmission, distribution, and generation systems.

Proponents of change may see this threat as a normal outcome from the inevitable introduction of disruptive technologies. Yet detractors claim that unwisely implemented DG poses an uneconomic threat to the traditional idea of a healthy public utility landscape. Either way, however, this one key fact remains: distributed generation will certainly prove disruptive if subsidies are provided to support these new technologies.

Economist Joseph Schumpeter described this process as "creative destruction." In the past twenty years, the telecommunications industry faced numerous challenges as new service options encroached on traditional landline, copper wire carriers. These new options, including microwave long-distance service, cellular phones, Voice over Internet Protocol (VoIP), and other technologies changed the telecommunications landscape in fundamental ways, creating creating a landscape of declining home and commercial subscriptions to landline service, with corresponding reductions in traditional streams of revenue. No one today should fail to see these parallels - how the threats that face energy utilities today track the lessons that were learned as the telecommunications industry worked through its own upheaval.

Yes, distributed generation warns of market disruption. Yet at the same time, it appears that DG has created new opportunities that are not necessarily cost-justified, and thus could could trigger cross-subsidies and non-economic bypass of vital regulatory mechanisms. Regulation today does not match the realities of the market and should be reassessed on an ongoing basis to ensure that policy keeps up with the changing market. In the telecommunications industry, ongoing regulatory reassessment helped ensure healthy shifts in technology. The energy industry should learn from telecom to steer clear of any transition that might jeopardize the health of the public utility industry.

Distributed generation marks a set of emerging technologies. That will require creativity from utilities and regulators in introducing laws, policies, and economic incentives - to ensure that revenue streams are captured and that cost recovery reflects market reality.

How Monopolies are Vulnerable

The large public utility electric distribution systems we know today are thought to be "natural monopolies." That means that one single firm can manage to serve the market at a lower cost than multiple firms can do, because of its economies of scale. The natural monopoly model for public utilities has served as strong justification for price and market regulation for the electric and natural gas industries.

Since the utility operates as a legal monopoly, the marginal cost of its energy (its product) is less than the average cost of the energy - over both the long-run and short-run. This basic tenet of monopoly regulation stands at odds with the competitive services and technologies that we see disrupting public utilities today. Unlike competitive markets that set their prices according to supply, demand, and marginal cost theories, natural monopolies cannot set prices equal to marginal cost. Setting prices equal to marginal cost would lead to the eventual destruction of the public utility.

The key point is that regulation needs to be continually assessed and changed to face the realities of the continually changing market. Gradual changes in the regulatory and economic structure need to be built into the transition to guide the market. This occurred in telecom, where laws and regulations were assessed and altered gradually between 1995 and 2010. In fact, during the early 1990s numerous telecom services were deemed "competitive" and no longer regulated. Thus the Telecom Act of 1996 rewrote the rules of the road at the federal and state levels, even as technology advancements took cellular out of the regulated agencies and hastened the continual decline of landline use for homes and businesses.

Energy Industry Market Disruption

Utility companies today are witnessing increases in the deployment of distributed generation and at the same time are reacting to potential decreases in revenue from their established businesses. And increasing levels of DG are likely to continue, given the changing energy landscape, which features (a) stricter environmental policies (such as the EPA's "Clean Power Plan," which mandates carbon emission reductions), (b) corresponding reductions in the use of sulfur-based fuels, and (c) the rising cost of building conventional, large-scale, central-station generation plants.

Onsite generation is becoming increasingly common, due to intermittent energy supplies from solar and wind. Regulatory disruptions are already occurring through regulatory policies such as net energy metering and tax subsidies (e.g., the Investment Tax Credit). To further complicate changing industry forces, Tesla Motors Inc. plans to build a large factory (the so-called "Gigafactory") that would produce more lithium-ion batteries annually than were produced globally in 2013. In parallel, certain western U.S. utility companies are in discussions with Tesla to use such batteries on an industrial scale to store solar electricity from solar farms so that the intermittency of solar energy can be greatly reduced.

The Tesla initiative marks an unprecedented technological event. If successful, it would further erode the efficacy of central-station generation, distribution, and transmission by allowing solar energy, as well as other lower-cost sources of energy, to be stored and used during system peaks or during the evening hours.

These are just a few of the disruptive elements that exist in the electric industry today.

Nevertheless, distributed generation typically is not a substitute for centralized electric service. And so regulators must distinguish between "substituted" versus "supplemental" service. For example, in the United States today DG systems generally are installed by customers who operate these systems in tandem with traditional electric utility service. Rarely are these systems designed to operate independently of the electric power grid. In contrast, competitive telecommunications services allowed for the complete severing of commercial relationships with traditional suppliers. In the case of the early telecommunication service providers, services were resold by the incumbent. VoIP and cellular service provided an adequate (if not perfect) substitute for traditional service. Unlike DG, telecom was able to provide a solution that allowed for the replacement of traditional service.

The difference between the two services is significant from a regulatory standpoint. A supplemental service requires that the incumbent provide complementary services; in some cases the complimentary service may provide the bulk of generation services required by the customer.

Solutions for Electric System Pricing

Key issues for system pricing include the following:

  • Unbundling of Service. The advent of distributed generation makes unbundling of electric service critical. Bundled tariffs lead to opaque price signals that could drive customers to make erroneous choices regarding energy investments, due to a poor understanding of the costs they are avoiding versus shifting.
  • Cross-Subsidies. If implementation of distributed generation allows customers to avoid tariffs that exceed costs, cross-subsidization will be triggered. Ultimately, other customers ultimately will need to absorb those costs.
  • Marginal Cost Tracking. End-use customers should be sent a price signal that is established by marginal costs for incremental or decremental usage. Absent system congestion, the marginal cost of a distribution system will be less than the average cost the pricing solution is two-part pricing.
  • Fixed-Cost Components. A fixed-charge component to pricing design is critical to recovery of costs. The economically efficient solution for distribution pricing requires that the tariff include two components. In addition, the non-volumetric component should be price inelastic and, therefore, cannot be bypassed by consumers. The possible pricing designs that could be employed include (1) a fixed charge, and (2) a demand charge triggered by connected load.

Periodic Reassessments

Aside from the important issues of regulatory pricing, the combination of new technologies, increasing costs, policymakers should keep aware that when customers change their trends of energy usage, that will open the door for alternative regulatory solutions. One point remains clear: the transition from non-competitive services to competitive services requires a continuous reassessment of regulatory structures so that state and federal agencies can engage with industry leaders to help guide these key changes.

Only fundamental changes to legal and regulatory rules, pricing mechanisms, and cost recovery systems will allow for further, sustainable growth and positive developments in the energy sector. Dysfunctional management of laws and regulations will lead to the opposite: unsustainable growth, negative industry changes, and investor frustration. For example, airlines and trucking were highly regulated and each of those industries experienced delays in developing appropriate rules, leading to industry confusion, poor pricing signals, and investor concern over which path to take in a changing landscape.

One area of ongoing focus will be utility economics and tariffs. Changing tariff structures play a central role in unraveling and rebuilding a competitive industry. That rings true especially in states with the potential for high rates of DG adoption. For those states, mitigating (or eliminating) cross subsidies and providing proper customer price signals will help support economic implementation of distributed generation, while limiting stress on non-DG participants and utility finances. As noted across the industry, this strategy should be carried out by most, if not all, policy-setting industry stakeholders. The electric utility sector will benefit from a periodic and ongoing re-assessment and planning to address disruptive challenges.

For example, 30-year investments need to be made on the basis that they will be recoverable in the future in a timely manner. To the extent that increased risk is incurred, capital deployment and recovery mechanisms need to be adapted accordingly.

Periodic Reassessments

Regulators are challenged with trying to find the middle ground that does not stymie innovation but also does not victimize the existing electric power system and the customers that use that system. However, it's quite clear that the current challenges facing the electric industry are not comparable to "Schumpeterian" creative destruction, but are more analogous to above-market PURPA machine payments of the 1980-90s.

We are not witnessing a wholesale shift away from one technology for the adoption of an entirely different, competitive technology. The electric industry is witnessing incremental shifts, driving large industry changes that require focused attention to legal and regulatory structural changes on an ongoing basis - probably for the next 20 years. A key point is that regulatory economic and regulatory can impact the outcome of DG investment and foster economic growth at the city, county, state, and national levels.

Conversely, ill-advised economic and regulatory changes (or the failure to act) are likely to result in stalled electric industry growth, inadequate system and technology investments, which can result in an overall weaker or slowly changing electric system. With the quickening pace of change and heightened attention to the industry from investors, this is an important area of focus that should be addressed at each public utility commission, in the relevant federal agencies, and in Congress. The new opportunities in energy technology have created an increasing number of non-cost-justified utility systems that could trigger cross-subsidies and non-economic bypass of vital regulatory mechanisms. This is not sustainable and is contrary to the continued growth and needed rebuilding in the electric industry.

 

Lead art © Can Stock Photo Inc. / timbrk