Razing the Regulatory Compact


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

Fortnightly Magazine - September 2007

When consultants start talking about creating new service models, the eyes of utility executives and regulators tend to glaze over. After all, transformation has been predicted before—loudly and insistently—many times. Many so-called “transformative” technologies have come and gone. And despite many qualitative changes in the way utilities run their networks, most U.S. consumers still buy and use electricity in more or less the same way they have for about 100 years.

But that is destined to change, according to Lynne Kiesling, a Ph.D. economist and senior lecturer at Northwestern University. The primary reason: smart metering.

“Loads will behave differently in a distributed network with price responsiveness,” Kiesling says. “We’ve never had that potential before, and it may well be a paradigm shift for the industry.”

Kiesling spoke to Public Utilities Fortnightly about the long-term implications of that shift. In short, she predicts new technologies will prompt the industry to revamp its regulatory structures and business models over the next 20 years.

Fortnightly: People have talked about transforming the utility industry for more than a decade, and it hasn’t happened. What makes smart metering and the smart grid truly transformational?

Kiesling: Digital communications technology is bringing the ability to achieve more decentralized control, and I think this means a transformation that is different from what we’ve seen in the past.

Historically, from its inception, electricity has been perceived as a dangerous service. As a result, the industry’s technology and regulatory institutions have evolved to provide top-down, centralized control. The physical and economic models we use to understand the industry are very top-down and centralized, because of the historical safety concern, and because of supposed natural-monopoly features of the network.

Now, the long-term vision for a smart grid describes a highly distributed industry, both in terms of operational control, as well as the ability to satisfy diverse customer preferences with innovative products and services, focused on supply and demand. Digital communications technology changes the network from being command-oriented to being transaction-oriented, and allows for the aggregation of distributed intelligence.

For example, the GridWise Olympic Peninsula test-bed project included grid-friendly appliance-controller cards that could sense frequency excursions and automatically change the behavior of appliances to help bring frequency back in line. Appliances and thermostats were programmed automatically to be price responsive.

Those technologies create the potential for distributed control—taking advantage of distributed knowledge about the network and customer preferences and behavior. Loads will behave differently in a distributed network with price responsiveness than they do in a network with centralized control and dispatch and without price responsiveness. We’ve never had that potential before, and it may well be a paradigm shift for the industry. That’s why it makes a lot of incumbents in the industry nervous.

Fortnightly: Many utilities and regulators are skeptical about the idea of innovative services and business models. How are these new models different from the retail-choice initiatives many people view as a failure?

Kiesling: More than any other type of change we’ve seen in this industry, digital-communications technology has the potential to improve quality of service and reduce costs. We can start to think about the feasibility of remote sensing and fault detection. These distributed digital capabilities enable utilities to reach that Holy Grail—the self-healing grid. That’s why people shouldn’t be too jaded about the potential for this, because there are major operational benefits.

And obviously, from the point of view of an end-use customer, no one wants to wake up in the morning and think about how they’re going to manage their electricity use today. Technology has made it possible to cost-effectively automate that process. To the extent a retailer can integrate and bundle that automation together with other services, the distributed network will allow innovation and value that we couldn’t think about within a central-command industry.

Fortnightly: But many people would argue that competition hasn’t worked because electricity is a commodity. It can only be differentiated on price.

Kiesling: As digital technology changes our daily lives, we see it’s not all about price. But technology can’t do it alone. The rules shape the activity that happens. Where we’ve seen retail competition implemented well, we see suppliers coming into the market and offering differentiated products and services. They’re not just competing on price.

It’s illuminating to look at what’s happened in Texas since 1999. They had a transition period where they operated under a price-to-beat mechanism. During that period a lot of the new competitive activity involved incumbent utilities competing against each other in their territories, mostly on the basis of price. In January 2007, when the price-to-beat constraint expired, different types of competitors started coming into the market and offering more differentiated products. They’re not just competing on price.

Telecom is another great example. I pay more for my telecom services today than I did in 1985, even after adjusting for inflation. But I get so much more for my money! That’s part of the mental shift that happens when you reduce entry barriers and enable retail competition. It’s not just about price, but about the variety of services and how you bundle them together.

For decades Bell Telephone argued telephone service was a commodity and a natural monopoly. That’s a convenient argument if you want to maintain entry barriers. But the more experience we have, the more we realize the only part of electric service that’s actually a commodity is the physical energy. You have wires, which provide the transportation function, and then you have the retail function with potential for innovation.

If retail competition seems to be in limbo, maybe it’s because the restructuring we’ve done in the United States has overlooked the importance of sending retail price signals between the customer and the load-serving entity and the generator. Competitive markets require price transparency, but a lot of stuff has gotten muddied because of the political compromises we’ve made. The paradox is that when you protect customers from prices, you undercut the market’s ability to innovate 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 mission: electrification, safety, and controlling the ability of franchises to exercise monopoly-pricing power. The industry achieved those objectives by the 1960s in a most glorious and successful way. But the 21st century means new objectives for the utility industry. Namely, we need to sustain economic growth using the fewest possible natural resources and having the least possible environmental impact; we need to maintain the existing cost protection for low-income consumers; and we need to provide services that allow our economy to compete internationally.

One of the amazing things about the electrification of the United States in the 20th century was the amount of value-creation it enabled. So much of our economic growth wouldn’t have been possible without this industry, and as a result we are the wealthiest country in the world.

To the extent our utility industry is still analog in its technology and offers such a limited array of differentiated products and services, in the 21st century other countries may be able to compete more aggressively to attract new business and support economic growth. International competitiveness is an important part of the story.

But the environmental and low-income issues are the two prevailing concerns we carry into the 21st century. We have to take those issues into consideration any time we think about regulatory policy. But certainly we can find other ways to manage those issues without having to perpetuate retail rate regulation based on cost recovery.