Beyond Balkanization

Deck: 

A proposal for utility regulatory and industry reform.

Fortnightly Magazine - April 2011

The nation’s ongoing search for energy solutions gives rise to the question: how is the electric utility industry doing and could it be doing better? The “deregulation” the industry went through in the late 1990s has turned out to be more about “restructured regulation” than it was about “deregulation.”

Today the industry faces significant challenges, many related to carbon. These include nuclear generation; wind power and renewable energy in general; natural gas; electric transmission; demand-side management; and technological innovation and the smart grid.

A common denominator of these challenges is they all require a lot of money to address. The electric utility business remains a capital-intensive one. And the business proposition for many initiatives is uncertain.

Regulators and legislators have resorted to various approaches, ranging from the development of state authorities to finance carbon mitigation, to the creation of state-operated regional cap-and-trade entities such as the Regional Greenhouse Gas Initiative (RGGI), to the creation of state-run renewable energy credit (REC) markets. These approaches overlap each other and would likely have been overlapped yet again rather than have been supplanted if a national cap-and-trade law were enacted.

Government will have a huge role in energy policy and energy regulation no matter what. However, the specific role that government takes is important. The distinction between government as regulator and government as industry actor is very important. We’ve known for a long time that the industry restructuring that began in the late 1990s was creating the need for new regulatory responses. We weren’t sure what the response was, but the pre-existing regulatory framework seemed unlikely to serve the needs of a restructured industry. We can’t complain too much about slow progress in developing good responses, because the problems and issues are really complicated. But we have made some missteps, in making recent “government as industry actor” assignments, and by now we probably should have made more progress.

My proposals probably won’t make anyone happy. In a nutshell I believe we need to encourage the formation of bigger utility companies, and we need to overhaul our regulatory processes, making them clearer and more robust as a result.

Small Isn’t Beautiful

The electric utility industry is reasonably positioned to meet today’s needs. However, it hasn’t changed or expanded fast enough to meet tomorrow’s needs. Industry growth is hamstrung; the industry isn’t being allowed to grow enough to address the many roles it ought to be addressing.

Some say the industry’s challenge today is to engage in more long-term planning so that solutions to today’s challenges can be identified. Long-term planning does make sense; more foresight is needed.

But some issues go beyond long-term planning; examples are capital formation and program creation and implementation.

Many projects we see as potential contributors to our energy challenges are simply too big for a fragmented industry to carry out effectively. Recent efforts to form utility industry coalitions and joint ventures are one response to this predicament, but such approaches usually prove inadequate to resolve the industry’s most challenging problems—i.e., the need to finance and complete large capital projects.

So instead of looking to corporations to address challenges, we are looking too frequently to government. Utilities are lining up for government loan guarantees to embark on major projects. Governments are forming agencies to carry out renewable energy programs. Developers are petitioning legislatures for feed-in tariff subsidies. Technology initiatives are presented to government for funding. Ronald Reagan (“government is not the answer, it is the problem”), where are you?

In the franchised utility industry, regulation is supposed to be a surrogate for competition. Ideally, regulated outcomes ought to resemble outcomes that would flow from competition. But our nation is dotted with smallish utility service territories, many defined by political jurisdictions. This isn’t remotely the outcome one would expect from competition. I am even putting aside the municipal utilities and rural electric cooperatives and the challenges they face in meeting tomorrow’s needs.

Why is the industry Balkanized? Why is it left too segmented and too undercapitalized to advance major projects? Efforts to “roll up” the industry have progressed too slowly. This has resulted in the “mom and pop” utility flavor we have today—and left America in a position where we’re looking to governments and state authorities, rather than the nation’s utility companies, to provide programs that address our energy goals.

Why has consolidation been so slow to occur? Economies of scale are there for the taking, but regulators have been leery of utility mergers and haven’t seen mergers as particularly beneficial.

EES North America

Why leery? From the state regulators’ perspective, it might boil down to a sense that there are many risks to consumers associated with mergers and all the benefits are lined up with management and shareholders. When regulators have this sense, it stands to reason they would insist that consumers see tangible near-term benefits from utility mergers. But from the utility standpoint, merger economics get destroyed if too many near-term benefits of a merger are allocated to consumers. The result is a stand-off.

It’s very important that we ask if this stand-off is really OK. Mergers and acquisitions happen much more rapidly in virtually every other industry. But consolidation doesn’t just benefit private-sector entities. Communities across the United States are talking about mergers of local governments—including vital local services like schools and fire companies. Recently, England and France announced they were merging part of their national defenses.

All this is happening in the name of saving costs. England and France, separated by a wide channel and hundreds of years of not-always peaceful history, can merge defenses for the sake of economic efficiency. Why not neighboring U.S. energy utilities? Is it possible to infer that utility regulators are erecting what amounts to a substantial uneconomic barrier to mergers?

Macro-Economies of Scale

It’s entirely possible that utility companies, along with most everyone else, are underestimating the benefits of mergers.

When people talk about merger benefits, they usually focus on direct synergies and complementary strategies resulting from two companies merging. But the societal benefits of more dramatic consolidation might vastly outweigh such micro-economic benefits. With a consolidated utility industry, the nation would save not only on utility administrative offices, but also could rationalize the many institutions that have sprung up to serve the wholesale marketplace.

For instance, if we had five energy utilities in the United States, would we need regional transmission organizations (RTO’s)? If so, how many? Would we need local reliability councils?

And even if we are underestimating merger savings, they’re probably the smaller part of the consumer benefits from industry consolidation. The real benefit of mergers would be the emergence of companies with the economic clout to make the investments the nation needs, and the operational scale necessary to create and implement the programs the nation needs to pursue.

Of course, the public would need assurances it’s protected from extremely large energy companies. “Big is bad” certainly resonates with many people. What type of assurances would the public accept? In the current environment, the typical answer is for a merged entity to enter into a treaty with regulators, under which the merging utilities promise to live up to relatively near-term rate and service standards. That sounds reasonable, except it doesn’t provide longer-term assurances.

The best approach to achieving longer-term assurances might be to give our regulatory bodies the ability to match firepower with firepower.

Instead of creating short-term merger barriers, governments should create regulatory staffs, equipped with adequate authority, to supervise large utilities, protect the public and work to address the energy challenges we face.

To do this, we need to recapitalize our nation’s regulatory staffs. Adequate resources aren’t common in state regulatory bodies today. The public expects a great deal from regulators, but the expectation is to be met largely with a firm eye on the budget. The downside of regulation on the cheap isn’t just that that regulators can’t always bring sufficient resources to bear on matters of substantial public importance. The bigger downside is that utility regulation isn’t viewed as a profession that highly talented and credentialed young people seek as a desirable career path.

This state of affairs isn’t the personal fault of any individual member of a regulatory staff. It’s the fault of a system that doesn’t see the benefit in investing in government institutions and doesn’t want to pay for thorough, in-depth analysis, identify broad solutions or work to create coherent programs that meet long-term needs.

Government as Expert

Many of my colleagues will say the last thing we need to do is invest in regulation, to hire more regulators. However, this view is short-sighted; we very much do need to reinvest in regulation.

For one thing, “expert regulator” is a far better role for government than “service provider.” Reinvesting in regulation is far better than the alternative—continuing the current trend of greater reliance on government to perform the role that businesses normally perform.

Instead, we need to build the resources of our regulatory bodies so they can perform the regulatory tasks in a robust and thorough manner, as the public expects. We need to enable regulatory bodies to take on and match the large utility companies the nation needs to meet our energy challenges. We need to invest in regulation to overcome the sense that “big is bad,” and to avoid a situation where regulators are outmuscled by large, well-capitalized companies.

Even more important is our need to develop creative and innovative regulatory approaches to the challenges we face. These challenges go far beyond cost-of-service regulation, which is complicated enough by itself. Even if the utility industry could identify new regulatory approaches on its own, regulatory bodies need the expertise, resources and confidence to see the merit of new approaches and support them.

Reinvesting in regulation also will bolster public confidence from the standpoint of regulatory ethics and professional competence, and will build a culture of excellence in regulatory institutions adequate to deal with tomorrow’s energy challenges.

While we’re at it, we also need to clarify the jurisdiction of utility regulatory bodies. Local state regulators are spending scarce resources on wholesale power and transmission issues that are properly, from a legal and practical perspective, within the realm of the Federal Energy Regulatory Commission (FERC). Wholesale power costs form a substantial part of the typical utility bill, but Congress has already given FERC exclusive and plenary authority with respect to wholesale electric rates. There may be a degree of inertia from state regulators who were accustomed to a larger role with respect to power supply and wholesale power transactions when the industry exhibited a greater degree of vertical integration. But vertical integration is more the exception than the rule today.

Similarly, local state regulators spend too many resources filling their role as the siting body for interstate transmission lines; when a proposed electric transmission line is to cross through three states, three states need to permit that line. By contrast, when a gas pipeline is proposed to pass through the same three states, FERC permits the line.

I don’t know the reason for the electric-natural gas distinction. Certainly there is a substantial national (federal) interest in electric transmission. It’s also true that an overhead electric transmission line is more visible to the public than is a ground-level gas pipeline. However, there’s substantial local interest in gas pipeline siting and construction, yet the federal government does an adequate job siting gas pipelines—and it should have the same authority over interstate power transmission systems.

Getting Ahead

Our nation faces significant energy issues, and we’re giving in to the temptation to address them on an issue-by-issue basis. We aren’t getting ahead of our challenges.

We need renewable resources, we need nuclear power, we need demand-side resources and energy efficiency. We need both plug-in electric vehicle deployment and natural gas vehicle deployment. And under the currently constituted industry structure, we’re looking too much to government to address these development issues.

We must build an industry and regulatory framework that fosters an adequately sized and capitalized industry, overseen by adequately resourced and staffed regulators with a clear mission, to meet today’s energy challenges. If we persist on the current path, we won’t get ahead of the issues we face, and as a result the nation will be less economically efficient and less technologically competitive than it could be.