Are Utilities and Government Skimping on R&D?

Deck: 

The future of the energy sector and environment is at stake.

Fortnightly Magazine - April 2016

R&D is a hard sell. And that goes for both government and the private sector.

The problem? We live in a society that is becoming increasingly myopic. We want immediate gratification - right now, or if not, then at least in the short term.

Yet we know we are just fooling ourselves.

That's because for decades now economists of all stripes have agreed that the new technologies that come from research and development (R&D) represent the major contributor to economic growth, ensuring long-term prosperity for the companies that innovate, and gains in overall economic-welfare for the citizenry at large. Without this impetus, countries stagnate and lose ground to the rest of the world. 

Public policy objectives become more difficult to achieve. Businesses lose their competitive edge (think of drug companies, computer software/hardware, and mobile phones).

Thus a major objective of R&D must be to advance the current state of technology. Basic research, for example, attempts to create new knowledge that will lead ultimately to profitable commercial applications of new technologies. 

Applied research uses the new knowledge created by basic research and applies it to products or services that society values. In other words, basic research provides the theoretical foundation for new technological innovations, while applied research and demonstration focuses on the feasibility of new technologies for practical and commercial applications.

But these inherent features of R&D pose unique challenges for private entities. R&D is expensive, with costs commonly incurred several years or even decades before a company can reap profits or other benefits. R&D by nature is also risky. 

Most R&D efforts end up as dry holes. And even when R&D proves successful, companies must overcome the minefields that lie between basic research and the eventual and hoped-for wide acceptance of a new technology or innovation.

External parties also can become free riders by appropriating the benefits. New knowledge is easily appropriable, unless one has acquired patent protection.

These features of R&D imply two things. First, companies are unwilling to innovate unless the payoff from successful innovation is substantial (which often comes from being first). Second, the market may under-allocate resources to R&D, providing a rationale for government support. This second threat is real. 

PUR Books - Principals of Utility Corporate Finance

Both conservative and liberal economists concur that governments should fund basic research as one of their major functions. Studies have confirmed that social returns on R&D are much greater than private returns, evidence supporting government involvement (e.g., via funding or performance) in R&D.

Trouble in the Energy Sector

In the energy sector, during the past several decades, we have pursued a perilous downward path in R&D expenditures. Policymakers should that find discomforting. Instead, regulators should revisit their current ratemaking and other practices to determine whether utilities need more motivation to innovate in ways that would benefit their customers.

For the electric and natural gas sectors, technological change has the special value of advancing policy objectives. Some industry observers, no less than Bill Gates, have lamented that the absence of breakthroughs in energy technology will make it more difficult if not impossible to attack global warming at affordable cost to society. 

The hope for grid modernization and the general transformation of the electric industry from a commodity provider to a service provider will also require new thinking and innovations that start with R&D. Even though we have witnessed some major technology developments in the energy sector over the past few years, further refinements for achieving global warming and other policy goals will demand yet further innovations. For example, nuclear technologies addressing the public's concern over safety and waste will require design and other changes that start with R&D. 

As evidence of success stories for R&D, the Gas Research Institute (GRI), funded by gas pipelines and gas utility customers, partnered with the federal government to help commercialize shale gas, which of course has had an enormous benefit for energy consumers and the general economy. Government R&D played a vital role in developing combined-cycle combustion turbines, which has also been enormously successful. 

Countless other innovative products have come out of government and GRI. The same can be said for the Electric Power Research Institute. 

The U.S. has seen a decline over the past several years in the level of energy R&D funding (in real dollars) by both government and the private sector. Current expenditures for energy R&D, for example, are about half the level in real dollars of expenditures in the late 1970s during the oil crisis. 

The federal commitment to R&D is less than 0.5 percent of the annual total energy bills for the country. The U.S. Department of Energy receives about 7 percent of the total federal expenditures for R&D, compared with 50 percent received by the Department of Defense and 25 percent by the Department of Health and Human Services. 

Private firms have also shifted their R&D dollars toward short-term projects with an expected quick payback. Many prominent observers have warned that the downward trend in R&D, especially for basic research, could ultimately inflict a high cost on society; for example, the slowing down of the economy's long-term productivity and growth, as well as lost competitiveness of U.S. products in the world market. 

For regulated utilities, technological change is critical for advancing long-term regulatory and public-policy objectives, like safety, reliability, cheaper energy, and a cleaner environment. Both electric and natural gas utilities spend little on R&D, with falling amounts since the 1990s. 

Compared to industries as a whole spending over 3 percent of their net revenues on R&D, the utility sector spends an abysmal 0.1 percent. Declines in the natural gas sector have particularly been striking, with collaborative, annual ratepayer-funded R&D dropping from over $200 million in the early and mid-1990s to around $30 million today. Natural gas distribution has encountered drastic cuts in R&D investments because of the combination of industry restructuring, loss of funding for collaborative industry R&D and the decline in government funding for R&D. 

One cannot know with certainty given these declines that public utilities are spending too little on R&D. It seems logical, however, that given the beginnings of major technological breakthroughs in the electric industry and the new challenges facing the natural gas sector related to methane emissions and safety, R&D activity should grow. 

Fixing the Problem

Public utility regulation has a role to play in stimulating R&D by energy utilities. Various features of public utility regulation affect how much and how utilities conduct R&D. 

The economics literature has devoted relatively little attention to the role of incentives that might encourage regulated firms to engage in R&D and adopt new technologies. The standard narrative, buttressed by observation, is that regulation causes utilities to be cautious about innovating and taking risks.

A major culprit, which is hard to dispute, is traditional price regulation, as it socializes the benefits from innovations. Why would a rational utility invest in R&D when regulators deny it the fruits of successes when risks always stare it in the face?

When utilities give low priority to technological change and other innovations, they are acting in the interest of their shareholders. After all, if a utility has a choice of two technologies, one conventional and the other new, that have the same expected rate of return, it will tend to favor the conventional technology since it has lower risk. 

PUF Books - New Regulatory Finance

History has shown that utilities are often accepting of new technologies, if only because they increase their profits or mandates require them to. Stronger regulatory incentives, however, could bring utility aims into better alignment with customer interests.

As for me, I'd like to leave the reader with three thoughts.

First, R&D plays a vital role in society that is often overlooked by policymakers. Second, the concern that the U.S. is spending too little on energy R&D seems very real. Third, public utility regulation could do a better job of providing incentives to utilities to encourage them to innovate.

For the country's sake, policymakers should take seriously these challenges. If they don't, the future state of the U.S. energy sector and the environment is at stake. It's time to take action.