Utilities Will Drive the Energy Transition, if Regulators get it Right

The nature of electricity as central to modern life and comfort can hardly be disputed—and so its distribution at a reasonable cost is an essential public policy goal of any society. Electric utilities are the engine for that goal, but that engine is in danger of breaking down under the weight of transition.

(Energy Innovation) – The past utility business model relied on growing sales and capital investment. But new technologies, economic realities, and environmental goals mean the way they make money will have to change to avoid obsolescence.

Technology

Falling costs of producing, storing, managing, and consuming one’s own energy are injecting competition into the utility business. Customers have more choices than ever about where their power comes from – and this is likely to continue. But for utilities, it means adapting to new realities where electricity flows in both directions.

Along with greater customer choice, these technologies enable tremendous opportunities to deliver more affordable, reliable, clean service to all. Utilities can now call on customers to reduce their demand at key moments, alleviating congestion and the need for costly upgrades. Distributed generation can provide local service to key infrastructure when the larger grid goes down. Utilities must become system optimizers that embrace these opportunities and grow as system performance improves.

Declining Demand

25 states have energy efficiency resource standards that require utilities to reduce demand – and they’re working. Electric utilities now become almost 1% more efficient each year, and electricity demand remains flat while the economy grows.

Efficiency reduces consumer costs and environmental damage, but it wreaks havoc on the traditional utility business model, which depends on sales growth and increased investment. As utilities optimize the system by comparing supply and demand, they need new revenue streams that reward efficiency.

Environmental Goals Meet Economic Reality

State-level climate ambition has never been higher. State renewable portfolio standards alone will require an additional 60 GW of renewable capacity by 2030, roughly a 50% increase from 2015.  In 2016, the market shifted – economics and corporate purchases were the main drivers of renewable energy development.  Wind is now the cheapest resource on the market, with long-term contracts under $0.02/kWh.

Policies and changing economics are driving innovation and investment in renewable energy, leaving many vertically integrated utilities and independent power producers with billions in potentially stranded investments in old, dirty generation. As zero-marginal-cost renewable energy floods the market, fuel-based generation must look for new sources of revenue or face early retirement.

When you add these three factors together, and consider carefully the financial implications for utilities, it becomes clear that the old utility business model is in trouble. With demand declining and costs rising, in order to break even, utilities must charge more for every unit of electricity they sell. At the same time, self-generation is becoming more cost-effective. Add in the vast potential for energy efficiency and demand response, and you have what looks like a death spiral for the utility business.

The solution to this quandary has thee parts: (1) Put the utility in charge of system optimization, rather than simply the supply of electrons; (2) promote the electrification of appliances and vehicles, and (3) reward the utility for performance rather than sales.

“System optimization” means that the utility should compare demand-side options (e.g. efficient appliance rebates, distributed generation, or peak time rebates) with those from the supply-side (new power plants). The utility should use all these options in combination with wires and poles to assemble the suite that best meets customer energy service needs. At the end of the day, customers care whether lights come on and bills are low, not about kilowatt-hours. So if it is cheaper to replace an office building’s old light bulbs than to build a new gas turbine, that’s where the money should land. If it is cheaper to import wind from the Midwest than to run a coal plant, the utility should be rewarded for that choice. And so forth.

Electric utilities should play a major role supporting transportation electrification, and as electricity providers, they will benefit from additional sales and infrastructure required to meet new demand. Research suggests utility investment in electric vehicle (EV) infrastructure can drive EV growth, while more than making up for lost demand from system optimization.  Meanwhile, to meet ambitious climate goals, home heating and water heating will also need to be electrified, further enhancing the utilities’ business model.  Key to managing this will be converting to smart devices that allow for even greater optimization.

Rewarding performance instead of sales means that the utility should have clear goals, set by the public utilities commission, for reliability, affordability, and environmental performance. The utility should make a good profit when it meets or beats these goals, and it should be penalized when it fails. A mandate for system optimization, together with clear financial incentives to deliver public goods (affordability, reliability, and cleanliness), sets the utility up to become an engine for innovation, service delivery, and financial efficiency.

In recent years, regulators have actively examined alternative revenue models to motivate utilities to provide more efficient, reliable, and cleaner electricity service:

  • In 2016, California Public Utility Commissioner Michael Florio is finalized a pilot exploring new utility incentives for pursuing DER alternatives.
  • In 2017, utilities in New York and Massachusetts proposed new performance incentive mechanisms to reward efficiency, customer renewables, and demand response.
  • Also this year, Illinois, Ohio, and Rhode Island launched proceedings to investigate how utility regulation needs to change to effectively modernize the grid and shift toward more renewable energy.

Results are still rolling in, but evidence suggests that utilities are responding positively to the new regulatory frameworks. New York’s Consolidated Edison is engaging in an innovative pilot to replace a billion-dollar substation upgrade with lower-cost customer-sided demand management. Hawaii’s utility has reduced its interconnection times for rooftop solar in response to new pressure from regulators. Illinois utilities have hit all-time highs for reliable service. And California’s Pacific Gas & Electric will soon start a pilot using third-party infrastructure to modernize grid communication.

U.S. states are once again serving as laboratories for democracy – this time reinventing the electric utility. There will not be a one-size-fits-all solution to the pressures on the current utility business model, but best practices will emerge as state regulators try novel approaches to adapt to new technological, economic, and environmental realities. Regulators and their utilities should watch closely for new opportunities to align utility profits with new system goals. If they can adapt together, utilities will remain engines for energy service and economic growth. If recalcitrance wins the day, the transition could leave some utilities behind.

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Michael is Energy Innovation’s Power Sector Transformation Expert. He works for the firm’s Power Sector Transformation program to uncover solutions for a clean, reliable, and affordable U.S. electricity system. Michael is also a leading expert for America’s Power Plan, a platform for innovative thinkers working to reform the utility regulatory model and identify opportunities for grid optimization. Michael graduated cum laude from ASU’s Sandra Day O’Connor College of Law, focusing on energy and international law. Michael also has a B.A from Vanderbilt University in Philosophy and Asian Studies, minoring in Economics.

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