July 2018 | Point of View

The new utility imperative: successfully navigating change

The new utility imperative: successfully navigating change

While large investor-owned utilities are experiencing stagnant and, in many cases, decreasing revenues from the reduction in sales due to deployment of grid-edge distributed resources and greater end-use energy efficiency, they continue to invest in new revenue and business opportunities.

This change requires that regulators focus more on providing direction and driving initiatives to define the playing field for how utilities address declining revenues while maintaining just and reasonable rates. Many eyes are watching to see how utilities navigate amid this change. In many respects “the ball is in the utility’s court” because, while much has been generalized about the changing nature of the electric utility industry and its business model, there is no consensus on the role utilities should play in the future – other than remaining the provider of last resort with the “obligation to serve.”

The challenge is to define a regulatory paradigm for utilities that ensures they fulfill their obligation to serve, remain financially viable with flat or declining sales, while more customers leave the system in whole or in part. To address the challenge, regulators and utilities need to assure customers that rates and costs are fair and reasonable for all remaining customers, regardless of the level of service.

The nimbleness and flexibility with which utilities navigate this change will determine whether they are able to adapt and help lead this change successfully − to the benefit of customers, shareholders, and regulators or succumb to disruption in a “death spiral” of sorts, leading to higher costs and increased customer dissatisfaction.

If utilities do not lead the change they will be forced to adapt to the change being driven by others. Early adaptors can structure the rules of the playing field along with regulators and market influences; whereas, adapting with the masses is less opportunistic and at times too late. By failing to lead the market to adaptation and embracing change, higher costs and increased customer dissatisfaction will lead to more regulation not less. 

A Challenge: Establishing a Regulatory Paradigm

This begs the question of the extent to which utilities are able and willing to identify and capitalize on new revenue opportunities — or extract additional revenue from existing assets — as sales continue to fall. The deployment of new grid-edge distributed energy resources and continued improvements in energy efficiency will further erode utility revenues unless new service offerings or pricing structures are proposed to cover the gap in revenue collections brought about by a reduction in sales.

The pace of technological change -  and the penetration of new products and services, enabling customers to better control their energy use and costs and diversify energy service providers - require that utilities look for new revenue opportunities and business models to remain viable. Diversifying offerings and defining new rate structures, either based on some combination of “cost-of-service” regulation or transactional, market-based “willingness-to-pay” pricing is key to ensuring fixed costs are recovered and opportunities exist for utilities to improve service and meet equity returns to maintain favorable bond ratings.

Some utilities, including Consolidated Edison Company, Commonwealth Edison, National Grid, and PG&E are launching marketplace platforms that avail customers to behind-the-meter technologies and “internet-of-things” that can be purchased, and when necessary, installed by third party vendors. Such platforms maintain the utility-customer connection and the use of installed grid assets to deliver services.

While utility rates are still predominately “cost-of-service” some utilities and regulators are experimenting with higher demand charges and lower commodity rates, and many states have implemented “decoupling” when sales do not meet forecast in the rate year to ensure costs are fully recovered. For example, Hawaii Gov. David Ige (D) on April 24, 2018 signed a bill directing the Public Utilities Commission to implement performance-based regulation by 2020 that breaks the link between utility revenues and capital investments. Further, SB 2939 directs the creation of a "new business model" for utilities, by basing revenue collection on metrics like customer satisfaction, renewable energy integration, and data sharing.

None of these are new concepts − setting demand and commodity charges to reduce dependency on revenue collection from commodity and decoupling to recover “lost-revenue” schemes have been in place for decades. Marketplace platforms, however, are new. While these strategies do mitigate the impact of lost sales on revenue collection due to energy efficiency, demand response, and distributed energy resources on the grid, they result in higher costs being borne by the remaining full requirements customers. The greater the erosion of utility sales and dependence on higher demand charges and decoupling to recoup lost revenue, the more rapid and severe the death spiral. To the extent that sales of new products and services through marketplace platforms can offset revenue losses, the death spiral will be mitigated. 

New Revenue Opportunities 

The utility industry has been experimenting with new revenue opportunities through creation of unregulated subsidiaries and to a limited extent, new products and service offerings, for some time. To date, there is no consensus on how regulators would like the industry to adapt to changing economic and social pressures and technological innovation − so utilities are free to help shape the narrative themselves.

With the repeal of the Public Utility Holding Company Act (PUHCA) in 2012, and interest in embarking on new competitive ventures, utilities have created new enterprises and offerings, some competing directly with other regulated utilities. PUHCA repeal provided opportunities for utilities to consolidate, resulting in the ability to capture efficiencies, gain strategic advantage, and operate in jurisdictions with more favorable regulatory treatment. Utility consolidations require regulatory approval with assurances that customers remaining with the regulated utility share in the savings from consolidation. 

Creation of unregulated subsidiaries requires separation of businesses and operations so that customers remaining with the regulated utility are not negatively affected by the actions of the unregulated subsidiary − controls and requirements are put in place to protect the regulated business and customers. Examples include, Edison International with its subsidiaries, SCE and Edison Energy; National Grid with National Grid Ventures; Exelon, Dominion, and other utilities that have a generation business selling into wholesale electricity markets. New revenues from unregulated subsidiaries flow to holding company investors, not customers of the regulated utilities. Such new business ventures do nothing to guard against lost utility sales, and sometimes compete directly with their regulated business; they only benefit the holding company shareholders from any loss in earnings in the regulated business.

Another Challenge: Deciding Who Benefits from New Revenue Opportunities

Proactive distribution utilities may embark on strategies for growth that benefit customers or shareholders. But, it does not have to be one or the other. If the desire is to seek growth through shareholder value creation, hands-down, creating and successfully running unregulated businesses will likely ensure greater returns for holding company shareholders. For this example, see the recent merger announcement of Vistra Energy and Dynegy, where Dynegy's generation capacity and existing retail footprint with Vistra Energy's integrated ERCOT model is expected to create the lowest-cost integrated power company in the industry and position the combined company as the leading integrated retail and generation platform throughout key competitive power markets in the U.S. If the regulated distribution utility is seeking growth to benefit utility customers and shareholders, new products and services need to be offered that provide incentives for customers to remain with the utility with revenue generated through some combination of cost-of-service and market-based, transactional or incentive regulation to meet revenue requirements. Another tactic is the purchase of gas and water businesses to accomplish economies in customer engagement and value delivery. For an example of this, see recent CenterPoint/Vectren announcement.

Regulatory Innovations

Regulated distribution utilities are challenged to continue delivering value to customers and stakeholders while their core business is being threatened by customers self-generating their power, improving energy efficiency, or receiving electricity directly from third-party providers, thereby reducing sales and revenue.

Revenue opportunities found through new regulated product and service offerings can take the form of improving operational efficiencies through which a utility shares in the cost take-out, selling anonymized customer usage data, leasing fiber telecommunications infrastructure to others for private or public use, or technology attachments to utility poles for third-parties, to name a few. It should be noted that any reduction in revenues, without corresponding reductions in costs, lowers shareholder returns and threatens bond ratings.

In the traditional utility business model, regulation seeks to achieve stable utility revenues and return to shareholders, efficient use of energy, and fair and equitable rates to customers. 

A hybrid of cost-of-service rate regulation applied to traditional in-kind infrastructure replacement, or transmission and distribution system investments, and transactional or market-based pricing for new products and services, presents a provocative model for protecting utility revenue from further erosion. 

Flexible traditional, and transactional market-based ratemaking along with earnings adjustment mechanisms (sharing savings with customers and shareholders), and decoupling revenue collection from sales provide distribution utilities with a myriad of choices to remain financially viable in an increasing competitive marketplace. While discussions are being had around hybrid rate-setting, regulators and utilities need criteria and guidelines on when and how such rates should be set.

Continue reading the full article on Pg. 11 of AESP Magazine


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