Grid modernisation is going to be very expensive. What’s the best way to pay for it? The financial incentives governments put in place now will determine what investments get made, how cost-effectively it’s done, and who ultimately pays. Meredith Fowlie at UC Berkeley’s Energy Institute at Haas explains that a common method is for a government to give some sort of guaranteed return on investment for the new asset. But it’s far from ideal. Firstly, it incentivises the building of new stuff but doesn’t reward efficiency gains on existing operations – that’s a big problem when new technologies and solutions for those existing operations (think digitisation, demand response, etc.) are potential game changers. Secondly, those higher rates of return come from higher electricity prices. That’s effectively a regressive tax where poorer households share the same burden as the rest. Fowlie says deep thinking is now required to come up with alternative financing tools, creative uses of limited government funds, and performance-based incentives instead.
The Biden administration is swinging for the fences with this new infrastructure plan. There’s a lot going on in this proposal. Electricity enthusiast that I am, I’ve been focused on the push to accelerate investments in grid modernisation.
Says Biden: “Put simply, these are investments we have to make.. we can’t afford not to.”
As far as the power sector is concerned, study after study suggests he’s right. If we’re serious about deep decarbonisation, we need significant investments in transmission and distribution system expansions and improvements.
The political equivalent of a rare bird sighting, there appears to be bipartisan support for grid infrastructure spending. Especially the kind that connects renewable energy projects in red states to urban electricity consumers in blue states.
How to incentivise private investment?
This come-together spirit quickly runs into trouble when it comes to figuring out how to pay for it. Raising the corporate tax rate- the proposed revenue source behind Biden’s infrastructure plan- could be dead-on-arrival. Big increases in federal spending on needed grid infrastructure will be a heavy political lift. It seems pretty clear that private investment will have a big role to play. But this begs a thorny question: How to incentivise these investments?
Here in California, we’re learning the hard way that old-school financial incentives (embedded in rate-of-return regulation) are not the right tool for this job. Along with grid infrastructure, our grid investment incentive structure needs to be re-invented.
The problems with rate-of-return guarantees
In the simplest of terms, utilities make money when they build new stuff. Utility profits are determined by multiplying the value of undepreciated assets (or the “rate base” in utility-speak) by an authorised rate of return.
Two of our newly minted Energy Institute PhDs, Karl Dunkle Werner and Stephen Jarvis, have recently joined forces to study trends in the authorised rates of return on equity (ROE). Their work is not done, but they generously shared this sneak preview…
The graph shows how the authorised ROE (inflation-adjusted) for utilities held pretty steady since 1990 while other market-based measures of borrowing costs have been in decline. What explains the widening gap? After all, utility debt/equity ratios have also been falling over this period. And utility credit ratings have been pretty stable.
I think part of the explanation could be that state and federal regulators are feeling pressured to authorise relatively high investor returns to entice needed (and often risky) investments in energy infrastructure projects. To see how this can work, consider this California example:
The $3bn Tehachapi Renewable Transmission Project connects huge wind farms in Kern County to millions of L.A. customers. To help get this project off the ground, FERC approved an ROE “adder” to increase the base rate for this project by 1.25% (bringing the total ROE to 12.87 percent). Over the life of the project, the ROE adder alone will likely earn the utility (and cost ratepayers) between $450-$500 million.
I’m not suggesting that we shouldn’t be compensating investors for taking on risky grid infrastructure projects. And it’s clear that juicing up the authorised ROE is a powerful tool that regulators can use to get this job done. The problem is that there are some unfortunate side effects.
Side-Effect #1: Capital Fixation
Under standard cost-of-service regulation, utilities earn a rate of return on capital investments. But operating expenses (labour, fuel, coffee) are typically recovered dollar-for-dollar. In other words, utilities earn profits for their shareholders if they build new stuff, but they do not similarly profit from figuring out how to use the stuff they already have more efficiently.
…efficiency solutions are not rewarded!
When it comes to modernising the grid, there are some highly cost-effective and cutting-edge innovations that involve the optimisation and digitisation of operations. Utilities are relatively well positioned- given the troves of data they hold and the assets they operate- to deploy targeted demand-response programs and grid enhancing technologies. But these kinds of solutions are at a relative disadvantage under standard cost-of-service incentives.
Side-Effect #2: Electricity taxation
Higher authorised rates of return mean higher costs for ratepayers. This typically translates to higher per-unit electricity prices. In other words, we are taxing electricity consumption to pay for grid modernisation. This a regressive way to raise needed revenues. Also, it slows progress towards electrification –the most promising path to deep decarbonisation.
…is a regressive tax
California is currently wrestling with this investment cost recovery predicament. Retail electricity prices are on the rise and capital investments in power system infrastructure are a key driver. Taking stock of this situation, our public utility commission analysts have warned that, going forward, “it will be essential to employ aggressive actions to minimise growth in the utility rate base and protect lower-income ratepayers from bill impacts”.
Financial innovation is needed
We’re hearing a lot about how hard it is to finance and build energy infrastructure projects. So it seems clear that we’ll need financial incentives (in addition to streamlined permitting, regional cooperation, etc.) to attract needed private investment. Given the sense of urgency and the political headwinds, it will be tempting to just lean into the incentives we already have in place. But when it comes to rate-of-return regulation, there are efficiency and equity drawbacks to consider.
There are encouraging signs that DOE and FERC and state PUCs are pursuing more innovative alternatives. This is important work! We should be seriously considering alternative financing tools, creative uses of limited federal funds, and performance-based incentives. The regulatory incentives we put in place now will determine what investments get made, what it costs, and who ultimately pays the price.
Meredith Fowlie is an Associate Professor in the Department of Agricultural and Resource Economics at UC Berkeley. She is also a research associate at UC Berkeley’s Energy Institute at Haas and the National Bureau of Economic Research.
This article is published with permission
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