How Will Your Utility Make Money in 2025?

by Bob Shively, Enerdynamics President and Lead Facilitator

“The business model of electric utilities is in a state of transformation due to rapidly proliferating changes, including demands for improved environmental performance, the expansion of distributed energy resources, a growing need for resiliency, new options to improve the performance of the grid, the advent of big data, and new expectations for customer choice.” ~ Navigating Utility Business Model Reform

For the last century, utilities have operated under the cost-of-service business model. Under this methodology, regulated rates reflect a utility’s cost of providing reliable service plus a return to cover debt costs and, in the case of for-profit utilities, to cover return on investment to shareholders. With deregulation in the mid 1990s, the generation sector in many parts of the U.S. and around the world transformed into a competitive business model with profits coming through market, not regulatory, mechanisms. Now as the business enters yet another transformation with the growth of renewables, smart grids, and distributed energy, an increasing number of utilities and their regulators must alter the traditional utility business model for the transmission and distribution sectors of the business.

A recent paper written jointly by the AEE Institute, America’s Power Plan, and the Rocky Mountain Institute titled Navigating Utility Business Model Reform- A Practical Guide to Regulatory Reform outlined four options for new models on how utilities might create earnings:

1. Adjustments to the cost-of-service model

2. A level playing field

3. Retirement of uneconomic assets

4. Reimagined utility business

State utility policymakers and regulators may choose all or portions of these models to achieve goals such as:

• removing the utility incentive to grow energy sales
• realigning utility profit-making incentives with customer and societal needs
• developing new utility revenue and profit opportunities
• revising risk and value sharing between utilities and their customers
• encouraging cost containment

The entire paper is worth reading for those who are interested in the future of the utility, but for those wanting a quick summary a description of each option follows.

Adjustments to the cost-of-service model

Under this option, the basic cost-of-service model would stay in place, but changes in traditional mechanisms provide opportunities to achieve many of the goals described above. Possible adjustments include:

• revenue decoupling that removes the tie between utility sales and utility earnings
• multiyear rate plans that put utilities at risk for performance between rate cycles as long as five years or more (during which rates are not adjusted except for a limited number of items specified in advance)
• shared savings mechanisms whereby the benefits of contracts signed by the utility are shared between utilities and ratepayers
• performance incentive mechanisms where utility earnings are tied to their performance against specific targets set by regulators

A level playing field

Under the traditional cost-of-service model, utilities earn profits through an allowed rate-of-return on capital expenditures while expenses are passed through to customers.  Some have argued that this encourages utilities to focus on capital solutions rather than finding lower-cost contractual solutions to system needs. Under this option cost treatment would change so that:

• treatment of capital expenditures and operating expenses would be altered to make utilities indifferent between the two types of solutions
• utilities that provide energy supply services to consumers would be incentivized to find the lowest-cost combination of centralized and demand-side resources

Retirement of uneconomic resources

This model addresses the current incentives for utilities to continue to utilize existing assets until they have been fully depreciated, even if lower-cost solutions are available in the marketplace. Methods include:

• securitization that allows utilities to retire assets early without earnings penalties by allowing them to refinance uneconomic assets through creation of a bond that pays down the remaining capital balance while including the cost of the bond in rates
• accelerated depreciation that allows utilities to increase rates to pay off assets more quickly so that they can be retired sooner
   

Reimagined utility business

This model envisions that utilities will find new types of value in their networks, and that this value could result in new revenues based on the market value of these services. The additional revenues could be shared between utility customers (reduction of rates) and shareholders (increased profits). Examples of possible new revenue streams include:

• revenues attained through offering services associated with integrating and coordinating energy services by a third party, or services such as data information available from operation of the distribution system
• value-added services provided to consumers by utilities based on new grid technologies and behind-the-meter services

In many cases, policymakers and regulators may choose to mix and match some or all of the concepts. Examples are already being implemented in states such as California, Hawaii, Illinois, and New York. But given the nature of the regulatory process, it will take time. And given state-level regulation in the U.S, we might come up with 50 or more solutions. This will make for interesting times and make it critical that everyone in the utility business understands the financial motivations associated with a specific utility.

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Enerdynamics offers multiple live seminars that you can bring to your company to better understand existing and future issues on how utilities make money. These include How Your Utility Makes Money, The Future of the Utility, and Utility Ratemaking Now and in the Future.

Contact us at 866-765-5432 ext. 700 or info@enerdynamics.com.