Pashos: Is cost-of-service regulation relevant in today’s world?

“No task more profoundly tests the capacity of our government … than its share in securing for society those essential services which are furnished by public utilities. Our whole social structure presupposes … dependence upon private economic enterprise. To think of contemporary America without the intricate and pervasive systems which furnish light, heat, power, transportation, and communication is to conjure up another world.” (Felix Frankfurter)

For over a century, Indiana’s public utility rates have been established by governmental agencies, acting as a replacement for a competitive marketplace. The “regulatory compact” under which such regulation takes place holds that public utilities should be given exclusive territories in which to provide these important services so as to avoid a duplication of facilities; in return, public utilities should provide adequate and reliable service to all customers in such territories, at reasonable rates determined by the government. Under this regulatory compact, public utilities submit to regulation and give up the potential upside of substantial profits that other competitive enterprises seek, and customers give up the ability to choose their utility providers.

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The linchpin of regulated ratemaking has been “cost of service” – rates set based on an estimate of the utility’s reasonable and prudent costs of providing utility services to customers going forward, plus a fair return for investors who supply the utility with needed capital. Cost-of-service regulation provides utilities with an opportunity, but not a guarantee, that they will recover their actual costs of providing service along with a fair return for their investors.

The traditional cost-of-service ratemaking model seeks to ensure that investors continue to provide needed capital and customers continue to receive near universal service at reasonable rates. As the U.S. Supreme Court stated, “the rate-making process … i.e., the fixing of just and reasonable rates, involves a balancing of the investor and the consumer interest.” Federal Power Commission v. Hope Natural Gas Co., 320 U.S. 591 (1944).

Today, public utilities are experiencing significant cost increases, due to issues such as federal environmental and other mandates, and the need to upgrade decades-old infrastructure. These cost pressures, combined with fast-paced technology, market changes and other states’ experimentation with retail deregulation, are causing policymakers and others to ask whether cost-of-service regulation remains relevant or whether deregulation might be a preferable alternative.

Given the very recent history of relatively low and stable natural gas and wholesale power prices, deregulation may appear to be an attractive replacement for cost-of-service regulation. But a more in-depth analysis of other states’ retail deregulation experiences indicates that retail deregulation may present more risk than reward.

A principal motivation behind retail deregulation has been the theory that competition would produce lower prices for consumers. A historical comparison of the electricity prices and price changes in regulated and deregulated states, however, indicates that retail deregulation does not impact electricity prices in any significant way. Rather, the price of electricity is determined by numerous other factors upon which deregulation has little to no impact (for example, fuel proximity and prices, wholesale power prices, construction costs, and government renewable policy requirements). Moreover, the distinct possibility exists that retail deregulation is unlikely to produce price reductions except possibly during periods of low natural gas prices, low wholesale power prices, and generating capacity surpluses. Deregulated Electricity in Texas, supra at 63. Retail Electric Rates in Deregulated and Regulated States: 2012 Update, American Public Power Association, April 2013, available at http://www.publicpower.org/files/PDFs/RKW_Final_-_2012_update.pdf. Kenneth Rose, State Retail Electricity Markets: How Are They Performing So Far?, ElectricityPolicy.com (June 2012). Mathew J. Morey and Laurence D. Kirsch, Retail Rate Impacts of State and Federal Electric Utility Policies, Christensen Associates, The Electricity Journal. Vol. 26, Issue 3 (April 2013).

Even if the price benefits were long term and persuasive, there are risks associated with deregulation that must be considered. These risks include price volatility, reliability of supply, complexity of deregulation, and loss of state jurisdiction.

Electricity is considered to be the most volatile commodity in the world, and natural gas is a volatile commodity, as well. Under regulation, utility customers are largely protected from this price volatility because the utility has “iron in the ground” assets and contracts to hedge against spot market price changes. But in deregulated environments, customers bear more price volatility themselves.

The construction of new-generation assets to ensure the availability of electricity and adequate reserves is a very real issue in deregulated markets. Deregulated markets have struggled to effectively incentivize sufficient construction of new generation, as is illustrated by brownouts and blackouts that have occurred in deregulated markets in Texas and California. Deregulated Electricity in Texas: A History of Retail Competition, Texas Coalition for Affordable Power, December 2012, available at http://tcaptx.com/wp-content/uploads/2013/03/SB7-Report-2012.pdf. The Western Energy Crisis, the Enron Bankruptcy, and FERC’s Response, available at http://www.ferc.gov/industries/electric/indus-act/wec/chron/chronology.pdf.

Retail deregulation legislation must necessarily address numerous complicated issues, many of which can produce unintended consequences (such as the California energy crisis in the early 2000s). As just a few examples of such issues: How will deregulation take place? Will incumbent utilities be required to divest their generating assets? How will “stranded costs” be calculated? How will stranded costs be recovered from customers? Should incumbent utilities be required to act as a “provider of last resort?” How should incumbent utilities be compensated for acting as a provider of last resort?

Finally, when states embark upon retail deregulation, they cede a significant amount of jurisdiction over generation and generation pricing to the federal government. Once a state deregulates, the construction of generating facilities and the pricing of electricity generation will, for the most part, take place at the federal, wholesale level, leaving states without much ability to oversee the adequacy of generation supply or the pricing of such supply to retail customers, as experienced in Maryland and New Jersey.

While Indiana may want to explore deregulation as an alternative to cost-of-service-based regulation, the complexity and risks associated with deregulation should not be ignored or underestimated. Similarly, Indiana should not ignore or underestimate the continued usefulness and possible beneficial evolution of cost-of-service regulation.•

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Kay Pashos is a partner in the Indianapolis office of Ice Miller LLP. She practices in the area of energy and utilities law, advising and representing energy and utility companies before state and federal regulatory agencies in a variety of cases. The opinions expressed are those of the author.