Research

Public utility regulation, planning for long-term costs and transitions to cleaner energy technology

Candidates for public utility commissions are on ballots across the country this fall. Those who win seats will determine the regulations and rates that govern public utility companies. It's an important job. Utility infrastructures are a major factor in determining whether a city or region is economically competitive. The companies responsible for infrastructure are also facing the technological changes required to provide a clean and sustainable energy supply. How do the utility commissions affect the ability of the utility companies to respond to these challenges?

2008-09-10

It's a big election year, but it's not only the candidates at the top of the ballot that will affect Americans' lives over the coming years. In lower profile races across the country, voters will choose public utility commissioners who will play an instrumental role in the future of their state's energy policies.

Recent reports have highlighted the huge cost of building critical public utility infrastructures. At the same time, environmental concerns are driving a move toward cleaner, more sustainable energy technologies. How do public utility commissions affect the ability of utility companies to plan for these challenges?

Some research suggests that the structure of the public utility regulatory bodies may affect the ability of utility companies to respond: whether the commissioners themselves are elected or appointed; the level and type of experience that commissioners have; and the way commissions set utility rates.

Do elected or appointed public utility commissioners affect utilities differently?

Nearly twenty years ago, W. P. Carey economics professors William Boyes and John McDowell considered whether utility rates would be lower under elected or appointed public utility commissions.

They found that it was not the institutional setting (elected or appointed) that mattered but rather how "close" the commissions were to their constituents. "In other words," Boyes said more recently, "the more regulators must face well organized consumers and/or producers, the more likely these groups will be able to influence the regulators' behavior."

In their research two decades ago, Boyes and McDowell didn't examine the question of how commissions affect utilities' long-run planning or transition to new technologies, but, Boyes said, "it might be logical to extend our analysis to ask whether regulators have a leeway to explore issues affecting future consumers and producers rather than current consumers and producers.

If the consumer and producer groups are stable, it would seem that regulators would have less leeway than if the groups change composition in membership and size. Although an answer can come only from an empirical examination, on the surface, at least, it would seem that in a state like Arizona where population has changed dramatically over the decades, that regulators would have more flexibility to focus on long term issues."

Heather Campbell, associate professor in ASU's School of Public Affairs, also considered the question of whether elected or appointed commissioners would set lower rates for regulated utilities. "At the time that Boyes and McDowell did their work in the area, there was a flurry of interest in the question of whether the election or appointment of commissioners made a difference.

Many states switched from appointed regulatory commissions to elected ones, based on the idea that elected commissioners would be more responsive to citizens than to the utilities. Yet subsequent studies couldn't find evidence to corroborate that idea," Campbell said. One of those studies, conducted in 1998, was Campbell's. "I found that, contrary to expectations, utility rates tended to favor the utilities more when commissioners were elected than when they were appointed," she said.

"There are two reasons for such a finding," Campbell said. "The first is related to the question of who votes for corporation commissioners in the first place. Most citizens don't." Those voters who do, Campbell said, often vote for non-policy reasons (they vote based on the commissioner's party affiliation, for example).

The majority of people who do take an informed interest in the commissioners' election, in contrast, are typically industry insiders — those who work at the regulated utilities, for example. "So when the elected commissioners make decisions, it may be that they're responding to their voters, it's just that their voters aren't voters in general," Campbell said.

The second reason for the unexpected outcome, according to Campbell, is strategic. "Regulated firms asked for more from elected commissioners than appointed commissioners," she said. But because firms padded their requests, it made it hard for the elected commissioners to "sort out the real story."

While Campbell's research didn't look beyond the elected versus appointed question, she says her findings do have implications for policy decisions made in today's commissions. Campbell said that, in general, it's easier for a utility to plan for long-term infrastructure costs if it's bringing in more profit.

And because elected commissioners generally allow utilities more profit than appointed commissioners, the implication is that utilities in an elected-commissioner environment would be more able to plan for those huge costs. "That assumes," Campbell added, "that the commission hasn't dedicated itself to helping utilities plan for transformative infrastructure costs, which it certainly could do, whether the commissioners are elected or appointed."

Either way, Campbell said, "The literature indicates that utility companies are more likely to successfully plan for long-term infrastructure costs and make transitions to new technologies if the commission tries to work with them on the transformation rather than treating the utilities like crooks trying to drain money from the public. A collaborative process is more likely to be successful than an adversarial one."

What are the effects of commissioners' experience?

Another feature that varies among commissions (and even within a commission) is the level and type of experience the commissioners have. Senior economics lecturer Nancy Roberts, who worked at the Arizona Corporation Commission before beginning her career at ASU, said that in her experience "certain backgrounds support better, more informed decisions about utilities.

Knowledge of accounting, finance, economics and engineering are all useful foundations." Tim James, director of research and consulting at W. P. Carey's Seidman Research Institute, said that in the UK commissioners are appointed, "and they bring with them knowledge and experience in the utility industry as well as regulatory economics." That, James said, allows them to understand a more complex rate-setting process.

"The way rates are set in the U.S. is, for the most part, very simplistic. That's partly because elected commissioners are not necessarily experts on utility regulation. The one dimension they focus on is keeping rates down, which is actually quite shortsighted," said James, who comes from the UK, bringing with him a different experience of utility regulation.

How does the commission's rate-setting process affect utilities' behavior?

How utility commissions set rates is another important difference among commissions in the U.S. and, certainly, between the U.S. and other countries. Utility regulation is actually a very complex subject, James said, though it's not always treated that way in the United States.

"One of the primary differences between utility regulation in the U.S. and the UK is that in the UK, regulators generally follow a multi-year regulatory cycle rather than employing an ad hoc rate-setting process. Knowing that they will face a rate case, say, every four or five years gives utility companies more certainty," James said. In many U.S. states, in contrast, utilities have little certainty, so they're constantly going back to the commission for rate increases, sometimes only months after the last rate case.

The mechanism by which rates are often set in the UK is also very different than in most U.S. states, James said. (While rate-setting and other regulatory processes differ by region and industry in the UK, the system there is broadly quite different than systems of regulation in many U.S. states.)

While utility regulation processes vary by state and by industry, in the U.S., rates are typically calculated as the utility's cost plus what the commissioners deem a fair rate of return, or profit. In many states, rates are set based on historical information, and they're not adaptable to changing circumstances, such as rapidly rising fuel costs.

That lack of adaptability affects everything from the utility's ability to plan for long-term infrastructure costs to its ability to transition to new technologies to its ability to borrow money. "If a utility in the U.S. wants to borrow money, all the information it often has to project future earnings is a rate that was set based on circumstances present during the last rate case," James said.

"Companies that had rate cases nine months ago, for example, when oil was dramatically less expensive, have to pay today's much higher fuel costs but often can't change their rates accordingly. So they don't have the kind of secure revenue stream that would satisfy potential bond buyers, which means that the company has to pay higher interest rates on borrowed money — which is yet another higher cost that wasn't factored into the rate.

And that, eventually, leads to a downgrade in the company's bond rating, which only further hampers the utility's ability to borrow money." In the UK, in contrast, the rate-setting mechanism can be more complex, including an adaptive retail price plus a reward factor. Rates can be adaptive to changing circumstances and designed to reward "desired" behavior — extra efficiency, top-notch customer service, the fewest service interruptions — anything the regulators want to incentivize.

That reward factor is the company's profit. Yet Campbell said that in the U.S., "profit" can be a sticky word. "The 'person on the street' tends to think of 'excess' profit as necessarily a bad thing," Campbell said. "But, it is not always, because firms that have good profits can do other things with them. For example, in the 'old days' when AT&T was a regulated monopoly and made a lot of profit, it did a lot of good things.

Its employees were well-compensated, had good benefits and perks and were happy. And, perhaps even more important, the company did a lot of basic research (through Bell Labs) that then benefited the whole nation. In general, a firm with a good profit cushion can afford to take some risks and/or do things that aren't in the firm's own specific self-interest."

Both in terms of planning for long-term infrastructure costs and transitioning to cleaner technologies, Campbell said that if utilities make more profit, or feel that the level of profit is more certain, they have a greater ability to think toward a longer-term future. With rates that include a "reward" factor, which translates into profit for the utility, as they often do in the UK, utilities can be incentivized to behave however the public commission feels is most desirable.

Perhaps it's improving customer service. Or resolving quality issues at the plant. Or, even, being more environmentally friendly. "In the UK, the 'reward' factor gives the regulatory authority the power to pull strings for policy objectives," James said. The current system of energy utility regulation in most U.S. states, James said, doesn't incentivize a look at, for example, non-oil sources of energy.

"Most U.S. energy companies perceive traditional forms of generation to be cheaper than newer, cleaner technologies. They're not inclined to pursue those new technologies because of the huge upfront costs." The solution, James suggested, is a system, like the UK's, that is built on incentives.

"There may be only one thing economists know for certain," he added, "agents do respond to incentives." Yet the ultimate responsibility, James suggested, still lies with the citizens. "If we gave the public utility commissioners a different mandate (other than to keep rates low), we might see policies that were more amenable to long-run goals of cleaner energy generation."

Bottom Line:

• Contrary to expectations, utility rates tend to favor the utilities when commissioners were elected rather than when they were appointed.
• When elected commissioners make decisions, they may well be responding to their voters. But their voters — those citizens who take an informed interest in the commissioners' election — may not be voters in general. That is certainly likely in Arizona, where there may be a large percentage of citizens who vote for commissioners but who are not directly affected by the Arizona Corporation Commission s decisions relating to electricity. For example, SRP — which serves much of the Phoenix metro area — is a quasi-governmental entity and like other government-owned utilities its rates are not regulated by the ACC.
• Because elected commissioners generally allow utilities more profit than appointed commissioners, the implication is that utilities in an elected-commissioner. environment would be more able to plan for huge long-term infrastructure costs
• Long-term planning and transitions to new technologies are much more successful when the utilities and their regulators collaborate.
• Certain backgrounds — accounting, finance, economics and engineering — among utility commissioners support more informed decisions and an ability to understand more complex rate-setting processes.
• Simplistic rate-setting processes which don't allow utility rates to adapt to changing economic circumstances adversely affect the utility's ability to plan for long-term infrastructure costs and its ability to transition to new technologies.
• With rates that include a "reward" factor, which translates into profit for the utility, utilities can be incentivized toward certain behaviors (transitions to cleaner technologies, for example).
• If voters gave public utility commissioners a different mandate (other than to keep rates low), we might see policies that were more amenable to long-run goals of cleaner energy generation.

Economics Faculty