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How Do Electric Utilities Make Money?

Coley Girouard's picture
Energy Policy and Regulatory Consultant Advanced Energy Economy
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  • Apr 28, 2015 9:00 pm GMT
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The times they are a-changin’. There have been a lot of discussions around the country of late about the regulatory changes needed to create a 21st century electricity system. New business models are needed to integrate higher levels of distributed energy resources, take advantage of new technologies, meet environmental goals, and address changing customer needs and expectations. In an industry that has been slow to change historically, there is a lot at stake for utilities, advanced energy companies, and consumers. In order to understand what transformations are needed, it’s first necessary to understand how electric utilities make money today.

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It’s not the way most companies do. Electric utilities are monopolies, so they have to be carefully regulated in order to protect the interests of their captive customers. 

Public Utility Commissions (PUCs) or their equivalent in each state serve as an replacement for the competitive market. In exchange for granting the exclusive right to sell electricity in a given service territory, PUCs determine how much the utility is allowed to invest and in what, how much it can charge, and what its profit margin can be. This is called the “regulatory compact,” and it was first laid out in the Binghamton Bridge Supreme Court case of 1865. The court stated, “if you will embark, with your time, money, and skill, in an enterprise which will accommodate the public necessities, we will grant to you, for a limited time period or in perpetuity, privileges that will justify the expenditure of your money, and the employment of your time and skill.”  

PUCs determine a utility’s total revenue requirement in what is known as a rate case. The revenue requirement represents the amount of money a utility must collect in order to cover its costs and make a reasonable profit. Individual utilities file rate cases, usually every few years, but sometimes less frequently. The PUC decides what the revenue requirement will be based on a number of factors, including the value of a utility’s assets, the cost of debt and equity financing, and operating and administrative expenses. The simplified formula looks like this:

Total Revenue Requirement = Rate Base × Allowed Rate of Return + Expenses

The “rate base” is the value of the company’s assets minus accumulated depreciation. The allowed rate of return (return on assets) drives a utility’s profitability. Expenses are simply passed through, including fuel in cases where regulated utilities own power plants. Historically, critics have said that so-called “rate of return regulation” does not properly motivate utilities to operate efficiently. By having a set rate of return, utilities essentially are incentivized to make unnecessary investments in order to increase their rate base and therefore, their profits – called the Averch-Johnson effect. They also have limited incentive to keep expenses in check if those costs are simply passed through to customers.

On the flip side, having a set rate of return ensures that utilities are able to raise sufficient capital to make improvements to their infrastructure and provide reliable service to all customers. Moreover, because this lowers the risk to investors, utilities have usually been able to secure a lower cost of capital than other businesses. The rate of return is a combination of the cost of paying back its debt holders with interest and the return utilities  provide to their equity shareholders. Not surprisingly, the most controversial part of this formula is calculating the utility’s allowed return on equity (ROE) – this is the only portion of the revenue requirement that a utility ultimately keeps as profit.

Because utilities are regulated, their allowed ROE is set by PUCs. The average ROE across 93 industries and almost 8,000 firms for the US market is 14.49%. As one might expect, utility companies – with an average of 10.13% – are on the lower end of the spectrum because they are viewed as less risky investments.

Rate of return varies significantly from state to state, as each PUC has exclusive authority to regulate utility operations as they choose. In AEE’s Power Portal database, which tracks ROE for over 100 investor-owned utilities across the country, the highest allowed ROE belongs to Alabama Power Co., at 13.75% while the lowest belongs to United Illuminating Co. (CT) at 9.15%. Alabama Power has a significantly higher return on equity than any other utility, which has led critics to wonder whether the Alabama Public Service Commission is properly balancing the interests of consumers and shareholders.

Despite generally being a lower risk investment, utilities do face risks that can be quite dramatic. The California Energy Crisis, a case of industry restructuring gone wrong, led to the bankruptcy of Pacific Gas and Electric. Also, the ROE allowed by a utility’s PUC is no guarantee. There are many factors that come into play for utilities to turn an allowed ROE into actual profits.

As market conditions and policy priorities have changed, various regulatory mechanisms and tweaks to the basic formula have been implemented over the last couple of decades, such as fuel cost adjustments, surcharges, riders, future test years, cost trackers, and revenue decoupling. These measures help to reduce risks that utilities face and drive desired outcomes, like encouraging utilities to invest in energy efficiency instead of pushing for higher sales.

A number of trends now gaining momentum threaten to undermine the utility business model and the existing regulatory compact. In the past, retail sales rose as marginal production costs fell, leading to growing profits for utilities and falling prices for consumers. Today, the need to reinvest in an aging and outdated grid is running up against flat or declining retail sales due to energy efficiency improvements and distributed generation, mainly rooftop solar, which has become increasingly popular. In response, utilities across the country are trying to raise fixed charges for solar owners as well as for basic service to try to stabilize their revenue stream and reduce their risk. Arizona Public Service and Tucson Electric Power both recently received approval for pilot programs in which they would own customer rooftop solar themselves. By entering the competitive distributed generation (DG) market these utilities are seeking a revenue stream to offset falling revenues from retail sales.

In this rapidly changing environment, PUCs around the country are starting to grapple with the fact that rate of return regulation, an approach that has worked well for decades, may not remain viable going forward. Flat to declining load growth, new investments needed to modernize the grid, changing customer needs, and government policies supporting new energy choices are prompting a reconsideration of how utilities make a profit. At a more fundamental level, these changes pose basic questions about what constitutes a natural monopoly today and what is the appropriate role for the utility in the future – giving rise to proceedings like New York’s on-going Reforming the Energy Vision docket. The grid is not going away anytime soon, but it is certainly changing. So, too, must utility business models.

For more information on utilities authorized return on equity and to track their next rate case sign up for a free trial for AEE’s PowerSuite today!

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Bob Meinetz's picture
Bob Meinetz on Apr 28, 2015

Coley, you lost me at the second sentence:

There have been a lot of discussions around the country of late about the regulatory changes needed to create a 21st century electricity system.

Implicit in this statement is the assumption that significant regulatory changes are needed to create the ideal 21st century electricity system. Before we start dissecting the American regulated utility model, upon which every grid in the world is based, you might want to provide some compelling reasons why it’s necessary.

I don’t believe it is. You go on to claim

New business models are needed to integrate higher levels of distributed energy resources…

without any evidence that integrating them isn’t another flavor of the deregulation which permitted Enron to disrupt energy markets – and service – a mere decade and a half ago (I realize the word disruption is now a trendy substitute for innovation; Californians too old to play video games in 2001 remember it differently).

There are other potential pitfalls in this glorious push for privatization (let’s call it what it is). For example: the regulated utility model serves as a wonderful equalizer in that everyone has access to the same electricity at the same price, and the public has a great deal of control over the emissions which result. If every individual can be a player in grid energy, what’s to stop my neighbor from generating electricity by burning diesel fuel, wood, or even coal? Do I have to breathe his emissions, or are you going to regulate and inspect him? Who’s going to pay for it?

Believe it or not, many of these lessons have already been learned. It would behoove DG enthusiasts to download a book on the history of the grid and try to understand why it is what it is. There are quite a few good reasons.

Joris van Dorp's picture
Joris van Dorp on Apr 29, 2015

 

Certainly there are good reasons.

 

Perhaps the US can learn from what is happening in Europe. Electric utilities have been haemorrhaging cash since the 2008 financial crisis. Estimates are that European electric utilities have lost over 500$B since that time. Increasingly, those losses are being exacerbated by subsidised renewable energy, which absorbs revenues (and subsidies) while still leaving the utilities footing the bill for keeping the lights on: a service for which they receive no compensation. This last factor of renewables distorting the electricity markets is so acute that it has started being mentioned in the evening news. Essentially, the renewables are depressing the price of electricity, while they are increasing the cost of electricity. They do this because only the renewables are guaranteed a profit through state subsidies, while the utilities have been liquidating their assets in order to cover their severe losses, year upon bloody year.

 

So this is now being mentioned in the news, but not the fact that absolutely nothing is being done about this problem. Even in Germany, ‘green’ politicians are doing little but cause confusion and delay about tackling the problem. A cynic would say that European politicians are deliberately aiming to bankrupt the entire European electricity sector. A realist would have to concede that the actions of politicians do indeed point in this direction, although it is very unlikely that it is deliberate. More likely is the observation that the political debate about energy and sustainability in Europe has been thoroughly undermined by the constant stream of junk science and junk logic coming from the popular ‘green’ groups.

 

In my experience, I have learned that it is easy to tell when a ‘green’ politician in Europe is lying or spouting nonsense about energy issues: His mouth will be open. Increasingly though, other politicians seem to be copying this behaviour. For example, even our own Dutch right wing liberal party has in recent years been propagating the myth that “wind energy is the cheapest way to reduce greenhouse gas emissions”. It seems that years of sustained misinformation and lies about energy have affected not just the ‘greens’ but also the other political parties, leading to the current quagmire in European parliaments of eye-watering money wastage, time waste, and the structural undermining of the fundaments of modern society as well as the environment.

 

 

 

 

 

 

 

Bruce McFarling's picture
Bruce McFarling on Apr 30, 2015

Increasingly, those losses are being exacerbated by subsidised renewable energy, which absorbs revenues (and subsidies) while still leaving the utilities footing the bill for keeping the lights on: a service for which they receive no compensation.”

This does not sound like the rate base price regulation described in the article.

It sounds more like price regulation based on marginal cost pricing, where the very low marginal cost of the harvest of variable renewables dictate that they should be taken at the bottom of the merit-order, so that in periods when there is a strong harvest, there is no need to use the most expensive fueled power sources and so the periods of high wholesale energy prices which are the most profitable periods for fueled power plants become less frequent.

Of course, any pricing system that allows coal fired generation to be profitable is a pricing system that is not doing the job of promoting long run economic efficiency. So in a systems of integrated utilities, where the operation of the grid is in the same commercial entity as the operation of fossil fueled generation, there is the issue of how to allow the grid operations to be operated at a normal profit, while allowing the fossil fired generation to be progressively driven into bankruptcy as their external costs are internalized.


donough shanahan's picture
donough shanahan on Apr 30, 2015

Joris

Just a clarificatrion. Bold words are mine

Essentially, the renewables are depressing the wholesale price of electricity, while they are increasing the retail price of electricity.

What happens in Germany and many other countries is that the wholesaler (simplifciation = generator) generates the electricity that they then sell to the grid. The grid then either distributes this and sells it directly to the consumer or sells it to a supplier who then sells it on. 

The problem is many comments do not appreciate the difference between wholesale and retail price and that they are set by different entities. Wholesale prices can be very low due to overcapacity and this is the case we see in Germany during times of peak production. Thus the generator/utility gets little to no money as it is competing against a lot of other generators.

The flaw though is renewable generators do not mind this. They can artifically lower their bid price even further if necessary as their FiT is paid after the electricity has been sold from the wholesale market. Even though they make a loss on the wholesale price, they recoup it afterwards. Traditional generators do not get such a FiT and thus have no luxuary.

Thus the retail prices do not mirror wholesale prices and we get negative wholesale but expensive retail. 

Not only that but to export electricity, it must go through the wholesale market and leave it before export. Therefore when we see correlations between solar and exports e.g. in germany, what we are also seeing is an export of the FiT.

Joris van Dorp's picture
Joris van Dorp on May 1, 2015

Yep, that’s right.

An additional feature of this dynamic, which we are seeing in The Netherlands today and presumably in other countries neighbouring Germany, is that the dumping of wholesale electricity spilling over from Germany into our country on a daily basis is crimping local electricity prices not only for Dutch stable generators, but also for Dutch utility solar, which is increasingly having to sell into a wholesale market which is feeling the price-depressing effect of dumped German electricity from across the border. Thusly, utility and commercial-scale solar – even while it is significantly more cost-effective than household rooftop solar – is put at an even more significant disadvantage to household rooftop solar, which recieves a very generous subsidy in the form of household energy tax exemption (which is more than 300% of the current average wholesale price) in addition to unlimited net-metering rights.

A chaotic and evolving patchwork of local, regional and national subsidisation policies and mandates for utility and commercial solar is attempting to move against this dynamic, while utility companies are developing ‘new business models’ targetting entry into the rooftop solar market. Having all but given up investment in (relatively) cost effective, but poorly subsidized utility and commercial solar, these companies know that the only way to make money from solar today is to capture space on household rooftops, leading to the development of various schemes such as solar-rooftop leasing, whereby the utility owns the rooftop solar installation, sells the electricity to the household and thereby indirectly gains access to the hefty subsidy for household rooftop solar. To promote this activity, both the government and the companies are even promoting the tired myth that rooftop solar is ‘cost effective without subsidy’ (which chooses to define household solar rooftop energy tax exemption and net-metering as not being a subsidy). The government has even gone so far as to create a scheme whereby households and even companies can claim that solar installations within a certain proximity of a participating household can gain the same status as actual household rooftop solar, and is thereby entitled to the full direct and indirect subsidy package available to rooftop solar.

Joris van Dorp's picture
Joris van Dorp on May 1, 2015

I don’t agree that low marginal costs of solar ‘dictate that they should be taken at the bottom of the merit-order’.

Electricity generators of whatever kind should sell only into the merit order at-or-above the price they need to cover their total costs, not just their marginal costs. If they are only considering their marginal costs, then they are distorting the market, undermining it fundamentally and putting society in danger. The fact that subsidies alone are allowing them to do this (for now) must be regarded as a market failure plain and simple.

“Of course, any pricing system that allows coal fired generation to be profitable is a pricing system that is not doing the job of promoting long run economic efficiency.”

How so? Coal fired electricity is some of the cheapest electricity there is. If the pricing system is such that even coal fired electricity is not covering it’s costs, then nobody is covering their costs, implying that the entire electric system is depending on subsidies, asset liquidation, or a combination of the two, which is a clear threat to society.

Introducing a firm and predictable ‘price on carbon’ or some other way to solidly internalise the cost of (fossil fueled) generation now and in the long term would prevent such market distortion of course, but that system – the ETS – is not working in the EU. It is not working by design. The ETS was always expected to be a failure, at least by the experts I’ve talked to, for some very simple reasons which I suspect most who read TEC are already familiar with.

Bruce McFarling's picture
Bruce McFarling on May 2, 2015

Electricity generators of whatever kind should sell only into the merit order at-or-above the price they need to cover their total costs, not just their marginal costs.”

Then you are working on a different economic theory than the one used to create artificial markets for electricity in order to price electricity. The rate-base system is one such alternative system that ensures that power is priced at average total cost rather than at marginal incremental costs. According to the mainstream economic theory, that is inefficient … by definition, since the marginal incremental cost is assumed to be the economically efficient price to use.

How so? Coal fired electricity is some of the cheapest electricity there is.”

Only commercially. In full economic costs, it is substantially more expensive than a wide range of alternatives. Just because a cost is not paid by the commercial entity generating the cost does not mean that the product is cheap … it just means that the expense of the product has been shifted onto others without their consent. Allowing access without payment to what is known to be a scarce resource is a subsidy in kind, and the fact that no money changes hands does not change that fact.

Introducing a firm and predictable ‘price on carbon’ or some other way to solidly internalise the cost of (fossil fueled) generation now and in the long term would prevent such market distortion of course, but that system – the ETS – is not working in the EU. It is not working by design.”

Its not working as effectively as a capped permit system might in part by design, because of political compromises in order to protect expensive, subsidized, fossil fuel power. It is also not working as effectively as a capped permit system might in part as collateral damage of the austerity economic policies being pursued within the EU, since an overly complex tradable permit system with an overly generous cap will still have a degree of effectiveness in the context of a growing economy, but it will lead to very low permit price if there are too many economies in the system somewhere in the range from depression to economic stagnation.

But that system not working still leaves us in the Theory of the Second Best situation, where it is massively subsidized fossil power that is bidding into incremental current cost markets, and the harvest of existing variables renewable ought to be brought in before the fossil power. 

 

Joris van Dorp's picture
Joris van Dorp on May 6, 2015

Then you are working on a different economic theory than the one used to create artificial markets for electricity in order to price electricity. The rate-base system is one such alternative system that ensures that power is priced at average total cost rather than at marginal incremental costs. According to the mainstream economic theory, that is inefficient … by definition, since the marginal incremental cost is assumed to be the economically efficient price to use.

Absolutely wrong.

A producer *must* obtain enough revenue to cover his costs. That means the price recieved per kWh of electricity delivered must represent *all* costs, not just a part of the costs. If he doesn’t recieve the price he needs, then his business is either going to go bankrupt, or it is dependent on production subsidies.

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