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Emerging Cost and Affordability Challenges in Time of Transition

Posted to ScottMadden, Inc. in the Utility Management Group
Gregory Litra's picture
Partner and Director of Research ScottMadden Inc.

Greg Litra is a partner with ScottMadden, with principal expertise in financial, economic and regulatory analysis, strategic planning, corporate governance, risk management, and transaction...

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Utility investment is a constant in traditional, rate-of-return regulatory constructs. It builds rate base and provides reliable and affordable electric and related services to customers. End-user costs of electricity have been relatively stable over at least the past decade.

Increased wholesale competition, consolidation (with scale economies), and low natural gas prices along with an increasing proportion of energy provided by gas-fired generation, among other things, have given U.S. customers abundant, low-cost electricity. Price moderation has also been assisted by the introduction of zero-marginal-cost energy from renewable resources. Moreover, electricity prices have moved in relative sympathy with broader, moderated inflationary trends.

By and large, low fuel costs (and related low purchased power costs) have helped stabilize customer bills and avoid significant rate impacts even as increasing capital expenditures on initiatives such as grid modernization have been added to rate base. Looking ahead, however, over the near to medium term, it is unclear whether and when a return to a low fuel cost regime may occur.

Increasing Investment Ahead

Utilities, however, are expected to significantly grow investment in all elements of the electricity value chain to reflect changing customer needs, public policies, increased operational risk from climate- and cyber-related events, and new technologies.

  • In distribution, electric utilities will invest in accommodating building and vehicle electrification, rooftop solar, modernizing the grid (e.g., smart meters, distributed energy resource management systems), adding energy storage and other non-wires alternatives, as well as expanding efficiency and demand response programs.
  • In transmission and system operations, capital is needed for expanding regional footprints, interconnection of renewables, resilience and safety (e.g., wildfire reduction) investments, load growth in growing regions, electrification, and investments in resource adequacy and flexible resource procurement.
  • In generation, utilities and merchants will be adding new resources (both dispatchable and variable and emitting and non-emitting), increasing gas interconnections, and piloting new technologies (hydrogen, advanced nuclear, carbon capture, utilization and storage).

With controversy over further hydrocarbon development and geopolitics and global LNG playing a larger role in demand for hydrocarbons, low fuel prices may no longer offset rising capital investment costs. This comes at a time when fundamentals that have underpinned utility ratemaking in recent decades are also shifting:

  • The industry has long relied on volumetric charges; this becomes a potentially less appropriate model as programs like energy efficiency, demand response, and resilience and system hardening are more demand or reliability based rather than usage driven.
  • After a long period of relatively modest cost increases for utility spending, higher inflation (especially for commodity and labor costs), may increase investment requirements.
  • After a decade of low to near-zero Federal Reserve policy rates, a higher interest rate environment, along with expected higher expected returns, could increase financing costs.

What Does It Mean for Customers and Utilities?

An emerging concern is about energy affordability or “energy burden”—i.e., the share of household income needed to pay home energy costs. Regulators will be sensitive to affordability (as are utilities) and will be monitoring and managing effects on households as investments in modernization and decarbonization/transition increase. In particular, utilities can expect more attention to affordability metrics, assistance programs or alternative rates, non-rate public sources of funding, and the impacts of cost allocation.

Rate design may need to evolve as more fixed, non-volumetric-driven costs are introduced into the system. For example, while more zero-marginal-cost resources are introduced into the power system, potentially higher-cost decarbonized and dispatchable flexible resources may also be required to accompany them as stand-by resources.

Grid investment will continue to grow to accommodate distributed energy resources, enable resiliency, and provide flexibility. Energy efficiency and demand response will likely become even more valuable, making load more fungible in response to intermittent generation resources. The investments to make the grid flexible enough to manage new sources and loads are critical; they also introduce the question of how best to recover and pay for them.

Utilities, regulators, and stakeholders needs to strike a balance between investment needs and affordability concerns. For example, electrification of large parts of the economy (especially transportation) will require hundreds of billions, perhaps trillions, of dollars in incremental investment. Given some ambitious goals—for example, Biden Administration goal of U.S. EV share of automotive sales of 50% by 2030 or the recently announced California goal of 100% of new vehicle sales by 2035—could require electrification at a pace at which it will hit a “cost wall” that cannot be easily absorbed by electricity customers. These “balancing” discussions need to occur before significant spending to ensure expectations are aligned.

Finally, the pace of investments will need to consider funding of the investment. Some of this funding will be in the form of higher utility bills, subject to affordability concerns. In addition, higher cost of electricity makes customer adoption of electrification (a public policy objective) more challenging. This may manifest itself as a pushback to transition, as some customers may question its cost effectiveness. Another potential outcome is a revisiting of utility “death spiral” concerns as bill impacts could make self-supply, or at least partial requirements, more attractive.

Some Potential Relief?

The recently enacted Inflation Reduction Act of 2022 is seen as a game changer in both government dollars allocated to new energy infrastructure as well as the scope of sectors affected. The cost of some utility investments may now be defrayed by the availability of federal dollars.

Another option to temper rate increases may be for utilities to seek public sources of funding to meet public policy objectives, in order to align of public policy objectives and funding sources.

Regardless of the effects of the IRA or other public funding sources, utilities and their regulators will need to monitor closely the amount and pace of utility investment and its effect on customer bills. To avoid frequent rate cases, “rate shock,” and regulatory lag, some mechanisms such as infrastructure surcharges and cost trackers may be considered. And all stakeholders will need to consider the pace and prioritization of utility capital plans. As such, the energy transition may become a measured trot rather than a sprint.

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ScottMadden is a management consulting firm focused on Transmission & Distribution, the Grid Edge, Generation, Energy Markets, Rates & Regulation, Enterprise Sustainability, and Corporate Services. We have served hundreds of utilities, large and small.
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Matt Chester's picture
Matt Chester on Oct 10, 2022

An emerging concern is about energy affordability or “energy burden”—i.e., the share of household income needed to pay home energy costs. Regulators will be sensitive to affordability (as are utilities) and will be monitoring and managing effects on households as investments in modernization and decarbonization/transition increase. In particular, utilities can expect more attention to affordability metrics, assistance programs or alternative rates, non-rate public sources of funding, and the impacts of cost allocation.

It's great that the outside regulators and governments are pushing for this, but I'm also curious how strongly the motivation for this is coming from the inside the utility companies? There's obviously a bit of a contrarian dynamic where a utility often wants to maximize profit, but when the product being sold is a daily essential you obviously don't want to price any customers out. How are utilities thinking about that push and pull? 

Katie Briel's picture
Katie Briel on Oct 13, 2022

On behalf of Greg Litra:

A good question, Matt. My comments are my thoughts and not necessarily a position of our firm. But I think different utilities may have different strategies, in part dictated by their policy environment and customers’ preferences.  

At a minimum, utilities are looking to continue or enhance resilience and maintain system reliability. But some utilities also see electrification, enabling distributed energy resources, and deployment of renewables as societal goods (perhaps mandatory) in a carbon emissions-reduction environment. And utilities want to be part of the solution. So that’s the push. 

In terms of the pull you reference, utilities are committed to affordability – no one wants customers that are unhappy about their bills. And as an essential service, no utility wants to jeopardize minimum levels of affordable service. So, the real balancing act on investment and cost recovery is how much and how fast, and that is where much of the stakeholder discussions are centered. It’s difficult to optimize along too many variables – but that is what utilities are trying to do: balance customer costs, environmental goals, and reliability.

John Corrigan's picture
John Corrigan on Nov 2, 2022

The topic of affordability is indeed top of mind for both regulators and utilities.  The author correctly segregates the elements of inflation and infrastructure investment as these are two primary drivers.  The author should have also mentioned the rising cost of capital to fund all of the required investment.  Whether fair or not, it will be incumbent upon the utilities to strike the balance between affordability, required investment and pace of decarbonization.  Additionally, they will have to include the high cost of natural gas (which serves to set power prices in most markets) which it has almost no control over.  

We must remember that the rapid and ongoing expansion of LNG facilities has linked North American gas markets to the global energy markets (current LNG exports are ~10% of US end use consumption).  Much like deregulation and unbundling in the 1990's, the export of natural gas is a genie that won't go back in the bottle.  For the first time, electric and gas prices in the US will depend on the global gas markets - both in Europe and Asia.  We may be in for higher utility costs for awhile.

Julian Jackson's picture
Julian Jackson on Oct 13, 2022

I definitely have a concern for the "energy poor": people having to cut back on heating, AC, lighting or fuel because of rising costs. Which seem inevitable given the global economic situation. I've heard of people giving up jobs because transportation costs made their job uneconomic.  It's not the utilities' responsibility, I'd say it is primarily a governmental one, to manage the bigger picture.  I do, however, wonder if utilities will find they are being blamed for social ills, because of governmental inaction. Energy Central readers know that companies don't get to set the global market price of natural gas or oil but people I encounter often don't.

Jim Stack's picture
Jim Stack on Nov 2, 2022

This article seems to be from a different tine and place. Our utility tells us tge price of Natural Gas is rising. Problem in Russia and Ukrane have caused shortages. Most NG is from Fracking so we have will be a short life.

    Electrification of vehicles is good for utilities. Most charge at night off peak. Utilities finally can sell more of that excess they have st night. 

 

Henry Craver's picture
Henry Craver on Nov 3, 2022

I'm working on a project in Moldova right now and the consequences of the energy crisis are very clear. Universities are planning to go back to COVID-era online schedule just to save on power, most soviet apartment buildings with central heating have yet to turn it on despite average night temperatures below freezing. Some locals and ex-pats I've talked to have told me their last utility bills amounted to about 3x as much as last year, despite having made big efforts to cut consumption. 

Obviously, western governments and citizens, even the poorest, are much better equipped to deal with price hikes than Moldova. But still hurts. 

All that being said, I'm hopeful that in the medium term energy diversification, electrification, and a relatively quick solution in Ukraine will lead to lower fossil fuel costs. 

Julian Jackson's picture
Julian Jackson on Nov 3, 2022

Unfortunately it seems to me that the era of low energy costs is receding in the rear-view mirror. It's not just the Ukraine war: energy costs were rising before it started, and the recent decision of OPEC+ to cut back on production is going to raise prices, along with increased demand from the East, for some time. At what point will this become a "pain point" for (1) Western consumers (2) Utilities? Is there anything anyone can do about it?

Michael Keller's picture
Michael Keller on Nov 7, 2022

The U.S. can easily become energy independent (again) by voting out the elitist Democratic Party. That party is deliberately driving up energy costs as part of an insidious means to make people more dependent on Democrats, thereby entrenching the party’s power. The dependency occurs by providing monetary “help” to combat the economic damage (high energy costs) being created by the green energy religion promoted by the Democrats.

Michael Keller's picture
Michael Keller on Nov 7, 2022

The need for an energy “transition” is weak, at best. Rather, the term is more of a marketing ploy to deflect opposition to liberal elitist’s attempts to control of the world’s economies. These attempts are nothing more than age-old pure greed.

Looks like most utilities are more than happy to go along with the scheme so they too can line their pockets with money while incurring little to no risk.

 

Todd Carney's picture
Todd Carney on Nov 9, 2022

Very interesting post! How do you think the election results will impact support for funding this transition? If at all?

Michael Keller's picture
Michael Keller on Nov 10, 2022

Not sure they will. The issue becomes more problematic as costs become higher and higher. However, as seen in California (and New York), regions under the control of the Democratic Party are more or less immune from addressing exceptionally high energy costs. Leaves citizens and companies little choice other than to leave.
The elite are not really affected by high energy costs. May end up with the Democrats in perpetual control, with the trapped remaining poor and middle class thinking they have no choice other than to rely on handouts from the Democratic Party. Can that scenario continue? Has so far and seems unlikely that will change. However Virginia did change course, so maybe there is some hope in states other than New York and California.

Paul Korzeniowski's picture
Paul Korzeniowski on Nov 27, 2022

Interesting points. The reality is that any business (regulated, unregulated, profit, non-profit) has to balance its cash flow positively. In the past, energy companies did a good job of building business models that delivered energy at low costs. Nowadays, they have more irons in the fire and more factors to consider. As a result, it has become more difficult for them to make needed investments without raising rates, especially with the current inflationary pressure. 

Gregory Litra's picture
Thank Gregory for the Post!
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