Explainer Episode 49 – Utility Rate Modeling
Energy consumers continue to see rising rates, but how do regulators decide the rate that consumers pay? In this episode, James Coleman and Mark Ellis explain the relationship between federal and state regulators and utility companies, the financing models behind regulated rates, and the incentives created by these models. What are the implications of state-regulated projects? How do utility companies respond, and what are the risks? What is the impact on consumers? In this episode, experts address these questions and more.
Although this transcript is largely accurate, in some cases it could be incomplete or inaccurate due to inaudible passages or transcription errors.
[Music and Narration]
Introduction: Welcome to the Regulatory Transparency Project’s Fourth Branch podcast series. All expressions of opinion are those of the speaker.
Sarah Bengtsson: Welcome to the Fourth Branch podcast. My name is Sarah Bengtsson, and I am the Associate Director of the Regulatory Transparency Project. Today, we are delighted to host two experts, James Coleman and Mark Ellis, for a discussion on utility rate models.
James Coleman is currently the Robert G. Storey Distinguished Faculty Fellow and Professor of Law at Southern Methodist University, where he specializes in energy trade and North American environmental and energy regulation. Mr. Coleman is a member of the Regulatory Transparency Project’s Energy and Environment Working Group, and he will also be our guest host for today’s episode.
We will also have Mark Ellis joining us. Mr. Ellis is an expert witness in utility regulatory proceedings on behalf of consumer advocates. Prior to being an expert witness, he was a utility finance and strategy executive for leading North American energy infrastructure companies.
Thank you both for joining us, and I will now hand it over to James.
James Coleman: Thank you so much, Sarah. It’s wonderful to be talking with both of you. So, Mark, I know that people around the country are concerned about the higher bills that they’re starting to see from their utility companies—from their electric companies, from their natural gas companies—and I know many of them are wondering what goes into calculating those utility bills. How are they regulated? How much money are the utilities supposed to get? And so, I’d love it if you could just tell us a little bit about your work and how those bills are calculated, why they’re going up now.
Mark Ellis: Sure. So utilities work under a very different business model than we typically think of. If you think about a company like Amazon or Ford, they have a price that they’re trying to charge, and then they seek to reduce the total cost relative to that price, and that’s how they generate profit.
Utilities, it’s completely flipped. So they’re regulated and, basically, they’re granted a regional monopoly, but in exchange for that monopoly, they have to — their rates and their amount of spending has to be approved by the regulator under a cost-plus model. So basically, whatever they spend, they just add it up, and then they roll it through into rates and recover it in rates. And including in their cost is their profit as well. Profit is part of the cost that’s passed through to customers.
James Coleman: And so, how much of their profit are they expecting? In an investment that they make in building a power plant or building power lines or natural gas distribution, how much profit are they expecting?
Mark Ellis: Yeah. So the profit is all driven from a financial perspective in terms of how do — these companies are privately owned or owned by shareholders. They’re not owned by the government. And so, it’s all — the profit model’s all driven by what’s required. The intent is to determine what’s required to attract investment in these long-lived assets. So when you’re building a power plant or a pipeline or a transmission line, it lasts for decades. And so, you invest upfront, and then they recover the cost over those decades. And so, they need investors who are willing to take that risk. And so, the profit is intended to compensate investors fairly for the risks that they’re taking when they invest in utility infrastructure.
James Coleman: Yeah. So what are those risks? You think about a company that — like, as you said, Amazon. Or you think about an oil company going out and drilling wells, and a lot of the wells, maybe, don’t produce anything or are not profitable. I imagine that the utilities are a lower-risk business because they have this monopoly area. So what kind of profit are they expecting? Is it less than you would see in a riskier sector of the economy?
Mark Ellis: Yes. You’re correct. The risk is quite a bit lower because they don’t face a lot of technology risk or market risk. In other words, if they project, “Oh, demand will be a certain amount in one year,” and it comes in a little bit short, they can often recover it in the following year, or it’ll just balance itself out due to weather. So they actually do not face a lot of risk, and it is, indeed, quite a bit lower than the rest of the economy or most other industry sectors. And you see this not just in terms of conceptually, like, “Oh yeah. They don’t have technology risk. They don’t have market risk,” but also you see it financially in terms of how their stocks perform—the volatility you see of the stock prices in the market.
James Coleman: So basically, on the high end, you’re never going to get the same rate of return that you would investing in some really risky business—or you shouldn’t, otherwise everybody would just invest everything in utilities. And then on the low end, it’s still riskier than investing in government bonds or something like that because, in theory — well, if you’re negligent or you’re wasteful—sometimes, in that kind of extreme circumstance—the regulator won’t allow you to get that money back from customers. Is that right?
Mark Ellis: Yeah. So there is — in some instances, there is a risk of non-recovery, but that’s pretty rare. When companies take a huge technology flier, for example — there’s some utilities that recently invested in nuclear plants that, even at the time, many in the industry questioned the wisdom of those plants. And so, some of those, they had experienced cost overruns and schedule delays, and so, they’re having some of their costs — they’re not able to recover some of their costs. But by and large, when they stick to their knitting—investing in basic infrastructure, transmission, and distribution infrastructure, power plants, where they’re allowed to—they’re usually able to recover those costs, in addition to all their operating costs.
I want to return back to your earlier comment about the risk and the return that they get. So there’s two different elements to this. There’s the profit that the regulators authorized, and in principle, it should reflect the actual risk that investors face. But what we find is that regulators tend to authorize rates of return that rolls into profit that are actually much higher than their true cost of equity.
And one way we can think about this is if you were to go to, say, BlackRock’s website or JP Morgan’s website and ask, “Oh, what’s the expected rate of return on U.S. equities?” — and they typically come in around six percent/seven percent if you were to pull up their current forecast. But utilities, which are much lower risk, their authorized return on equity is typically in the 9-10 percent range. And it’s been — that discrepancy has been in place for decades.
James Coleman: If that’s the case, though, at some point, if there was an imbalance, you would see investors getting way overweight into the utilities sector, correct?
Mark Ellis: So what they do — what happens is the price of the utility stock gets bid up so that the investor, when they invest, they actually still get somewhere on the order of five percent—or an expectation of five percent—but the profits are still flowing through the utility. So it’s, basically, previous investors, as the — every time a utility makes a new investment, the stock gets bid up a little bit, and that benefits the shareholders.
James Coleman: Okay. Well, I’m going to have to take a small [inaudible 7:44]. We have had some utility bankruptcies recently, correct?
Mark Ellis: Mm-hmm.
James Coleman: If it’s all just gravy—better than normal stock returns—what’s the — what are those bankruptcies about?
Mark Ellis: So I’m from California, and I’ve done a lot of work in this jurisdiction—spent a good chunk of my career in California. So one notable bankruptcy is PG&E. And that was, really, an anomalous set of circumstances and events where they did have — and this is all well documented. They had some maintenance shortcomings in terms of their transmission lines, and then you combine that with a very, very combustible environment in terms of the forestry management practices of the state. So there’s a combination of things that they were — shortcomings among the utility and then also just the environment that they’re in pushed them into bankruptcy. So their equipment started some fires. Those fires turned into conflagrations that caused tens of billions of dollars of damage.
James Coleman: Right.
Mark Ellis: And then the unique laws in California of inverse condemnation put all the liability onto the utility, and that pushed them into bankruptcy. So that’s the example I’m familiar with.
James Coleman: Yeah. A couple ten-billion-dollar fires, and you start talking real money.
Mark Ellis: Yes. Yes.
James Coleman: So I wonder — to return to this basic question, so why are utility bills rising now? I mean, I know this is a story in pretty much every state in the country. Right? You’re seeing higher electricity bills, higher natural gas bills. So what’s the reason for that, given what you’ve talked about, about how utilities make their money?
Mark Ellis: So, going back to the model. So it’s a cost-plus model, so anything that’s an operating cost—salary, rent, just general maintenance, paying meter readers, if they still have meter readers, and so forth—they just pass that through in the bills as they’re incurred, pretty much.
Another operating cost that’s passed through as it is incurred is natural gas. Whether it’s for your gas stove or to run a power plant, that just gets passed through as it’s incurred. And for a variety of reasons, natural gas prices have been quite volatile over the last year. Despite the fact that we have abundant supply in the country, there’s some infrastructure constraints and also constraints on developing new gas resources, so that’s going to contribute to higher gas prices. Gas prices also flow into the — utilities also often purchase power. Where they don’t own the power plant themselves, they’re purchasing from a third-party power plant, which runs on natural gas, so the higher natural gas prices will flow through to electricity — procured electricity prices as well.
So that’s one factor—just commodity costs have gone up. Another factor is inflation has contributed to increases in salary, so that’s going to flow through to rates and just general supplies, in general. Right? That’s going to flow through to the rates. A third factor is the energy transition. Right? So utilities are being asked to invest in greener technology and more secure technology to mitigate cyber risk. So they’re basically rebuilding the grid in real-time, continuously. And the demands for new infrastructure investment are probably growing faster than inflation, so that’s going to contribute to rising rates as well.
And then the final contributing factor goes back to the profit model and the return on investment that investors in utilities — I’m sorry, the return on capital that investors in utilities expect. And, in general, we talked about the profit margin, but there’s another element there where utilities actually finance some of their investment with debt. And then the debt is just — they pass through the interest cost, and so, interest rates have been rising, so that’s going to flow through over time into rates. And regulators frequently will peg the return on equity to interest rates. So that’s another factor that could be potentially pushing up the costs.
James Coleman: Yeah. And that’s interesting that both — when regulators are thinking, “What kind of rate of return do these utilities need?” one benchmark they might use is, “Well, you could make a completely safe investment by investing in federal treasuries.” Right?
Mark Ellis: Yes.
James Coleman: And so, as the rate on those rises, people — the rate that utilities say they need is going to rise as well, and I think you’re seeing that across the country. But also, as you say, that also increases the rate that the utilities are going to have to pay, to the extent that they borrow money. Now, one thing that I think — so I think some people don’t realize how that’s a part of the bills and the rate-making process.
The other thing that you mentioned is the green transition. Right? And I think — this is something I find is interesting. A lot of students don’t necessarily — isn’t necessarily intuitive. You might think that, as the polluters—the utilities—when they get a requirement, “Hey. Clean up your act. We want you to build a bunch — shut down this coal power plant. We want you to build a bunch of windmills and battery facilities and new transmission to connect them.” And you might think that — as a normal business might say in that circumstance, “Well, I don’t like this regulation. It’s going to cost me money.” But basically, for the utilities, that’s all just more profit, right?
Mark Ellis: Yes. I really appreciate the way you characterized that. It is a bit of — when you go to a utility and say, “Hey. I want you to build x, y, and z,” they may put up a show like, “Oh, it’ll raise rates and so forth.” But it’s a bit of twist my arm, where they’re more than happy to do that. They love putting things in rate base because every time they add to rate base their profits grow, and then their share price grows in line with their profits.
James Coleman: Right. They’re not in the business just to get — to just get paid back for their operating expenses. Really, how they make money is making big capital investments. And I think you’re — I mean, you’re right. Sometimes they might push back a little bit if they think that it’s going to require a raising rates so much that they’re going to alienate their consumer base. But, pretty much, short of that, they’re happy to make any investment you ask them to make because that’s just more money in their pocket.
Mark Ellis: Yeah.
James Coleman: Is that pretty much what you see?
Mark Ellis: Yeah. It could be deemed imprudent, one, because it just causes rates to skyrocket or, two, because it doesn’t do what they anticipated it would do.
James Coleman: Yeah, but it’s hard to say it’s imprudent if the government made you do it. All right.
Mark Ellis: Yes.
James Coleman: It’s a good defense, and to be able to say — so, just so that’s clear. But often, the thing you’re terrified of as a — because remember, utilities generally are relatively low risk. So the thing that utilities are terrified of is somehow, some way, the utility commission—state utility commission—or the regulator’s going to come back and say, “No. Actually, you don’t get paid back for this investment that you made because it was imprudent.”
And the other thing that they can get into trouble a lot of times for is in some way that they were negligent or otherwise, like with these fires. “It’s your fault. You made a mistake, and so, you’re not going to get paid back for it.” But because that’s so rare in the utility business — it is the worst nightmare of utilities that that kind of thing could happen to them because their general view is that they should recover for every cost that they lay out.
Okay. So I wonder — so you’ve been a consumer advocate. I mean, that’s an interesting role because consumers have a lot of different — I mean, consumers are basically just talking about all the people that use electricity, and they may have different opinions of what they want out of their electricity system. Right? Some of them — I think, most commonly, we think about consumer advocates asking for lower rates, and that is often what they’re focused on.
But I think you see in utility proceedings around the country, depending where you are in the country, they can look very different, where you have — sometimes you have a number of advocates involved say, “Well, yeah. We want low rates, but we also have these clean energy goals that we want to — that are very important to us.” In other places, you say, “Yeah. We want low rates but don’t close this coal power plant which is going to affect local mining and — as well as the jobs at the plant, etc.” And sometimes, it has a political aspect as well. So I wonder what kind of different consumer advocates do you see out there between how it might be different for somebody representing residential consumers or more general interests versus people representing commercial and industrial interests, etc., in those sort of utility rate-making proceedings?
Mark Ellis: Yeah. I tend to work with consumer advocates that represent residential customers and small commercial customers, and like anybody, they want everything. Right? They want low rates and clean energy and reliable energy, and it’s always just a horse trade on prioritization. That’s why I like the work that I do because I actually don’t have to get into the politics because what I focus on is trying to just — if you’re going to provide whatever service you’re providing, let’s make it as cheap as possible. Right? If you decide you want to go green, well, let’s at least try to finance it as cheaply as possible.
I’ve done some work related to wildfire insurance. Right? And so, if you’re going to insure against wildfire risk, let’s make it as cheap as possible. So I try to thread that needle by staying out of the — because you’re right, it’s a political decision. Which is more — greening costs money. Rooftop solar costs money. How much of that — and you’re subsidizing it, and those subsidies come out of the pockets of your average residential — and even sometimes it’s biased. It hits lower-income customers because they can’t actually take advantage of rooftop solar. So they’re actually — yeah. If they don’t own or they just don’t have an appropriate roof or whatever or don’t have the — or just can’t get financing. Those are political questions that, frankly — at least in my role, I try to skirt that and focus on, “Hey. Let’s just keep it inexpensive—as inexpensive as we can.”
James Coleman: That’s interesting. But do you — you must see — I mean, there must be other advocates for consumers in those circumstances that are making other arguments about some of their other policy goals and goals for the energy system.
Mark Ellis: Yes. Yeah. Yeah. I do. Yeah.
James Coleman: How does it differ — there must — I would imagine that one of the other big forces that you see in those utility rate regulation disputes is industrial and big commercial consumers and what are they — what are their priorities in those rate-regulation disputes?
Mark Ellis: Yeah. So I have not done a lot of work for industrial consumer advocates, but my observation is a few things. One, they tend to prefer low rates. Two, they’re very, very concerned about cross-subsidizations among different customer classes—so, for example, allocating more of the total system cost to big industrial customers and so forth versus residential. It tends to — my understanding—and I haven’t done a comprehensive study, but it tends to work in the reverse. In other words, the big industrial customers oftentimes — because they can threaten to leave, they oftentimes have rates that are very, very — that are either subsidized or just at their true cost or as close as possible to their true cost. And then, the various subsidies are born by small commercial and residential customers.
James Coleman: Yeah. That’s interesting. I was just looking at electricity prices in Minnesota, and it was — the reporting I saw was that it was actually higher prices for industrial consumers. But you’re right that around the world and around the country, it’s probably more common that, actually, residential consumers end up paying more. And that might seem like, “Why do the residential users have to pay more? They don’t have any choice about — it’s hard for them to conserve electricity if they really need it for light and heat.” And it’s for exactly that reason, which is that they don’t have any choice about the prices.
So, especially in places like Germany, you see that there’s much higher prices for residential users than there are for industrial users because the theory is, “Well, industrial users might leave or shut down if we raise their electricity prices.” Whereas I think that for the residential users, they’re like, “Well, they’re not going to leave California.” Although they are starting to so we’re seeing a lot of that here in Texas.
Mark Ellis: Yeah. I’d like to share an anecdote if you don’t mind. So as I mentioned, I do a lot of work on the cost of capital determining that ROE, that the regulators authorize, and when you go through these proceedings, we’re not the only consumer advocates. So you’re right, other industrial and commercial and federal agencies, they’re all — they hire experts, and they submit testimony, and one thing that you notice is you don’t see a lot of — one of the largest — the fastest growing sources of industrial demand is data centers and big tech, and you don’t see them participating in these regulatory proceedings very often. And then one company that you do see participating a lot is Walmart. And it’s interesting because you think about their different business models.
So big tech, they’re going — and they have whole teams that are dedicated to strategically locating their data centers for cheap — optimizing between cheap power in proximity to their demand, where their consumers are approximated to cities. And so, they can go to multiple utilities and even multiple states and say, “Hey, I want to build a data center in the Northwest or the Southeast or the Midwest,” and they can play everybody off each other—the state for incentives and the utilities off each other. So they get a good deal, and then they keep quiet.
Then contrast that with a large retailer like Walmart. They have to build their plants — I’m sorry, they have to build their stores where their customers are. They can’t say, “I want to build a store in downtown Chicago,” and say, “Well, I’ll build it in Minnesota instead.” Right? They don’t have that option. And so, they actually are very active in these cost of capital proceedings, to their credit. Yeah.
James Coleman: Well, that’s interesting. So I wonder what — you’re starting to see in California some places where they have started to ban new gas hookups. Is that right?
Mark Ellis: Yeah. I think — I haven’t followed the issue very closely, but I believe the regulation now or the law now is new home construction, no gas.
Mark Ellis: But I’m trying to — yeah.
James Coleman: And that’s not having an effect — I mean, is that having an impact on those proceedings? I mean, at some point — one challenge that you find in utility regulation is if a sector is shrinking in terms of its size, then sometimes the utility, because it’s guaranteed to get its money back, basically, ends up raising the rate on everybody who’s left. Right? So if you have a brand-new town and it just goes to — so it’s all electricity—you never use natural gas. That’s just a simple question about — if you like electricity better then that’s fine.
But if you have an existing town where there’s a gradual transition away from natural gas, it can mean that, basically, the natural gas customers that are left end up paying bigger and bigger bills. Is that something, yet, that they’re worrying about in California?
Mark Ellis: Yeah. This is a big issue not just in California but countrywide. So many states and regulators want to phase out natural gas over time, and that transition is very complicated because these are long-lived assets. You have people whose homes would be very, very expensive to retrofit for electricity. And then, at the same time, you have infrastructure that needs to be replaced. Right? So the pipeline infrastructure in many parts of the country is very old, but you can’t just say, “Well, we’re just going to have everybody — we’re not going to replace it because” — it’s have everybody switch to electricity because the home stock — the housing stock can’t switch over that quickly. So you have this conundrum. We want to phase it out, but we have to continue to make investment in it, and I don’t think that anybody has a silver bullet solution on how to manage that transition. It’s just something that the regulators are wrestling with and utilities are wrestling with.
James Coleman: Yeah. And this may not be as much of a challenge in California, to the extent that you have less very cold weather, but in Texas—places that do have cold weather—I mean, one big challenge is that the — if you’re relying on electricity for heating, typically, when it’s really cold, the grid—most of the electric grid—is mostly relying on natural gas. And electricity is not a very — resistance heating, which is what most people have if they have electric heating, is not a very efficient way to heat a house. And so, basically, you end up using — it’s a little bit ironic, but if you switch from natural gas to that resistance heating, you actually end up using a lot more natural gas. So you end up, two and a half times, using that much more natural gas.
And so, that’s a big challenge because, basically, the idea of moving from natural gas to electricity is, “Oh. Well, then we’ll use less natural gas.” And it’s true. On a good day, you use less natural gas. But when it gets really cold, you actually use a lot more natural gas. So trying to build this infrastructure that you’re only going to need in those couple really cold days every few years is a huge challenge how to finance that. And I imagine when utilities come forward and say, “Hey. I need to build all this new natural gas infrastructure. I’ll only need to use it every ten years, but without it, the lights are going off.” I mean, that’s a really high-stakes sort of regulatory fight because it’s a lot of money. It’s not to use it often but of course, you never — as a utility, you want to make sure the lights never go off.
Mark Ellis: Yeah. And unfortunately, I have not researched this issue in detail, but it’s not uncommon for regulators to push a plan or an agenda that, if you ask the engineers and the economists, “Hey. Is this the optimal way to do it?” even incorporating environmental costs and technology development and so forth, those two may not coincide—where the regulator pursues an agenda that is suboptimal.
James Coleman: Right. Right. And there’s often things that work really well, in theory, that don’t necessarily work out so well in practice. So, for instance, one that’s often said, “Well, for electricity, you don’t need that inefficient electric heating. You could get a heat pump.” And I did that. I got a heat pump. And it does save electricity on an average basis. It doesn’t really work below 40 degrees. So when you have — and they do have modern — they have newer — I mean, this is only a couple years old, and it was cutting edge at the time, but they have — they’re getting better. And so, in the future, they’ll have better heat pump designs.
But anytime you try to revolutionize, in a very short period of time, the way our houses are constructed, that’s actually a big challenge. And I can tell you the heat pumps have lots of other problems. And it’s just — that’s true with any new HVAC thing, and so, it is a — it’s definitely — some of the regulatory goals that we’re seeing are going to be very challenging, at best, to meet. But they’re also having an impact on these regulatory price proceedings in terms of making — moving to newer sources but making sure that we have all the traditional backup capacity to ensure that we have the reliability that we had hoped to expect from our utility service, even though across the U.S., as we’ve been moving this way, we’ve actually had somewhat deteriorating electricity service.
Mark Ellis: Yeah. I mean, in my experience — for example, in California, where they’ve really pursued rooftop solar quite aggressively, and they created what they call the duck curve, where during the day, it reduced the effective load on the grid during the day, but then in the late afternoon when people — as the sun was setting, and people were coming home and turning on their A/C and their TV and cooking, they had this tremendous spike. And then, it created a big problem for grid management in terms of managing that step change in the late afternoon.
James Coleman: Yeah. I think that’s one other challenge that — I think, sometimes people don’t understand with the electricity system — one thing that’s challenging about the electricity system is you always have to exactly balance how much power is being provided by the hundreds or thousands of power sources to the grid with the power demanded by the millions of people that are flipping on their light switch or plugging in their phone or plugging in their Tesla. And so, that’s a huge challenge, particularly when some of our new big sources like solar really completely ramps down just when we need power most, which is in the early evening hours.
And wind, unfortunately, also is kind of like an early morning hour — it’s a little different in California, but in most of the country, is an early morning hours power source, which we really don’t really need as much power then. And so, basically, neither of these sources provide much energy in those early evening hours, which in much of the country are the peak time for demand, which is why, again, we have a system that says, “Let’s use natural gas less as much as possible,” but, again, every day and every season and every bad storm it better be available to ramp up to meet that full demand, and maintaining all that infrastructure to use it as little as possible is a big challenge.
Mark Ellis: Yeah. Yeah. I think, just to build on that, one thing that people often don’t understand about the power grid is the whole system, going back to Thomas Edison’s time, it’s designed — there’s never been — and even today, still is not cost-effective storage for electricity. And so, the whole system is designed to meet the needle peak, that one second per year, where demand spikes. The whole system has to have the capacity to meet that plus a cushion—10/15 percent cushion on top of that. And that’s how the system has been designed for a hundred years. And electric storage would be revolutionary, and they’ve made tremendous progress. Right? It’s gone down by a factor of 10, but it’s still not economic to deploy at the scale that you would need to rethink how we design the electric grid. So for the foreseeable future, we’re still going to need the electric grid to be designed to meet that needle peak plus cushion.
James Coleman: Exactly. Well, anyway. It’s been wonderful talking with you, Mark, and look forward to talking to you again about this issue. But thank you so much for coming on the podcast.
Mark Ellis: Thank you.
Conclusion: On behalf of The Federalist Society’s Regulatory Transparency Project, thanks for tuning in to the Fourth Branch podcast. To catch every new episode when it’s released, you can subscribe on Apple Podcasts, Google Play, and Spreaker. For the latest from RTP, please visit our website at www.regproject.org.
This has been a FedSoc audio production.