We started the course with a discussion of how important energy is to the economy and the society. WIth such an important (some would say existential) dependence on reliable, affordable and safe energy, it is little wonder that the government might have something to say about how these important products and services are provided. There are some great books and even treatises that have been written by economists and attorneys on the regulation of the energy industry in the US and globally. This lesson will focus only on the United States because a global survey would be too broad for inclusion and because many of the lessons learned in the US will be applicable to the rest of the developed world.
By the end of this lesson, you should be able to:
This lesson will take us one week to complete. Please refer to the Course Calendar in Canvas for specific due dates. Specific directions and grading rubrics for assignment submissions can be found in the Lesson 9 module in Canvas.
If you have any questions, please post them to our Questions? discussion forum (not email). I will not be reviewing these. I encourage you to work as a cohort in that space. If you do require assistance, please reach out to me directly after you have worked with your cohort --- I am always happy to get on a one-on-one call, or even better, with a group of you.
In theoretical economics there is the idea that certain services and goods are most efficiently provided by what is defined as a “natural monopoly.” A natural monopoly is a type of monopoly [3] in an industry or sector with high barriers to entry and start-up costs that prevent any rivals from competing. As such, a natural monopoly has only one efficient player. This company may be the only provider of a product or service in an industry or geographic location. Here's a nice definition of a natural monopoly [4]. One can see that there are places in the energy value chain where it might be most efficient to have a natural monopoly. For instance, it does not make sense from an efficiency standpoint to have more than one set of electricity distribution wires in the street. This also makes sense for natural gas distribution. Electric and natural gas transmission also are more efficient with fewer rather than many players. In the case of natural gas transmission, regulators allowed for limited competition among certain pipeline companies to many city gates in the Northeast and Midwest while there is pretty unbridled competition in the Texas and Louisiana markets. Regardless, large infrastructure projects are usually more efficient if not duplicated. For instance, do we need more than one wastewater system or more than one transit authority in a particular geographic region?
While it is quite likely that the best outcome from an efficiency perspective comes from a natural monopoly, there is an asymmetry that occurs with respect to pricing power particularly when the good or service provided is considered to be very important by the end user like heat or water or power. This price “inelasticity” for the consumer sets up the owner of the natural monopoly with significant pricing power. This pricing power over time could make the goods and services unaffordable to the consumer and allow for significant monopoly rents to be earned by the supplier.
This is where utility regulation seeks to “level the playing field” by regulating the prices (rates) of these granted natural monopolies. We will further discuss this process in section 9.4
Environmental regulations are governmental incentives or laws passed in attempts to protect the environment in a variety of ways: such as by reducing waste, requiring companies to cut back on production in order to reduce nation-wide emissions, or banning the use of harmful chemicals and substances to protect the environment, human health, and biodiversity.
In general, environmental regulation is dedicated towards the initial activities at the production site and how the waste is handled following the manufacturing process of a product.
The main goal of environmental regulation is to require strict rules on the measures necessary in order to reduce emissions and protect the environment – many of which would not occur if it weren’t for environmental regulations. Environmental regulations do the same: many wouldn’t commit to the environmental measures necessary on their own, but with the environmental regulations – it no longer becomes a choice, but a legal requirement that makes a global difference. There are many other courses in the RESS curriculum that cover Environmental regulation and policy. It is an extremely important topic and compliance with these regulations can be costly and is something that in a more complex development of a project like the ones we are doing here would require significant due diligence. Further - there are environmental policies which promote the development of renewable energy like Renewable Portfolio Standards (RPS), carbon taxes and feed-in tariffs. Please check out this link if you want more information about this: Our 2023 Guide to Environmental Regulations in the US [5].
Municipalities, State and the Federal Government also have other regulations such as labor, zoning, procurement and land use regulations. Think about some other types of regulation your project may come under as you work through it.
Authorities Having Jurisdiction (AHJ) are governmental or non-governmental entities responsible for enforcing building codes, fire codes, and other regulations in a given jurisdiction. These entities can have a significant impact on your project. You may want to circle back to your Stakeholder Register to see if you’ve covered the important AHJ’s in that document. The AHJs we will be covering in this lesson have mostly to do with the regulation of the various functions of the energy business. There are other AHJs that are important like environmental regulators, taxing authorities and zoning boards, but these AHJs are outside the scope of EME801.
In the United States there are three levels of government: Federal, State and Local. Each of these levels of government regulates the various aspects or functions of the energy delivery systems. When it comes to the economic regulation of the energy business, the Federal and State governments provide the vast majority of economic regulation. At the federal level, we have the Federal Energy Regulatory Commission (FERC), which is responsible for regulating the interstate sale and transmission of crude oil, refined products, natural gas and electricity. We will mostly focus on the regulation of the transportation of natural gas and electricity. FERC ensures the proper operation, expansion, abandonment and rate structure and level for interstate natural gas pipelines, which move gas from production areas like Texas, Louisiana, and the Appalachian regions of Pennsylvania, West Virginia and Ohio to load centers like New York City, Chicago and San Francisco. FERC also regulates interstate electric transmission through its regulation of Regional Transmission Organizations like PJM, ISONE and CalISO.
At the state level, each state has a utility commission which ensures the safe operation and fair rates for natural gas and electricity. These bodies include the Pennsylvania Public Utility Commission, The Illinois Commerce Commission and the Massachusetts Department of Public Utilities. These agencies provide important oversight to gas and electric utilities due to the nature of most utility service being a natural monopoly.
Remember back in the beginning of the course when we started talking about certain accounting terms and definitions? Well here we go again. In the first sections, we focused on starting with developing a time series of revenue and expenses by assuming some prices and volumes and costs (both capital and O&M). Using some financial analysis techniques we determined whether we had a viable project or not. Well, the way that the utility makes its rates is a little sideways from that. The utility starts with certain assumptions about the return required to allow investors to buy equity in the enterprise. This cost of equity is a heavily debated topic in a rate case because there are many views on how to determine how risky an enterprise is. But let’s just say that we agree that this cost of equity for the utility can be determined. Once this cost of equity is determined, we can then determine the total cost of capital because the debt used to finance the capital in the utility is already a known quantity and the capital structure has been set by how much capital is financed through debt vs equity. Now the next step, once we know the cost of capital, is to determine the amount of net operating income (NOI) that is required to be earned by the utility to recover its cost of capital. This is derived by multiplying the cost of capital by the “rate base” for the utility. The utility’s rate base is defined as the total value of a utility’s assets (e.g., plant, equipment, working capital, and deductions for accumulated depreciation). This then gives us our targeted NOI. We then add to NOI all the expenses of the utility. This includes taxes, depreciation and amortization, operating expenses and administrative and general expenses. The sum of these is equal to the revenue requirement for the utility. This revenue requirement is then divided by the billing determinants (in energy this could be kWh, MMBtu or MCF). Dividing the revenue requirement by the volumes then gives a rate in $/kWh or $/MMBtu. This is called then the rate for service.
Rates are set in quasi-judicial proceedings called rate cases. These are usually presided over by administrative law judges at the state and federal level. The utility “puts on” its rate case through a very large filing of a lot of data. Other parties to the case like consumer advocates, Commission Staff, Industrial Intervenors and activists will also file evidence in the rate case. These parties will typically represent the interests of their constituencies. You could imagine a large industrial customer saying his rate was too high so that the other customers should pay more. Consumer advocates will say that residential customers are paying too much so those folks will advocate for higher costs to other rate classes. All the intervenors will likely say that the utility is asking too much in general and will try to argue for a lower cost of equity, a smaller rate base and higher volumes, as each of these factors would keep rates lower overall.
Please be sure to read the assigned readings, complete the deliverable, complete the quiz, and play around in the utility rate-making spreadsheet.
You have reached the end of Lesson 9! Double check the What is Due for Lesson 9? list on the first page of this lesson to make sure you have completed all of the activities listed there before you begin Lesson 10.
Links
[1] https://www.e-education.psu.edu/eme801/sites/www.e-education.psu.edu.eme801/files/PDFs/powellgoldstein-bonbright-principlesofpublicutilityrates-1960-10-10.pdf
[2] https://extension.psu.edu/electricity-deregulation#section-0
[3] https://www.investopedia.com/terms/m/monopoly.asp
[4] https://www.investopedia.com/terms/n/natural_monopoly.asp
[5] https://greenly.earth/en-gb/blog/company-guide/our-2023-guide-to-environmental-regulations-in-the-us