Resources Article

Responding to the Clean Power Plan and the Utility of the Future: Recommendations for States

May 25, 2016 | Joseph A. Kruger

Summary

Using the same guiding principles to navigate two transformational forces in the power sector will lead to a lower-carbon electric grid with more options for electricity customers.


Market trends and technological advances in the power sector, coupled with new carbon emissions regulations, are transforming the energy landscape, bringing about a lower-carbon electric grid with more options and new services for electricity customers. In response to market and technology changes, states, utilities, and energy companies are moving ahead with regulatory reforms, investments, and planning for what is sometimes called “the utility of the future.” Meanwhile, it is clear that some form of carbon regulation is inevitable—either through the Clean Power Plan (under the US Environmental Protection Agency’s Clean Air Act authority) or as a result of future legislation.

Some of the same principles that are guiding the creation of new market and regulatory structures in the power industry also can help shape the design of carbon reduction policies. Ultimately, states that embrace the utility of the future will be well positioned to comply with the Clean Power Plan at lower cost, and states and utilities that are planning for carbon regulation will benefit from exploring how emerging market and regulatory structures and new technologies can provide new choices and services for consumers.

"In response to market and technology changes, states, utilities, and energy companies are moving ahead with regulatory reforms, investments, and planning for what is sometimes called ‘the utility of the future.'"

The Changing Power Sector

Together with explicit policies and incentives to promote renewable energy at state and federal levels, several market trends are changing fuels, technologies, and energy services.

  • Implementation of energy efficiency standards and policies has led to slower growth in demand for electricity.
  • Lower costs and increased penetration of distributed energy resources, such as residential and commercial solar panels, energy storage, microgrids, and combined heat and power, are reducing market share for utilities in some regions, as third parties or electricity customers implement smaller-scale energy resources.
  • The electric grid is changing from a system of centralized power plants where power flows in one direction through transmission and distribution lines to consumers to a more complex system where information and electricity flow back and forth from the grid to consumers, guided by “smart” technologies, powerful “big data” analytical tools, and device-to-device communications (sometimes known as “the Internet of things”).

This transformation is potentially at odds with the financial incentives built into traditional regulatory and market structures. Under the traditional paradigm, utilities earn a return, based on their capital investment in power plants or grid infrastructure, to cover their costs of serving customers and earn a rate of return for their shareholders. If customers or third parties provide assets for the grid, the utility and its shareholders lose the opportunity to earn a return on those assets. In addition, if customers decide to generate their own electricity (or contract with third parties for energy generation), the fixed costs of utilities will be spread among fewer and fewer customers, thereby driving a need to increase electricity rates to recover these costs. In theory, these higher rates could create a continuing cycle of further defections from the grid followed by additional rate increases.

Key Issues for the Utility of the Future

In response to changing market conditions and consumer demand for distributed energy resources, some states—including California, New York, and Minnesota—are exploring the types of changes needed to incorporate these resources into the grid. Although the details of state approaches will differ as they address new market developments, some fundamental issues are cross-cutting: Who should own and operate distributed energy resources? How should these new services be valued? And what types of regulatory structures will be necessary to align the financial incentives of utilities with evolving markets and technologies?

Who Should Own and Operate Distributed Energy Resources?

In the traditional market structure, utilities have a monopoly over electricity distribution and a duty to serve customers at just and reasonable rates. However, some analysts have expressed concerns about whether utilities, rather than third-party energy providers or electricity customers themselves, can provide the most innovative and lowest-cost approaches to deploying new technologies. Moreover, some observers argue that incumbent utilities have an incentive to use their regulated status to discriminate against rivals by favoring their own distributed energy affiliates. Other analysts contend that, with appropriate oversight by regulators, utilities can equitably provide an open platform that facilitates distributed energy provided by a variety of participants. New York’s Public Service Commission has proposed this type of utility-run platform as part of its “Reforming the Energy Vision,” or REV, initiative.

How Should New Technologies and Services Be Valued?

A critical component of evolving regulatory approaches is how to value the new electric system services provided by emerging technologies so that they can be incorporated appropriately into utility planning and ratemaking. This debate has been particularly prominent for rooftop solar, where there has been controversy over the rate paid to customers who sell excess electricity back to their utilities under net energy metering programs. Critics of these programs have argued that while consumers with solar panels can receive the full retail rate for their excess electricity, they also should be responsible for sharing in the costs of maintaining the electric grid, either through paying a fixed charge or through receiving less than the retail rate. Otherwise, critics say, the costs of these programs are shifted to other ratepayers who are not participants in the solar programs.

However, there are benefits to the electric system provided by distributed energy that may not be determined in markets or reflected in the current utility regulatory structure. These benefits could include avoided energy costs, avoided capacity costs for generation, reduced costs for ancillary services, lower line losses on the transmission and distribution system, and fewer investments needed in transmission and distribution facilities.

What Types of Regulatory Innovations Will Be Necessary?

If traditional cost-of-service regulation is no longer aligned with emerging utility market structures, what types of new approaches are necessary? Some analysts believe that performance-based ratemaking—an approach that ties utility profits to achievement of specific targets or benchmarks—will fill the void. In the past, regulators have experimented with performance-based ratemaking on a number of utility issues, including nuclear unit performance and energy efficiency programs. More recently, New York has proposed a series of incentive mechanisms that would be measured and monetized. These mechanisms address metrics such as peak reduction, energy efficiency, customer information access, affordability, and interconnection.

Principles for the Utility of the Future and the Clean Power Plan

Several groups of experts have put forward high-level principles that could guide the development of new market and regulatory constructs. For example, one group of analysts proposed in a recent Public Utilities Fortnightly article a conceptual framework they call “grid neutrality” (analogous to “net neutrality” for the Internet) that views the electric grid as a fair and open platform that can facilitate new and innovative technologies and services. With a similar goal of guiding future market and regulatory structures, the Rocky Mountain Institute e-Lab concluded that the “ideal” structure should ensure efficiency, resilience, and reliability; create a level playing field for all resources; foster innovation; provide transparent incentives where necessary to promote technologies that result in social benefits; minimize complexity; enable transition from traditional business models to new structures; and support the harmonization of business models of regulated and nonregulated service providers. Some of these principles are directly applicable to thinking through how different designs for state implementation of the Clean Power Plan can accommodate emerging utility regulatory structures.

The Clean Power Plan sets statewide standards for coal and gas electric generating units, based on the generation mix in the state. The standards are based on three “building blocks”—essentially types of technologies or approaches that could reduce emissions: heat-rate improvement at coal plants, a shift to natural gas generation from coal generation, and increased generation from new renewable energy.

While the targets are based on the three building blocks, EPA has stressed that the approaches to the plan available to each state are diverse and include a wide range of options on both sides of the electric meter. For additional flexibility, EPA provides states with two categories for the standard: a rate-based standard, in pounds of carbon dioxide per megawatt hour, and a mass-based standard, denominated in annual tons of carbon dioxide emitted.

Each state must develop a plan for meeting the standard and may band together in trading markets with other states that have chosen the same type of target. The following recommendations could guide those efforts or other future carbon regulation and would complement broader regulatory changes.

Provide a Transparent Price Signal

A mass-based target with allowance trading, like the classic structure of the successful Acid Rain Program, will set an explicit price on carbon dioxide and provide clear signals for utility planning, regardless of the new market or regulatory structures that evolve. This is preferable to a rate-based target with tradable credits for energy efficiency or renewable energy (known in the Clean Power Plan as emission rate credits), because the quantity of credits is unpredictable and must first be generated and verified. Past trading programs have shown that eliminating the need to approve or certify a trading commodity on a case-by-case basis reduces administrative and transaction costs and leads to more active markets.

Create a Level Playing Field

As market and regulatory structures evolve, it will be important to encourage fair com-
petition among incumbent utilities and third-party providers of distributed energy resources, energy efficiency, and other energy services. One important aspect of the Clean Power Plan—allowance distribution—could tip the balance in favor of different technologies and market participants. Key parameters that could affect a level playing field include whether allowance value is allocated to electricity producers, electricity consumers, or the government; whether allowances are auctioned or distributed directly to different parties; and whether states create allowance incentives for specific technologies and programs. Finally, a critical factor is whether allowances are distributed based on historic generation or will be updated periodically based on generation output, which will create an incentive to produce more electricity from a source to receive more allowances.

Foster Innovation

The convergence of the Clean Power Plan with new utility business models could be a significant driver of innovation as companies look for new sources of revenue that don’t depend on selling more electricity. Mass-based targets will be able to adapt rapidly to innovative technologies or combinations of technologies. This is because neither will there be a need to create new verification protocols to calculate credits every time a new grid technology is deployed, nor will it be necessary to have those methods approved by regulatory agencies. In the utility of the future, combinations of hardware and software innovations will create infinite variations, and the emissions reductions of each would need to be verified on a case-by-case basis by an independent third party under a rate-based plan. It is unrealistic to assume that regulators will be able to keep up with emerging approaches, and it will be important to avoid incentives to use the most easily verified measures at the expense of less verifiable but more cost-effective or innovative measures.

Facilitate State and Regional Priorities

A variety of policies and approaches could complement a mass-based emissions target, including ramped-up energy efficiency and renewable energy programs. Moreover, under a mass-based target, states could use changes to utility regulatory structures—such as updated rate design and improved utility resource planning practices—to drive emissions reductions and lower the costs of compliance. Finally, a mass-based target—with its clear price signal, well-defined tradable commodity, interstate flexibility, and streamlined emissions accounting rules—will best accommodate the regional power planning processes that will be critical for the evolving industry structure.

Provide Flexibility for a Range of Market and Technology Scenarios

Past experience illustrates that a cap-and-trade system with mass-based emissions targets is a particularly good structure for accommodating unanticipated market and technological developments. For example, the onset of the Acid Rain Program in the 1990s coincided with the deregulation of the railroads, which facilitated the transportation of western, low-sulfur coal to power generators and was a contributing factor to a dramatic drop in sulfur dioxide emissions in 1995. Similarly, the Regional Greenhouse Gas Initiative benefited from unexpectedly low natural gas prices driven by technological innovations that led to the shale gas boom in the United States. This ability of a mass-based target to seamlessly incorporate market trends will be critical as utilities incorporate new “grid edge” technologies and market structures in the coming years.

"The ability of a mass-based target to seamlessly incorporate market trends will be critical as utilities incorporate new ‘grid edge’ technologies and market structures in the coming years."

Planning for the Future

Addressing the issues associated with the “utility of the future” will take enormous effort by regulators, utilities, third-party companies, electricity customers, and other stakeholders. New technologies and services have the potential to create significant benefits for electricity customers and the environment, but only if the regulatory and market structures can be developed to facilitate these benefits. Given the difficulty of predicting exactly what mix of technologies and institutions will develop in the coming years, a mass-based approach to carbon regulation that covers the entire electric generation sector is the most flexible and “future-ready” pathway.

About the Author

Jospeh Kruger is a principal at Kruger Environmental Strategies, LLC, and a visiting fellow at RFF.

Further Reading

Hu, J., S. Kann, J. Tong, and J. Wellinghoff. 2015. Grid Neutrality: Five Principles for Tomorrow’s Electricity Sector. Public Utilities Fortnightly, October.

Kruger, J.A. 2016. The Clean Power Plan and the “Future-Ready” Utility. Discussion paper 16-05. Washington, DC: RFF.

Rocky Mountain Institute. 2013. New Business Models for the Distribution Edge. Snowmass, CO: Rocky Mountain Institute e-Lab, April.