The challenge of aligning incentives: electric utilities and the new energy economy

The AllEarthRenewables South Burlington Solar Farm in Vermont.

The AllEarthRenewables South Burlington Solar Farm in Vermont.

Here’s one thing we know about climate change: if we continue to dump greenhouse gasses into the atmosphere at the current rate the planet is going to be a very unpleasant place to live. And we know the solution: dramatically reduce greenhouse gas emissions by using less energy and by rapidly transitioning from fossil fuels to clean energy.

Some of the challenges get a lot of attention, like the technological hurdles around energy storage and the number of federal lawmakers who don’t believe climate change is occurring. But one of the most interesting and important challenges – how electric utilities make money – receives a lot less attention.

Here’s the problem in a nutshell: electric utilities in the U.S. mostly make money by selling electricity and by building power plants and other infrastructure. The more juice they sell, and the more power plants and transmission lines they build, the more they make.

And the problem isn’t hard to tease out. If our goal is to reduce greenhouse gas emissions, a national electricity system that incentivizes maximizing power plant construction and energy consumption presents a messy collision of misaligned incentives. In some cases it works all right, since reducing greenhouse gas emissions will require construction of more power plants (of the clean energy variety, such as the new Abengoa concentrated solar plant in Arizona) and more transmission (to connect those new plants to energy users). But it often doesn’t, so utilities end up building more of what we don’t need because we’ve incentivized them to do so.

Energy efficiency is one casualty, since reducing energy use conflicts rather forcefully with a utility’s financial incentive to increase energy sales, and building new power plants generates a sizable return for the utility’s investors, further undercutting the case for aggressive energy efficiency efforts. And more sophisticated strategies – demand side management, smart meters, smart grids – can suffer from the same misaligned incentives problem.

In some ways it’s an immensely complex problem. There are multiple independent authorities operating at various levels interacting in messy ways (FERC, RTOs and ISOs, PUCs). Some states are “regulated” while others are “deregulated” (although all are tightly managed by government and quasi-governmental entities). Ownership patterns across generation, transmission, and ultimately selling to consumers varies widely. Federal and state laws can interact in messy ways, and the private sector players engage in fierce battles to defend or expand their role in the grid.

But what makes this problem so unusual is that the utility business model is contrived. We created it in order to entice substantial and reliable capital investment in energy infrastructure, and we can choose to tweak it to produce different outcomes. In other words, instead of incentivizing decisions that result in increased greenhouse gas emissions through the utility business model that we’ve created, we can rewire those incentives to produce the outcomes we do want: reducing energy use, shifting energy generation from fossil fuels to renewable sources, and maintaining a highly reliable and resilient grid.

Some states are already tackling this. Vermont created a statewide energy efficiency utility that collects money from everyone purchasing electricity on the grid, uses that money to improve energy efficiency across the state, and is rewarded for its success in reducing energy use. It essentially grafts an energy efficiency revenue model onto the underlying electric utilities. Despite the structural awkwardness it actually works quite well.

Renewable portfolio standards, like those in California and Colorado, force the inclusion of renewable energy generation into the mix, and they are clearly driving market penetration of solar and other renewables. This is helpful, but they tend to operate in tension with the underlying utility business rather than fixing the business model itself; utilities are required to meet their RPS obligations, but because doing so can undercut their revenue model they have little incentive to exceed the minimum standard and they usually have a lot of incentive to resist expanding the RPS requirements.

Decoupling a utility’s profits from its energy sales can also help reduce the misalignment (which we’ve seen for both natural gas and for electricity). Decoupling doesn’t necessarily incentivize aggressive movement toward a clean energy system, and it doesn’t necessarily remove the financial incentive to build more transmission and power generation, but it is a modest, important step.

In some cases, the utilities themselves are simply adopting a much more progressive, long-term view, which is exciting to see, but then other parts of the ecosystem kick in to limit the renewable energy transformation. Again in Vermont, Green Mountain Power is investing heavily in the smart grid and in renewable energy generation, but because the ISO perceives growing renewable generation capacity as a threat to grid stability the utility has been regularly directed to curtail wind production during peak demand episodes even as the ISO has directed fossil fuel generation plants to ramp up generation.

These questions about how to redesign the utility business model do get a lot of attention from the policy wonks, think tanks, and academics. Plenty of very smart people are figuring out both the broad strokes and the gory details of this transition (for example, this post about emerging investment opportunities for utilities). But the business model issue – how investors will actually make money in the utility of the future – isn’t yet very much part of the political conversation.

By tackling that question head on, we might be able to create some space for productive dialogue rather than the more traditional entrenched-industry-fights-change dynamic. The industry is already facing enormous disruption from distributed generation. Distributed generation – people around the country installing their own energy production (usually solar but not always) on their own homes – is extremely threatening to the traditional business model because it means the homeowner needs less of everything the utility makes money doing.

The rapid growth in distributed generation (as well as the growing promise that storage technologies will enable a truly decentralized grid) is so unnerving that the utility industry is mounting an aggressive national attack against the “net metering” provisions allowing homeowners to get compensated for the energy they produce and contribute to the grid (in addition to paying for the energy they consume from the grid).

The Edison Electric Institute, representing investor-owned electric companies, earlier this year published a frequently cited report on the threat posed by distributed generation, demand-side management, and other emerging technologies. The report reads more like a call to arms in defense of the status quo than a call to lean into the opportunities of a clean energy transformation.

While the various disruptive challenges facing the electric utility industry may have different implications, they all create adverse impacts on revenues, as well as on investor returns, and require individual solutions as part of a comprehensive program to address these disruptive trends. Left unaddressed, these financial pressures could have a major impact on realized equity returns, required investor returns, and credit quality. As a result, the future cost and availability of capital for the electric utility industry would be adversely impacted. This would lead to increasing customer rate pressures.

In every fight like this there are losers. The fossil fuel industry won’t fare as well as we transition to the New Energy Economy unless they transform themselves. But for the utilities, and for the public utilities commissions, the ISOs, and the RTOs responsible for managing their electricity markets, it’s a different story. Historically they have largely resisted the aggressive growth of clean energy generation and distributed generation, but with the right kind of policy space and leadership across the issue the utilities, their shareholders, and they communities they serve can all come out ahead.