Last month French economist Jean Tirole won the 2014 Nobel Prize in economic sciences. According to the Royal Swedish Academy of Sciences, he deserved the award because he has “clarified how to understand and regulate industries with a few powerful firms.”
With the increasing penetration of renewable energy driving conversations about appropriate utility rate and regulatory structures for the 21st century, in this post we explore three takeaways from Tirole’s work as they apply to electric utility regulation.
Jean Tirole: Three Key Takeaways for Regulation of Electric Utilities
1. Offer regulatory choices that provide incentives while avoiding the ratchet effect
Suppose regulators do not know the true potential of firms they regulate to reduce cost. If they offer cost-based, rate-of-return structures firms will have little incentive to reduce cost even when it is possible. On the other hand, if they offer fixed-price structures firms will have a strong incentives to reduce costs, yet depending on the price level allowed it may be the firms—not ratepayers—that capture the benefits.
Tirole showed that regulators can resolve this dilemma by offering firms a carefully designed menu of regulatory schemes and letting the firms choose between the options. Offered the two polar choices above, firms without good cost reduction opportunities would take the rate-of-return option, while firms with them would take the fixed-price option. A regulator can use a more sophisticated menu to ensure some of the benefits of cost reduction are shared with ratepayers.
Tirole also showed that regulators must be able to offer long-term contracts for high-powered incentives (such as fixed prices) to be optimal. If regulators can ratchet prices down after firms have made investments, firms will avoid making investments that require longer payback periods. To avoid this ratchet effect, such regulators should offer only modest incentives in the short run.
2. Incentives for firms offering network access should depend on competitors’ output
Regulated firms often control access to an intermediate good that other companies can use to compete in end markets. If the regulated firm’s profit is dependent only on its own level of output (or assets) it has an incentive to overstate the cost of providing access to such companies to foreclose that competition. Therefore, Tirole says “the regulated firm’s incentive scheme should depend not only on the firm’s cost and outputs but also on the output produced by its competitors”!
3. platform markets require network externalities and are sensitive to price allocation
Tirole has been a leader in the study of platform markets, such as those for video game systems, operating systems, payment systems, and newspapers. He defines such markets as those in which:
(a) the amount users benefit from the platform depends on the number of other users of the platform (i.e., video game developers prefer platforms with many gamer customers), and
(b) the volume of transactions depends not only on the total price level, but on the distribution of prices between parties that use the platform (i.e., advertisers and subscribers to a newspaper are charged different prices).
As we will see below, New York would like to set up a platform market for distributed energy resources.
Several states, including Arizona, California, Hawaii, Massachusetts, Minnesota, and New York are considering changes to their regulatory frameworks for electric utilities to manage or encourage the use of distributed energy resources, fairly allocate costs, and improve efficiency.
Let’s look at how some of the takeaways from Tirole’s work could be applied in two of these states: New York and Hawaii.
New York: Reforming the Energy Vision
New York’s efforts, known as Reforming the Energy Vision, call for utilities to become “distributed system platforms.” In this role, utilities would both manage and participate in markets for distributed generation, storage, energy efficiency, and demand response.
Today, New York utilities are allowed a regulated rate of return based on assets. However, New York Public Service Commission chair Audrey Zibelman has emphasized several times she would like to see an incentive-based approach that rewards efficiency, not assets. We applaud the move towards more incentives. Per Tirole, the PSC could take the opportunity to develop the menu of regulatory options that provide the right balance between providing incentives and avoiding the ratchet effect—that is, between incentives and cost-based regulation.
Another area the PSC has focused on is mitigating the market power of distribution utilities. For example, it suggests limiting utility investments in distributed energy resources to energy efficiency programs, utility-sited storage and generation, and other investments approved on a case-by-case basis. An incentive based on the output of competitors, such as third parties offering storage or generation, would also seem to be worth examining. For example, the PSC could give a price incentive to utilities that achieve certain load shape goals using third-party resources.
Finally, we encourage the PSC to think carefully about market design if it wants to create a true platform market. First, at least one set of participants needs to benefit from the number of other participants. Perhaps community solar developers and their consumers, who can transact through the grid platform, can fill this role. Second, the PSC should ensure the distribution of prices charged by the platform (utility) encourage maximum participation. Even if the final design fails one of these tests, however, it may be sufficient to create a mechanism by which third parties compete to offer services the utility needs to buy to optimize load shape and network stability.
Hawaii: Inclinations on the Future of Hawaii’s Electric Utilities
Hawaii has the highest penetration of distributed generation in the country. This has had a significant impact on both distribution circuits and the amount of utility-scale generation required. In Figure 1, below, see how peak system load on Oahu has decreased from about 1,200 MW to 1,050 MW in six years. Note also the shorter duration of peak demand than was the case historically.
Figure 1: Oahu system load (MW)
This puts The Hawaiian Electric Companies (“HECO”) in a bit of a pickle because they have to deal not only with the impacts of distributed PV on the distribution network, like New York, but also manage the financial impacts of decreased utilization of their generating plants. HECO generates a larger share of the energy it distributes than utilities in other states with high penetration of DG, such as New York and California:
Figure 2: Percent of energy distributed that is self-Generated, Selected Utilities
(Source: Company documents)
In April the Hawaii Public Utilities Commission issued a regulatory order and white paper called Commission’s Inclinations on the Future of Hawaii’s Electric Utilities that instructed HECO to put together plans to develop a 21st century generation system, create a modern transmission and distribution grid infrastructure, and assist in policy and regulatory reforms. As it evaluates HECO’s responses, the PUC might consider some policy and regulatory reforms of its own that would be consistent with Tirole’s research:
First, the PUC ought to consider mixing Hawaii’s traditional rate-of-return regulation model with one that includes an incentive for the amount of DG connected. HECO’s response to the PUC order spends a significant amount of time explaining all the technical complexities and costs associated with accommodating DG―exactly what Tirole suggests will happen when monopoly firms are asked to provide network access that enables competition. An appropriately designed incentive for DG connections would balance HECO’s understandable desire to limit competition or increase its asset base with an equally powerful incentive to enable DG.
The Hawaii PUC should also offer HECO a menu of regulatory options. Some options would be largely rate-of-return and others would have more fixed-price elements. If HECO has few real prospects of reducing cost it will choose to continue with rate-of-return regulation. On the other hand, if the boom in distributed solar actually allows long-term cost reductions it will choose an option that includes some fixed price components that allow it to capture some of the potential savings as increased earnings. Designed appropriately, Hawaii ratepayers could also share in the benefits.
As we’ve seen, Jean Tirole’s work has significant and useful implications for the regulation of electric utilities. This is not to say that application of these principles is simple. For example, developing an actual menu of regulatory options requires a deep understanding of the particular local conditions and significant analysis. We hope this brief introduction, however, helps regulators and utilities develop more efficient solutions.
About Woodlawn Associates
Woodlawn Associates is a management consulting firm with extensive experience in energy and distributed solar. We have advised some of the largest utilities in the United States on strategy for integrating or dealing with DG. If you would like to discuss any of these ideas at more length, we would love to hear from you.