Playing Monopoly; or, How Utilities Make Money

To achieve our climate goals in the Northwest (or any other region in North America), we’ll need to clean up the power grid while also shifting whole sectors of the economy from dirty fuels to electricity. That two-pronged approach is central to every serious study of decarbonization, even in places like Cascadia where we already boast relatively low-carbon power systems. A starting place is utilities. To decarbonize, policymakers will need to  fundamentally change how utilities make money. Today, utilities are primarily incentivized to build new infrastructure—more pipes and wires—rather than boost efficiency, make repairs, or invest in operations. And, utilities may see third-party-owned climate-friendly energy systems like solar panels and batteries as a threat to their business model. Understanding how we can realign utility profit incentives is key to decarbonizing the Northwest.

The utility business is not like most other businesses. Utilities inhabit a world of special accounting rules and pre-established investment returns, where ordinary business incentives often do not matter, and where changing course is exceedingly hard. 

Utilities’ profit doesn’t come from the natural gas or water or electricity they provide to customers. That’s right, utilities do not earn profits on the products they sell—gas, water, and power are provided “at cost” to consumers—but rather from the investment in the assets (the pipes, substations, transmission lines, etc.) that are used to provide the service. In short, the more infrastructure that a utility builds, the higher the profits it can generate. 

Utilities do not operate in a normal free market system where prices and profits are determined by the willingness of consumers to pay. Instead, they are “regulated monopolies” in which public officials guarantee the companies a monetary return on their investments while also fixing prices for consumers. In practice, that means before a utility can earn money, it needs to convince regulators how much it should make. In public proceedings called “rate cases,” utilities appear before a dedicated state agency known as a utility commission (it’s the Utilities and Transportation Commission in Washington and the Public Utility Commission in Oregon) and lay out their argument for how much money they need to bring in to run their business and make a reasonable profit, namely the “revenue requirement.” 

This is the basic formula that governs how a utility makes money:

Revenue Requirement = (Rate of Return on Equity)*(Value of Assets After Depreciation) + Expenses 

Let’s take a closer look at the parts of this formula. 

Revenue requirement—a disincentive to innovate

The revenue requirement is the key outcome of a rate case. It determines how much utility customers will have to pay and how much profit the utility will make, but it is designed in a way that discourages innovation.

What’s a rate case? That’s when utility officials present the state utility commission with reams of documents that spell out its need to earn a specific amount of money to pay for salaries, equipment, and the like and on top of that, to earn a 9.5 percent profit. The commission is supposed to thoroughly examine the request and weigh the prudence of each part, rejecting costs that are not necessary or not allowed. Ultimately, in negotiation with the utility, the commission will decide on the amount of money that the utility can collect, known as the revenue requirement. Once determined, the revenue requirement is then divided up—by the number of customers and the amount of commodity they are expected to use—to determine the rates that customers pay. 

It’s easier for utilities to play it safe, plodding ahead with business as usual that can reliably turn a profit rather than try to innovate or design new systems for a changing energy environment.

It’s easier for utilities to play it safe, plodding ahead with business as usual that can reliably turn a profit rather than try to innovate or design new systems for a changing energy environment.

Rate of return on equity—a disincentive to reduce waste and boost performance

Like many other businesses, utilities must find investors willing to loan and invest money that the utility will spend to grow, operate, and maintain its business. The utility seeks both debt (borrowed money) and equity investments (money invested by shareholders), all subject to meeting regulators’ requirements for maintaining a specific ratio of debt to equity for the utility. However, unlike other businesses, the shareholder return is pre-established by regulators. This predictability means that utilities can pay above-average dividends to their investors while offering a much lower-than-average risk investment. 

If you buy a share of Tesla or Boeing stock, there is a much higher risk that the stock will not return the profits you expect due to uncertainties like the company’s profit potential and customer growth. But when you buy a share of utility stock, you have a pretty good idea of what you will get in return. Utilities don’t lead the stock market, but they do offer low-risk, steady returns.  

The utility commission determines a maximum allowable profit margin or “rate of return on equity” for utilities. The 2019 authorized return on equity for the utilities in the Northwest was:

• PSE: 9.5 percent
• Avista: 9.4 percent
• Northwest Natural: 9.4 percent
• Idaho Power: 9.5 percent
• Portland General Electric: 9.5 percent

These profit margins are not guaranteed to investors though; utilities bear some of the risk of actual costs exceeding forecasted costs and must effectively manage their business to achieve this rate of return on equity. If the utility generates a larger return—i.e. makes more profit—than allowed by regulators, it typically returns the excess money to its customers in the form of reduced rates in future years. That’s good because it protects the public interest, but it has a downside too: capping the financial benefits for a utilities’s shareholders discourages the utility from pushing too hard to reduce waste and improve performance.

Capping the financial benefits for a utilities’s shareholders discourages the utility from pushing too hard to reduce waste and improve performance.

Value of assets after depreciation—an incentive to add new pipelines rather than repairing old ones

Asset value is at the root of the utility profit margin because a utility only earns a return on its investment in physical assets. And utilities own heaps of assets, not by accident. In fact, utilities are motivated to build more infrastructure because every year they recoup the cost of their investment in those assets plus an additional percentage of those costs (that’s the rate of return on equity) which is their profit. 

Consider all of the power poles, power generation plants, substations, pipes, regulators, meters, and other equipment that is part of the system that delivers electricity and gas. Each of these assets has an initial value (its installed cost) and a depreciation schedule (e.g. 30 years of straight-line depreciation means it loses 1/30th of its value every year until the 30th year when it is worth nothing). 

For example, if a utility were to spend $5 million building a new pipeline it would pass along the cost of the project to its ratepayers. Then the utility would also earn a guaranteed annual rate return on its investment in the pipeline. So if the rate of return were set at 10 percent, the utility would earn $500,000 in the first year ($5 million x 10 percent) and then slightly less in each subsequent year as the value of the pipeline depreciates over time. Understanding these guaranteed profits is key to understanding why a utility might be eager to pursue questionable new infrastructure projects like new pipelines or LNG facilities.

Expenses—passing off costs to customers discourages efficiency and upkeep

Expenses are those costs that utilities pass through directly to their customers with no markup for profits. Maintenance costs (e.g. repairing natural gas leaks) and the cost of fuel (e.g. natural gas, coal) are examples of expenses that the utility cannot mark up. That is, a utility must charge its customers the same cost that it pays. Selling natural gas to consumers does not return a profit to the utilitiy’s shareholders and neither does maintaining the natural gas pipeline. Since efficiency and upkeep don’t make money for the utility, there’s little financial incentive to do more than the bare minimum.

Since efficiency and upkeep don’t make money for the utility, there’s little financial incentive to do more than the bare minimum.

Instead, profitability is driven primarily by the value of the assets. So while a utility has little incentive to spend money on upkeep, it does have a built-in incentive to buy new assets—the more infrastructure it builds, the more profits it can generate. As a result, it is common to see utilities prioritize replacement of an asset over repair. For example, utilities have been replacing sensors when the batteries die, rather than simply replacing the battery. The replacement of the whole sensor can earn profit for the utility while upkeep on a battery is a pass-through cost. We don’t replace our phones when the batteries need to be charged, but too often that is exactly the kind of tradeoff utilities make to juice their earnings.

It follows that  utilities have little motivation to find efficiencies in the pass-through categories of costs. For example, gas leaks waste fuel, but since the cost of the gas is passed through to customers, the expense of fixing gas leaks is likely not an attractive investment—especially if the repair does not result in a new physical asset that can earn a profit. Similarly, energy efficiency programs administered by utilities do not earn a profit, which may disincentivize a utility from going the extra mile to help their customers save energy. For example, local utilities have been very slow to implement voltage management on their distribution lines, a method of conservation that dwarfs all of the energy efficiency rebate programs, because the costs to implement this method cannot earn a profit.

How utilities make money: Home solar hikes prices and low-income customers bear the brunt. Photo: @tami.s.kelly via Twenty20.

Using less energy can raise rates and penalize low-income consumers

In the last decade, two trends in energy have emerged that affect both how utilities make money and the price that consumers pay for energy: energy efficiency and net metering (in which utility customers sell the power they generate from rooftop solar back to the utility). Both of these trends drive down the volume of energy sold by utilities, but they come with complications.

In the Northwest and in many other states, a utility’s revenues are “decoupled” from profits. That means the money-making formula is adjusted annually with a balancing account to allow utilities to collect enough revenue each year, independent of how much energy customers use. If the weather in one year drives customers to use more energy, the balancing account will refund to customers the extra revenue collected. Conversely, if customers focus on conservation and use less energy, the balancing account will allow the utility to collect a little extra revenue from customers to make up for the loss (by charging a slightly higher rate). This makes sense from the perspective of stabilizing utility finances, but there’s a downside. 

Using less energy can raise rates and penalize low-income consumers.

Both energy efficiency and net metering reduce how much energy customers want to buy, which means, the utility sells less energy on a per-customer basis. In this case, the balancing account will allow rates to adjust upward to make up the difference so that the utility is able to collect the revenue it expected. Hence consumers ultimately pay more for less. What’s more, the consumers who opt-in to net metering and energy efficiency, and who therefore are buying fewer units of energy, are likely the wealthier consumers who can afford solar panels or new high-efficiency appliances. So, while the wealthiest consumers may send a smaller payment to the utility, lower-income consumers who make no changes to their energy consumption (often because they are tenants) may bear the brunt of the increased rates. Yet the utility comes out ahead because it collects its required revenue, regardless of the economic inequities that its consumers face.

How to align utility profits with community values and climate goals

The business model for utilities based on cost-of-service regulation was built for a time when safe and reliable power were the principle public interest. Nowadays, there are other priorities too: reducing greenhouse gas emissions, improving system resiliency, promoting consumer equity, customer choices, and offering a degree of local control. Having infrastructure owned by utilities infrastructure may not be the best way to achieve these priorities. 

Instead, investment in grid operations and third-party-owned distributed resources (e.g. batteries, demand response, solar panels) may be better for energy customers. As a result, many public utility commissions are starting to look at a new strategy called performance-based regulation (PBR) that may better align utility performance with the public interest. PBR can support new business models by tying utility profits to achieving desired outcomes like reducing greenhouse gas emissions or making bigger investments in decarbonization. 

In 2017, the Oregon legislature passed a bill that opened an investigation into utility regulation. The law required the state utility commission to review industry trends, technologies, and policy drivers  in consideration of changes to the regulated utility business model. Though the final report was published in 2018, Oregon has not yet moved forward on the recommendation for PBR. Similarly, the Washington legislature has empowered the state utility commission to use PBR to help reduce carbon emissions as part of the 2019 Clean Energy Transformation Act. Other Northwest states have made no efforts in this direction. 

In the coming years, the Northwest, like other regions, will begin to rebuild its economy from the disruption of early 2020. It is possible that states will even receive federal stimulus investments that can speed transformation of the energy sector. So, as we begin the process of reconstruction, it is an ideal time to consider whether the regulatory models that now govern our utilities—and how utilities make money—are designed to best meet the needs we’ll have in the decades ahead for resilience, innovation, climate stability, and fairness.