Innovation inside a regulated utility

Working for an investor-owned electric utility is like no other business.  The company works to make a profit, so it is not like the government; but price, quantity, and delivery of the product are dictated by regulators, so it is not like a normal business.  A common expression of this duality is “working for a utility is like working for the government, but with twice the paperwork.” The difference between a typical business and a utility business is best shown by looking at their respective business models:

utility business model

Why do utility businesses operate differently? To explain, one must understand the concept of a natural monopoly. An idea borne of the Robber Baron era, the term “natural monopoly” refers to industries with very high startup costs (such as railroads, water, electricity, telecommunications etc.) that, if left unregulated, would come to be monopolized leaving customers held hostage. This is due to the “virtuous cycle,” or vicious cycle, depending on one’s perspective.  Industries with large startup costs often have positive economies of scale, meaning that the more capital company’s invest, the cheaper their product becomes. The cheaper the product, the more customers the company gets, and thus the more capital they can raise to lower prices further. The cycle repeats itself until all competition is gone and the winning monopoly can then gouge consumers because there is no alternative.

As an interesting side note, the virtuous cycle today is being used by technologists like Ben Thompson to explain why the big continue to get bigger and Facebook will soon rule the world. 

Photo Credit: Utilities and Monopoly have always gone hand in hand.

To counter this outcome, regulated utilities are granted a monopoly over a specific “service territory” where the law prohibits competition, but in exchange the utility’s costs and expenditures are reviewed and approved (or denied) by government regulators, and a “reasonable rate of return” (typically around 8-10%) is added to the capital expenditures to encourage investment. These costs and the return on investment are used to create rates set by the regulatory agencies, which are then paid by customers connected to the utility’s grid.  This is how electric utilities in the U.S. have operated for over a hundred years, since Samuel Insull first developed the model.

And, over the past hundred years the model has remained largely unchallenged, until now.

As good as the utility model is, there are certain drawbacks that can be derived from the model:

  • There is no incentive for utilities to spend on operations and maintenance (O&M) because there is no return on investment; which means that there is a constant downward pressure on O&M wages and proper maintenance activities.
  • There is an incentive for new capital expenditures; meaning utilities are incentivized to forego maintenance in favor of replacing assets entirely despite the potential cost savings of proper maintenance.
  • If a typical business finds a cheaper way to produce their product, they can charge the same price, earning a greater profit. Conversely, if a regulated utility finds a cheaper way to produce its product, it might reduce its capital expenditures, reducing the total business return.

The agency regulating the utility is responsible for countering these drawbacks, but that typically means scrutinizing every expenditure.  If an expenditure looks suspicious, the regulatory agency can deny it from rates, making it a stranded-cost for the utility, which directly eats away at the company’s return.  Utility executives do not like this.  As a result, the utility model highly discourages risk. And without risk, there is seldom innovation.

regulated utility

Enter the rooftop solar industry. Leveraging tax incentives, low interest rates, and net-metering tariffs, several rooftop solar companies have developed rooftop solar services that promise to deliver consumers green solar energy at a lower cost than their current power bill.  There are problems with the model, from homeowners being stuck with liens on their property, to under-capitalization, to claims of reverse robin-hood subsidization of wealthy homeowners. Yet, the fact remains that for the first time in almost a century, the utility industry is facing a relatively unregulated and innovative competitor.  Couple the ongoing innovation in distributed solar with the continuing price reduction in energy storage (down 23% from 2015-2016), and utilities could be caught flat-footed as their customers flock to rooftop competitors.

Fortunately, some utilities are starting to catch on, and it has triggered the beginning of an industry revolution that is certain to spawn tremendous innovation and likely better serve all electric customers.  Innovation inside of strict regulation can be discouraging, but it is certainly not a contradiction.  Traditional utilities can no longer rely on regulatory protections; they must begin to use divergent and lateral strategies to maintain market dominance.

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