Impasse Over Cost Recovery Stymies Grid Modernization in Illinois

Written by David O'Brien

Traditional utility rate setting is arguably incompatible with innovation in electric power transmission and distribution. But there is a ready solution: performance-oriented ratemaking that supports innovation, measures operational results and rewards performance.

On Oct. 3, the Illinois Commerce Commission (ICC) handed down the final Order on Rehearing in Docket 11-0721 regarding Commonwealth Edison's (ComEd's) new formula rate for reimbursement of the utility's upcoming multi-billion-dollar investments in grid modernization. There was an immediate reaction by utilities in Illinois, which warned that the order would have a profound effect on their plans to deploy AMI and distribution automation consistent with the state's ambitious Energy Infrastructure Modernization Act, enacted in October 2011.

"The adverse rulings on the interest rate and rate base issues significantly impair ComEd’s ability to finance long-term investment programs," said Anne Pramaggiore, ComEd's CEO. "With this ruling, we have no choice but to delay some elements of the grid modernization rollout, at least until we have an outcome in the courts."

What is occurring in Illinois is a seminal moment for the emerging "smart grid" in the United States. Internationally, decisions about investments in grid technology are made in what amounts to a command and control environment, where the utility is part of a provincial or national government. Political policymakers preside over organizations that own the utilities whose futures are at stake. The United States is a collection of fifty independent states, each with their own energy statutes, utility commission and tradition. Every state has a healthy amount of pride about the way it does business and the priorities it sets.

Still, core ratemaking principles are common to all states. New regulators are initiated into the same basic disciplines, whether they are based on "Bonbright's Principles" or Camp NARUC guidelines, just as accountants and lawyers and engineers are taught essentially the same rules. The situation in Illinois brings us face to face with the urgent issues of whether traditional regulatory principles will be adaptable to modern circumstances, and whether there can be broad agreement on revised principles across all states.

The energy modernization legislation passed last year in Illinois was precisely the sort of wholesale change that is required to move forward into the era of the digital grid. It is performance-based ratemaking (PBR) written into statute. Proponents of the legislation – representatives, senators, utilities and utility workers – all recognized that a new paradigm based on embracing technology and rewarding performance was required. They chose to "cross the Rubicon." However, for opponents of these sweeping changes, the focus has been to enforce the status quo.

In the traditional regulatory system, ratemaking means just what it says. Electric utility revenues are based upon the approved costs being recovered at rates set by state regulators, and thus are equivalent to the amount of money charged per unit of electricity multiplied by the amount of electricity consumed. It is not a value-pricing environment based on what the market will bear, but a cost-plus formula where the key inputs are operating costs (staff costs, equipment, and so on), capital spending and the allowed rate of return. Revenues and earnings are capped by what regulators approve.

For many decades, this has been a largely winning formula that has underwritten core grid investment with electricity made broadly available to all at affordable and stable prices. The basis of the bargain has been that the utilities do not face the risk of total failure characteristic of competitive markets, as their customer base is guaranteed and they are more than likely to be reimbursed for their costs. They do not have to worry about attracting enough consumer demand to realize a profit.

In return, the government, through regulators, exercises tremendous control over their business and allows a modest return on investment. Regulators want to foster a risk-adverse environment because customers are captive to a monopoly provider, and are thus hostage to the fortunes of their local utility. The institutional preference is decidedly on the side of the known or proven, not the unknown or experimental.

Rates are adjusted over time on a fairly sporadic basis, in reaction to outside forces such as general inflation, capital needs and the ever-changing cost of energy generation. Utilities come in with rate requests when warranted by conditions, including when they are proposing a major investment project that is not covered by current rates. The rate review process is conducted in a court of law. The utility commission reviews and hears live evidence, where lawyers on both sides make their arguments. At the end, it is the utility commission’s job to issue an "order" that details what has been approved or denied and what, if any, conditions are being imposed. A regulatory order has the force and effect of law, and is binding on the utility and subject to any appeal that might be made to a separate court.

Many utilities see risks in the mere prospect of having a rate case because there is always the possibility of unexpected outcomes: their requests may be denied, and new, possibly onerous, requirements might be imposed on them. It is for this reason that many utilities will "stay out" for years at a time, content to somehow make things work with the rates they have in effect.

Within this static price-setting environment, regulators use a variety of imprecise means to reward and penalize utilities. These methods can include delaying cost recovery, varying the interest rate applied to uncollected items and allowing extended over- or under-collection. Regulators have found means of slowing, accelerating, contracting or expanding utility revenues to foster particular outcomes or policies. Even so, natural conditions have sometimes enabled utilities to "over-collect," and anecdotally, those have been times when there was an uptick in both innovation investments and shareholder returns.

It is easy to see that the risk-averse environment of traditional ratemaking is not one in which new technology and solutions are best evaluated. Digital automation has transformed our world, and yet the electric industry has not joined in. There is certainly risk involved: risk that particular infrastructure solutions will be proven sub-optimal or end up having much shorter useful lives.

There is of course a fair amount of human or cultural adaptation involved in introduction of any new technology. Novel devices like in-home displays and load control thermostats, and innovative rules like variable electricity rates, are among the obvious adaptations that come to mind. As utility customers, we are not accustomed to being engaged when it comes to our consumption of electricity. The prospect that consumers might be quite unhappy about change weighs heavily on the minds of regulators.

A look at the Illinois Energy Infrastructure Modernization Act may be instructive. Under the law, there are significant changes to the traditional ratemaking process with major "gives" on both sides. On the one hand, utilities are required to implement a cost-effective automated metering and automated grid platform, and must meet specific performance criteria. In return, rates will be set according to a new "formula rate" that is designed to allow utilities to recover their investments on a much more timely and predictable basis, eliminating much of the traditional regulatory lag. A legacy regulatory environment in which costs are not always covered or covered in timely manner, and in which failure is penalized only when mistakes are made, is replaced with a symmetrical bargain where the utility can reap financial reward for exceeding expectations and experience financial loss for missing the mark. What we all want – or so it seems to me – is a regulatory world in which utility executives and line workers are motivated to wow us by providing superior service. That, after all, is what we expect from others who provide us with products and services.

As I write this, it is unclear how the situation in Illinois will turn out, but I do know the core principles in the energy modernization legislation represent the direction the industry should be heading in. Think value-added instead of least-cost. Think excellence instead of acceptable. The idea of alternative regulation or PBR is not a new one, in many states it has been enabled in statute for years but has not been put into practice. Perhaps regulators and utility leaders can come together soon to discuss ways to transition to a performance-driven industry that will embrace innovation for our collective benefit.



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David O'Brien is a former Vermont Commissioner of Public Service and is now a strategic consultant to utilities at the Bridge Energy Group, where he advises ComEd, among others, on regulatory matters. As a Vermont commissioner and member of the state governor's administration, he was responsible for regulation of the electric, natural gas, telecommunications and water industries. He holds a bachelor's degree in accounting from the University of Bridgeport, in Connecticut, and a master's in finance from Fairfield University.