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Pashos: Is cost-of-service regulation relevant in today's world?

February 26, 2014
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Indiana Lawyer Focus

“No task more profoundly tests the capacity of our government ... than its share in securing for society those essential services which are furnished by public utilities. Our whole social structure presupposes ... dependence upon private economic enterprise. To think of contemporary America without the intricate and pervasive systems which furnish light, heat, power, transportation, and communication is to conjure up another world.” (Felix Frankfurter)

For over a century, Indiana’s public utility rates have been established by governmental agencies, acting as a replacement for a competitive marketplace. The “regulatory compact” under which such regulation takes place holds that public utilities should be given exclusive territories in which to provide these important services so as to avoid a duplication of facilities; in return, public utilities should provide adequate and reliable service to all customers in such territories, at reasonable rates determined by the government. Under this regulatory compact, public utilities submit to regulation and give up the potential upside of substantial profits that other competitive enterprises seek, and customers give up the ability to choose their utility providers.

pashos Pashos

The linchpin of regulated ratemaking has been “cost of service” – rates set based on an estimate of the utility’s reasonable and prudent costs of providing utility services to customers going forward, plus a fair return for investors who supply the utility with needed capital. Cost-of-service regulation provides utilities with an opportunity, but not a guarantee, that they will recover their actual costs of providing service along with a fair return for their investors.

The traditional cost-of-service ratemaking model seeks to ensure that investors continue to provide needed capital and customers continue to receive near universal service at reasonable rates. As the U.S. Supreme Court stated, “the rate-making process ... i.e., the fixing of just and reasonable rates, involves a balancing of the investor and the consumer interest.” Federal Power Commission v. Hope Natural Gas Co., 320 U.S. 591 (1944).

Today, public utilities are experiencing significant cost increases, due to issues such as federal environmental and other mandates, and the need to upgrade decades-old infrastructure. These cost pressures, combined with fast-paced technology, market changes and other states’ experimentation with retail deregulation, are causing policymakers and others to ask whether cost-of-service regulation remains relevant or whether deregulation might be a preferable alternative.

Given the very recent history of relatively low and stable natural gas and wholesale power prices, deregulation may appear to be an attractive replacement for cost-of-service regulation. But a more in-depth analysis of other states’ retail deregulation experiences indicates that retail deregulation may present more risk than reward.

A principal motivation behind retail deregulation has been the theory that competition would produce lower prices for consumers. A historical comparison of the electricity prices and price changes in regulated and deregulated states, however, indicates that retail deregulation does not impact electricity prices in any significant way. Rather, the price of electricity is determined by numerous other factors upon which deregulation has little to no impact (for example, fuel proximity and prices, wholesale power prices, construction costs, and government renewable policy requirements). Moreover, the distinct possibility exists that retail deregulation is unlikely to produce price reductions except possibly during periods of low natural gas prices, low wholesale power prices, and generating capacity surpluses. Deregulated Electricity in Texas, supra at 63. Retail Electric Rates in Deregulated and Regulated States: 2012 Update, American Public Power Association, April 2013, available at http://www.publicpower.org/files/PDFs/RKW_Final_-_2012_update.pdf. Kenneth Rose, State Retail Electricity Markets: How Are They Performing So Far?, ElectricityPolicy.com (June 2012). Mathew J. Morey and Laurence D. Kirsch, Retail Rate Impacts of State and Federal Electric Utility Policies, Christensen Associates, The Electricity Journal. Vol. 26, Issue 3 (April 2013).

Even if the price benefits were long term and persuasive, there are risks associated with deregulation that must be considered. These risks include price volatility, reliability of supply, complexity of deregulation, and loss of state jurisdiction.

Electricity is considered to be the most volatile commodity in the world, and natural gas is a volatile commodity, as well. Under regulation, utility customers are largely protected from this price volatility because the utility has “iron in the ground” assets and contracts to hedge against spot market price changes. But in deregulated environments, customers bear more price volatility themselves.

The construction of new-generation assets to ensure the availability of electricity and adequate reserves is a very real issue in deregulated markets. Deregulated markets have struggled to effectively incentivize sufficient construction of new generation, as is illustrated by brownouts and blackouts that have occurred in deregulated markets in Texas and California. Deregulated Electricity in Texas: A History of Retail Competition, Texas Coalition for Affordable Power, December 2012, available at http://tcaptx.com/wp-content/uploads/2013/03/SB7-Report-2012.pdf. The Western Energy Crisis, the Enron Bankruptcy, and FERC’s Response, available at http://www.ferc.gov/industries/electric/indus-act/wec/chron/chronology.pdf.

Retail deregulation legislation must necessarily address numerous complicated issues, many of which can produce unintended consequences (such as the California energy crisis in the early 2000s). As just a few examples of such issues: How will deregulation take place? Will incumbent utilities be required to divest their generating assets? How will “stranded costs” be calculated? How will stranded costs be recovered from customers? Should incumbent utilities be required to act as a “provider of last resort?” How should incumbent utilities be compensated for acting as a provider of last resort?

Finally, when states embark upon retail deregulation, they cede a significant amount of jurisdiction over generation and generation pricing to the federal government. Once a state deregulates, the construction of generating facilities and the pricing of electricity generation will, for the most part, take place at the federal, wholesale level, leaving states without much ability to oversee the adequacy of generation supply or the pricing of such supply to retail customers, as experienced in Maryland and New Jersey.

While Indiana may want to explore deregulation as an alternative to cost-of-service-based regulation, the complexity and risks associated with deregulation should not be ignored or underestimated. Similarly, Indiana should not ignore or underestimate the continued usefulness and possible beneficial evolution of cost-of-service regulation.•

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Kay Pashos is a partner in the Indianapolis office of Ice Miller LLP. She practices in the area of energy and utilities law, advising and representing energy and utility companies before state and federal regulatory agencies in a variety of cases. The opinions expressed are those of the author.
 

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  1. You can put your photos anywhere you like... When someone steals it they know it doesn't belong to them. And, a man getting a divorce is automatically not a nice guy...? That's ridiculous. Since when is need of money a conflict of interest? That would mean that no one should have a job unless they are already financially solvent without a job... A photographer is also under no obligation to use a watermark (again, people know when a photo doesn't belong to them) or provide contact information. Hey, he didn't make it easy for me to pay him so I'll just take it! Well heck, might as well walk out of the grocery store with a cart full of food because the lines are too long and you don't find that convenient. "Only in Indiana." Oh, now you're passing judgement on an entire state... What state do you live in? I need to characterize everyone in your state as ignorant and opinionated. And the final bit of ignorance; assuming a photo anyone would want is lucky and then how much does your camera have to cost to make it a good photo, in your obviously relevant opinion?

  2. Seventh Circuit Court Judge Diane Wood has stated in “The Rule of Law in Times of Stress” (2003), “that neither laws nor the procedures used to create or implement them should be secret; and . . . the laws must not be arbitrary.” According to the American Bar Association, Wood’s quote drives home this point: The rule of law also requires that people can expect predictable results from the legal system; this is what Judge Wood implies when she says that “the laws must not be arbitrary.” Predictable results mean that people who act in the same way can expect the law to treat them in the same way. If similar actions do not produce similar legal outcomes, people cannot use the law to guide their actions, and a “rule of law” does not exist.

  3. Linda, I sure hope you are not seeking a law license, for such eighteenth century sentiments could result in your denial in some jurisdictions minting attorneys for our tolerant and inclusive profession.

  4. Mazel Tov to the newlyweds. And to those bakers, photographers, printers, clerks, judges and others who will lose careers and social standing for not saluting the New World (Dis)Order, we can all direct our Two Minutes of Hate as Big Brother asks of us. Progress! Onward!

  5. My daughter was taken from my home at the end of June/2014. I said I would sign the safety plan but my husband would not. My husband said he would leave the house so my daughter could stay with me but the case worker said no her mind is made up she is taking my daughter. My daughter went to a friends and then the friend filed a restraining order which she was told by dcs if she did not then they would take my daughter away from her. The restraining order was not in effect until we were to go to court. Eventually it was dropped but for 2 months DCS refused to allow me to have any contact and was using the restraining order as the reason but it was not in effect. This was Dcs violating my rights. Please help me I don't have the money for an attorney. Can anyone take this case Pro Bono?

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