Decoupling Series: What is a regulated territorial monopoly?

This is part one of a three part series on the past, present and future of utility regulation alongside the growing renewable energy industry.  REIA supports introducing a decoupling mechanism to PNM because it will change the way utilities do business in New Mexico.  If you’re interested specifics about the rate case, that information is here.

Status Quo Blues:  Regulated Territorial Monopolies

Utilities set up as regulated territorial monopolies for a couple of reasons.  As utilities began, they needed enormous initial investment, a barrier to entry requiring government intervention.  With high fixed costs, utilities also needed large numbers of customers to obtain a meaningful return on investment.  Because competition created crisscrossed electric wire madness, the government allowed monopolies to form.  Competition usually discovers the optimal way to produce services to maximize profit and efficiency, so a monopoly does not naturally work to a customer’s advantage.  As a result, monopolies have potential for abusive behavior.  This made government oversight and regulation necessary.

In New Mexico, the Public Regulatory Commission weighs the requests of the utility against the public interest for consistent and affordable access to electricity.  Currently, regulated monopoly utilities provide a given utility service on a “cost-plus” approach.  The regulators determine the price of electricity as the “cost” and guarantees a rate of return(profit) of to the utility capital investors (shareholders).  In the past, this has been a good investment that brings consistent returns.

Utility Business Model:

While fixed costs can be pre-determined for service, markets fluctuate and can only be estimated.  Unfortunately, this regulation method has historically rewarded higher capital spending by utilities because regulators allow almost all of the company’s durable assets into the “rate base,” where it can earn the allowed return (profit).  This has resulted in a large pool of profits that can afford big executive salaries.  Fortune Magazine summed it up nicely in the quote from Erroll Davis, the former CEO of Wisconsin Electric Power, “your new desk goes into the rate base.  This is the only industry I’ve ever seen where you can increase your profits by redecorating your office.” (Fortune, Nov. 13, 1995) As a result, utilities have a natural disincentive to cut costs, increase productivity, or eliminate waste.  Coal and gas systems require centralized generating stations with high operation costs, fluctuating fuel costs (usually on an upward trend), and long-term amortization that relies on a large base of rate payers to reimburse.  Up, up, and up!

But times have changed.  Given more efficient ways of generating electricity, even static estimates no longer make sense.  Because the utility is a regulated monopoly, is has no incentive to find better ways to provide utility service on its own.

This has given rise to legislation like the Renewable Portfolio Standard (RPS) that legislates the percentage of generation that must come from renewable energy.  In addition, independent producers, according to the New York Times, “have been responsible for 53 percent of the new generating capacity in the last four years.”  (New York Times, Aug. 8, 1994) The traditional utility business model is under attack from all sides, and has been for a while.

Today, renewable energy technologies and energy efficiency products trend down in price (rather than up) and involve smaller upfront capital investments followed by minimal operational expenses. This throws a wrench into the traditional economic model of a utility.  For example, renewable energy built by individuals (distributed generation—or DG) creates logistical complications and competition for utilities.  These renewable energy mini-power generation stations add uncertainty to the traditional grid, while also reducing rate revenue for the utility.

In New Mexico, for example, the anticipated growth in the customer base of 1% is negatively offset by a 1.5% increase in distributed generation (DG).  With this direct hit to the bottom line, utilities request cost recovery mechanisms from the regulators, like solar tariffs or changes to net metering to make up for this shortfall. (See the report: “Nevada gets it wrong, big time”)

Utilities see the writing on the wall.  Some create rate structures or fees that disincentivizes renewable energy.  Others create long term contracts with high energy users in order to keep them as customers.  All of these measures work in the short term, providing temporary solutions to a growing problem.  As renewable energy technology becomes ever more accessible to the mainstream market, however, the inevitability of increased adoption means these sorts of rate recovery protection attempts will fail, eventually.

If you want to support our efforts to introduce decoupling to New Mexico, please support us here.

Go to part 2:  Why decoupling?