The Case for Utility Price Caps

The Case for Utility Price Caps

Just last month, the U.S. Energy and information Administration announced that natural gas had surpassed coal — for the first time ever — as the main source of electricity generation. The news may have sparked delight for those who want to see the end of coal, and for those who view the recent boom in domestic natural-gas production as a means to lower consumer prices.

To others, however, the news brought puzzlement. While consumer gas prices fell by 24 percent from 2005 to May 2015, residential electricity costs rose by 37 percent. The stark divergence in prices has left policymakers and regulators wondering — if natural-gas prices are falling, and if natural gas is becoming the most important input in electricity generation, why are consumer utility prices still rising and by so much?

There are a number of easy explanations for why electricity prices are not dramatically decreasing — such as regulatory mandates that are increasing operational costs and shutting down lower-cost coal-fired plants, as well as the investment costs that are needed to improve the basic infrastructure of the power grid and protect plants from terrorist attacks, particularly cyber attacks. These are obvious costs that all electric utilities face.

Not so obvious, but very significant, is that many electric utilities are still regulated in much the same way that as they were over 70 years ago. That form of regulation, "rate-of-return regulation," guarantees a "fair return" for public-utility investments in plant and equipment, and it has long been known to create incentives to run up costs. According to reports from earlier this year, some utilities are accumulating excess capital for the purpose of increasing their profits, not for serving the public.

Corporations are always under pressure to increase shareholder value. For rate-of-return electric companies, regulators try prevent unreasonable utility profits by setting a rate-of-return, say 10 percent, on the size of the public-utility rate base. If the utility is a large one and requires more plant and equipment to serve its customers, it earns 10 percent of the larger base, which means more profit to cover its investment. Therein lies the incentive problem — public utilities get more profits by making more capital investments, needed or not.

As a recent example, Warren Buffet-owned NV Energy is in the midst of a regulatory-approval process with the Nevada Public Utility Commission to explore building a new billion-dollar natural-gas plant, rather than purchasing excess energy from other suppliers, as it has done in the past. While purchasing energy may be cheaper for NV Energy's customers, there is no money to be made for the utility. Building a new energy plant, on the other hand, would increase NV Energy's rate base, increase its profits and potentially raise consumer electricity bills.

In testimony before the Nevada's Public Utility Commission on June 10, the president of Wynn Resorts testified that NV Energy had announced to investors that it would grow its profits by spending more money. He estimated that the public utility has grabbed more net income than the entire Las Vegas Strip combined. Looks like NV Energy may be the best bet on the strip.

Rate-of-return regulation has been long regarded as wasteful, encouraging over-investment and "gold plating" by public utilities. In the 1960s, economists began to refer to the waste as the Averch-Johnson Effect, where utilities invest and accumulate excess capital stock in order to "pad" their rate base and increase profits.

Several studies emerged in the 1970s that proposed ways to make utility regulation more efficient by mimicking how competitive markets work. One such regulatory reform, price caps, automates changes in utility prices by keeping utilities from increasing rates faster than market costs, thereby encouraging productivity improvements. If utilities are able to outperform the market and cover a productivity factor, they can keep any additional income as profits. In other words, price caps would give consumers lower prices and provide utilities profit incentives to be more inefficient.

While all major telephone companies and some electric utilities have moved to price-cap regulation over the last two decades or so, rate-of-return regulation persists for some electric utilities. This means that some utilities continue to misallocate resources and over-invest in capital equipment, which pushes these unnecessary costs onto the backs of ratepayers. Price caps would give utilities the incentive to control costs and treat capital stock as just another input of producing electricity.

It is time to end archaic rate-of-return regulations and, in the absence of effective competitive, move to price-cap regulations. That reform would simplify regulatory oversight, keep consumer costs lower, and allow utilities to increase profits through efficiency.

Steve Pociask is president of the American Consumer Institute Center for Citizen Research, a nonprofit educational and research organization. Twitter: @consumerpal

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