Understanding the regulatory compact

IT HAS BECOME APPARENT THAT MANY SMART GRID advocates don't understand the current regulated electric system. They don't understand how we analyze utility investments or how prices are set. They don't understand the incentives provided to utilities or protections required by customers. Put simply, they don't understand the "regulatory compact" between customers and utilities.

The smart grid has the potential to change our electricity system in fundamental ways. But to effectively create positive change, it's necessary to understand the present. In other words, for the smart grid to live up to its potential by fundamentally changing the electric system, we have to begin with our current system. We can and should desire to change it, but it is necessary to begin by understanding and accepting the existing electrical grid.

Responsibility to protect customers
In the Pacific Northwest, we rejected the Enron-sponsored deregulation proposals a decade ago. This means that we have integrated monopolistic utilities that are regulated by the states' regulatory agencies or are accountable to locally elected boards. Regulators and local boards have the responsibility to protect customers from monopoly abuses and get power at just, reasonable and affordable rates. And that regulation is subject to legal requirements and historic policies and principles. Some of the key elements applicable to the smart grid:

• Rate base as an incentive for investment. The current structure of regulation for investor-owned utilities was developed in order to incent long-term capital investment. Building power plants, transmission systems and distribution networks costs billions of dollars. The current system is designed to encourage capital investment by providing a utility a return on invested capital-utility profits from investing in power facilities, not directly from selling the kilowatt hours.

• Utilities can generally only charge customers for investments that are "used and useful" for providing utility service. It may take a utility more than a year to build a power plant or construct a transmission line, but it cannot put those costs into rates until the asset is up and running. Likewise, utilities are generally discouraged from keeping assets in rates after those assets stop providing service.

These two regulatory principles tell us a lot about utilities. In the 1990s, we heard a lot of complaints that utilities were not generally making investments in renewable resources, particularly wind turbines. Today, there is not a utility in the region that isn't investing hundreds of millions of dollars in wind turbines. This can be explained by the two principles mentioned. Utilities like capital investment, once that capital investment is considered low-risk.

In the 1990s, utilities might have been concerned that wind turbines were untested, that their useful lives were not well documented, and that shareholders would take on a significant risk that the investment would not be "used and useful" for a long enough period to recover the cost of the investment and see a return on the investment. Once wind facilities were well proven, utilities were happy to make huge investments in wind power. Similarly, once smart grid technology becomes mature and "safe," getting utilities to invest in it will not be difficult. And so, the problem right now is: How do we get smart grid technology to the mature and safe level?

Customers own the assets
Other important principles in understanding the regulatory system that guides investor-owned utilities include:

• Cost-based rates are required. Rates are based on actual utility costs of providing service, not the marginal cost of power in the marketplace. Although some smart grid proponents would like customers to be subject to the marginal costs of the marketplace in order to create an incentive for customers to purchase smart appliances and home energy applications of the smart grid, Oregon law requires rates based on the utility's actual costs.

• Regulatory compact. As utilities make investments on behalf of customers, customers pay the utility that cost of that investment plus a reasonable rate of return. That is all to which the utility is entitled. The asset itself becomes dedicated to customers for its useful life. In many respects, utility customers are buying the actual system from the utility and, as we pay off the rate base (mortgage) on each asset, that asset belongs to us and is dedicated to us. We are the owners of the electrical system, not the renters.

These two provisions are important. Smart grid proponents, who believe smart meters will lead to customers paying real-time prices related to the prices in the wholesale market, need to recognize that customers have actual generating assets that serve our load at cost. We own those assets because we have spent years purchasing them from our utilities. Just as my housing costs do not increase as rents rise in my neighborhood because I am purchasing my house on a fixed-rate mortgage, my utility rates do not change simply because the wholesale power market changes.

There are clearly smart grid advocates who disagree with each of these principles. Some argue that investments should not be made by a utility because that will interfere with the competitive market. Others argue that utilities should be allowed to invest in research and development that will not necessarily be used and useful. And some believe that rates should be based on the marginal costs of new generation, not the depreciated costs of decades-old hydro facilities.

Although regulatory principles are important elements in protecting consumers, some identify them as roadblocks to the future development of a smart grid. Regardless of whether you agree that these principles are necessary structures that protect customers or see them as roadblocks that prevent new technology integration, they do exist and are integral to the regulation of utilities in this region. And whether you want to build on them or tear them down, stakeholders in the smart grid conversation must acknowledge that they are currently there and plan to deal with them.