For SmartPlanet this week, I reviewed the failure of utility deregulation and pondered what’s next for the utility sector: Capacity markets? Re-regulation? Transformation to a new business model? Creating a renewably-powered grid will be easy compared to crafting a new regulatory framework that will make utility investors whole during the transition.

Read it here: The next big utility transformation

The utility industry has been through several big transformations in its history. Now, it seems poised to undergo another one.

The last big transformation was so-called deregulation in the late 1990s, when the U.S. government and 22 states began working on ways to breaking up vertically integrated utility monopolies. The approaches varied from region to region, but in practice this mainly amounted to separating the power generation side of the business from the transmission, distribution and billing functions, and created a competitive wholesale market for generation.

More competition, the theory went, would improve efficiency and performance, and reduce grid prices.

Disgraced Texas Congressman Tom DeLay, currently out on bail release while appealing his 2011 conviction on money laundering and illegal election contribution charges, was a major proponent of deregulation.

DeLay was closely connected to and sponsored by Enron, the Texas energy company that gamed the California market and sent grid power prices soaring in 2000. The Enron experience effectively ended California’s brief experiment with partial deregulation. Enron itself was brought down in 2001 amid a massive scandal that wiped out billions in shareholder assets, sent several of its executives to prison, and destroyed the Arthur Anderson accountancy.

In 1997, DeLay — who got the nickname DeReg in Texas for championing deregulation — presented his “free-market vision” for the electricity industry at a lecture to the Heritage Foundation, a conservative think tank: “Bringing electricity into the competitive world will unleash new products, greater efficiencies, business synergies, and entrepreneurial success stories. It will create new industries, new entrepreneurs, and new jobs. And, if done correctly, it will lower the cost of electricity to all consumers,” DeLay asserted, noting that deregulation had lowered prices in industries like railroads, trucking, and telecommunications.

Apparently, it was not done correctly.

According to a February article in Bloomberg, deregulation has “backfired” in Texas and other states, and been “tragic for ratepayers.” In Houston, high-yield bonds marketed by Goldman Sachs for a local utility have increased consumer costs by approximately $47 million. In part, those bonds were issued to recover costs for “stranded assets”: investments in generation and grid equipment made before deregulation. Texans paid 6.4 percent less than the national average in the decade before deregulation, according to a cited coalition of 34 municipalities, but in the decade since they have paid 8.7 percent more.

Investor-owned utilities (IOUs) aren’t truly deregulated; in fact they’re more regulated than the alternatives: co-ops, municipal utilities, federal utilities, and power marketers.

Regulators at public utility commissions (PUCs) control rates by approving or rejecting rate increase requests made by IOUs, and decide what their “return on equity” is for their various assets. In some cases, this has actually stifled investment in generation and other assets that the utility might have made. In other cases, it has enabled utilities to invest in expensive assets such as nuclear power stations that they might have considered too risky if they weren’t guaranteed a return on the investment.

Consumers have tried deregulation and seen that it didn’t give them anything but more volatile and higher grid power prices, while the entrenched incumbents essentially stayed in place. Now they’re looking for new options.

The ‘problem’ of free energy

IOUs now face a new set of challenges as distributed generation from wind and solar systems grows. They have positioned this as a threat to grid stability, but as I’ve explained previously (here, here and here) those problems are soluble. The real threat to the IOUs is financial.

A recent policy paper from the Edison Electric Institute (EEI), an association of shareholder-owned U.S. electric companies, explains the many “disruptive challenges” IOUs face. In short, the more consumers produce their own power with wind and solar, and reduce their power consumption by implementing efficiency improvements, the less they pay utilities for providing grid power. Transmission and distribution is a big part of the utilities’ revenue base, and that base is eroding.

As the march to a mostly renewable grid proceeds, utilities will be left holding a massive — and massively expensive — set of infrastructure assets but a diminishing customer base onto whom they can pass those costs. Their profitability is under attack,and it’s not at all clear how they can and should respond within the regulatory bounds in which they must operate.

I asked Richard Caperton, Managing Director of Energy at the Center for American Progress and an expert on utility regulation, how he thought the industry might react.

“The more renewable energy you bring into the competitive power market, the lower the prices are in that market,” Caperton explains. “Take that to its logical conclusion in an 80 percent renewables future. Assume that the marginal cost of renewable power is zero … and it just won’t send the price signals that it needs to send. I think there’s going to be a lot of regulatory interest in that.”

Why would the cost of renewable power be zero? Because once a wind turbine or solar plant is built, it produces power without incurring any additional cost. If renewables had a large share of generation capacity, they could satisfy all of the power demand on a particularly windy or sunny day, and drive the cost of generation to zero.

Caperton continues:

“In the wholesale power markets, like in MISO or ERCOT or PJM [Regional Transmission Organizations and Independent System Operators, discussed here], all the generators bid what they’ll sell power for, for an hour. And there’s a clearing price — the most expensive price that meets a need. Now when the need is met by a zero cost, the market will clear at zero dollars. Now even a wind turbine can’t make any money, and it won’t cover fixed costs.”

One way of addressing the ‘problem’ of free energy, Caperton notes, is through capacity markets, where power generators are paid for merely maintaining capacity, whether or not their plants are actually producing power. Essentially, this would create an artificial floor under grid power prices so that the marginal cost of power generation never actually reaches zero, and the owners of the generation assets can still get paid.

Capacity markets are being considered in Germany, where renewables meet about 25 percent of grid power on a sustained basis and occasionally meet as much as 50 percent on a peak basis — destroying the economics of traditional fossil-fueled generation.

Re-regulation

Another option would be to re-regulate the industry in a new way.

“You could just re-regulate, and roll the cost of generation back into the rate base,” Caperton says. “You’d go back to regulated markets, where generation is treated just like transmission and approved by the PUC, and they each earn a rate of return.”

Caperton hastens to add that he wouldn’t necessarily advocate re-regulation, but wouldn’t advocate against it either. It’s just a potential solution.

I asked Scott Thomasson, a Washington, D.C.-based independent energy consultant with extensive experience in federal energy regulation and litigation, what he thought of that idea.

“I’m biased by having so much experience in the Southeast, where they joke about digging a moat around the South and keeping the Feds out of restructuring the markets there,” Thomasson says. “There’s basically a consensus that retail deregulation didn’t bring everything it promised. They would be resistant to it.”

“I think that’s why in the Southeast they haven’t deregulated to the same extent,” he observes. “They’ve never really tried to force the utilities to take on even a half-share of non-rate-based generation. … In some ways, I think maybe they’re saying that’s right, we want to do this in a conservative way — conservative in scale. They want to keep control of solar generation and keep the market from spinning out of control, in a pseudo-utility way.”

Capacity markets might be a better tool than re-regulation, Thomasson thinks, because each region has its own mix of long-lived generation assets.

“Things like capacity markets are important to explore and put out there as tools, because you’re not sure what the right combination is going to be in every region,” he says. “In the same way that the utilities are culturally dependent, they’re capacity-dependent with their existing generation assets.”

Even so, twiddling around the edges of the existing arrangement of utilities might be insufficient to make the transition to a mostly renewable grid. Something more radical might be necessary.

“The utilities have to change their model, and the regulators of the utilities have to change their model of regulating,” Thomasson muses. “When you’re reinventing the regulatory approach, maybe you could throw it all out and start over nationally.”

“I could see a model were you have an all-new Federal Power Act, say of 2016,” he speculates, “to move the line on federal control (FERC) where retail utilities are part of interstate commerce. You could have national market rules, with cross-sharing across regions, with Order 1000 shifting marginal costs across RTOs (which RTOs have fought as hard as they can). So on a national level, we’d be aggregating things like efficiency into wholesale, tradeable commodities, like they’ve done with efficiency in MISO.”

That’s essentially what I proposed last November (”Beyond carbon policy: A national feed-in tariff“).

But, Thomasson admits, “there’s a reason why there isn’t a bill like that out there”: the entrenched power structure in Congress wouldn’t permit it. “Maybe a guy like [Independent Senator] Bernie Sanders could suggest nationalizing the grid and actually plan our resources nationally.”

There are no simple answers to these questions, and their complexity reinforces what I’ve said before: The main obstacles to a renewably powered grid are not technological. They are cultural, political and financial. Generating nearly all of our grid power with renewables while maintaining grid stability is easy compared to crafting a new regulatory framework that will make utility investors whole during the transition.