Franchise rights: History, consequences, and opportunities for reform
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In my last piece, I explored the business model of retail energy providers and how they might play a key role in a future with a higher penetration of distributed energy resources. In that piece, I noted the key activities REPs did not engage in:
REPs don’t build or own any transmission or distribution infrastructure, meaning they don’t own any of the big high voltage lines that move power long distances, nor do they own the distribution infrastructure you see in your neighborhood. In all markets, even the most unregulated markets like Texas, the utility continues to control the distribution infrastructure. REPs can control the power that flows through those lines, but the utility is responsible for maintaining the infrastructure. I will come back to this point in a future piece
This piece aims to make good on that assertion, and here I will dive into franchise rights and the why utilities have the exclusive right to build, maintain, and own distribution infrastructure in a public right of way. More specifically, I will explore how franchise rights inhibit the deployment of greater number of DERs and keep the grid from achieving true resilience.
Context and definitions
To first set context, this article will focus primarily on deregulated markets where REPs and other non-utility players are allowed to buy and sell power. However, it’s important to note that franchise rights apply anywhere there are distribution wires and an entity responsible for maintaining them, including more regulated markets with fewer competitive forces at play. Second, to provide some background reading on the cast of characters involved in this discussion, I recommend you check out this piece to learn more about utilities and how they work and this one to learn about retail energy providers. With that, let’s dive into franchise rights.
According to the National Renewable Energy Laboratory, a franchise agreement is a negotiated contract between a municipality and electric service provider, such as a utility, that grants that provider the exclusive right to serve customers in the municipality’s jurisdiction. Such an agreement ensures that every constituent in the municipality’s jurisdiction is able to access the service provided by the electric service provider while granting the provider the exclusive right to build and maintain the infrastructure necessary to do this. In exchange for this exclusive right to serve a pre-determined geographic region, the electricity provider pays the municipality a franchise fee, which is typically some fixed percentage of revenues from the provision of the service. The costs of the franchise fees are not ultimately borne by the electric service provider, however, because the provider simply passes the costs on to consumers via their electric bills.
How did we get here?
How did franchise rights come about? That requires a trip back to the turn of the 20th century, where the discovery of thermal efficiency and the emergence of centralized power generation dawned. For more background on the history of the grid and how we arrive at the systems of today, I highly recommend The Grid: The Fraying Wires Between Americans and Our Energy Future by Gretchen Bakke, PhD. During this period and into the 1920s and 30s, the electricity industry went through a phase of massive build-out and centralization. As power plants got larger, they increasingly benefitted from the thermal efficiency effect, allowing them to produce power at a lower marginal cost and experience increasing returns to scale (up to a point, the thermal effect has an upper bound). As power generation became increasingly consolidated, finding ways to efficiently move that power from the point of generation to many points of consumption became incredibly important.
Enter an important historical figure named Samuel Insull, who figured out an efficient way to do this given the constraints of the system at the time. He convinced the city of Chicago to give him the exclusive right to build electricity distribution infrastructure in the city in order to bring power to everyone, and in exchange for his exclusive access to this right to build he would allow the city to regulate him. Given the centralized generation model of the time, the distribution of that power to many nodes across a geographic area was a natural monopoly and thus it made sense for the city to grant Insull’s company the right to build, so long as they could regulate him.
Moreover, Insull’s discovery of capacity factor provided additional compelling reasons for the city to grant his company the right to build and own distribution infrastructure. As a reminder, capacity factor is the observed energy output as a percent of total possible output of an asset within a given time. Insull discovered capacity factor in the context of large, centralized power generating assets: if the power plants could provide power to homes and business during the day and to heavy industry during the night, they would increase their uptime and generate more revenue over the fixed cost of the assets. This would result in lower average energy prices for customers, since the overall demand curve would be spread over more evenly across time and pricing pressures would ease (remember, this is before wholesale energy markets were deregulated, so this is all vertically integrated). To (1) serve a bunch of nodes from centralized power and (2) generate power to sell to customers 24 hours a day 7 days a week, the most straightforward path for both the city and for Insull was through a franchise agreement and regulated monopoly status.
What has changed today?
In today’s world, where wholesale energy markets are deregulated, transmission has been opened up, and DERs are proliferating at a rapid pace, the notion of franchise rights seems rather quaint. Why should a single utility company have the exclusive right to build something as crucial as distribution infrastructure? Why should individuals or communities be prohibited from investing in and building their own solutions to generate and distribute power, especially when utilities continue to engage in regulatory capture and abuse their market power? What I’m really getting at is this fundamental question: Why should distribution still be considered a natural monopoly?
In general, I do not believe distribution is a natural monopoly, at least not in the way it was for the better part of the 20th century. There are three main reasons why I believe this is the case: first, the growth in renewable energy sources, second, the colocation of supply and demand through the rise of DERs, and third, the historical precedent of transmission, which was once a “natural monopoly”, opening up.
As DERs have proliferated and renewables have grown increasingly prevalent, the notion that massive scale is needed to get the benefits of thermal efficiency and cheap energy prices no longer applies. As a result, large, centralized power generation is less critical relative to historical periods. To be clear, I’m not arguing that centralized energy production disappears, as we will certainly always have some sort of centralized power generation, but rather that energy generation and storage is becoming more distributed at the end-consumer level in general. As this happens, it no longer makes sense for one entity to own the rights to move power from point A to point B, since power is now being generated and stored at hundreds of nodes across the distribution grid. These individual nodes ought to be able to engage and transact with each other without the arbitrary interference of a utility. If the utility is allowed to insert itself into a bilateral transaction between two nodes as a third party and engage in regulatory capture, that essentially prevents the owner of the distributed asset from recognizing the market value of their generating capacity and prevents the buyer of that energy supply from getting access to power at the efficient market price. In other words, the utility’s franchise rights allows it to distort the market for energy produced or conserved by nodes on the distribution grid, which prevents their full value from being realized by the market.
Next, let’s take a look at the example of transmission, which was also a natural monopoly before that market was restructured. Before restructuring, the high capital costs required to build infrastructure, the need for interoperability, and the lack of competition in wholesale energy markets all made it pretty clear that transmission was a natural monopoly and was most efficiently built by single entities with exclusive rights to certain areas. However, as wholesale energy markets liberalized and supply disaggregated from the rest of the energy chain, suddenly transmission seemed like less of a natural monopoly. In fact, once clear standards for building and integration of transmission lines were established, there were no real reasons why project developers couldn’t propose their own projects with their own cost and revenue models, get selected based off those proposals, and contract to build. And that was a very good thing, because it meant that market forces produced outcomes at the lowest possible costs, since only those developers capable of meeting project requirements could build out the infrastructure. In other words, markets worked how they were supposed to and produced optimal outcomes, which monopolistic entities were by definition incapable of doing.
What will happen going forward?
My big takeaway from the example of transmission is that when underlying assumptions change, our understanding of what is and is not a natural monopoly should be revisited. In the case of transmission, wholesale markets were deregulated and suddenly single entities building and owning transmission made less sense. In the case of distribution, might the same thing be true? As end consumers increasingly have the ability to control or even generate their own energy in response to market signals, do franchise rights for distribution even make sense? If the one-way system of distribution (utility to customer) is now a two-way system in which the customer has the ability to generate his/her own energy, that customer should be able to send that energy back to the grid and receive fair market-based compensation in return.
This shift to a two-way system does not strictly mean franchise rights must be abolished, but at the very least it suggests the current stranglehold utilities have on distribution is abusive of their market position. A potential, slightly less radical solution to the challenge of the ownership of distribution is the following: allow utilities to own the distribution level infrastructure, but only under the conditions that they open up the system and allow third parties to bid in at marginal cost and do not distort the market by abusing their monopoly status to increase profits. In other words, distribution should be busted open, subject to neutral third-party oversight by some sort of Distribution System Operator (DSO), and clear standards for how the distribution level markets function ought to be established. This includes setting standards around interoperability, how bidding at the distribution level works, and how DERs connect into the distribution infrastructure. These are not small feats, but they are important to establishing a distribution system that will best serve the inevitable rising tide of DERs across the distribution grid.
Once this shift has occurred, the true value of DERs will be realized by their owners, which will drive adoption even higher and build greater resilience into the grid. As wildfires, blackouts, and storms increase in frequency as a result of a changing climate, this will be a welcome addition. And moreover, it will help the grid accommodate greater deployment of renewable energy resources, which will help drive down carbon emissions and build the energy resources of the future.
In the end, franchise rights are the last bastion of an older era of electrification — an era that relied on centralized power generation and single-entity delivery of energy from generation to consumer. We’re not in that era anymore, thanks to the rise of renewable energy sources and the growing trend of distributed generation. The legacy of that model lives on, however, in the form of utilities abusing their market power by greedily guarding their ownership of distribution. This prevents the true value of DERs from being realized by their owners and keeps the grid from becoming more resilient in the face of fat tail weather events and a generally more volatile climate.
If we replaced the utility with the Apple App Store in this situation, franchise rights would be the equivalent of forcing third party app developers to pay an extremely high and ever-changing arbitrary price to Apple for distribution rights. And, in the case of Apple, that appears to have generated some negative attention from regulators. So that begs the question — why are utilities allowed to abuse their market power, given the changed environment in which they operate? My hope is that people interested in and willing to develop new frameworks for how distribution occurs and the role of utilities in that will engage in that fight, as the future of a resilient and decarbonized grid depends on it.
