On Regulation

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With this outlet, I’ve spent a lot of time digging into much of what I’ll call the infrastructure and content of energy markets and the electric grid. Scattered throughout the pieces I’ve written so far you’ll find the lurking shadow of regulation. Without addressing it explicitly, it’s appeared subtly in the background of almost everything I’ve written — sometimes as a facilitator, a gating function, or something else entirely. Since it’s October and Halloween is around the corner, I figured I’d celebrate my second favorite holiday by writing about that lurking shadow — regulation. I’ll discuss what regulation should accomplish in theory, what it actually does today, and propose some paths forward to bring the reality closer to the ideal. Happy Halloween people.

Why should we regulate?

If you know me or have read any of my writing, you will know that I have a deep reverence for the mechanism of the market and its ability to produce the optimal outcome most efficiently. However, I am not ultra-dogmatic and willingly acknowledge the existence of market failures — for example, negative externalities, adverse selection, monopoly power, etc. In these cases, regulation is crucial for addressing the market failures, providing a remedy, and allowing the market mechanism to continue humming along with as minimal intervention as possible. Thoughtful, well-executed regulation that interferes with market-driven events at the optimal level — no more and no less — is the best kind of regulation.

As I see it, there are 2 main purposes regulation should serve:

Where there exist market failures, establish clear rules for how to respond to such failures, examples of which I’ve listed below:

1. Negative externality — impose a tax on the private actor such that they bear the full social cost of the action.
2. Monopoly — clearly define what a monopoly is and establish a process for parties impacted by the monopoly’s behavior to seek recourse (i.e. lawsuit).
3. Adverse selection — set a sufficiently high threshold for what industries or companies merit rescue or bail out from an adverse selection-induced spiral (i.e. healthcare, certain financial markets).

Where there is a nascent market developing, provide the lightest weight infrastructure necessary to promote the establishment of that market. That generally is means clarifying how the market operates and what penalties exist for violating the operating rules such that new participants can enter with a solid understanding of the environment. The key component here is to make sure the body responsible for providing this regulatory infrastructure is a neutral third party with respect to market participants and has nothing to gain or lose from the market’s evolution one way or another over time. If this neutrality is upheld, then the regulation should facilitate the growth of the market by giving participants a degree of trust and therefore a greater appetite for risk-taking.

I tend to think that this minimalist approach is sufficient, and anything more distorts the market and introduces incentives beyond those inherent to the market. From a macro perspective, an overly regulated market is more likely to produce outcomes that are not optimal for the market as a whole, since each actor will be focused on optimizing around the regulatory nudges (also known as regulatory capture). This optimal level of regulation is challenging to achieve, since industries change over time and our lawmaking bodies have an awfully tough time keeping up with it all. In all likelihood, that is probably how we ended up where we are today in energy and electricity market regulation.

Regulation Today

In the old days, as I discussed in my writing on utilities and on the liberation of transmission, vertically integrated utilities were responsible for generation, transmission and distribution of energy because, given the technology available at the time, a vertically integrated model was the most efficient way to bring electricity to the masses. In exchange for a utility’s monopoly hold over a specific region, the government was granted oversight ability and got to tell the utility what prices it deemed reasonable and how it ought to operate to ensure the public good — in other words, the government was there to prevent an abuse of the utility’s market power.

As technology improved, technological constraints eased in a way that allowed for market deregulation, and ultimately wholesale energy markets did just that. Today, the wholesale energy market and transmission industry are largely deregulated across the country, meaning generation and transmission providers compete on cost. To manage all of these generation and transmission actors, the transmission-level grid is divided up into Electric Reliability Councils. These organizations manage the flow of electricity across regional grids and ensure transmission is planned for in such a way as to ensure grid reliability. The North American Electric Reliability Council (NERC) is responsible for overseeing all the regional reliability councils.

Within the reliability councils sketched out to the right, there are separate ISOs and RTOs which act as neutral third parties responsible for operating the wholesale market. They make sure power plants can bid into the market, supply and demand get matched based on price, and generally keep the market functioning. I analogize ISOs and RTOs to the NYSE or other stock exchange — they are a neutral platform that facilitates transactions.

Moving beyond generation and transmission, distribution is a whole different game. In some ways, this makes sense. The distribution grid is much closer to consumers and therefore any errors or problems with that system could produce major downside, including injury or death, for end customers. Here’s an example of what I mean — say a distribution utility operating in a certain municipality doesn’t want to service customers that pay bills in installments because they can’t afford the upfront cost of the month of electricity. Without regulation and enforcement of a utility’s obligation to serve, the utility would simply exclude those customers from service, producing what may be the utility’s private optimum but absolutely devastating the lives of the customers that were passed over for service.

This is where the Public Utilities Commission, or PUC, comes into play. The PUC exists at the state level and is typically comprised of 3–5 appointed or elected commissioners, plus a team of staff that includes lawyers, economists, engineers, and admin. The PUC is responsible for regulating the investor-owned utilities in the state, since those are private companies that the government granted monopoly status in exchange for oversight. In most cases, municipal power companies and public utilities are not regulated by the PUC, as there is no profit incentive that could drive adverse outcomes.

In theory, the PUC is the neutral third party tasked with the review and judgement of the actions of the utility, including the utility’s revenue requirement, energy portfolio standards, long-term investment plans, prudence reviews, standards and quality of service, and more. PUCs have two sets of rules that they write and enforce: the first are procedural rules, which outline how a regulatory procedure should occur; the second are operational rules, which govern how a utility should operate. During these proceedings, the PUC will hear from a range of stakeholders including representatives of the utility, the general public, and expert witnesses. Additionally, the PUC lays out processes by which other actors can raise issue with the utility’s conduct or adherence to the regulations and have a hearing to examine and either prove or disprove the claims.

In general, the overall institution and responsibilities of the PUC align with the first purposes of regulation that I laid out above — addressing market failures. However, I believe regulatory institutions and specifically PUCs currently fail to address the second purpose of regulation, which is to provide the lightest weight infrastructure necessary to promote the establishment of new markets. Examples of the new markets currently being ignored or, even worse, hampered, by regulatory bodies include the rapidly growing market for distributed energy resources, demand response services, and utility data, to name a few. In these cases, regulatory capture prevents the true value of those markets from being realized and that ultimately hurts consumers and stifles innovation.

So how can we change this?

In almost every industry, regulatory change is slow. However, the right changes can often be an Archimedean lever to drive growth and open doors to new technological possibilities or business models. In my head, there are four main themes the Powers That Be in energy markets should focus on if they care about building the electric grid of the future.

One: Ensure there are no conflicts of interest for the commissioners serving on state PUCs. While it can be helpful to tap someone for that post who is intimately familiar with how utilities operate, it’s hard to argue that a commissioner will act as a neutral third party if they have in the past been employed by or worked closely with the utility they are now tasked with regulating. And this goes beyond just conflicts of interest with respect to a utility — this standard should extend to all parties that may fall under the regulatory scope of the PUC.

Two: PUCs should intentionally focus on removing or rewriting rules that stifle innovation on or transformation of the grid. Too often, consumers have to settle for utility performance that is no better and sometimes worse than historical performance. That this is the case despite the great innovations in cloud computing, AI / ML applications, and smart DERs is incredible. PUCs should be figuring out how to incentives utilities to leverage these technologies to perform even better, rather than forcing consumers to accept the status quo service.

Three: As a corollary to two above, PUCs should bias towards allowing utilities to pilot new programs with customers willing to act as test subjects. The same way tech companies ramp experiments across different user groups to measure the value of a new product, utilities ought to be allowed to experiment with new service models and technologies for a subset of customers interested in participating. This will allow utilities to learn how to integrate new technologies in a lower-risk environment before rolling out what works to an entire service area. It also gives the PUC a chance to see where there may be holes in the utility’s approach and what changes need to be made to meet its obligation to serve.

Four: Regulators should take cues from other industries and figure out how to implement rules that have many use cases (i.e. are highly transferrable) and are minimally invasive while still protecting the consumer. I often think about data in this context. For example, regulators should ensure that customers have the right to own, access, and grant access to their energy usage data (whether from the utility or otherwise), and that privacy rules around that data are strong enough to prevent abuse.

Writing these things down is always much simpler than actually doing anything about it, of course. It takes time, organization, and patience for the gears of a regulatory organization to begin to shift. I’m proud to help run an organization called the DER Task Force, which launched a policy arm recently with the express intent of getting involved in regulatory proceedings across the country as the voice of DERs, a typically underrepresented perspective in many of these proceedings.

This effort is absolutely worth the time spent, because so much of the way energy markets and the grid work is a product of the regulatory framework upon which they sit. And if we can get the right people talking in the right forums making the case for smart regulation, then just maybe we can actually change it for the better. If this is something you care about, come check us out at dertaskforce.com or reach out to me on Twitter or email. We’d love to have you join us.