US Utilities Sector Primer

In market-based economies, the utility sector is unlike any other. In competitive industries, customers have numerous purchasing options. In the automotive or consumer products industry, customers can select from the product offerings of many different providers, and product quality and price influence consumer purchasing decisions.

If a seller’s prices are too high or the quality of the product does not meet the customer’s standards, the customer can select the wares offered by another seller. Prices in competitive industries are set by supply and demand in the marketplace.

Utilities, however, cannot simply set up shop wherever they choose. Utilities are natural monopolies because their capital costs are enormous.

Therefore, monopolies, by definition, also have high barriers to entry. However, a company with monopoly power cannot be allowed to operate without oversight. Otherwise, the price of the company’s product could be exorbitant.

For this reason, the US states created utility commissions to regulate the rates charged by utilities. These regulatory commissions, together with the utilities themselves, investors, and customers, comprise what is known as the “regulatory compact.”

The US rate-setting process is grounded in the fact that utilities operate as monopolies where there is no market for competitive pricing of the utility’s product in the absence of regulation. This has different consequences, however, in jurisdictions considered either “restructured” or “non-restructured.”

In non-restructured jurisdictions, vertically integrated electric utilities own generation, transmission, and distribution infrastructure, which is rate regulated.

In restructured jurisdictions, formerly vertically integrated utilities have either divested their generation plants to a merchant generation company or transferred them to an affiliate. In such jurisdictions, regulators deem the power commodity competitively priced and not subject to rate regulation.

A utility's "current" rate base refers to the value the state commission that oversees it has most recently adopted for its rate base for ratemaking calculations. Industry stakeholders and regulators find determining and agreeing on that value challenging. While it might seem reasonable to use RRA's rate case history database to arrive at an approximate rate base value, calculating a current rate base, at best, is an arduous task and, at worst, may be fraught with mistakes.

Although there are guidelines on what is often included in rate base, reasonable parties can and often do greatly disagree on the items reflected in rates at a given time and how their value should be calculated for ratemaking purposes. This phenomenon is readily evident in the differences between rate base values requested by a company, recommended by the intervenors, and ultimately authorized by the commission in a given case.

There is no way to know what a commission may or may not approve. In addition, rate case settlements may be silent regarding rate base, making tracking the parameter even more difficult.

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Federal and state regulators play an increasingly critical and often overlooked role in the energy transition. FERC will continue to address many critical issues and policies impacting the electric power and natural gas industries in the coming months, including the following:

Clean energy and the environment: Climate change and the clean energy transition present regulated electric and gas companies with unprecedented challenges and growing regulatory uncertainty. Evolving state and federal policies and transformational changes in the US generation portfolio mix are introducing new regulatory complexities and testing current regulatory frameworks. Including the challenge of integrating increasingly modern resources into the electric distribution and transmission system while maintaining reliability and grid security.

More frequent extreme weather events in the electric power sector increase stress on the aging electric transmission grid and threaten system resilience and reliability. New renewable energy resources, particularly those located in remote locations, highlight the urgent need for new transmission infrastructure to interconnect these resources to the grid.

Advances in battery storage and other technologies, as well as states’ authority over generation resource planning, are increasing tensions between state and federal regulation, with significant implications for the design of wholesale electricity markets.

In the natural gas sector, there's growing opposition from environmental and landowner groups. Meanwhile, state and federal permitting disputes are increasing the risks and challenges for infrastructure developers, often adding considerable costs and causing delays for new pipeline and liquefied natural gas projects. All of these factors contribute to regulatory uncertainty and risk for companies in the electric and gas sectors.

Return on equity: The commission's controversial policy for establishing base ROEs for electric utilities has been modified multiple times in the last eight years and has since been applied in other cases at FERC.

The methodology was first modified to apply a two-step discounted cash flow, or DCF, analysis to establish a utility's ROE instead of the one-step DCF analysis the commission had used historically. The commission subsequently proposed to modify and expand the methodology to apply four financial models, then adopted a two-model approach, and finally adopted the current three-model approach.

The changes in the commission’s methodology came in two long-running cases addressing the appropriate ROE for transmission owners in ISO New England and the Midcontinent ISO, resulting in multiple adjustments to the authorized ROE in the two regions since 2014.

FERC’s ROE policy is back before the commission after a federal appeals court vacated and remanded orders adopting the current three-model financial methodology in August.