The Public Utilities Commission of California (CPUC) recently introduced a draft regulatory incentive proposal addressing issues regarding the utilities’ business models, financial interests and role with respect to distributed energy resources (DER) deployment. Given the potential magnitude of this rulemaking to the utilities’ business models, I suggest that utilities and other stakeholders nationwide follow this docket closely.
The pilot program is offering regulatory incentives to the state’s three large investor owned utilities (IOUs) for the deployment of cost-effective DERs. The current proposal offers a shareholder incentive for the deployment of cost-effective DERs that displace or defer a utility expenditure, based on a fixed percentage of the payment made to the DER provider (customer or vendor). Below is a quote from the order that explains the concept:
“There are two roadblocks . . . to understanding financial value. Many in the regulatory community believe that: (1) the utility’s return on equity is the sole value driver; and (2) regulators set returns on equity at a rate equal to the cost of equity. Neither of these perceptions is correct, and understanding why is key to developing effective utility incentive mechanisms.
THE VALUE ENGINE: (r-k)
Many regulatory reform discussions focus on the utility’s return on equity as the sole driver of financial value, but that does not align with the concept of investor value creation. It is not the absolute level of a company’s return on equity (r), but rather the difference between r and its cost of equity (k), that creates the value opportunity that drives the stock price. (Appendix B, p. 6)
This discussion leads to the following correction to the investment incentive proposition espoused by many:
INCORRECT: r > 0 utilities have an incentive to expand
CORRECT: r > k utilities have an incentive to expand
r = k utilities are indifferent as to whether they expand
r < k utilities have a disincentive to expand Capital, like any other input to a production process, is not free.
This should have intuitive appeal. Does it seem likely that utilities would rush to expand their facilities if regulators allow them to earn, for example, a 2 percent return on such investment? Clearly there is some minimum acceptable level of return. The cost of capital, by definition, is that minimum return hurdle.
This corrected incentive structure should give some readers pause. Many, if not most, regulators say that they set utility rates of return equal to the cost of capital. If that condition held, utility management focused on creating value should not care whether it ever makes any plant investment. Just as buying apples for 50 cents and selling them for 50 cents creates no value for the grocery store owner, raising capital at a cost of 10 percent to invest in assets that earn 10 percent is similarly a financial wash—no matter how large the investment, it creates no investor value. (Appendix A, p. 3)”
Comments and responses to the questions are to be filed no later than May 2, 2016. Reply comments may be filed not later than May 16, 2016. Some of the questions to be addressed are:
- Is the proposed incentive, in the range of 3.5% grossed up for taxes, approximately correct?
- Are there other disincentives to the deployment of DERs that this proposal does not address that should be considered at the same time? If so, please explain.
- Is the suggested process for identifying and approving DER projects that would generate an incentive reasonable and appropriate? How could the process be improved?