Trystan Casey
Electric utilities are monopolies, which means they need to be carefully regulated to protect the interests of their customers. In the US, there are three types of utility companies: investor-owned, publicly owned, and cooperative companies. Investor-owned utilities, or IOUs, are for-profit companies that aim to generate revenue for their owners. They are regulated by Public Utility Commissions (PUCs) or their equivalent in each state, which determine their total revenue requirement, investment allowance, pricing, and profit margin. IOUs are incentivized to build more infrastructure, which increases their profits, rather than boost efficiency or invest in operations.
| Characteristics | Values |
|---|---|
| Type of company | For-profit |
| Ownership | Owned by a group of shareholders and publicly traded |
| Name | Investor-Owned Utilities (IOUs) |
| Monopoly | Yes |
| Regulation | Heavily regulated by the government, state and local authorities |
| Revenue | Generated through investment in assets (the pipes, substations, transmission lines, etc.) that are used to provide the service |
| Profit | Not from the electricity provided to customers but from the investment in the assets |
| Risk | Low-risk investment |
| Number of customers | 72% of U.S. electricity customers in 2017 |
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What You'll Learn
- Electric utilities are monopolies, so they are regulated to protect customer interests
- Public Utility Commissions (PUCs) determine a utility's revenue requirement
- Utilities don't profit from electricity, but from investment in assets
- Utilities are incentivized to build new infrastructure, not boost efficiency
- Government agencies regulate prices, budgets, and services of utility companies
Electric utilities are monopolies, so they are regulated to protect customer interests
Electric utilities are monopolies, and they are regulated to protect the interests of their captive customers. Public Utility Commissions (PUCs) or their equivalent in each state serve as a replacement for the competitive market. In exchange for granting the exclusive right to sell electricity in a given service territory, PUCs determine how much the utility is allowed to invest and in what, how much it can charge, and what its profit margin can be. This is called the "regulatory compact," and it was first laid out in the Binghamton Bridge Supreme Court case of 1865.
The benefit of a vertically integrated monopoly electricity service is reliability. Since there’s only one entity responsible and no competitive pressure to cut costs, utilities are free to solve the reliability problem by overbuilding capacity. Contracting for reliability services outside the utility is not only risky, it represents potentially lower returns. The opportunity cost of a vertically integrated monopoly is innovation. Utilities are large organizations with enormous sunk costs and years of bureaucratic inertia, overwhelmingly focused on reliability, with returns protected by law and every move watched by regulators.
The basic utility model has been around for almost a century without changing much. Utilities and their regulators have developed cozy, familiar relationships. There’s no longer any compelling reason for all those services to be bundled by a single “vertically integrated” monopoly. The only thing left that calls for monopoly control is the distribution grid itself, managing it and interfacing with customers. As for the rest — electricity generation, procurement, and management — they should be “unbundled,” spun off into competitive markets to accelerate innovation.
The demise of "bigger is always better" led, starting in the mid-1990s, to a wave of "restructuring," whereby power generation was unbundled from other electricity services and turned over to a competitive market. Independent system operators (ISOs) and regional transmission organizations (RTOs) were set up to manage these wholesale power markets, reduce the transaction costs of communicating the needs of distribution utilities to generation companies, and maintain the long-distance transmission grid. Restructuring raced through about 20 states and then, in the early 2000s, Enron happened in California, and the process came to a halt, where it remains frozen today.
While wholesale competition made it to 20 states, retail-side competition made it to almost none, and only incompletely. The distribution grid and the services involved in it are generally considered still a natural monopoly, left to regulated distribution utilities.
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Public Utility Commissions (PUCs) determine a utility's revenue requirement
Public utility companies are monopolies, and as such, they need to be carefully regulated to protect the interests of their customers. Public Utility Commissions (PUCs) or their equivalent in each state serve as a replacement for the competitive market. In exchange for granting the exclusive right to sell electricity in a given service territory, PUCs determine a utility's revenue requirement. This is called the "regulatory compact" and was first laid out in the Binghamton Bridge Supreme Court case of 1865. The court stated:
> "If you will embark, with your time, money, and skill, in an enterprise that will accommodate the public necessities, we will grant to you, for a limited time period or in perpetuity, privileges that will justify the expenditure of your money, and the employment of your time and skill."
PUCs determine a utility's total revenue requirement in what is known as a rate case. The revenue requirement represents the amount of money a utility must collect to cover its costs and make a reasonable profit. Individual utilities file rate cases, usually every few years, but sometimes less frequently. The PUC decides what the revenue requirement will be based on a number of factors, including the value of a utility's assets, the cost of debt and equity financing, and operating and administrative expenses. The simplified formula looks like this: Total Revenue Requirement = Rate Base × Allowed Rate of Return + Expenses. The rate base is the value of the company's assets minus accumulated depreciation. The allowed rate of return (return on assets) drives a utility's profitability. Expenses are simply passed through, including fuel in cases where regulated utilities own power plants.
The most controversial part of this formula is calculating the utility's allowed return on equity (ROE) – this is the only portion of the revenue requirement that a utility ultimately keeps as profit. Because utilities are regulated, their allowed ROE is set by PUCs. The ROE allowed by a utility's PUC is no guarantee. There are many factors that come into play for utilities to turn an allowed ROE into actual profits. As market conditions and policy priorities change, various regulatory mechanisms and tweaks to the basic formula have been implemented over the years, such as fuel cost adjustments, surcharges, riders, future test years, cost trackers, and revenue decoupling. These measures help to reduce the risks that utilities face and drive desired outcomes, like encouraging utilities to invest in energy efficiency instead of pushing for higher sales.
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Utilities don't profit from electricity, but from investment in assets
Electric utilities are monopolies, and as such, they are carefully regulated to protect the interests of their customers. Public Utility Commissions (PUCs) or their equivalent in each state determine how much a utility is allowed to invest, how much it can charge, and what its profit margin can be. This is called the "regulatory compact," and it was first outlined in the Binghamton Bridge Supreme Court case of 1865.
Utilities' profits do not come from the electricity they provide to customers. Instead, they make money from the investment in the assets (the pipes, substations, transmission lines, etc.) that are used to provide the service. In other words, the more infrastructure a utility builds, the higher the profits it can generate. Utilities are "regulated monopolies," where public officials guarantee the companies a monetary return on their investments while also fixing prices for consumers.
The asset value is at the core of the utility profit margin because a utility only earns a return on its investment in physical assets. Utilities are incentivized to build more infrastructure because they recoup the cost of their investment in those assets plus an additional percentage of those costs (the rate of return on equity), which is their profit. For example, if a utility spends $5 million building a new pipeline, it will pass the cost of the project to its ratepayers. Then the utility will also earn a guaranteed annual rate of return on its investment in the pipeline.
While utilities are incentivized to build new infrastructure, they are often disincentivized to invest in additional clean power due to the rate increases customers would face for both the new infrastructure and what they already pay for old fossil fuel plants. This misalignment between the utility business model and climate goals is a critical challenge in decarbonizing the power sector.
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Utilities are incentivized to build new infrastructure, not boost efficiency
Electric utilities are monopolies, so they are carefully regulated to protect the interests of their customers. Public Utility Commissions (PUCs) determine how much a utility can invest, what it can invest in, how much it can charge, and what its profit margin can be.
The utility business is unique in that profits don't come from the electricity they provide to customers. Instead, utilities make money from investing in the assets used to provide the service, such as pipes, substations, and transmission lines. This means that utilities are incentivized to build more infrastructure because they recoup the cost of investment in those assets plus an additional percentage of those costs (the rate of return on equity), which is their profit.
For example, if a utility spends $5 million building a new pipeline, it will pass the cost of the project to its customers. The utility would earn $500,000 in the first year ($5 million x 10%) and then slightly less in each subsequent year as the value of the pipeline depreciates. Since efficiency and upkeep don't make money, there is little incentive to do more than the bare minimum. Instead, utilities prioritize the replacement of an asset over its repair. For instance, utilities have been replacing sensors when the batteries die, rather than simply replacing the battery.
To achieve climate goals, policymakers will need to change how utilities make money. Currently, utilities are primarily incentivized to build new infrastructure rather than boost efficiency, make repairs, or invest in operations. Third-party-owned climate-friendly energy systems like solar panels and batteries may be seen as a threat to their business model. Understanding how to realign utility profit incentives is key to decarbonization.
One example of a new approach to incentivizing efficiency performance comes from the New York Public Service Commission, which has adopted an outcome-oriented metric that focuses on the policy goal of reduced energy use overall. This represents a radical departure from program-based efficiency regulation and could become a powerful new tool to expand investment.
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Government agencies regulate prices, budgets, and services of utility companies
Government agencies play a crucial role in regulating prices, budgets, and services of utility companies, particularly in the context of their monopoly power. Utility companies often hold "natural monopolies" over essential services such as electricity, water, and natural gas. To protect consumers from undesirable monopolistic practices, government intervention is necessary.
In the United States, utility companies are regulated at the state and municipal levels by public service commissions or Public Utility Commissions (PUCs). These commissions are composed of commissioners appointed by governors and dedicated staff who implement and enforce rules, approve or deny rate increases, and monitor relevant activities. The rates paid by customers are set to ensure reliable service at a reasonable cost. This rate-setting process takes into account factors such as the utility's assets, debt, equity financing, and operating expenses.
The Federal Energy Regulatory Commission (FERC) is another key government agency in the United States, regulating the interstate transmission of electricity, natural gas, and oil. FERC's mission is to ensure consumers have access to reliable, efficient, safe, and secure energy at a reasonable cost.
In Kazakhstan, public utilities are mostly state-owned, and their activities are directly regulated by akimats. This allows the government to have a direct influence on commercial activities, ensuring compliance with state interests. The Committee for Regulation of Natural Monopolies, Competition and Consumer Protection (CRNM and CP) sets tariffs for utilities, ensuring accessibility to the public.
The regulation of utility companies is essential to balance the interests of the companies, investors, and consumers. While utilities need to generate profits to sustain their operations and attract investors, government agencies play a crucial role in ensuring that consumers are not exploited and that the companies operate in the public's best interest.
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Frequently asked questions
Electric companies make money from the investment in the assets (the pipes, substations, transmission lines, etc.) that are used to provide the service. The more infrastructure a utility builds, the higher the profits it can generate.
Electric companies are regulated monopolies. Public Utility Commissions (PUCs) or their equivalent in each state serve as a replacement for the competitive market. PUCs determine how much a utility is allowed to invest, how much it can charge, and what its profit margin can be.
There are three types of electric companies: investor-owned, publicly owned, and cooperative companies. The first is privately owned, the second is run by the state or federal government, and the third is made up of not-for-profit, member-owned utilities.
According to the U.S. Energy Information Administration, almost 3,000 electric distribution companies were operating in the U.S. in 2017. Investor-owned utilities served 72% of U.S. electricity customers in 2017.
