What Makes Energy Policy so Important?

This week in Present Value, ESI asks Senior Advisor David Boonin the question, “What makes energy policy so important?” “DB” will mark David’s responses to the questions.

The energy industry is undergoing significant changes, which have influenced business decision making and public policies at all levels of government. ESI has been a long-term partner of energy actors across the spectrum. Learn more about our capabilities.

What makes energy policy so important?

DB: Energy policy in general and public utility policy (including water and sewer) in particular affects the economy, the environment, quality of life, and the ability to survive for the less fortunate.

How is energy policy economic policy?

DB: Gas, electric, and water are everyday necessities. Lower utility bills stimulate the economy, all else being equal. Lower utility costs make most goods and services cheaper to produce and provide. Lower utility bills generate more disposable income for residents, businesses, and governments who then utilize income more efficiently. This does not mean that lower prices are always the best solution. Sometimes higher prices, (passed along to rate payers as higher bills), are needed to support utility infrastructure and reflect externalities. When this happens infrastructure investments further stimulate economic activity, and can make service more reliable, efficient, and cleaner.

Is all utility pricing equal, even if in the short-term it produces the same bills?

DB: No. Rates sufficient to produce a utility’s revenue requirements should be an important goal of rate-setting but not the primary one. The first goal should be setting price signals that internalize externalities (e.g., carbon) and reflect marginal costs. If these prices do not produce the appropriate revenues, then regulators should change the price component with the least price elasticity (e.g., the customer charge). All too often, rate design focusses on accounting issues of cost causality rather than economic efficiency. This produces inferior results in the energy sector and throughout the economy. If a particular rate design causes greater uncertainty of income stability, regulators can deploy income decoupling adjustments, eliminating the need for recovering fixed costs from fixed charges.

How should we assess new resources?

DB: Here are some useful guide posts:

  • Never use price (i.e. average cost per kwh or mcf) as a metric. Focus on bills and not rates. Averages are often a misleading metric. Remember the six-foot man who drowned trying to walk across the stream with an average depth of five feet?
  • Look at complete economic analysis including environmental impact, jobs, and economic stimulation. By doing so, energy policy, economic policy, and environmental policy can move in lockstep.
  • Assess for the risks and uncertainties associated with various options. Use expected values of cases rather than just counting cases as a way of determining a project’s costs as compared to another project. Better yet, perform scenario analyses rather than sensitivity analyses, searching for solutions that produce always acceptable results.
  • Consider using internal rate-of-return measures, rather than discounted net-present-value, as the chosen discount rate can affect the analysis.
What about nuclear subsidies?

DB: Many states have or are considering subsidizing nuclear power. Here are some guiding thoughts:

  • If all electricity, at both the wholesale and retail level, internalize costs, such as carbon, technology-specific subsidies might not be necessary.
  • As with all public policy, complete economic analysis is necessary. Ask: what jobs are gained or lost by keeping a power plant open; what is the rate and economic impact of the options; what are the environmental effects; what is the effect on uncertainty and reliability of fuel diversity?
  • What are the alternatives to nuclear subsidies? Based on the same type of analysis as discussed above, would energy efficiency provide better economic results than propping up any particular technology?
  • If the results of economic analysis show localized or temporal economic displacement, are there more efficient or well-targeted solutions to the challenge?
What financial strategies would you consider in energy policy?

DB: There are two major deviations from standard operating practice that have the potential of significantly decreasing the cost of utility service: asset-backed financing; and cash-flow based rates of return.

Asset-backed financing or securitization can lower the cost of mandated or approved projects by financing with 100% or nearly 100% debt financing, rather than nearly 50% equity, which has a much higher cost of capital, particularly after adjusting for income taxes. It can make projects, like renewables, environmental controls, system hardening, repairs, and the like. Always seek to retain appropriate efficiency incentives so that utilities retain profit motivation.

Cash flow-based return on equity provides a calculably superior return on equity, rather than the all-too-common hand-wave. This approach looks at how return on equity (ROE) affects cash flow indices, and how they affect the utility’s bond rating. The end result might be to have higher ROE and bond ratings during periods of higher capital expenditure, and lower ROE and bond ratings when less capital is needed. This approach should produce longer-term lower rates for a region with accompanying economic benefits.

What should policymakers do when a policy seems to benefit the many but hurt a few?

DB: Regulators should never use the “no losers” test, especially when evaluating technology over another. Regulators should seek the best overall economic solution, as their job is to first emulate competition. If a policy change causes there to be winners and losers, keep in mind that the existing, supposedly inferior policy has its own set of winners and losers. For example, a proposed move to time-of-use pricing causes some customers to pay more than before—it is likely that they were not paying their fair share under the existing pricing paradigm.

Don’t dismiss a policy because it hurts a class of customer that cannot defend itself; rather, set a secondary policy to help them. If a new policy hurts consumers making them unable to take advantage of the new policy, low-income customers in particular, the regulator should consider a secondary policy adjustment, using equitable versus efficiency criteria to help disadvantaged customers

What happens when energy policy does not look at economic and environmental impacts?

DB: Everyone loses. Energy bills are higher. Regional economies become more sluggish. Ignored externalities damage the environment. Future generations pay for short-term or inferior decision making.

Econsult Solutions Senior Advisor David Magnus Boonin is a nationally recognized regulatory public utility economist, thought leader and change agent with over four decades experience in public utility regulation, policy, and strategy. Mr. Boonin synchronizes the public and private interests.

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