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The regulatory compact.

Around the turn of the century, state legislatures across the country imposed economic regulation on the developing electricity industry. Legislatures recognized that the electric industry was a classic natural monopoly; that is, because of economies of scale, the costs of service were lower with a single provider than with several firms in competition.

State legislatures established a "regulatory compact," which imposed responsibilities on both the utilities and the states. Utilities were obliged to provide universal, adequate service and to submit themselves to rate and service regulation so customers would be protected from the abuses of monopoly power (high prices and poor service). States agreed to afford companies an opportunity to earn a reasonable return on prudent investments. Regulation was imposed as a substitute for competition.

This regulatory compact is applied in a rate case, a quasi-judicial proceeding in which state commissions establish prices utilities may charge. These prices are derived from:

1) expenses a utility legitimately incurs providing service, including a return on the capital investment in plant, which is included in the utility's "rate base," less depreciation;

2) allocation of costs to classes of customers--residential, commercial, industrial and irrigation--usually based on usage patterns; and

3) a rate design which reflects the cost of service and enhances economic efficiency while allowing the utility to collect adequate revenues.

It sounds straightforward enough. But economic regulation is an exquisite challenge--especially for a lay commission--since rate cases involve complex accounting methods, depreciation schedules, and return on shareholder equity, just to name a few of the more intricate issues.

Moreover, a rate case isn't just arithmetic. It can involve the relative strength of commission and utility staffs, personalities, posturing, public opinion, politics, law suits, strategy, surprises, and theater.

In short, regulation is hard to do well. And its results seldom satisfy all the stakeholders. But over the long haul, public interest is far better served by conscientious, competent regulation than by unbridled monopoly power. Or endless lawsuits.

The Traditional Electric Utility

Intense competition characterized the industry in the early years of this century, as electric utility companies frantically strung line to reach new customers. But after abuses by some holding companies in the 1920s and federal regulatory reforms of the 1930s, a compromise evolved and the industry stabilized. Customers welcomed dependably low prices and expanding uses for electricity. Utilities accepted low risk and protection from competition.

For a long period during mid-century (1940s - 1960s), the industry was characterized by economies of scale, steady growth, and declining real prices. Consumer and societal demands seemed straightforward. Both utilities and regulators were able to respond simply.

Some utilities matured into vertically-integrated corporations. That is, they built and operated both generating and transmission systems. And why not? Fuel costs and interest rates were stable. Declining block rates, or charging less for using more, promoted electricity consumption. And new supply was cheaper than existing supply, further promoting construction and growth in the electric utility industry. Everyone was happy. Or were they?

Traditional Economic Regulation in Montana

In 1913, the Montana legislature authorized regulation of public utilities. The Public Service Commission, or PSC (then known as the Board of Railroad Commissioners), was charged with economic oversight of the state's electricity, gas, water, and sewer service providers, as well as intrastate motor carrier transportation. It now also regulates telecommunications. The first Commission adopted a declining block electric rate starting at 14 cents per kwh.

Unlike many states, the Montana PSC's regulatory effort focuses on rates charged and services provided. It does not grant exclusive franchises for particular service areas; instead, these territorial battles (usually between the Montana Power Company and a smaller electric cooperative) have been waged in the legislature. Montana's PSC is unusual also in that its commissioners are elected, rather than appointed; only about a dozen states elect their Commissions.

Whether elected or appointed, commissioners' decisions have never been free of controversy. In Montana as elsewhere, critics alleged that commissioners were "in the back pocket" of the very industries they were supposed to regulate. Until the 1970s, however, the real price for electricity was stable or declining. So the impetus for reform remained weak. Then things changed.

A National Energy Revolution

For decades, utility planners had forecast load growth by placing a ruler on semi-log paper. They thought the future would be just like the past, and for decades they were right. Events of the 1970s, however, ruined this approach.

For one thing double-digit inflation dramatically increased construction costs. Two Arab oil embargoes drove up fossil fuel prices and made us feel queasy about energy security. At the same time, the National Environmental Policy Act signaled an increasingly strong conservationist mentality; and the new consumer protection movement, awakened and led by Ralph Nader, turned its critical eye on electric rates.

Abruptly, the old premises and measures no longer applied. The electricity industry was seen to have vastly overestimated demand. Moreover, it had underestimated potential conservation and underestimated the powerful appeal of new environmental and consumer movements. In short, the industry had overbuilt.

Across the country, state commissions began disallowing investments (over $12 billion worth) in large, expensive nuclear and coal-fired generating plants. In 1978, Congress moved to reform the industry. The Public Utility Regulatory Act (PURPA) opened the door to generation by independent companies. PURPA also required state commissions to consider new rate-making principles such as marginal cost pricing.

Meanwhile, Under the Big Sky

The 1970s brought political change here at home too. Montanans adopted a new constitution which gave citizens the explicit right to a clean and healthful environment and established a new Consumer Counsel to represent consumer interests before the Public Service Commission. In addition, legislative action aimed to make the PSC more in tune with consumer interests. Effective in 1975, the PSC itself was expanded from three to five members; these five were elected from districts rather than statewide, to better accommodate the diverse regional views within Montana, and put commissioners more in tune with consumers.

Meanwhile, the Montana Power Company had projected substantial load growth for the 1970s. No more good, cheap hydroelectric sites remained, so the company went with coal. Along with several other Northwest utilities, Montana Power built two coal-fired plants totaling 700 megawatts (Colstrip 1 and 2), and proposed two more larger plants (Colstrip 3 and 4) at 700 megawatts each.

Many Montana groups (the Northern Plains Resource Council, Montana Environmental Information Center, Northern Cheyenne Tribe) and thousands of individual Montanans opposed the Colstrip projects. So did the Public Service Commission.

But the company, which insisted that Montana needed the projects' electricity and jobs, continued to fight for Colstrip 3 and 4, and squeaked them through the siting approval process. The PSC disallowed placing Colstrip 3 into Montana Power's rate base; then a Butte judge overturned PSC's disallowance. The company sought to add Colstrip 4 to its regulated cost structure in 1988. After the PSC rejected that proposal, Montana Power decided to market its 210 megawatt share of Colstrip 4 power to other regions--at a loss.

This struggle, though costly and divisive, helped create a climate for change in Montana's utility industry. So too did the forces, described earlier in this article, that were helping forge a new industry-wide emphasis on energy efficiency and conservation.

The Montana Power Company made a major commitment to conservation and to a new collaborative planning process. The process was to focus on so-called integrated least-cost resource planning (IRP), a fancy term for the idea that conservation and efficiency savings are potential energy resources--just as a new dam or nuclear plant--and must be integrated into the menu of options. (See Nybo and Hammarlund, this issue, for more on IRP and related concepts.)
Table 1

Montana Power Company Revenues by Customer Class

 Percent Revenue
 (rounded) (Millions of $)

Residential 32 98.7

General Service
Primary 5 16.1
Secondary 30 93.4

Substation 24 74.5

Interruptible 4 11.8

Lighting 2 7.5

Irrigation 1 4.3

TOTAL 98 310.4

This is a breakdown of the percentage of revenues paid by
various classes of MPC customers, and the amount paid, in
millions. These amounts are based on MPC's last general rate
case, PSC Docket No. 90.6.39. The total utility revenue
requirement, the cost of providing service to each class, and
rate design are all subjects in two current MPC case.

Included in the new collaborative effort were representatives from the Montana Power Company and environmental groups, large industrial customers, state agencies, and consumer advocates. Wary at first, these traditional adversaries produced a series of policy statements and supporting materials which were presented to the PSC.

Late last year the Commission adopted an official set of principles which now guide "least-cost" planning efforts in the state. At the most fundamental level, the PSC emphasized conservation and public involvement. It defined costs as total, societal costs, including environmental costs which might not yet be internalized. In addition, the PSC said that energy planning should incorporate issues of rate design, transmission as well as generation, and existing resources as well as prospective ones.

The Commission stressed that least cost planning could not be construed as "preapproval" of any specific resource decisions--which still will be subject to review in contested rate cases. Least cost planning is not designed to transfer risk from shareholders to ratepayers.

Rather, through an open and thorough planning process, risk should be reduced and better managed.

In the 1993 legislative session, the Commission, the utilities, the Consumer Counsel and other parties to the collaborative effort joined in supporting legislation to clarify the Commission's authority to require least cost planning. The legislature readily adopted the measure. At this writing, Montana Power's first integrated resource plan--along with extensive consumer and interest group commentary--is being evaluated by the PSC.

Future Trends

The changes we see now, both nationwide and here in Montana, are probably just the tip of the iceberg. By the year 2010, electric companies may be "distributed" rather than centralized. That is, electricity may be generated near the point of end use by relatively small resources such as gas turbines, diesel engines, fuel cells, photovoltaic arrays, and batteries, as well as from demand-side resources such as conservation and energy efficiency measures.

Consider the analogy of the computer industry: The traditional vertically-integrated utility is like a "Big Blue" mainframe; the distributed utility is a network of personal computers. In the latter model, electricity supplies may come from non-utility sources such as neighborhood-scale generating plants, and even customer-owned sources such as wind mills, photovoltaic arrays, or fuel cells. A customer may, through an interactive meter, receive a weather forecast and a price schedule based on short-run marginal costs, operate a model of energy use in the house or business, choose among electricity suppliers, or select from an array of conservation measures.

A distributed utility could have many advantages. Transmission and distribution costs, which now comprise over two-thirds of utility capital expenditures nationwide, would be reduced. Small increments of generating resources would more closely match load growth, both in time and in place. Lead time for new resources and the risk of each new investment would be reduced. Diversity of fuels--gas, coal, sun, wind, hydro--would be increased, reducing risks associated with changes in the price or availability of any one fuel. Locating the power source near end users could increase reliability for especially sensitive customers like hospitals.

The distributed utility, if it comes, will pose new challenges, some technical and some cultural. Utility managers will have to become entrepreneurs. System dispatchers will have to develop sophisticated new computer programs to coordinate many small, independent components.

Regulators must determine to what extent they will (or can) shape market developments, how to respond to what they cannot control, how to maximize the advantage from new technologies or market approaches, and how to mitigate negative consequences for the core residential and small business customers who will have fewer market choices.

We're seeing the trend already. At the federal level, the National Energy Policy Act of 1992 expands competition in electrical generation, in part by requiring state commissions to consider a new series of rate-making standards. Montana's PSC has opened the first of several cases which include issues related to new federal standards.

Montana's PSC is considering several measures to counter alleged conservation "disincentives" in its rate-making process. One approach would be to refine current methods: denying rate recovery for investments in supply-side resources when demand-side resources are more cost effective; tightly controlling the utility's rate of return; and setting prices more precisely at the marginal cost of service, taking into account external costs such as unregulated pollution.

Two new methods have been proposed as well. With "lost revenue recovery," a utility would be compensated for revenue lost because successful energy-saving programs lowered demand. Critics worry this mechanism could encourage utilities to invest in unsuccessful conservation programs and inflate estimates of electricity saved.

A more novel approach suggests "decoupling" utility profits from sales. Instead, revenues are pegged to something else, such as the number of customers. Thus, between rate cases, the modest incentive to cut costs would remain, but the incentive to boost sales would decline. The utility might be more interested in meeting customers' end use needs rather than selling more juice.

While simple in theory, decoupling is challenging to apply without shifting risk from utilities to their customers. (See sidebar, Nybo and Hammarlund, on Puget Power's decoupling experience.)


We all have an economic stake in the health and efficiency of Montana's utility companies. Regulated utilities generate the electricity most Montanans depend on, and they generate nearly a billion dollars in sales (see Figure 1 for recent Montana Power revenues). Utilities also produce substantial numbers of generally stable, well-paying jobs. And they are important to Montana's overall competitiveness, as relatively low cost electricity may offset other relatively high-cost factors like transportation.

But as we have seen in Montana and elsewhere, the utility industry is undergoing fundamental change. New tools abound, and so do new risks. Utilities, regulators, and end users alike must be prepared for rigorous analysis, thoughtful planning, and difficult trade-offs.

Bob Rowe is vice chair of the Montana Public Service Commission; Bob Anderson is chairman. Their article does not necessarily reflect the views of the PSC, and is not intended to prejudge any issues that may come before the Commission.
COPYRIGHT 1993 University of Montana
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Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Title Annotation:The New Energy Economics in Montana & the Region; economic regulation on developng electricity industry
Author:Rowe, Bob; Anderson, Bob
Publication:Montana Business Quarterly
Date:Sep 22, 1993
Previous Article:The new utility economics: managing the demand side.
Next Article:The Montana Power Company perspective.

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