A new staff report on cloud computing is putting members of the Illinois Commerce Commission in the hot seat.

A new ICC staff report recommends commissioners initiate a rulemaking on how costs for utility-scale data analytics software should be handled by the regulatory process. The staff says utilities should join their corporate peers in banking, healthcare other regulated industries by migrating their data to the cloud.

Current regulatory rules don’t make that easy.

The ICC’s 2016 Notice of Inquiry (NOI) proceeding revealed “a strong consensus that current regulatory accounting rules have not kept pace with technological innovation,” the staff report concluded. “Utilities should be encouraged to make decisions based on business and ratepayer needs.”

Regulatory accounting rules are currently interpreted to allow utilities to earn a rate of return for on-premise software, but categorize cloud-based software as an operating expense on which no return is allowed. This creates “a disincentive for utilities to invest in new technology” despite the fact that “these systems can serve the same functions,” staff reported.

The cloud may soon be the only place with the computing power to handle the exponentially escalating amount of data being generated by new smart technologies, according to testimony in the NOI proceeding.

The U.S. now has 70 million smart meters installed in over 55% of households, according to Adam Cooper, Director of Research for the Edison Foundation Institute for Electric Innovation. Based on his research for the just-released “Grid Modernization Technologies,” Cooper foresees 90 million deployed smart meters by the end of 2020.

That is just tip of the spear. Investor-owned utilities put $32 billion into grid modernization in 2016, according to Cooper. Much of that spending was for sensors and other system monitoring and management systems that produce data that “is already creating new use cases and value opportunities.”

Led by tech giants like Siemens, GE, Oracle and Amazon, a shift away from on-premise software is coming, according to Chris King, global chief regulatory officer for Siemens.

“At some level of penetration, though there is a debate about what it is, the grid cannot support additional renewable energy without this kind of technology," he said.

In Illinois, the NOI proceeding is laying bare the potential benefits of a move to cloud computing for utilities. If the ICC chooses to change its financial treatment, insiders say it could enable more advanced distributed resources on utility systems and pave the way for similar reforms for energy efficiency and other resources. 

The ICC report

The ICC proceeding was supported by a non-binding resolution approved by the National Association of Regulatory Utility Commissioners (NARUC) at its 2016 annual meeting. The resolution called for the elimination of regulatory barriers and disincentives to cloud-based computing.

“Utilities best serve customers, society, the environment, and the grid by making software procurement decisions regardless of the delivery method or payment model,” declared NARUC’s “Resolution Encouraging State Utility Commissions to Consider Improving the Regulatory Treatment of Cloud Computing Arrangements.”

“NARUC encourages state regulators to consider whether cloud computing and on-premise solutions should receive similar regulatory accounting treatment,” it concluded. “Both would be eligible to earn a rate of return.”

The ICC staff reviewed testimony in the NOI proceeding that addressed possible regulatory barriers to utilities’ move to cloud-based services. It also compared the cost, reliability, and security benefits to utilities, customers, the grid, and the environment from deployment of cloud-based solutions.

Many utilities are lagging behind their unregulated peers in cloud computing system deployment, which may be preventing ratepayers from receiving the benefits that cloud-computing systems can offer,” staff concluded.

To make the benefits from cloud-based software equally available to regulated utilities, the staff urges the ICC to consider a rulemaking. It would not be a debate about the value of cloud-based software, but rather seek to update and clarify rules about capital expenses (CapEx) and operating expenses (OpEx) as they apply to cloud-based and on-premise software.

Generally Accepted Accounting Principles (GAAP) permit utilities to capitalize and earn a return on the cost of Microsoft’s on-premise Office product, staff reported. But the cost of licensing Microsoft’s cloud-based Office 365 product, which does the same thing, is an expense on which utilities cannot earn a return, staff wrote.

Cloud proponents and utility representatives testified in the NOI proceeding that this is an incentive to on-premise software over cloud solutions, staff wrote. The incentive is “without regard to technical or functional merits because utilities favor fixed assets that are included in rate base on which the utility is allowed a return.”

The incentive to invest in on-premise software is significant, according to energy consultant Jill Feblowitz. A provider of cloud-based software would need to reduce the typical $1/customer/month charge by half to make up for the utility’s financial benefit, she told Utility Dive.

Ratepayer advocate pushes back

Not everyone in Illinois is so gung-ho about allowing ROI on cloud computing.

Susan L. Satter, the Public Utilities Counsel to the Illinois Attorney General, wrote in the NOI proceeding filling that the attorney general's office "question[s] the notion that treating cloud-computing as an ongoing expense is a disincentive.”

Expensing cloud-based software services “reflects the way the cost is actually incurred,” she wrote. It allows recovery of pass-through costs “contemporaneously with consumption.” That frees utility capital for “infrastructure investment related to system safety and reliability.”

Cloud-based software can provide both short-term and long-term services, Satter acknowledged. But regulatory scrutiny and not the rewriting of accounting rules is the way to determine whether it should be CapEx or OpEx.

Financial Accounting Standards Board (FASB) rules may allow a way around the disincentive if the utility’s use of the cloud-based software fits the definition of a “hosting arrangement,” Satter acknowledged.

She rejected the argument that utilities would not make “prudent, least cost expenditures” on software because it is an OPEX and offers no return. Presentations in a 2015 ICC forum showed Microsoft, Facebook, Linked-In, Uber, and Amazon among the users of cloud-based services, demonstrating their “significant value,” Satter wrote.

“The question for the Commission may not be whether accounting rules are correct, but whether the utilities are prudently managing their operations if they fail to take advantage of opportunities to save costs and enhance operations,” she added. 

The disparity in accounting rules could also be an advantage for utilities, Satter suggested. The current approach allows them to pass the cost of software through to customers and pass the burden of software to “vendors that specialize in business support systems.”

Utilities can then focus their attention on “their essential and critical responsibility for grid investment and maintenance” while keeping “a clear eye on prudency, efficiency, and least cost service,” Satter wrote.

Cloud providers push for CapEx distinction 

Oracle Utilities’ January 2016 survey of 100 utility executives found 45% had turned from on-premises software to some form of cloud-based applications. But a 2014 multi-industry survey showed 83% of healthcare companies already used cloud-based services. And a 2016 survey of more than a thousand IT professionals by Rightscale found that “95% of respondents are using the cloud.”

One way to make a transition to the cloud work under existing accounting rules is to treat cloud-based software "as miscellaneous intangible property, which is how it treats on-premises software,” said Oracle Regulatory Affairs Director Richard Caperton.

Miscellaneous intangible property goes into the rate base and allows the utility to request a “reasonable” rate of return during its rate case, Caperton said. “We are confident a commission would see the investment as prudent.”

Caperton agreed with Satter that the FASB “hosting arrangement” ruling, used in 2016 by the New York Public Service Commission, could accomplish the same end. As part of the Reforming the Energy Vision Track 2 proceeding, the NY PSC ruled, in Matter 14-00581, that utilities may rate-base leased software paid for upfront because it gives the utility a type of host-like ownership, Caperton said.

Either approach will make utilities “whole and indifferent between the two types of software,” Caperton said. “That is the important thing. Regulated utilities’ investment decisions should be based on the public interest and the interests of the ratepayer and utility, not on archaic accounting rules.”

Caperton objected to Satter's argument that there are better CapEx opportunities for utilities than cloud-based software. “You can’t run a utility without software and IT solutions just like you can’t run a utility without poles and wires,” he said.

More fundamentally, he added, allowing utilities a return on only one type of software “will skew their choices and keep them from delivering the best customer services.”

From OpEx to CapEx

Shifting cloud-based computing from OpEx to CapEx does not need to involve lengthy changes to underlying accounting rules, said Danny Kermode, an accountant and assistant director at the Washington Utilities and Transportation Commission.

Changes to accounting rules are unnecessary because “regulatory bodies are not bound by GAAP accounting,” he said. “Regulatory bodies can alter GAAP rules to fit their oversight duties and can require utilities to do things differently.”

The cost of converting from on-premise to cloud-based software includes migration costs like converting data and retraining personnel, he said. Under GAAP, those costs are OpEx, but regulators can allow the utility to accumulate them instead passing them through to customers.

The commission and the utility can agree on a reasonable time for migration costs to remain on the balance sheet and not be recovered,” Kermode said. “The utility can then ask the commission for recovery of those deferred costs.”

The investment funding the monthly charge for cloud-based software should be rate based as “working capital,” Kermode added.

“All regulated companies have a working capital component that can be rate based to fund current obligations," he said. "A capitalized expense, as proposed by some, is inconsistent with the short-term characteristics of the cloud computing business model.”

Kermode opposes changing the rules because the change suggests creating long-term assets out of short term operating costs. "That is simply incorrect accounting, GAAP or regulatory basis."  

But companies are going to the cloud, he said. “The Oracle survey showed that.”

All utilities are concerned with their quality of service and that makes cloud-based software “a no brainer,” Kermode said. “It is a prudent decision because it provides better service to ratepayers.”

ROI for innovation

Former California Public Utilities Commissioner Dian Grueneich, now a Stanford research scholar, said there is good evidence that earning a return is a strong incentive to IOUs.

Grueneich cited staff’s report that “almost every utility” in the NOI proceeding agreed there is a “perverse incentive” in the current interpretation of accounting rules.

“It’s a case-by-case matter but the last thing I would want as a commissioner is to keep the best tools from utilities because of regulatory rules,” she said.

“Without changing the current regulatory treatment of cloud based solutions, there is a concern that the utility industry will fail to fully realize the substantial customer service, operational, and financial benefits of analytics solutions delivered via the cloud,” Guerneich quoted from the report.

But there is a larger issue, she added. “Where do we see utilities going? Where will innovation come from? And should regulatory rules be part of the answers to those questions?”

Grueneich is currently focused on energy efficiency and has found there are three factors that drive utility investment. The first is allowing them to recover costs for rebates and other incentives they offer customers. The second is making utilities indifferent to revenue losses from energy efficiency growth.

“The third is providing shareholder incentives,” Grueneich said. “And the highest performing states and utilities have all three.”

She rejects the argument that utilities don’t need a return for moving to the cloud or to energy efficiency as long as they can recover the expense.

"It gets management’s attention when the utility can earn a profit," she said.

A utility faced with whether to build a power plant or do energy efficiency is in a similar position as one deciding whether to use on-premises or cloud-based software, Grueneich said. “They are going to look much more seriously at each if the ratemaking treatment is basically the same for either option.”

Regulators need to look at “prudency and reasonableness” but they also need to support utilities in embracing new technologies, she added. “I want regulators and utilities to see clearly what reliability, customer service, and costs are possible and not see the one up in the cloud with one hand tied behind its back.”