Technologies are quickly advancing, providing a wide array of industries from transportation to healthcare to financial services with tools to modernize their products and services, while utility regulation has struggled to keep up. A key stumbling block is that many solutions are only offered as services rather than capital investments that a utility owns and operates.

Utilities earn a rate of return on capital equipment, such as poles, wires, transformers and on-premise IT systems. By contrast, operating expenses, such as salaries, maintenance and payments for services, come out of a limited budget, so utilities manage these expenses to avoid overspending and eroding their earnings.

The net effect is a significant disincentive for utilities to procure service-based solutions provided by private advanced energy companies.This limits utilities from taking advantage of many new technologies that are solely offered through service contracts, such as cloud computing, since these services displace an earnings opportunity.

In order to encourage utilities to make IT investments that are in the best interests of both them and their customers, two states — New York and Illinois — have looked at changes in how cloud services are treated for accounting purposes. These accounting innovations could potentially be applied to other utility needs that could be met more cheaply or flexibly as services than as capital assets.

For decades, utilities have made significant investments in their own IT equipment and on-premise software, hiring staff to manage and operate their systems. In contrast, cloud-based software — networked servers, databases, storage, software and analytics — offered by specialized technology companies can be accessed over the internet without the end user having to own the equipment or purchase, maintain and update the software. Leading companies providing these cloud computing services include: Oracle, Amazon Web Services, Microsoft Azure, Google, and Dropbox.

Cloud computing allows the customer, or subscriber, to take advantage of the scale and operational expertise of specialized technology companies while avoiding the cost of equipment, maintenance and software — and risk of technological obsolescence. Cloud services also pool and manage capacity efficiently, providing cost savings over meeting needs with dedicated computing capacity.

Although the traditional regulatory paradigm discourages utilities from taking advantage of these services, even today's financial accounting rules provide regulators with flexibility in how they allow utilities to capitalize costs as so-called regulatory assets.

The table below gives an overview of a number of different options that regulators can consider to address this discrepancy, which also apply to non-cloud expenditures, such as non-wires alternatives to capital investments. (See AEE Institute's report on Utility Earnings in a Service-Oriented World for more analysis of the options available to regulators.)

New York and Illinois have been the leading states in putting a couple of these accounting options to work in creating a level playing field for cloud computing.

New York: Rate of return for pre-paid services

In May 2016, the New York Public Service Commission (PSC) issued a declaratory statement in its Reforming the Energy Vision (REV) Track 2 order that utilities could capitalize pre-paid contracts for software services.

The PSC phrased its approval in such a way that indicated it was confirming an existing capability under accounting rules rather than providing a new capability:

Utilities can earn a return on some types of REV-related operating investments within the current accounting system. Numerous IT applications will need to be developed and implemented. Rather than developing their own software, many businesses find it more efficient to enter contracts to lease software services over extended periods, typically three to five years. To the extent that these leases are prepaid, the unamortized balance of the prepayment can be included in rate base and earn a return. As utilities evaluate whether to purchase or lease these applications, their ability to earn a return on a portion of the lease investment should help to eliminate any capital bias that could affect that decision.

The tack that the PSC took, prepaying the total cost of a service contract and recording it as a regulatory asset in the rate base, is a simple solution that resolves the disincentive for utilities to utilize cloud computing services and places them on equal financial footing with on-premise solutions, allowing the utility to select a solution that provides the most value to the system and to customers. But it has some shortcomings:

●      If the service contract offers significant savings relative to the capital investment, the utility may lack motivation to pursue that option as it will decrease the utility's opportunity for earnings.

●      If the prepaid service is a shorter term contract than an on-premise solution it will produce lower utility earnings for the same investment amount.

●      Pre-paying for more than a few years in advance may be unfeasible and may limit the options available to the utility over the life of the contract.

Illinois: Partial return for pay-as-you-go services

Illinois is looking to an approach similar to New York, but taking it one step further.

Following an extensive inquiry into cloud computing in 2016, the Illinois Commerce Commission (ICC) issued an order in December 2017 charging the ICC staff to develop a rule to level the playing field between on-premise and cloud computing solutions. In its order, the ICC wrote:

The disparity between on-premise and cloud computing systems create a disincentive for utilities to invest in new technology. There must be a level playing field between on-premise and cloud computing systems, especially because these systems serve the same function. Specifically, the Commission recommends that the Staff initiate a rulemaking to level the playing field between on-premise and cloud-based computing systems by clarifying the regulatory accounting rules to provide comparable accounting treatment of on-premise and cloud-based computing systems.

The ICC then initiated a rulemaking. In January 2019, after a year-long stakeholder process, the ICC issued a second notice order in the state register that would allow utilities to pre-pay for a cloud service and amortize those costs and derive earnings from them as it would a typical asset.

It also allows some earnings on pay-as-you-go services, though not on the same level as pre-paid cloud computing services. This is an important extension of accounting options.

A pay-as-you-go model, in which the utility pays based on its actual usage of a service rather than lock itself into a predefined quantity of service, allows the utility to leverage the flexibility and scalability of cloud computing, while providing customers with potential cost savings if it uses less of a service than anticipated. The proposed rule has been adopted by the ICC and is now before a legislative review committee, the Joint Committee on Administrative Rules, for final approval.

For state regulators looking for an easy first step to resolve the impact of lost earnings to utilities when they choose a service solution rather than a capital investment, the capitalization of a prepaid service is a good option because of its existing uses in other similar situations.

Relying on services allows utilities to transfer equipment, operating and obsolescence risks to third parties and benefit from third parties' ability to achieve synergies and economies of scale, thus providing savings compared to utility investments in many situations.

But for services like cloud computing to be fully integrated into utility procurement programs, the industry needs to move beyond prepaid contracts so that the full flexibility and cost savings can be realized. In order for utilities to get the most value from these and other services, they will need to be able to contract for varying lengths and flexible terms, with no regulatory accounting — or earnings — to favor a capital investment when an alternative is better.

If done right, these options have broad applicability beyond cloud computing, with utilities and customers both standing to benefit.