Ray Gifford is the managing partner and Matt Larson is a partner at the Denver office of Wilkinson Barker Knauer.
The energy policy avant-garde — those most eager to dys-integrate the traditional public utility industry — have a problem. The “regulatory compact” that they deride variously as non-existent, at worst, or pernicious, at best, is reasserting its durability as a bedrock principle of public utility regulation. The regulatory compact may be an unwelcome guest in a world of zero-marginal cost and distributed resources, but its vitality as a measured, foundational principle will not go away.
What is the regulatory compact? For our purposes, it is good enough to define it as an implicit (or imagined) bargain between the utility and its regulators: In exchange for regulation of its profits and an exclusive service territory, the utility agrees to prudently invest sufficient capital to serve all demand within that territory. On the utility side, it gets assurance that its prudent long-term capital investments will be returned; on the customer/regulator side, it agrees to pay back the invested up-front capital to build and sustain the network, but also gets to limit profits and, in part, exercise direction of utilities’ decisions.
But, like all bargains real and imagined, the compact can be broken and suffers from an evergreen human impulse — opportunism. Once a utility sinks its capital, political convenience or technological change might make it convenient for regulators or policymakers to renege on the compact. By the same token, a utility’s incentives to hedge on the compact certainly exist. The compact has to exist and be treated in balance: regulators and customers need to honor the deal for capital investment to remain ongoing by the utility; the utility cannot hedge on the margin.
No less than Warren Buffett has emerged as the leading voice for the necessity of the regulatory compact. While Buffett has pointed to Jay-Z as “the guy to learn from,” it is the Oracle of Omaha himself who is showing the way on the need for the regulatory compact. In this year’s installment of his legendary and always hotly anticipated investor letter, Buffett — talking his book, to be sure — notes the challenges to Berkshire Hathaway’s considerable utility investments caused by limitless liability risk related to wildfires. Citing not only the losses of Berkshire-owned utility PacifiCorp but also wildfire liability risk faced by Pacific Gas and Electric and Hawaiian Electric, Buffett raises the specter of states implicitly rescinding the regulatory compact: “the fixed-but-satisfactory- return pact has been broken in a few states, and investors are becoming apprehensive that such ruptures may spread.” In the end, Buffett warns that the public power model might be the only viable solution if investors like Berkshire refuse to put capital in an investment that offers limited returns but boundless liabilities.
Warren Buffett and Berkshire Hathaway will, in the end, be fine. The world’s most famous investor didn’t become that by throwing good money after bad. But his cautionary note should be heeded.
The U.S. is experiencing eye-popping demand growth for electricity. Policymakers are clamoring for an energy transition, albeit toward various ends and at different paces. The amount of capital that needs to be invested in the U.S. electric grid is not just substantial, but gargantuan. And these capital needs are not just driven by those states pushing for a rapid energy transition. The demand forecasts confronting all utilities predict significant resource needs to meet electrification, data center, industrial and overall increasing consumer demands. Whether motivated by “drill, baby, drill!” or “decarbonize now!”, the U.S. utility industry needs mountains of capital to keep up with demand. Meanwhile, analysts are noting weakening credit metrics for utilities — a problematic trend when those same entities are a lynchpin to advance the grid of the future and national and state energy priorities, regardless of what those priorities are.
Some commentators are calling out the need for “utility reform” or “regulatory reform” to combat a so-called “force field of tedium.” After some research, “tedium” is “the state of being tedious,” and tedious means “too long, slow, or dull.” Not sure that is the problem, candidly. The issue is a need for stability to accelerate investment and advance the energy transition in a time of load growth, leading us away from The Atlantic and back towards Warren Buffet and the OG of regulatory principles: the compact.
The fundamental insight reflected by the regulatory compact is as old as network industries themselves. Railroads, the original network industry that emerged in the 19th century, took massive capital investment to make happen. But railroads displayed the same economic imperatives of all network industries: the need for massive up-front capital to build the network, followed by relatively low marginal costs to deliver the product. Furthermore, competition in these network industries occurred on a knife’s edge between being beneficial for consumers or ruinous for all.
The regulatory compact is a necessary principle that needs to be considered by lawmakers and regulators as a necessary tool to attract and keep capital in the sector. Furthermore, the principle is agnostic to one’s underlying policy preferences. If you think the utility sector needs to rapidly de-carbonize and invest heavily in clean energy and large-scale transmission, then you need massive amounts of capital to make those investments. If you think the utility industry sector needs rapid electrification of transportation and heating, then you need massive amounts of capital to make those investments. If you think nuclear is the only viable long-term answer to a decarbonized energy sector, then you need massive amounts of capital to make that happen. No matter the preferred version of an energy future, it is a capital-intensive one with capital needs just enhanced by the demand wave and load growth ongoing across the country.
To be clear, the regulatory compact as an unconstrained principle can be too much of a good thing. It cannot go so far as to protect every mal-investment of capital, nor should it. Performance-based regulation, done right (and which is easier said than done), can soften some of the incentive problems embodied in the original conception of the compact. Nonetheless, in proportion, the regulatory compact is a necessary principle to induce investors into sinking capital into long-lived assets, and we need it now more than ever.
