David O'Brien is director of regulatory practices for Bridge Energy Group, a reader of Intelligent Utility and an occasional contributor to our forum. We spoke with him recently on what needs to change to foster a positive regulatory environment for grid modernization efforts. This is Part I of a two-part conversation. 

Intelligent Utility: What are the drivers for regulatory change that would support grid modernization?

O'Brien: The need for real change is probably not well understood, including in the regulatory community. There seems to be a presumption out there that what we have now—the so-called status quo—is working well. I'd be one to question whether or not what we have now is a highly functional approach, especially when you consider the groundbreaking nature of grid modernization.

The knottiest issue is how to balance risk between ratepayers and shareholders when you look at smart grid investments. If you look at the orders that came out of Maryland and early staff recommendations in Michigan, both went to that issue of risk. If this project doesn't quite work out as planned, who ultimately bears the burden? In those two cases, regulators said that's the utility's problem. We're not going to let ratepayers bear this risk. 

It's a conundrum for the industry as a whole. Traditional rate-making methodology is a cost-plus exercise in which the utility gets its investment back plus a rate of return set by regulators. It was established many decades ago and premised on investment in largely stable, known commodities (poles & wires as compared to digital switches and advanced IT).  For utilities, if their shareholders are going to bear the risk inherent in a smart grid investment, whatever that might be, then a regulated rate of return is not going to be sufficient, at least not without a means to float up and down in response to performance. With grid modernization and the prospect of large scale disallowance, the risk profile begins to look a lot more like what a competitive industry expects on return on invested capital.  

I'm interested in looking at the rate of return, performance and symmetry between the two sides of the equation. Meaning that good performance should earn a return that's better than average; non-performance gets less than average. That creates a perform-for-return sort of environment. That makes a lot more sense. Because if you're a utility company deploying smart grid, think about how complex it is, all the moving parts, all the things that need to be managed, this is not like building a new substation. There's a lot of things that can happen over time to a smart grid-based technology investment, so there's a question around to what degree is a utility "responsible" for what might occur? That's an open question. So, for the utility to face the prospect of "get it 100 percent right, don't make any mistakes and you'll get your costs plus a modest rate of return back" or get it wrong and you're facing a potentially tremendous loss—that's daunting. Investor-owned utilities have to satisfy investors and it seems to me that investors won't warm to that environment. 

IU: That scenario would constrain grid modernization. 

O'Brien: Exactly my point. Suppose a utility, on its own—we're talking non-stimulus money now—wants to propose a smart grid investment. If what I've just described is the environment they're looking at from a risk- and regulatory-standpoint, I wonder whether senior management will be willing to go down that road.  

IU: Has anyone or any party identified practical steps to transition the regulatory environment to a more incentive-based approach? 

O'Brien: Not in any significant way that I'm aware of. Probably the most significant example I'm aware of was done legislatively in Illinois, where legislators said to Commonwealth Edison, "We want you to pursue grid modernization and we're going to measure performance and if you perform a certain way we'll reward you a certain way." If you don't perform well, we'll penalize you in a certain way. That was done by statute. And many states don't have the leeway to do what's known in utility circles as "alternative regulation" or performance-based rate-making. It's something I was a big fan of when I was a regulator in Vermont. But it's not common, from what I can see.

IU: Which stakeholders could or should drive these sorts of changes? 

O'Brien: That is the question, the heart of the matter. Let's go to the notion that this is a state-by-state exercise. States will decide this. There's no way around that. I've given this some thought and the best I can come up is that industry—the smart grid industry—could probably do more, along with the investor-owned utilities, to find some way to be more constructively engaged with the regulatory community.  

I've been to every conference known to man between the smart grid industry itself to the NARUC (National Association of Regulatory Utility Commissioners) conference to EEI (Edison Electric Institute) this year. And for the most part, each group is sort of talking their line to themselves. There's not a lot of cross-talk. The situation is not without effort—there are plenty of examples. I've been involved with the Smart Grid Roadshow and we've hosted regulatory panels. Will people come and offer open dialogue or do they need to be cautious out of respect for other things that are going on? The short answer is not as much is needed for real change to take place.  By and large, I don't think we're at a place where we can sit down and say, `Let's revisit our assumptions, shall we? Let's revisit how we've regulated this industry and look at the utility's point of view on how they're rewarded for performance or penalized for mistakes. How can we use smart grid technology to benefit consumers? How can we, in a manner of speaking, come closer to providing the comfort to regulators they need so they're more inclined to support it?'  

Over the span of time I was a regulator, I was involved in many cases, some were settled, some were litigated. Ultimately, for the matter to be resolved, especially if it's going to be settled, people have to come off their established position and start thinking about how to solve the problems of the other party. That's really how a deal gets done. How can I look at where my counter-party sits and how can I help solve the problems they face?  In return my expectation is they consider my position, my own unique challenges.

If you look at regulators, for example, they are politically appointed or elected, so they live in a political environment. They're closely watched by all sorts of parties —legislators, NGOs. Everything they do is under a microscope. If you think of them in that way, they need to be in a place where they can say, "We've got here on the evidentiary record all the substantiation we need to make this decision. And even if people are going to criticize the decision, we feel good about the record we base this on and we'll stand behind the decision."

At the end of the day, it's a legal proceeding and they have to be able to say they have a sound evidentiary record on a decision they put forward. So if I was coming from the utility side of the table I would want to look at what issues/variables are vital to the utility commission and find ways to solve them.  Anyone who has been in the regulatory process or negotiated business transactions would recognize the dynamic I am describing. It is all very human and natural. We need to drop some of our pretense and get about the business of structuring a rubric that is in step with modern circumstances.

[Editor's note: Please join us tomorrow for Part II of this discussion on the regulatory environment for grid modernization.]

Phil Carson 
Intelligent Utility Daily