Thursday, July 31, 2014

Will the Integrated Grid Need a New Kind of Economic/Planning Analysis?

Jeffrey Roark

System planning techniques evolved in a world of one-way energy delivery from power plants to consumers. However, as two-way power flow continues to develop on the distribution system, new questions are raised by a variety of different stakeholders. These stakeholders see the issues from different perspectives. Some of these perspectives may be rooted in deeply held principles or beliefs, while others may be economic or financial, either from profit motivation or other social objectives.

Different stakeholders addressing these questions from different perspectives may also require different analysis techniques, but all of them should be rooted in the same physical causes and impacts, and reflect the same utility planning practices that will adapt the electric system to its new requirements. The benefit-cost analysis framework for the Integrated Grid establishes this sound engineering and economic foundation; multiple perspectives can be examined upon it.

Varieties of Economic and Financial Analysis: This discussion examines the economic analysis techniques that utility planners use, and compares them with both more general economic and financial analysis that other stakeholders may be used to. While all of these forms of analysis are relevant and useful in the new integrated-grid world, they are useful in different ways to different stakeholders.

As an engineer, I first learned how to do utility planning analysis on the job, trained by other engineers. Some years later I studied accounting, finance, and economics as a part of an MBA program, and had to reconcile what I was learning academically with what I had learned in the investor-owned utility. In time I found a way to understand and appreciate the differences in analysis techniques; it all boils down to your point of view. In short, who is the focus of the analysis?

Economic Analysis: Is this project beneficial to society? Economic analysis has a broad focus, addressing questions of optimal use of scarce resources in a broadest applicable sense. Taking a societal view examines alternative projects or courses of action in terms of net benefit to a community, to an economy, or to society as a whole. The analysis may initially be agnostic about who within society pays the cost and who receives the benefits. If the costs outweigh the benefits, then the societal analysis needs to go no farther. If the benefits outweigh the costs, then the project is considered a benefit to society, because it makes the total economic pie larger. How those costs and benefits are potentially paid or captured by individuals or corporations is a separate but important question that leads to a financial analysis. One might learn about economic analysis in an economics class.

Financial Analysis: Is this investment profitable for investors? Financial analysis, such as one might learn about in a business finance class, assumes the perspective of investors. An investor (which may be an individual or corporation) is primarily concerned with whether the monetary returns from a prospective investment are commensurate with their risk, and how those returns compare with other investment opportunities of similar risk. If the returns are too low relative to their risk (the probabilistic spread of possible outcomes), the investor will look elsewhere for a place to invest. Societal costs may not be of concern unless they result in cash flows that reduce financial returns to the investor or increase their risk. It is important that investors who are under no particular obligations can walk away from any investment that doesn’t provide sufficient returns. This is just as true of investments in traded stocks as it is of direct venture capital or other investment activities.

Economic analysis can identify projects that are a good idea from a community or societal perspective, but such projects may not be financially profitable as an investment by an individual. If there is no viable way for an investor to capture the value brought by the investment (thus failing the financial analysis), it may still be a candidate for a public works investment for the benefit of an entire community.

Utility Planning Analysis: Does this utility investment a) minimize cost of service, or b) produce net benefits for customers and/or society? Utility planning analysis is a special case of economic analysis, constrained by obligation to serve. That is, there are certain jobs a public utility must do, such as extending service and maintaining safety and reliability within standards. Because they must invest, the utility’s shareholders are granted an opportunity (not a guarantee) to earn a return on prudently invested equity capital, commensurate with the risk. (Otherwise, potential investors in the stock market would walk away until the stock price dropped far enough that the returns would be commensurate.) But in return for that opportunity, the utility must choose investments that minimize customer costs within constraints that regulators or policy makers impose. Regulators may require some inclusion of societal costs or concerns, but generally, customers are the focus of utility planning analysis, whether for public or private power.

Government utilities—federal, state, and municipal—and cooperative utilities are not for profit and do not have third-party shareholders. They are generally debt financed, but they do accumulate surplus revenues (revenue minus all expenses, including depreciation), which over time may partially displace debt on their balance sheets. Customers are implicit investors in these entities, receiving implicit “equity returns” by virtue of not having to pay a third party for the use of equity funds. Nevertheless, the same cost-minimization logic applies for these entities, even though they may not be directly regulated by public utility commissions.

Financial Analysis among Unregulated Entities in Electricity: Many for-profit firms conduct business in the electricity industry without the obligation to serve, and also without any competitive or territorial protections. Competitive independent generators and demand-response providers are examples of this type of firm. These firms naturally view investments through their investors’ point of view, taking on investments only when a financial analysis indicates that uncertain revenues from market transactions provide sufficient expectation of returns on the investment, commensurate with the risk. They can also walk away from any investment where returns appear too low or too risky.

In contrast, utility planning analysis is not oriented toward estimating uncertain revenues associated with an investment, and there is not usually an option to walk away. Rather, the planner is faced with alternative approaches to meeting the firm’s obligations. For each alternative, the planner calculates the revenue that is required to fully recover the cost of the investment over its lifetime (i.e., Revenue Requirements) including an assumed return on equity and all operating expenses. The utility is assumed to recover all cost, but only cost (including the cost of capital), regardless of the alternative chosen. The shareholders, if any, are rendered indifferent to the choice, whereby the utility chooses the alternative with the lowest cost to customers. This may appear backward to those schooled in financial analysis, but it is consistent with the obligations and conditions associated with being a utility in service of the public.

Utility Planning Analysis for the Integrated Grid: Minimization of utility revenue requirements isn’t sufficient or appropriate for all utility planning questions. Analysis of utility programs that encourage customer demand response, for instance, must be analyzed in terms of their impact on participating and non-participating customers. Further, there are possibly beneficial projects that the utility isn’t required to do under its historical obligations. Discretionary investments that improve customer service or reliability beyond historical standards may require a full cost/benefit analysis to show net benefits. Integration of generating resources on the distribution and medium-voltage systems brings a new class of investments to bear, and questions about how the utility’s obligations may change. How will utilities address these new issues?

Even before distributed energy resources, the utility’s obligation for universal service had its limits.  If long lines were required to connect unusually rural customers, those customers may have been required to contribute the excess amount in aid of construction before being connected.  The idea is that extending service to a new customer should not impose undue cost on existing customers.  This concept may carry forward, but the rules of thumb may give way to deeper analysis. A customer with DER may impose some new system costs, but may provide some system benefits as well. Calculating those costs and benefits may not be straightforward either, as the costs of integrating the next distributed generation customer may depend existing construction or the presence of other DG systems on the feeder.

Ultimately, new technologies and potential investments will require new tools for utilities, policymakers, and other stakeholders to make informed decisions in this future power system.  However, critical to using the tools is an understanding of the perspective of all parties involved.

Perspectives of Other Stakeholders in the Integrated Grid: Today we are seeing new players making new inroads into the electric utility business, with a variety of perspectives among them. For some the most important matter may be increasing the use of renewables and ensuring long-term societal benefits, while for others the most important matter is minimizing the cost of electric service. Others, with a product to sell, may be most interested in maximizing the incentives that support their business. Reconciling these different perspectives to a point of agreement may be difficult if not impossible, but the chances of success are raised if all can share an accurate vision of the physical requirements for grid integration.

One thought on “Will the Integrated Grid Need a New Kind of Economic/Planning Analysis?

  1. Good overview and discussions of the different perspectives of different stakeholders. There is no optimal solution to recocile these but understanding the motivations of all-goes a long way to come up with a solution.

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