It’s no secret that America’s energy systems are under unprecedented pressure. Our energy infrastructure—everything from our electric grids to gas pipelines—are now dealing with a combination of challenges like load growth, technological advancement, and climate change.
By and large, utilities distribute the energy that powers our homes, businesses, and industry (some also produce it). Most utilities are geographic monopolies regulated by Public Utility Commissions (PUCs) that try to ensure prices are fair and service is reliable. The relationship between utilities and PUCs is generally ruled by the”Utility Regulatory Compact,” a mostly informal 100+ year old framework that outlines how utility investments are made and energy rates are set for customers.
To tackle America’s energy challenges, the Utility Regulatory Compact needs to be updated to better align with electricity growth and the clean energy transition.
The Utility Regulatory Compact is old
Let’s face it: the Utility Regulatory Compact is no spring chicken. Established over a century ago, it was a compromise between utility business interests and progressive policymakers looking to control the power of monopolies.
That’s not to say the regulatory compact hasn’t been important. After its advent at the beginning of the 20th century, the regulatory compact enabled the rapid growth of our energy systems, one of society’s greatest achievements that turned the lights on across the country and transformed everyday life.
Utilities were able to accumulate the capital necessary to expand both the electric grid and gas pipelines because they were rapidly gaining new customers. As more and more people eagerly embraced the conveniences of electric lighting and new appliances, demand for energy services surged. At the same time, energy rates stayed fairly low as fixed costs were spread across more customers.
In recent decades, however, this system of growth has plateaued. (At a certain point, you’ve managed to reach every customer.) In an attempt to fix the problem, adjustments were made to the Utility Regulatory Compact. The introduction of retail energy competition in the 1990s and the efforts at decoupling in the 2000s were attempts to rejigger this aging agreement.
Yet the basic structure remains the same. Utilities are granted a monopoly to distribute and/or sell energy in specific geographic areas. In exchange for this exclusive right, utilities are allowed to earn a return on the capital they invest, but only for expenditures deemed “prudent” — or reasonable, necessary, and in the public interest — by PUCs.
Regulators set rates based on allowed investments and a target Return on Equity (ROE), which takes into account capital costs and utility performance. Operating costs and other non-capital costs—such as money spent on energy efficiency—are typically considered “pass through” expenses, and therefore receive no return. In practice, it means that utilities are incentivized to spend money on conventional, centralized infrastructure instead of directing their funds to new, and oftentimes, distributed solutions.
The Utility Regulatory Compact needs to be updated
While the Utility Regulatory Compact 1.0 served society reasonably well, it has started to hit a wall in the last few decades. In a world where both electricity demand and clean, distributed energy is exploding, myriad new challenges now face the utility sector.
The good news is that our energy supply is getting cleaner and cheaper. The bad news is that fixed costs are rising faster than supply costs due to the challenges in building and repairing infrastructure. Looming over all of this are “black swan” utility bankruptcy risks, driven in large part by catastrophic events such as flooding and wildfires that are intensifying due to climate change.
“[T]he regulatory climate in a few states has raised the specter of zero profitability or even bankruptcy (an actual outcome at California’s largest utility and a current threat in Hawaii). In such jurisdictions, it is difficult to project both earnings and asset values in what was once regarded as among the most stable industries in America.”
-Warren Buffet’s 2024 annual letter to Berkshire Hathaway shareholders
Such challenges make the current Utility Regulatory Compact outdated. The virtuous cycle of delivering more energy with lower rates is broken. To even maintain our existing energy system, raising rates is inevitable. Additionally, the rise of Distributed Energy Resources (DERs), such as solar energy and electric vehicles, are disrupting energy forecast models and making the definition of a utility “asset” increasingly complicated.
And while electricity demand is increasing due to AI data centers, industrial onshoring, and both building and vehicle electrification, producing more energy is no longer universally perceived to be a good thing. Our electrical systems now have to cope with climate change and ever increasing grid constraints. And in some cases, policymakers are even pushing for the downsizing, if not elimination, of energy systems (e.g. gas distribution pipelines) due to cost, climate, and safety considerations.
A new Utility Regulatory Compact can evolve our energy systems
A new Utility Regulatory Compact can bring our energy systems from the original centralized system that ran on fossil fuels into a 21st-century model built on clean, distributed energy. The Utility Regulatory Compact 2.0 must include the key paradigm shifts necessary to evolve America’s energy system.
For one, the grid should be managed through the lens of both supply and demand flexibility. Currently, most utilities view demand as fixed and ramp up supply (e.g. “peaker” power plants) to meet the demand. But we have the tools to dynamically manage both supply and demand, ramping energy use up and down via price signals and technology.
Utility investments also need to be considered from both an engineering and probabilistic lens. Currently, most utility planners take a bottom up approach to infrastructure investments—looking at the physical state of distribution systems compared to near-term load forecasts. But utilities can do better by investing in distributed energy technologies (energy efficiency, batteries, etc.) that “bend the curve” of demand growth in critical areas.
None of this is possible, however, without updating the utility business model to better align with what society needs today. Currently, utilities have a low-risk, low-return capital structure with a bias towards capital investment—Wall Street investors get steady returns but nothing that can outperform high growth companies. While it is not in anyone’s interest for utilities to become “meme” stocks, there needs to be both an opportunity for rewarding outstanding performance (based on outputs not inputs) and true financial accountability that aligns ratepayer value creation and utility equity value.
Cultural change across stakeholders is also a must. Utilities need to move from a “don’t get fired” attitude to a “get promoted quickly” mentality. Regulators need to make the shift from “preside” to “lead”. And when it comes to resourcing, we need stakeholders (consumer groups, environmentalists, legislators etc.) to support investments in the resources necessary to hire the best people for staffing key roles — strategic planning, forecasting DER management, and so on — at both utilities and PUCs.
This Utility Regulatory Compact 2.0 can be a win for everyone. Let’s not forget the famous quote (that is incorrectly attributed to Albert Einstein time and again):
Insanity is doing the same thing over and over and expecting a different result—which is the place where we find ourselves right now.
Luckily, a new, updated compact has the potential to restore sanity to our energy systems by aligning incentives across utilities, policymakers, and ratepayers.
Over the course of this series, we will explore the vision for a new Utility Regulatory Compact. We’ll dive deeper into the history of the Utility Regulatory Compact, why it needs to be updated, the key challenges to be solved, and the specific solutions that can be embraced by utilities and policymakers across the U.S.