Over one hundred years later, the Utility Regulatory Compact endures as the primary governing idea for how we invest in domestic electricity and gas infrastructure. As we approach the end of the first quarter of the 21st century, regulators and other policymakers are grappling with new challenges — challenges that demonstrate that a 100-plus-year-old compact no longer makes sense. Our energy system is under greater strain than ever before. At the same time, utilities are facing existential business challenges that limit their growth and can even threaten bankruptcy.
It’s time to rework the Utility Regulatory Compact. But to do so, we have to diagnose why it needs to change.
In this series, Sealed president and founder Andy Frank explains the vision for a new Utility Regulatory Compact. We’ll dive deeper into 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.
Explore other pieces in this series:
- Introduction: Utilities need a new regulatory compact
- Part 1: The deal that unlocked 100+ years of energy growth
More energy is no longer a universal good
During the first ~70 years of the modern utility industry, executives and policymakers only saw electricity demand grow. Providing electricity and gas to people who never had it before was a relatively straightforward means of growing the entire sector — one that benefited both parties. By investing in infrastructure that added more customers, and therefore more sales, utilities could keep the rates low, a win for consumers. Eventually, however, virtually all homes and businesses were electrified (with some of this due to governmental investments in public power entities, like the Tennessee Valley Authority), and load growth began to slow.
By the 1970s, the traditional growth enjoyed by utilities for decades was no longer inevitable as electricity usage began to level out, with virtually no electricity growth from 2000 to today. The primary driver for this shift? Energy efficiency. Between 1970 and today, energy efficiency has more than doubled as economic growth became decoupled from energy usage.
In addition, energy-driven economic growth at all costs was superseded by a new set of societal priorities: protection of the environment. Disasters like the Cuyahoga River Fire led to major environmental laws at all levels of government that mostly regulated point-source pollutants. And after the new millennium, the dangers of climate change became more clear to the public. Dangerous pollutants like carbon dioxide became more of a focus for regulation. Taken together, these forces led to a transition to cleaner fuels — first, to gas as a “bridge” fuel, and, second, to solar, wind, and other low-carbon energy sources.
But while energy growth flattened over the last three decades, that’s starting to change. The onshoring of manufacturing, the construction of AI data centers, as well as building and vehicle electrification are all on track to dramatically increase the electricity demand. Electricity usage is forecasted to increase by roughly 20% over the next decade and by more than 50% by 2050. (And peak usage, which drives most utility costs, can be even higher.) If this growth is not properly managed, there could be real consequences for our energy bills and our planet.
In other words, the world has changed — more energy of any kind isn’t seen as an unequivocally good thing. We still need to grow our economy, but we want to use as little energy as possible and we want our power to be as clean as possible.
Capital investments are no longer directly related to ratepayer value creation
One of the foundational realities of the Utility Regulatory Compact is that utility financial value creation is tied directly to utility capital investments. The policy justification for this is that monopolistic investments in capital are more efficient than distributed investments. This assumption was largely true for energy generation until the early 1970s, with capital efficiency and an expanding system leading to consistently lower electricity prices.
After this period, however, the capital efficiency of power plants started to flatten and eventually decline. Hitting a cap on capital efficiency (i.e. not being able to drive higher thermal efficiency with bigger and bigger power plants) meant that electricity prices stopped dropping as well.
The period after the 1970s saw a dramatic shift in cost structures for utilities… the marginal cost of providing electricity to new customers began to exceed the rate impact benefits, due to a combination of regulatory changes and increasing complexity in grid management.
Severin Bornsetin
The passage of the Public Utility Regulatory Policies Act (PURPA) in 1978 also opened the door for energy generation competition, including combined-cycle natural gas plants that were both smaller and more capital efficient than the large power plants (many of them nuclear) in which utilities had historically invested. As Virginia Tech history professor Richard Hirsch writes in his seminal book Power Loss: “Unlike traditional turbine generators built before the 1970s, gas turbines did not demonstrate appreciable economics of scale … [M]oreover, gas turbine powerplants in the mid-1990s could be installed quickly.”
At the same time, nuclear construction costs skyrocketed, leading to some of the first major regulated utility bankruptcies, including the Long Island Lighting Company (LILCO). LILCO estimated the costs of its Shoreham nuclear plant at $75 million, but it ended up being more than $4 billion, or two times the book value of the company’s assets.
The upshot is that capital investments continued to grow faster than supply costs. Over the last two decades, utility capital investments increased 60%+ from 1997 to 2017 (~$30B to ~$50B in 2017 dollars) while load growth was virtually flat. Meanwhile, the percentage of the utility bill going to deliver power (as opposed to generating it) increased by 65% between 2010 and 2020.
If these trends continue, utilities could start to see a “utility death spiral” dynamic. More and more customers defect to non-utility energy sources (solar, storage, etc.), which in turn raises prices for the remaining customers, which only serves to encourage more system defection. Alarmist? Perhaps, but check in with MySpace and Blackberry to see what happens when network effects reverse.
Part of the problem here comes down to the cost and feasibility of capital investments. Utilities (and others) struggle to actually build capital projects. Permitting challenges and related NIMBY effects make it difficult to construct major infrastructure; utilities that rely on capital investment to sustain growth are betting on local buy-in that may just not be there.
And it doesn’t matter whether projects are coded “dirty” or “clean.” In California, utilities are unable to install the electric infrastructure necessary to enable the demand for electric trucking in part due to local permitting requirements that can delay projects for years. Local opposition to renewable energy projects has been increasing significantly. Large battery projects, for instance, are being canceled due to local opposition around fire safety.
At the same time, ”dirty” projects like large gas pipeline projects like the Northeast Supply Enhancement (NESE) project have been canceled due in large part to environmental pressure. Similarly, permits for gas power plants are being denied in California and other parts of the country due to local pollution concerns. Even utility substations can face local opposition due to safety and aesthetic concerns.
Utility capital is not getting the safety it desires
Another key tenet of the Utility Regulatory Compact is that having a monopoly creates the financial safety necessary to keep the cost of debt low for ratepayers. This has arguably never created the capital safety that regulators and utilities (and their investors) desire. Interest rates have been the biggest driver of the cost of capital even though most rate cases don’t automatically adjust earning potential based on changes in interest rates.
In other words, when interest rates are low, regulators sometimes allow utilities to earn above-market returns. But when interest rates are high (as has been the case for several years), utilities earn less and therefore underperform the market.
Climate change, meanwhile, is creating more severe weather events that threaten to bankrupt utilities. PG&E, the largest utility in the U.S., for example, has gone through several rounds of restructuring and bankruptcy due to wildfire liabilities. Thanks to a concept called “inverse condemnation,” utilities can be liable for disasters like fires if their infrastructure plays a role in starting or exacerbating them.
PG&E’s century-old infrastructure played a role in a series of devastating fires in California, putting them at the mercy of regulators and creditors. Over in Hawaii, Hawaiian Electric recently settled wildfire claims for $2 billion, the size of its entire market capitalization. And today, Southern California Edison is facing lawsuits over the devastating fires in Los Angeles.
Investors are essentially playing Russian Roulette with many utility stocks and bonds. That puts utilities in a tough position. No entity (other than taxpayers) has deep enough pockets to compensate victims of wildfires and other natural disasters that can be tied to utility liability. However, the costs required to effectively mitigate utility-driven disasters are often too high for the public to bear.
Even Warren Buffett shows little faith in the ability of utilities to both build new infrastructure and keep costs low for consumers. In his 2024 letter to investors, Buffett noted that stronger storms, more grid issues, and higher regulatory standards make it harder for utilities to make money.
For more than a century, electric utilities raised huge sums to finance their growth through a state-by-state promise of a fixed return on equity (sometimes with a small bonus for superior performance) … Now, the fixed-but-satisfactory return pact has been broken in a few states, and investors are becoming apprehensive that such ruptures may spread. Climate change adds to their worries. Underground transmission may be required but who, a few decades ago, wanted to pay the staggering costs for such construction?
Warren Buffet
When the Oracle of Omaha thinks the Utility Regulatory Compact is broken, it’s time to rethink our assumptions. The current Utility Regulatory Compact is bad for ratepayers, bad for utilities, and bad for the planet. Ratepayers are seeing higher utility bills even as the cost of producing energy is dropping. Utilities are seeing meaningful limits to their growth even as climate change and severe weather put power generation in a precarious place. And our planet is seeing the effects of too much energy waste driven by outdated policy incentives.
We are entering a new period of energy growth — the difference this time is that bigger is not necessarily better. And that means, we need to re-think (and re-negotiate) the Utility Regulatory Compact that was built on the premise that bigger is better. The question is how to do that.
The foundation of utility regulation is the truth that all regulation is incentive regulation. To update the Utility Regulatory Compact, we need to dive deeper into the economic incentives created by existing regulatory policies and understand the specific mechanisms that are creating so much pain.
Over the course of this series, we will explore the vision for a new Utility Regulatory Compact. We’ll dive deeper into 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.