How innovation and regulation can work together

Posted by Matt Futch, Global Policy Director, IBM on Apr 23, 2013 9:40:00 AM

IBM logoA guest opinion post from IBM. Connect with Matt Futch on Twitter: @energyfox.

The Bloomberg New Energy Finance Summit has two key words; “new” and “finance.”  These words help define the dilemma which U.S. energy regulators find themselves in now.  From its inception, the legal foundation for energy regulation has been focused on reliability and low cost.  However, new energy resources, policy demands, and industry dynamics are placing increasing stress on the financial model that supports our century-old regulatory charters.  Addressing these stresses requires innovation in business models, technology, and – perhaps most importantly – regulation.

Simply put, the grid requires modernization, but the current regulatory/financial model often hinders modernization efforts. Today, energy regulation favors investment in traditional grid assets like power plants, sub-stations, and “stringing more copper.” These kinds of investments are still needed, but over time, they are woefully insufficient to meet new system challenges. 

Let’s take the explosion of solar PV as an example. It is generally more expensive to keep adding more “hard” grid assets and additional backup power to compensate for the variability solar introduces to the mix on the grid.  The solution is to develop smarter energy systems that can help monitor, predict, balance, and reduce the need for expensive traditional approaches to managing volatility, but traditional regulation may not support the necessary investment. 

The big problem seems to be risk.  While criteria for evaluating traditional grid expansion are fairly well known, “smarter energy” investments may appear comparatively challenging. This is because they are both new and subject to very different investment cycles.

Given these dynamics, I’m suggesting that incentive-based regulation might deserve a closer look.  In incentive or performance-based regulation, the regulator sets out specific metrics for the utility and judges the prudence of investments based on success in achieving these metrics.  A revenue premium is established to incent the utility to overachieve, while penalties are assigned for underperformance. 

Arguably the most advanced example of this regime is the RIIO – “ree-oh” – model in the UK. The RIIO model has three key features: a realistic investment cycle (eight-year price controls), clear outputs (customer satisfaction, availability, reliability), and strong financial incentives (revenue adjustments linked directly to outputs).  This seems like a model that could be adopted elsewhere to provide lower-risk frameworks for the kinds of investments in innovation both regulators and utilities agree are needed to modernize our energy systems.

The Bloomberg New Energy Finance Summit will examine critical trends, increased environmental regulation, high penetration of renewable power, rising consumer expectations, and efficiency mandates.  Many of these trends pose real financial and business model problems for the utility industry.  I think everyone can agree that energy providers cannot address the challenges posed by these changing industry dynamics simply by adding “more of the same.”  But most people also agree that the current regulatory system is not built to stimulate smarter energy investments needed to achieve these goals.  As such, let’s encourage the global regulatory community to consider new approaches that help develop an enabling environment for a reliable and cost effective grid.  

Topics: Guest Post