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This is the sixth in an occasional series from AEE published in Utility Dive that addresses how the power sector can successfully transition to a 21st Century Electricity System.

Throughout the economy, businesses rely heavily on services to fulfill their needs. In the utility sector, however, the use of services has taken hold more slowly, especially when those services reduce the need for capital investment in their systems. At the heart of the matter is the way utilities recover costs and generate earnings. At stake is faster adoption of modern technology, better service, a more efficient system, and lower costs for customers.

Not every company can be the best at everything. Companies specialize in certain functions and in doing so are able to perform those functions more efficiently, with better quality and at lower cost. The economy at large runs more efficiently when companies specialize and sell their expertise to other companies as a service. Utilities have tremendous expertise in distribution planning and engineering, but should we also expect them to be equally proficient at operating, updating and securing IT systems? How about developing and running demand response programs, or making sure energy storage systems are operating at peak efficiency? Yet, this is what utility regulations push them to do.

The regulatory model in place today has served us well for many years, but is not keeping up with the way business is done today — or what's best for customers as they meet their energy needs. How can regulation encourage utilities to optimize service versus capital expenditures to keep up with a changing grid?

Cost-of-service regulation, which is what we have today, allows utilities to collect earnings as they put money into long-term capital investments — a model developed to encourage utilities to expand and upgrade physical infrastructure in a context of growing demand for electricity. Services that utilities procure do not earn them the same rate of return. Rather, utilities may earn or lose money on services depending on how their operating expenditures match up with expenses projected in rates approved by regulators.

This sets up a business model for profitability whereby utilities expand capital investments in the grid for the long term while minimizing operating expenditures over the short term. But if a service, such as demand response or capacity provided by customer-owned storage, can reduce or defer the need for a utility capital investment, such as a transformer upgrade, the regulatory model may put customer interests at odds with utility financial performance. For the utility, choosing the service solution means forgoing the earnings it would get from investing in a capital solution. For customers, if the service-based solution is lower cost, they end up paying more when the utility pursues the capital investment.

It doesn't have to be this way. Several states are working to provide utilities with the freedom to choose the best solution for customers without sacrificing their own financial performance. Illinois is in the middle of a rulemaking on cloud computing services (which replace utility capital investments in IT hardware and software) while New York and California both allow utilities to earn on distributed energy resource (DER) services that reduce the need for utilities to invest in their distribution systems. Other states are allowing utilities to pre-pay for cloud computing services and earn on them as if the costs were invested capital.

Pre-paying may be a good solution in the short term, but it does not make the most of a service for the benefit of customers. Many services are highly flexible — the best example of which is cloud computing, where additional capacity can be provided on demand and the user can be billed only for the capacity that is actually used. Demand response is another service that is flexible, with different amounts provided year to year as needed.

The difficulty in resolving this problem is that utility earnings on capital investments are embedded in the cost of capital. Utilities pay upfront for investments in their system; over time, customers pay the utilities back, including the cost of the capital that the utility carries while the investment is being paid back. This is the same for a prepaid service, because the utility pays upfront and is paid back over time. However, if a service is paid for as it is used, the utility does not carry the cost over the long term and does not collect associated capital costs from which it derives its earnings.

States that are trying to solve the earnings problem of services and maintain the benefit of their flexibility for customers have to get creative, meshing pay-as-you-go service costs with a cost-of-service model that was built around upfront investments in fixed assets. Both Illinois and California are devising solutions to this problem, but not completely. Illinois' draft rule only applies to cloud computing and California's pilot program only applies to DER for non-wires alternatives.

California's solution is to apply a fixed 4% markup for periodic service expenditures. Illinois, on the other hand, is using a modified amortization schedule that allows for payments over time, but only partially fixes the earnings issue. While the effectiveness of each solution will be determined over time, these states are leading the pack, developing ideas that will be useful to other states as they consider their own solutions.

While the performance of regulatory options can vary, if a service solution is a more cost-effective way to meet a need, regulators should ensure that customers can benefit from it without punishing utility investors.

It can be done. For the sake of an electric power system that meets the needs of consumers as technologies evolve and innovate, they must.