Electric utility regulation and investment in green energy resources

Abstract

Electric utility investment in end-use efficiency and renewable energy resources is examined with current forms of Pigouvian taxes and subsidies that encourage investment in green energy resources. A model of a rate-of-return-regulated firm considers the impacts of policies on social optimality. It shows that cap-and-trade/floor-and-trade forms of Pigouvian taxes and subsidies cause electric utilities to (over) underinvest in conventional generation and (under) overinvest in green resources when the allowed rate of return (is above) equals the cost of capital. Therefore, these forms of taxes and subsidies combined with rate base rate-of-return regulation result in suboptimal investment in one type of asset or another regardless of the level of return exogenously set by regulators. Therefore, public utility investment is always suboptimal, one way or another. The form of regulation is empirically tested from stock price signals and observed by lack of investment in the electric power infrastructure and too much investment in green resources that will not meet renewable portfolio standards and the demand for electric services.

Keywords:

• electric utilities
• energy efficiency
• renewable resources

JEL Classification:

• D92
• L50
• Q40

Acknowledgement

This paper has benefitted from participants at various conferences of the Center for Research in Regulated Industries.

Disclosure statement

No potential conflict of interest was reported by the author.

Funding

This paper is funded in part by the Summer Research Grant Program of the Rutgers University, School of Business – Camden.

Notes

1. The Brattle Group is a premier utility finance and economics consulting group based in Cambridge, MA, USA, that testifies on the cost of equity capital for public utilities.

2. Ê (C) is a production function for emission credits or SRECs as a function of investment in green energy resources, C stands for conservation and renewable resources.

3. Emission permits are sold at competitive auction by the Chicago Board of Trade and SRECs are traded through such exchanges as the Flett Exchange.

4. This is a commonly maintained assumption, which does limit the degree of increasing returns possible, given demand. See Averch and Johnson (1962), Klevorick and Kramer (1973), Baumol and Klevorick (1970), Crew and Crocker (1991), among others.

5. The ratio of the marginal products (slope of the isoquant) is less than the ratio of factor input costs when the allowed rate of return is sufficiently greater than the cost of capital to the extent that α – r ≥ 1/{λ (1−λ)} and λ is the shadow price of increasing the sum of consumer and producer surplus by one unit.

6. The results of stock price event studies are usually questionable since the expectation of a potentially significant event that affects stock prices can be reflected in stock prices before the actual event date. The question still stands as to whether there was some other cause–effect relationship that created falling investment risk in utilities at the time.

7. Muller, Mendelsohn, and Nordhaus (2011) find that the damage from coal-fired plants cause $0.028 per kWh in gross external damage, whereas the recent price (lowest prices since SRECs have existed) of an SREC in New Jersey is $0.15 per kWh and has been as high as almost $0.70 per kWh.