Policy reforms to address California’s electricity rate crisis
California’s high electricity rates have to come into focus in recent weeks with affordability packages proposed by the State Legislature and Administration. These packages consider alternative ways to finance transmission infrastructure as one way to reduce costs.
In this blog we provide context for these proposals by examining a suite of potential options to reduce electricity rates. We show how alternative financing strategies such as public financing or securitization can directly reduce utilities’ revenue requirement. We also highlight the potential for indirect strategies, including increased competition, reduced siting and permitting risk and public ownership of assets.
A key takeaway message is that, to generate meaningful and sustainable rate reductions, major changes to the way transmission infrastructure is delivered in California are likely needed. Recent research commissioned by CSG and Clean Air Task Force shows that a combination of the above reforms could save ratepayers billions of dollars annually while enabling the state’s climate goals.
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California has set ambitious clean energy deployment goals, including to quadruple its solar and wind capacity by 2045. A key hurdle to this deployment is keeping electricity rates in check. Although clean energy is in general cheaper than fossil generation, an enormous expansion in transmission is needed to deliver these resources from regions including the North Coast (offshore wind), Central Valley (solar) and Salton Sea (geothermal). This presents an intermediate issue where rates could spike to pay for this infrastructure and undermine the transition to clean energy. With rates having increased by about 50% in the last three years for most utility customers, there is little margin for error in addressing this problem.
Multiple strategies have been identified as having the potential to reduce rates. Rate reform such as fixed charges could reduce costs for low-income households. Alternative transmission technologies such as advanced reconductoring and grid-enhancing technologies could increase efficiency and reduce the need for new infrastructure. An expansion in western power markets could lower clean energy procurement costs. Moving wildfire hardening from utility bills to other funding sources (e.g., General Fund, Greenhouse Gas Reduction Fund) could provide large near-term rate reductions.
In this blog we focus on a strategy that is less examined but appears to have significant potential: changing the way transmission infrastructure is financed and developed in California. The recent affordability proposals touch on one aspect of this strategy (i.e. a specific approach for infrastructure financing called securitization). Here we step back and highlight a broader set of policy opportunities.
Understanding the revenue requirement
A key concept to understand rate reduction policies is the revenue requirement. This is the amount of money that utilities are authorized to collect by the California Public Utilities Commission each year. It is equal to utilities’ total costs plus a margin for shareholder returns. Policies that reduce one or more of the variables – including return on assets, depreciation, operations and maintenance and taxes – will reduce the revenue requirement and the overall charge passed on to ratepayers (Figure 1).
Figure 1: Revenue requirement calculation for utilities
Strategies to reduce the revenue requirement
We now highlight a series of policies related to infrastructure financing and development capable of reducing the revenue requirement. Although the relative impact of each policy is scenario-dependent, as a guide we estimate that each could provide a double-digit percentage reduction compared to an investor-owned utility scenario. (We provide numerical estimates in the next section).
Alternative financing
Investor-owned utilities finance transmission projects with a mix of debt and equity. The cost of servicing this capital (interest, dividends) is the rate of return. Public financing and securitization are two strategies that aim to generate low-cost debt to replace higher-cost financing – particularly equity – in the capital structure. Public financing involves a public entity issuing a bond and typically provides the lowest-cost debt due to the high credit rating of governments and the bond being tax-exempt. Securitization (in this context) involves a utility issuing a bond that is secured by future rates. This strategy can also provide relatively low-cost debt and overcome barriers such as low credit ratings or weak balance sheets. In general, public financing may be more suitable to high-voltage greenfield projects while securitization could be used for distribution system investments that are the responsibility of investor-owned utilities.
Competitive solicitation
An increase in competition can reduce the revenue requirement by reducing the rate base, which represents the transmission asset value. This is based on evidence from The Brattle Group, which found competitive bids on transmission projects reduced the capital (physical infrastructure) cost by 20-30%. On a $1 billion project, this equates to $200-300 million in savings. A lower rate base would also generate flow-on effects including lower depreciation and taxes. Between 2013-17 less than 7% of all transmission projects were subject to competitive bid in California. Although not all transmission projects are eligible for competition, the state could significantly increase this share for the benefit of ratepayers.
Public ownership
Publicly owned assets are typically not required to pay income tax and may also be exempt from property and sales tax. This can reduce the revenue requirement significantly. Note that public ownership does not necessarily mean public operations – the private sector can continue to operate and maintain transmission assets. In fact, private sector operation may be desirable for efficiency and – by using a special purpose vehicle to implement projects – can shield a public owner from certain operational risks.
Accelerated development
Pre-construction development costs are often capitalized in and can substantially increase the rate base. This is because the pre-construction period is highly uncertain and, at least in California, often takes about 7-years. If we assume a new $1B transmission project incurs 20% of its total cost in pre-construction ($200M) and has a 50% chance of failing, this would add $200M * 50% = $100M to the project in the form of a risk premium for investors.[1] Siting and permitting reforms that increase the certainty of project implementation (e.g., 50% chance of failing down to 25%) and reduce the development time frame (20% of total costs down to 10%) could therefore reduce the rate base.
Other factors
Although not the focus of this blog we can use Figure 1 to highlight how other rate reduction strategies could reduce the revenue requirement:
Alternative transmission technologies: This could reduce the rate base relative to building new transmission infrastructure and therefore the revenue requirement;
Western market expansion: This could reduce the operations and maintenance expense from utilities procuring clean energy and therefore the revenue requirement;
Removing non-essential programs (e.g. wildfire hardening): This could also reduce the operations and maintenance expense and therefore the revenue requirement.
Putting it altogether: Alternative deployment models
A key question is – how meaningful are these policies for reducing rates? CSG and CATF commissioned independent experts to answer this question. We provide a snapshot of the findings below, with a full report and accompanying policy analysis from UC Berkeley–CLEE to be released in the fall.
Approach
To generate cost estimates we needed to identify a potential transmission line or lines. For this we used CAISO’s 20-Year Outlook, which identifies needing up to $63.2 billion in new high-voltage transmission to achieve the state’s climate goals. We then needed a reference scenario to measure cost savings. We assumed a business-as-usual utility scenario with 50% debt and 50% equity financing. We then considered three alternative scenarios that were compatible with some or all of the above policies, including: (i) a wholly-public scenario (public ownership, financing and operations); a public-private partnership (PPP) scenario with private financing and operations (“concession” model); and a PPP scenario with public ownership and financing, and private operations (“lease” model).
Results
The results are shown in Figure 2. The key finding is that alternative models could reduce the cost of new transmission by up to 57%. On the package of CAISO 20-Year Outlook lines, this equates to $133 billion over 40-years, or $3.3 billion in annual ratepayer savings. (Note that the 20-Year Outlook lines are only a portion of California’s total new transmission need.). The main drivers of the savings include: using low-cost public debt to replace equity in the capital structure; ensuring competition in the procurement of the lines; and public ownership to reduce taxes. Private sector operation is also assumed to provide some efficiency improvements. Although not directly assessed, securitization could provide a decent portion of the first tranche of savings, provided it replaced a large amount of equity in the capital structure. Note that we did not assess the benefit of accelerated development and that the CAISO base cost estimate ($63.2 billion) excludes right-of-way acquisition and possible undergrounding, the latter being 8-10 times the cost of conventional transmission infrastructure.
Figure 2: This bar chart shows the potential for 57% cost savings – equal to $3.3 billion annually (left-hand axis) or $133 billion over a 40-year asset lifetime (right-hand axis) – via a PPP-Lease model relative to a business-as-usual IOU financing and development scenario of the 20-Year Outlook portfolio. Technical note: we excluded $4.7 billion of subscriber lines (SunZia, TransWest Express) from the base CAISO estimate ($63.5 – $4.7 = $58.5).
Conclusion
California’s climate goals hinge on deploying an enormous amount of new transmission infrastructure. A key intermediate challenge is developing this infrastructure while keeping electricity rates in check. Different strategies have been highlighted as having the potential to reduce rates, including rate reform, advanced reconductoring and/or moving certain items (e.g. wildfire hardening) from utility bills to other funding sources. In this blog we examined an alternative strategy, which is to change the way transmission infrastructure is financed and developed in California. A combination of reforms including the use of low-cost public debt to replace high-cost equity in the capital structure, increased competition, public ownership and reforms to accelerate development could generate significant ratepayer savings. Public-Private Partnership models are one way to operationalize the suite of reforms and could be suitable for multi-billion dollar greenfield projects that are essential to delivering the state’s climate goals.
For more information please contact Sam Uden (sam@csgcalifornia.com) or Neil Matouka (neil@csgcalifornia.com).
[1] The estimate of 20% of total costs occurring in the pre-construction phase of other transmission projects in the US, including the Northern Pass project in New Hampshire (incurred $318 million in sunk costs during pre-construction, equal to 20% of the total $1.6 billion project cost) and Hydro-Quebec project in Maine (incurred $450 million in pre-construction, equal to 43% of the total cost). For more information, see: New Hampshire, Maine.