Applying Stakeholder Theory to Utility Regulation

[ Click Here to Comment ]
[  Download PDF ]

Many in the energy sector have called for a transformation of the traditional utility model to accommodate developments in distributed generation, address declining utility financial returns, and facilitate a transition to a low-carbon future.[1] These proponents envision this transformation in a number of ways. Some suggest a shift from traditional cost-of-service ratemaking to more performance-based methods.[2] Others focus on allowing competition to develop within nascent renewable and micro-grid industries.[3] Still others advocate for a new model in which the utility is a service provider and integrator of a variety of energy options, rather than a peddler of kilowatt hours.[4] All of these options appear to maintain one basic paradigm: the bilateral relationship between the utility and its regulator. More precisely, they maintain the regulatory paradigm that pits the investor-owned utility—whose fiduciary duty is to maximize returns to its shareholders[5]—against the regulator—whose goal is to protect the utility’s customers from the utility itself.

While some state legislative schemes purport to allow utility regulators to consider environmental impacts and sustainability issues,[6] the jurisprudence and history of the U.S. regulatory system has essentially locked regulators into a narrow perspective that requires utility investments and business strategies to provide only short-term economic benefits to current customers.[7] Within this restrictive perspective, utility regulators can only consider other interests to the extent that they do not result in additional costs to utility customers. This essay posits that one of the key flaws in the U.S. utility regulatory system is its requirement that utilities and regulators adopt this myopic decision-making process, which limits the potential for consideration of stakeholder interests and more comprehensive systems thinking.

As demonstrated in the corporate context, stakeholder orientation can (1) create value for the firm and improve financial performance, (2) enhance relationships with customers, employees, and regulators, and (3) improve corporate image.[8] Research suggests that positive, active stakeholder relationships are crucial to the successful implementation of environmental policies.[9] On the other hand, when stakeholders are perceived to lack power, urgency, and legitimacy, their interests become less important to firm managers.[10] While expanding the circle of interests considered by utilities and regulators will not solve other problems embedded in traditional utility regulation,[11] a broadening of the consideration of stakeholder interests will almost certainly allow for more comprehensive long-term planning, greater attention to environmental and other stakeholder concerns, and the potential for transformational policy choices.

Stakeholder Theory in the Corporate Context

In the standard model of corporate governance, most consider the basic corporate objective to be the maximization of shareholder value.[12] This principle creates legal barriers that prevent corporate directors and managers from prioritizing other interests ahead of shareholder wealth maximization.[13] In contrast, “stakeholder theory” suggests that all corporate stakeholders—broadly defined as the groups and individuals who impact or are impacted by corporate decisions—stand in relationship with each other[IS2] , and no single stakeholder group should have its interests elevated above all others.[14]

Business scholars and economists have studied and debated the adoption of stakeholder theory from normative and instrumental standpoints, considering both the efficacy of stakeholder theory for value creation and the ethical justification for considering a broad range of stakeholder interests.[15] Some instrumental stakeholder theorists argue that stakeholder theory is consistent with the maximization of shareholder value, because, inter alia, healthy communities are necessary for corporate success, and happy employees work harder and more effectively.[16] In a normative context, stakeholder theory suggests that businesses have moral responsibilities to stakeholders, and that business decisions and ethics are inescapably intertwined. This “integration thesis” asserts that all decisions have an implicit or explicit ethical view and will benefit or harm some stakeholder parties.[17] It is therefore essential to consider the impacts that business decisions have on people and communities.[18]

In the legal literature, debates over stakeholder theory always begin with the question of whether corporate actors can legally pursue such a strategy, given that the notion of fiduciary duty has been interpreted to run narrowly to shareholders.[19] In response to a series of hostile corporate takeovers, in which the drive for corporate profits resulted in harsh consequences for employees and communities, states passed constituency, or stakeholder, statutes in the 1980s and 1990s. These statutes were intended to give corporate directors and officers greater freedom to consider non-shareholder interests.[20] More recently, academics in both business and legal realms have begun to apply stakeholder theory to environmental protection and sustainability issues, examining the responsiveness of corporations to environmental stakeholder concerns.[21]

This Is Not Your Grandmother’s Electric Utility

The original utility regulation model—“Utility 1.0”—sought to provide safe, reliable, low-cost utility services as widely as possible.[22] Utilities were seen as natural monopolies, meaning that significant economies of scale in the generation and distribution of energy would lead to lower rates. Therefore, governments would need to protect, rather than dismantle, utility monopolies.[23] Regulators were expected to be a substitute for competition, acting to protect customers in a market in which utilities were granted exclusive service territories.[24] As part of the classic “regulatory compact,” the utility agreed to serve all customers, including the unprofitable ones, in return for the opportunity to earn a fair return on its investment, comparable to firms with similar risk or industry profiles.[25] The higher expense of serving non-profitable customers was folded into system-wide costs, embedding a system of cost-sharing and subsidies into utility rates. Of course, such a system worked because profitable customers had no other options for service. If they had other options and could seek out alternative, lower-cost providers, they would simply leave the system.

Figure 1: In the traditional bilateral regulatory model, the regulator, typically a public utility commission (PUC), represents customer interests in having low rates and adequate services, while the utility is expected to maximize returns to its shareholders. The regulatory compact, in which the utility agrees to serve all customers at reasonable rates in exchange for regulated monopoly status, underlies this model.

While the classic rate-setting formula, which ties utility profits to invested capital, creates a significant incentive for utilities to make capital investments,^[26] it also makes utilities wary of significant investments that may not be deemed prudent. And it reduces the incentive for utilities to invest in research and development, because utility regulators, which focus on certainty and predictability in creating customer benefits, are unlikely to deem risky new technologies to be prudent.[27] Even if a utility received approval to invest in new technologies, it would only earn back the cost of the investment plus its normal rate of return. Thus, pursuing new technologies not only costs the utility its time and effort, but also yields no additional return. Given these built-in disincentives, it is both predictable and somewhat unfair for critics to lambaste utilities for being too conservative and risk-averse.[28] Indeed, the system has been structured to make them so.

When utility infrastructure was first developed, this regulatory structure made sense. Utilities were encouraged to invest in their systems and all customers received service on a non-discriminatory basis. The regulatory compact maintained the pretense of a market-based system and limited utility profits while ensuring universal access. The system also kept interest rates low for utilities that needed significant infusions of capital, because of the certainty of cost recovery for items included in rate base.[29]

However, in the century since the creation of the regulatory compact, electric utilities and their role in society have transformed. As late as 1907, only 8 percent of United States households had electricity.[30] Thanks to Utility 1.0, that picture changed rapidly. By 1940, that number had grown to 85 percent.[31] In 2014, electric utilities are, quite simply, essential to the basic functioning of our society. We rely on the utility grid for everything from national security to the treatment of drinking water.[32] Damage to the electric grid could “create disruptions of a scale that was only hinted at by Hurricane Sandy and the attacks of Sept. 11.”[33]

Initially, utilities developed as separate entities, confined primarily to single cities or, at most, regions. Today, the situation could not be more different. The interconnected nature of the utility grid means that the actions of any single utility can affect millions of people.[34] The scale of this potential was realized in 2003, when mistakes made at a small utility provider in Ohio resulted in a massive blackout along the East Coast that affected over fifty million people and caused damages that have been estimated between $4 billion and $10 billion.[35]

New technologies and the push for the reduction of greenhouse gases have created profound environmental and privacy issues associated with utilities. In 2010, the energy sector created 87 percent of greenhouse gas emissions in the United States while electricity generation alone accounted for 42 percent of total U.S. carbon dioxide emissions.[36] Tackling climate change will clearly require innovation within the electric utility system. The “smart grid,” which is essential to the integration of distributed generation, allows utilities to collect massive amounts of energy usage data that may be as granular as when customers used a particular appliance, and for how long.[37] While creating the potential for significant improvements in energy efficiency, the smart grid also raises significant privacy issues.[38]

Today’s utilities thus have a complex and far-ranging web of stakeholders with deep interests in the way utilities are operated. Yet due to the operation of the current regulatory structure, utilities are precluded from considering the input of any stakeholders beyond current customers.

Figure 2: The current regulatory model requires the PUC to make decisions based solely on the economic interests of current customers, effectively precluding it from considering the interests of other stakeholders. In turn, the utility is prevented from considering stakeholder input because its decisions must be approved by the PUC.

Regulation Must Evolve to Consider This Web of Relationships

For decades, utilities were considered among the most stable and reliable of investments. Because they regularly returned dividends to their investors, they were considered “widow-and-orphan” stocks, meaning that they were a good choice for those needing a certainty of returns, even if they were never wildly profitable.[39] However, utility credit ratings have dropped significantly since 2001.[40] In May 2014, Barclays downgraded the entire bond market rating for the U.S. electric utility sector.[41] A number of factors have led to this declining financial position, including: (1) the growth of distributed generation and the degradation of the regulatory compact, (2) falling load growth, and (3) an increased need for investment.[42]

The inability of utilities to respond to many stakeholders has arguably exacerbated this situation. For example, utilities have been roundly criticized for their hostility toward the spread of distributed solar generation in their service territories, and have almost certainly alienated customers in the process.[43] Yet this response is hardwired into the regulatory system. As part of the regulatory compact, utilities are required to serve all customers on a non-discriminatory basis, and the cost of serving more expensive, less profitable customers is spread across the lower-cost customers. If those customers leave the system and generate their own energy, costs to other customers rise and, due to the way traditional cost-of-service rates are calculated, utilities may not be able to recover their fixed costs. Moreover, because utility profits are tied to capital investments, if the opportunity to make new generation investments is limited by the growth of distributed renewable resources, utilities lose a key aspect of their value proposition. Unless changes are made to the way utility rates are calculated or utility programs are developed, utilities should be fighting solar projects—their fiduciary duty to their shareholders requires it.

The development of new technologies, including the smart grid, provides another good example of the impact of the blinders placed on utility regulators. Spending money on research and development is unlikely to return a financial benefit to current customers, so it is rarely approved, in terms of cost recovery, by utility regulators.As a result, the firms with arguably the greatest expertise in the retail energy market are precluded from engaging in significant research and development. Even if new technologies are developed, utilities cannot invest in them until their cost is equivalent to or less than other resource options. This problem was illustrated when Virginia’s utility commission rejected a utility proposal to develop a carbon capture and sequestration project because the technology was too expensive and had not been sufficiently demonstrated.[44] Utility regulators have rejected proposals for smart grid projects—which are essential to the evolution of distributed generation and improvements in energy efficiency— simply because they do not return benefits to current customers.[45]

Policy makers have attempted to address these problems through piecemeal legislation that prioritizes certain projects, technologies, or resources, such as renewable portfolio standards or feed-in tariffs.[46] Yet, by their nature, piecemeal solutions often fail to place utilities within a larger policy context, address interrelated project impacts, or consider the impacts of various policy initiatives on unrepresented stakeholder parties. I suggest that, just as there was a call for stakeholder statutes in the 1980s and 1990s, we should be calling for utility stakeholder statutes, in order to begin to address this regulatory failure and improve the functioning of our utility system.

A Proposal

While the concept of adopting a stakeholder statute for utilities sounds relatively straightforward, the regulatory structure, in fact, makes it quite complicated. If regulation were to permit a utility to consider other stakeholders, rather than utility customers alone, when making resource acquisitions, numerous questions would need to be answered. What criteria should the utility commission use when determining if that resource acquisition is prudent? Should the utility be able to include the cost of that investment in its rates? How should the utility prioritize stakeholder interests? In a competitive industry, market prices for the cost of competing goods and services put natural limits on the ability of a company to incorporate stakeholder interests. In the utility sector, there is no significant competitor to provide those limits, and the PUC (public utility commission) would have to decide whether to allow utility customers to pick up the bill for stakeholder initiatives.

Though challenging, this concern should not preclude the development of a utility stakeholder statute. First, the PUC could develop a new prudence standard that does not rely solely on considerations of customer benefits. This could be addressed by creating a stakeholder board to approve utility initiatives, either by a majority or unanimous vote. Initiatives approved by the board would be deemed prudent.

The stakeholder statute could also incorporate by reference state energy policies, such as a reduction in carbon emissions or the development of distributed generation technology, that would have to be achieved by utility programs but do not directly benefit utility customers. The statute could include a cost cap, as is the case with many renewable portfolio standards,[47] permitting the utility to acquire resources or pursue other programs only in the event that its decision did not raise rates more than, for example, 10 percent above the utility’s costs absent the resource or program.

Lastly, states could form regional stakeholder groups to create energy policy plans that would be adopted and implemented at the state level. Creating regional plans and policy goals, such as the adoption of time-of-use rates, the acquisition of smart grid technologies, and the implementation of a carbon capture and sequestration project, would create the potential for regional cost sharing of new technologies and the implementation of controversial new rate structures across similarly situated utilities.

Significantly, the implementation of such stakeholder statutes would require a directive demanding the PUC to adopt programs or approve recovery for resource acquisitions that were deemed prudent under the new policy. If such a directive were not implemented, the PUC would continue to be bound by existing jurisprudence, which limits prudence to only the initiatives that return a financial benefit to current customers. Of course, the PUC would have to be included as one of the stakeholders on a regional policy taskforce or stakeholder board, in order to ensure that the PUC’s experience, foresight, and skills are brought to the table.

Conclusion

Energy usage in general, and electric generation in particular, are integral parts of the current climate-change crisis and are key to the mitigation of future carbon emissions. Working Group III of the Intergovernmental Panel on Climate Change noted that scenarios limiting global temperature increases to 2°C require “more rapid improvements of energy efficiency, a tripling to nearly a quadrupling of the share of zero- and low-carbon energy supply from renewables, nuclear energy, and fossil energy with carbon dioxide capture and storage (CCS), or bioenergy with CCS.”[48] Additionally, the first stage in President Obama’s plan to reduce U.S. carbon emissions focuses on cutting emissions from existing power plants.[49] Yet, progress toward environmental goals is regularly stymied by the utility regulatory system, which cuts off considerations of environmental impacts not directly and financially affecting current utility customers.

As noted above in Figure 1, in a traditional regulatory scheme, the utility acts in the interest of its shareholders, and the regulator acts to protect utility customers and to simulate the forces of competition. This regulatory structure limits creativity and innovation and drives short-term decision making that fails to take into account the diversity and complexity of the utility stakeholder web. Until the regulatory structure recognizes the value and importance of stakeholders beyond the immediate utility customer, the system will not evolve to address the environmental and technological challenges that it faces. The application of stakeholder theory is only one piece of a broader revolution in utility governance, but it is an essential part of this much-needed transformation.