A new kind of problematic regulation

A forthcoming paper lends some structure to the intuition around regulated utilities (these are the vertically-integrated kind, with a local monopoly and their own generation facilities – they’re “regulated” because a state Public Utility Commissions, rather than the market, sets their rates). Gowrisankaran, Langer, and Reguant look to explain why coal has hung on so much longer in regulated markets than deregulated ones during the start of the natural gas boom – 26% of coal capacity in deregulated states was retired between 2006-2018, versus 17% in regulated areas.

They find that the standards Public Utility Commissions use to set rates are likely part of the explanation – to be included in a utility’s rate base (the pool of capital investments on which a utility can earn a rate of return), generation facilities must be “used and useful.” This creates a perverse incentive for utilities to keep expensive legacy facilities operating even if a cheaper option (in this case, natural gas) becomes available.

Interestingly, emissions don’t really factor into the decision over the long term; the authors find the cost advantage alone would be enough for a cost-minimizing utility to retire practically all coal generation over a 30-year horizon. However, the authors make an important caveat on reliability – reducing the rate base too far, without other compensation, could hamstring utilities’ ability to invest enough in the infrastructure that keeps the lights on.