Affordability and Energy Transformation Investment

How does the scale of utility investment for the energy transformation affect customers’ affordability? My essay today addresses that important question:
 

Imagine an electric utility proposing to invest two and a half billion dollars every year for the energy transformation. Or, instead, imagine it proposing to invest three and a half billion dollars every year. Or four and a half billion. Or five and a half billion. Or even six and a half billion.

The energy transformation may indeed require utilities to invest enormous sums, or even more. So, a natural question to ask is, how would magnitudes this large affect customer affordability?

To address this question, I developed a straightforward revenue requirements model. The model characterizes a utility making such investments. It calculates the increase in average residential customer electric bills.

And, importantly, it tracks for the average customer the percentage of their household expenditures for all goods and services that is necessary to pay for one of those services, electric utility service. In other words, electricity’s share of wallet.

The electric bills percentage, or electricity’s share of wallet, is a telling metric for affordability. The lower the percentage, the more money households have left over for their purchase of other goods and services, other than electric utility service. The higher the percentage, the less money they have left over for other goods and services.

Base Case Scenario

The base case assumes that the utility has two million residential customers. The model I developed is flexible. I could have just as easily chosen a smaller or larger utility and other assumptions accordingly.

The model also assumes the utility has a typical capital structure and costs of debt and equity. The overall cost of capital in the base case is 7.35 percent. Debt is assumed to be fifty-eight percent of the capital structure. Equity is the remaining forty-two percent. Debt’s weighted average cost is assumed to be 5.8 percent. Equity’s weighted average cost is assumed to be 9.5 percent. I can vary these parameters too in running the model.

Depreciation expense is assumed to be four percent of net rate base. This ratio is not unusual and keeps the model simple and comprehensible.

The residential class’s allocation of revenue requirements is assumed to be thirty percent. Similarly, this proportion is simple and keeps the model simple and comprehensible.

The growth per year for the number of residential customers is set at one and a half percent. The growth per year for average customer household expenditures, for all goods and services, is set at three and a half percent.

Before the model considers the investment of billions for the energy transformation, average customer household expenditures and average electric bills are set at seventy-three thousand dollars and sixteen hundred and eighty dollars, respectively, per annum. These were the national averages in the year 2022.

So, the average percentage of customer household expenditures necessary to pay electric bills at the beginning of the model’s year one is 2.3 percent. That’s the initial share of wallet.

Investing $3.5 Billion Per Annum

Our first exercise of the model is to further assume that the utility invests three and a half billion dollars in each of three years, for a total of ten and a half billion over the three-year period. Doing so would raise the utility’s total revenue requirements by about three hundred and ninety-seven million dollars each year. The revenue requirements for the residential customer class would rise by about a hundred and nineteen million dollars each year.

Average residential electric bills would consequently go up by around sixty dollars, another fifty-nine dollars, and another fifty-eight dollars in years one, two, and three. Or, on an average monthly basis, a little less than five dollars in each of the years.

The average percentage of total household expenditures that is necessary to pay electric bills would remain at 2.3 percent throughout the three-year period. Electricity’s share of wallet in this scenario is unchanged.

So, affordability remains unchanged. Average household expenditures for other goods and services, that is, other than for electricity, increases from about seventy-one thousand before year one, to about seventy-four thousand after year one, to about seventy-six thousand after year two, to about seventy-nine thousand after year three.

Investing $4.5 Billion Per Annum

Our second exercise of the model was to assume that the utility invests four and a half billion dollars in each of three years, for a total of thirteen and a half billion over the three-year period. Doing so would raise the utility’s total revenue requirements by about five hundred and eleven million dollars each year. The revenue requirements for the residential customer class would rise by about a hundred and fifty-three million dollars each year.

Average residential electric bills would consequently go up by around seventy-seven dollars, another seventy-six dollars, and another seventy-four dollars in years one, two, and three. Or, on an average monthly basis, a little more than six dollars in each of the years. The average percentage of total household expenditures that is necessary to pay electric bills would rise, albeit slowly, from 2.3 percent before year one, to 2.32 percent after year one, to 2.34 percent after year two, to 2.36 percent after year three.

Electricity’s share of wallet has risen a little. But to a level that is not too far from the recent norm nationally. The national average share of wallet was 2.6 percent in the year 2017. And it was higher than that in the years 2018 and 2020.

So, affordability is slightly affected in this scenario. Still, average household expenditures for other goods and services, other than for electricity, increase from about seventy-one thousand before year one, to about seventy-four thousand after year one, to about seventy-six thousand after year two, to about seventy-nine thousand after year three. That’s roughly the same as in the scenario of three and a half billion dollars invested in each year.

Investing $5.5 Billion and $6.5 Billion Per Annum

Affordability is more affected in the scenarios in which the utility invests five and a half billion dollars each year, totaling sixteen and a half billion over the three-year period, and in which the utility invests six and a half billion dollars each year, totaling nineteen and a half billion over the period. At the rate of investment of five and a half billion per annum, the average percentage of total household expenditures that is necessary to pay electric bills would rise from 2.3 percent before year one, to 2.35 percent after year one, to 2.39 percent after year two, to 2.42 percent after year three. The share of wallet in this scenario has risen to 2.42 percent from the initial 2.3 percent.

Affordability is most affected, among the modeled scenarios, when the utility invests six and a half billion dollars each year. At that robust rate of investment, the average percentage of total household expenditures that is necessary to pay electric bills would rise from 2.3 before year one, to 2.37 percent after year one, to 2.43 percent after year two, to 2.48 percent after year three.

Even though the electricity’s share of wallet reaches as high as 2.48 percent, this level isn’t anything close to unprecedented. Indeed, the national average was 2.47 percent as recently as the year 2020, and higher, 2.52 percent, as recently as the year 2016. During the period of 2005 through 2016, the national average was above the 2.48 level in every one of those dozen years.

Revenue Requirement Model’s Dilutive Mechanisms

It is a remarkable result. The rate of investment for the energy transformation has been quite substantially increased in this modeling, almost doubled, from three and a half billion dollars per annum to six and a half billion. Yet, because of the dilutive mechanisms of utility regulation’s revenue requirements model, the impact on affordability is comparatively moderate. A more aggressive investment program and pace would of course impact affordability more.

The costs to support utility investment in my scenarios, and indeed for all utility investment, are spread thinly by regulation’s mechanisms across myriad customers and multiple decades. In the modeling of the four scenarios discussed herein, for every dollar of revenue requirements allocated to the residential class, the utility invested approximately nine dollars.

Steve Mitnick, Executive Editor, Public Utilities Fortnightly, and President, Lines Up, Inc. | E-mail me: mitnick@fortnightly.com