On November 20, the California Public Utility Commission (CPUC) approved a settlement between California utilities and ratepayer advocates in which utilities will reimburse California ratepayers $1.45 billion for the failed upgrades to the San Onofre Nuclear Generating Station (SONGS). Ratepayers, however, will still end up paying about $3.3 billion for the replacement power and decommissioning costs for SONGS. One might wonder why either the utilities or ratepayer advocates would agree to this deal. However, when one considers the regulatory and constitutional implications of the SONGS failure, the compromise might indeed make sense for the parties involved. Nonetheless, the resolution highlights how ratepayers often end up on the hook for expensive and risky investments. It also may illustrate how risky investments may lead to further risky investments. Thus, the SONGS resolution should serve as a case study of why least-risk regulation and incremental investments are necessary in this era of profound change in the electricity sector.
In 2001, Southern California Edison (Edison) and San Diego Gas & Electric (SDG&E) sought CPUC authorization to upgrade two units at SONGS. The CPUC’s authorization to proceed came in the wake of the California electricity crisis, which may have convinced the CPUC that the state needed baseload power from nuclear plants to prevent future blackouts and power shortages. (Never mind that many analysts believe that California had plenty of power generation capacity during the crisis and primarily attribute the crisis to a poorly designed restructuring law and market manipulation.) With the CPUC’s authorization, the utilities set out to retrofit the aging nuclear plants, contracting with Mitsubishi Heavy Industries to perform the work.
During the retrofit process, it became clear that the SONGS upgrades had technical problems. The chosen retrofit technologies had never been tested in the size of the nuclear generators at SONGS. Although some observers (including a vice-president with Edison) voiced their concerns about the possible technological problems the project would face, the SONGS retrofits proceeded nonetheless.
And they failed. In fact, one unit failed after operating for less than one year, and the other lasted about two years. In mid-2013, the utilities closed the SONGS plant permanently. The utilities then asked the CPUC to bill their customers, not their shareholders, for the costs of the upgrades, other capital expenses, and replacement power.
Ratemaking and Failed Investments 101
In a typical industry, this type of failure would be an embarrassment, a huge economic loss for the company (unless it could recover contract damages from the contractor responsible for the upgrades, which the utilities are seeking to do), and possibly the start of bankruptcy proceedings. In the world of electric utilities, however, this type of failure typically spurs a lengthy regulatory process in which the utilities seek to recover expenses for failed investments from their customers.
There is a rationale behind compensating utilities for failed investments: in the world of regulated monopolies, captive customers depend on solvent companies to provide reliable electricity. If an electric utility becomes economically unstable, that utility may not be able to provide the service and future infrastructure upgrades customers need. Thus, even if a utility’s investment goes horribly wrong, the argument goes, customers should still pay for it so that the utility’s shareholders do not abandon the company, which could cause long-term harm to the customers.
This rationale came under heavy fire in the 1970s and 1980s, when investor-owned utilities sought to bill their customers for more than 100 failed nuclear power plant investments. Although several states had laws on the books that assigned the costs of failed investments to the utilities and their shareholders, state regulators nonetheless often required customers to pay at least a portion of the sunk costs of failed investments. Ratepayers were outraged by these decisions, and this outrage led to the development of integrated resource planning in many states, electricity restructuring that broke up vertically integrated monopolies in some states, and the passage of clearer laws making utilities fully financially responsible for their failed investments. California actually pursued all three strategies at different points.
In terms of paying for failed investments, California has a law that states, “the commission may eliminate consideration of the value of any portion of any electric . . . generation or production facility which, after having been placed in service, remains out of service for nine or more consecutive months, and may disallow any expenses related to that facility.” Moreover, if the CPUC finds that the unit retrofit costs resulted from “any unreasonable error or omission,” it “shall” disallow expenses. As a matter of regulatory law, the CPUC thus had authority to reject the utilities’ requests for compensation, particularly if it found the utilities acted unreasonably when retrofitting the units. In fact, the law—“the commission may . . . disallow any expenses related to that facility”—seems to give the CPUC discretion to reject compensation claims for the decommissioning costs. One might wonder, therefore, why CPUC and the ratepayer advocates would have agreed to the settlement terms.
Two justifications likely explain their behavior. First, as discussed above, ratepayers may benefit by keeping shareholders happy. Indeed, Edison’s shareholders seemed relatively nonplussed by the settlement agreement, so Edison should have sufficient capital for further investments in electricity infrastructure. Second, had the CPUC and ratepayers not settled the case, the utilities might have been able to successfully litigate a takings claim.
The Takings Angle
Disputes about failed utility investments involve potential claims under the U.S. Constitution’s prohibition against taking private property without just compensation. In essence, utilities argue that their property has been taken when regulators fail to compensate the utilities for investments the regulators have themselves blessed. Takings law as it applies to regulated monopolies is somewhat unique, however. Courts must consider only the “end result” of a rate order, or how that order will affect the utility’s overall financial integrity and ability to attract investors. Under this doctrine, the Supreme Court itself upheld a rate order that denied utilities any repayment for their $45 million failed investment in nuclear plants, because the resulting loss would amount to less than 2.5% of each utility’s rate base.
Had the CPUC refused to bill ratepayers for any expenses associated with the SONGS retrofits or decommissioning, the utilities likely would have filed a takings claim. Indeed, Edison launched a media campaign in 2013, in which it argued that failure to reimburse the company for the plant would prevent the company from operating effectively. Whether the utilities would have been able to prove a takings claim is unclear, but the potential losses of $4.7 billion, with Edison’s share amounting to almost $3.7 billion, are much higher than other losses courts have forced utilities to bear. The risk of takings litigation thus may have motivated the ratepayer advocates to settle. (Interestingly, some consumers have filed their own lawsuit alleging the CPUC has illegally taken ratepayers’ property by forcing them to pay for failed investments.)
The Cycle of Risky Investments
While the SONGS settlement may make sense from a legal and practical standpoint, it also illustrates how failed investments can actually benefit utilities and even incentivize future bad investments. With SONGS offline, the utilities will need to obtain electricity from other sources, and they will earn a profit if they build new power plants and infrastructure to get that replacement power. Edison had already received authorization from the CPUC to build 1,000 MW of new natural gas generation before it developed its plan to build replacement power for SONGS. The CPUC has since granted both Edison and SDG&E authorization to build more natural gas plants; Edison may now add another 100 to 300 MW and SDG&E may add another 300 to 600 MW of power from any source, including natural gas, to make up for the lost SONGS generation. While both utilities must also get a significant amount of replacement power from energy storage and “preferred resources,” which include energy efficiency, demand response, and renewables, the CPUC has nonetheless authorized an additional 900 MW of natural gas to replace SONGS.
As my colleague, Amelia Schlusser, has written, least-risk planning might help mitigate over-investment in risky fossil fuel plants. Fossil fuel plants are especially risky today because they are typically built to operate for decades, but the energy system is experiencing unprecedented changes. Rather than invest in fossil fuels, utilities would be better off investing in renewables, distributed power, and energy storage systems, as Amory Lovins and others at the Rocky Mountain Institute argued 12 years ago in Small is Profitable. Although the CPUC seems to recognize the wisdom of this approach, it has yet to fully embrace it. Ultimately, by allowing California’s utilities to build new natural gas plants, the CPUC may prove, once again, that one bad decision often begets another in the world of electricity regulation.