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.
Background
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.
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