In the second installment of Brattle’s Retail Energy Practice Briefing Series, Brattle economists examine how “Utility of the Future” (UoF) developments could affect the measurement and compensation of business, regulatory, and other risks of a utility, especially as measured in its cost of capital.
For many regulated industries, accelerating trends that are challenging their business models may also be causing heightened business and financial risk. “Compensating Risk in Evolving Utility Business Models” discusses how utility cost of capital estimation for regulated industries is likely to face increased need for innovation in both the short and long term. The brief argues that these potential new risks need to be compensated or mitigated so that utility costs can be recovered and investors can continue to have an unbiased opportunity to earn their cost of capital while also continuing to modernize the grid. The brief also explains why mitigation (e.g., by improved rate design and cost-benefit standards for distributed technology adoption) may be easier and more effective than compensation.
The brief outlines several key questions posed by the changing business environment that utility managers and regulators will need to consider:
- Will traditional approaches to measuring the cost of capital continue to serve their intended purpose? If not, what other methods can inform the proper rate of return allowances?
- Should the observed cost of capital be augmented by additional risk premia for asymmetry?
- What other adaptations to ratemaking, rate design, or allowed returns on capital are appropriate to address changing risks?