California regulators know that utilities stand to lose money when they choose distributed energy resources (DERs) over traditional grid investments, as they’re being asked to do as part of the state’s grand energy policy overhaul.

After all, replacing poles, wires, transformers and substation upgrades with rooftopsolar behind-the-meter batteries, demand response and energy efficiency is supposed to reduce costs, as well as make the grid greener.

But utilities make a guaranteed rate of return on their billion-dollar distribution grid investments -- and any lower-cost DER replacements to that spending could threaten to undercut those revenues. That's a problem for the California Public Utilities Commission (CPUC), which wants to balance the need to bring DERs on-line with the need to keep utilities financially healthy. 

This week, CPUC Commissioner Michael Florio released a proposal to test out one possible solution to this problem -- offering utilities a better rate of return for DER projects that replace more expensive capital upgrades. It's the first CPUC proposal specifically laying out an alternative economic structure to resolve the "conflict between the Commission’s policy objectives and the utilities’ financial imperatives."

Florio heads up the CPUC’s distribution resources plan (DRP) proceeding, which is creating values for DERs as potential replacements for grid investments. But since it was launched in 2014, the DRP has left unaddressed a fundamental problem -- "If the utility displaces or defers such investments by instead procuring DER services from others, it earns no return on the associated expenditures -- such operating expenses are merely a pass-through in rates." 

Florio's suggestion is to “offer a shareholder incentive for the deployment of cost-effective DERs that displace or defer a utility expenditure, based on a fixed percentage of the payment made to the DER provider (customer or vendor).” That incentive would be based on a calculation of how utilities create shareholder value -- that is, make money -- by ensuring that their return on equity, or “r," is greater than their cost of capital, or “k.”

In recent years r has consistently exceeded k by roughly 2.5 to 3.5 percentage points in California and across the country, he wrote. "If this Commission desires to [incentivize] the IOUs to displace some of that investment by procuring DERs, it should offer utility shareholders the opportunity to achieve equal or greater value by so doing." Specifically, “IOUs could be [incentivized] to pursue DERs if they could achieve shareholder returns equal to, say, 3.5% when they choose DERs over more traditional rate-base investments.”

Florio quickly notes that he’s not suggesting that particular figure for the pilot, or any other number at this point. “If the concept is adopted, the next step would be to establish a methodology to determine k and the appropriate incentive rate relative to the difference between r and k," and to vet those values with a stakeholder group that could fact-check the utilities' assumptions. 

At the same time, Florio’s proposed pilot project would ask utilities to identify opportunities for DERs to replace grid investments in a cost-effective manner, and define all-source request for offers (RFOs) for DERs to fit those needs. It would also require them to inform customers in the area of what it’s doing, so that they could “propose their own DER projects or, more likely, various vendors and aggregators could offer packages of DERs in the defined area.”

Opening the floodgates for utility business models

Whether this is the best of many ways to revamp utility business models to incorporate DERs is an open question. One problem with Florio's concept that it may not provide enough of an incentive to make up for the difference between grid investments and DER alternatives, Jim Baak, grid integration program director at nonprofit group Vote Solar, said in an interview this week.

Beyond that, it doesn’t get at “the institutional barriers that utilities have -- the irrational risk-avoidance of doing anything innovative,” he said. “They see third-party DER as a potential risk, because they don’t have control -- they can’t assure that it will show up.”

At the same time, “this is at least addressing an issue that was almost taboo in the last few years,” Baak said. “This has been the Achilles' heel of the entire DRP effort up till this point. Why would investor-owned utilities invest in DER when they have zero incentive to do so?”

In fact, Vote Solar has been asking the CPUC to take up this issue for a long time, he said. In a CPUC filing from August 2015, the nonprofit group suggested several “interim or transitional financial incentives or DER procurement incentives that mitigate or eliminate this misalignment.”

Those could include incentives, such as performance-based ratemaking pilots tied to meeting certain DER deployments, or even “an interim allowance for the IOUs to place DER procurement into the rate base up to the amount of the deferred capital investment until a permanent mechanism is developed." But Vote Solar also suggested prescriptive measures, such as establishing minimum DER procurement targets similar to the state’s renewable portfolio standard. 

SolarCity has its own ideas for how to revamp utilities’ relationship to DERs that it’s been submitting to the CPUC. On the prescriptive side, it’s offered a “distribution loading order” for DRP planning, which would require utilities to assess green and customer-sited DERs ahead of new wires, poles and transformer upgrades.

On the incentive side, SolarCity has proposed an “infrastructure-as-a-service” model that could allow utilities to recover shareholder value for investments in third-party DERs, while sharing some of the savings with ratepayers. Florio’s proposal notes, however, that “split-the-savings” structures have proven problematic in the energy-efficiency programs that have used it in the past, since ”the amount of the savings is uncertain and subject to dispute,” and has led to litigation of the type he’d like to avoid in the pilot he’s proposing.

It’s likely that we’ll see more proposals like these emerge over the coming months, as California’s revamp of its distribution grid investment regime moves forward. As we noted in a recent GTM Squared article, renewable energy companies and environmental groups are pushing for pilot projects that offer approaches to incorporating DERs into grid planning beyond the utility RFP models used to date.