by Jeff St. John
August 03, 2020

Utilities are facing a future that will require massive investment in software. So why are they lagging behind many other industries in tapping the cost, speed, flexibility and scalability benefits of switching from utility-owned and managed servers and software to software-as-a-service and cloud computing alternatives?

One reason is the cost-of-service regulatory model that allows utilities to earn a guaranteed rate of return on capital expenditures, or capex, while relegating operating expenditures, or opex, to being a mere cost of doing business. Among the multitude of unintended consequences of this regulatory incentive structure is a preference for capitalized “on-premises” information technology, versus the opex costs of cloud computing, at least for large-scale IT expenses.   

Over the past decade, utilities have slowly shifted some computing needs to the cloud despite this disincentive. But the rise of renewable energy and customer-sited distributed energy resources (DERs) is driving an exponential increase in the complexity of utility grid operations, and thus in the computing power they’ll need to manage it. 

That’s why cloud computing proponents are mourning the death of a three-year effort in Illinois, one that could have served as a template for other state regulators to free up utilities to invest in the cloud. By a 3-2 vote earlier this month, the Illinois Commerce Commission (ICC) rejected a proposal to allow investor-owned utilities to treat 80 percent of future cloud computing investments as a capital expense subject to a return on equity. 

The denial shocked clean energy and IT industry groups that have supported the initiative since its 2017 launch. In a scathing dissent, ICC commissioners Maria Bocanegra and Sadzi Martha Oliva called the majority’s decision “an illogical, flawed and severely strained attempt at coming up with reasons to deny a Proposed Rule that achieved consensus” and won unanimous approval from the same commission late last year. 

Cloud computing can allow for cheaper, faster and more effective IT implementations, and avoid the risk of legacy utility-owned systems becoming obsolete, they wrote. And while Illinois’ utilities may have been able to get along without these efficiencies so far, “pressing and known concerns, such as achieving Illinois’ clean energy goals, will require utilities to process huge data sets from renewables, storage, and energy efficiency programs and for managing distributed energy resources,” they wrote. 

That's a view echoed by both U.S. utilities and their state regulators. U.S. investor-owned utility trade group Edison Electric Institute wrote in January that allowing for capitalization of these investments could “provide a level playing field for electric companies to work with third-party technology providers” to help boost reliability, resilience and security of the grid and utility IT systems, integrate clean energy, deploy more advanced customer solutions and reduce customer costs.

The arguments against, and for, capex treatment for cloud computing

In the order denying the Illinois plan and closing the proceeding, ICC Chair Carrie Zalewski and commissioners Ethan Kimbrel and Michael Carrigan wrote that the rule “lacks necessary consumer protection mechanisms” and imposes an “arbitrary” cost recovery method that “provides little oversight” over utility cloud-computing spending. The dissenting commissioners challenged those assertions, noting that the 80-20 split between capex and opex was built on methods already used to determine the capital versus operational value of utility-owned IT investments. 

The majority’s order also noted that changes made last year to Financial Accounting Standards Board (FASB) rules allow companies including utilities to capitalize and expense costs associated with cloud computing. But supporters of the Illinois proposal say that’s not enough to solve the existing disconnects between regulation and IT needs.   

The FASB rule ”never contemplated the impacts of cost-of-service regulation on utilities,” Danny Waggoner, a director at trade group Advanced Energy Economy, said in an email. AEE represents companies including Microsoft, Amazon, Oracle, Salesforce and a host of clean-energy software vendors with cloud-based utility offerings.  

Instead, Waggoner said, the FASB only applies to “implementation costs — the costs incurred to be able to use a solution — and not the solution itself. These upfront costs are typically small in comparison to the actual on-premises or cloud-based solution.”

The Illinois proposal, by contrast, would have been the first in the country to assert a general principle that utilities have so far only been able to argue on a case-by-case basis, he said. In AEE’s view, the reduced costs, increased speed to deployment and greater levels of technical expertise and scalability of applications offered by the cloud offer significant benefits to utilities and the ratepayers that are ultimately responsible for covering the long-term costs of every utility IT implementation. 

“While accounting rules may allow for some expenses adjacent to cloud computing to be capitalized, that’s not the same as a utility regulator providing ongoing authority to capitalize the cost of a cloud solution itself once it passes regulatory scrutiny," Waggoner said. 

Cloud progress and the continuing barriers

The ICC’s order also noted that “more and more utilities are taking advantage of cloud-based solutions without this rule in place” as a reason for voting it down. That view is backed up to some extent by surveys conducted by major utility software provider Oracle. 

For example, from 2016 to 2019, the number of utilities using cloud software has risen from 45 percent to 71 percent. Four-fifths of respondents said they’re planning to use cloud computing for advanced metering infrastructure and meter data management, customer information systems (CIS), geographic information systems and mobile workforce management within the next five years.  

“I think we’ve seen an evolution in what utilities have been willing to invest in in the cloud,” Marisa Uchin, Oracle Utilities’ vice president of global regulatory affairs, said in an interview. In the past 12 months, Oracle has seen a doubling of the number of utilities signing up for enterprise software-as-a-service items such as CIS, meter data management, asset management and customer engagement, for example. 

But the incentive toward capex is still determining which IT services they’re choosing to migrate to the cloud, she noted. “A CIS replacement system for a large utility can run in the large nine figures,” she said. “If they’re going to miss an earnings opportunity on a nine-figure investment, that’s material” — even if the software-as-a-service alternative is far less costly on both an upfront and ongoing basis.

Oracle presents utility clients with “total cost of ownership” comparisons that show clear long-term savings for cloud-based versus utility-owned software implementations, Paul McDonald, senior director of industry strategy at Oracle Utilities, said. But from the utility perspective, “you can see how much better the math works out when the capitalization option is available.” 

Why cutting-edge utility applications may need the cloud

Utilities tend to have an easier time contemplating cloud computing for smaller-scale investments, such as demonstration projects of more cutting-edge applications such as DER management systems, McDonald said. But utilities contemplating scaling up these applications to full implementation will also face some big decisions about how much of the data-intensive capabilities they entail can be cost-effectively hosted as a utility asset. 

“Some of the new ways that our clients want to be able to operate their systems require embedding predictive analytics” and other computing-intensive tasks, he said. But the amount of computing power needed to dispatch DERs and reconfigure networks “is going to fluctuate through the day and the system,” meaning that utilities that want to host those applications will face the choice of overbuilding their on-premises IT assets to match those rare maximum data-processing needs, or move them to the cloud.  

Outsourcing the massive computing requirements of cutting-edge utility applications saves time as well as money, Wood Mackenzie Senior Analyst Fei Wang said. “Customer analytics, energy efficiency engagement — all of those DER management systems can be done significantly faster through the cloud. "

That’s a big deal for utilitywide IT implementations that can take years, she said. “It would make sense that utilities want to capitalize on that” to better align costs on their balance sheets. “If there is no regulatory signal to push for the cloud-based solutions, I don’t see why they would risk it.” 

Utilities tend to downplay the opex-capex divide in their explanations of why they aren’t shifting to the cloud more quickly. Instead, they’ve most often cited concerns about data privacy and system security, which remains the top reason cited in Oracle’s ongoing surveys. 

But there’s little reason to presume that an on-premises implementation by utility IT staff would be more secure than a cloud-hosted implementation conducted by IT specialists, said Gavin Sallery, CTO of Kiwi Power. By way of example, the U.K.-based distributed energy aggregation software vendor has certified its on-premise hardware under the UL 2900-2-2 cybersecurity standard in advance of most utility industry vendors, he said. “People are starting to understand that it is OK to run these important things like control systems in the cloud,” Sallery said. “It would be really expensive to store and process that data in the old model.”

Access to the massive scale of computing available in the cloud “is the only real way to achieve the insights people are looking for.” 

Baby steps toward changing cloud computing’s regulatory status

As for changing accounting treatments for cloud computing, about half of the utility regulators Oracle surveyed in 2017 said they were exploring the option. But the changes that have come about have been limited in value, cloud proponents say. 

For example, Pennsylvania regulators have allowed utilities Duquesne Light and UGI Utilities to treat cloud implementation costs as a regulatory asset. And New York regulators have allowed utilities to prepay for cloud services and treat that expense as part of their rate of return. But these changes have the same drawbacks as using the FASB rule: They don’t include the entirety of cloud computing costs, Oracle's Uchin said.

Alabama may serve as a better example, she said. Last year, Southern Company subsidiary Alabama Power asked regulators to “establish a regulatory asset to amortize and earn a regulated rate of return on software investments that included the cloud,” and the state Public Service Commission approved it within the month.

“Alabama now has a precedent," Uchin said. "I think that will perhaps be the more common path forward,” with utilities seeking dispensation through direct appeals to regulators. 

But this approach doesn’t pack the precedent-setting punch that Illinois’ proposal would have accomplished, in terms of getting broad stakeholder agreement on how to standardize an approach for all cloud computing investments in the future, she said. 

“There were many years of work in Illinois by the commission and its staff, and many stakeholders. It was definitely disappointing to come to this conclusion. That being said, it provided an excellent body of evidence that others can work from.” 

AEE’s Danny Waggoner agreed. “It’s good to just recognize that regulation, however it’s designed, creates incentives. We can make those incentives intentional to drive outcomes we want, or we can live with the unintended consequences of what we have and have suboptimal outcomes for customers.”