What a Difference a Rate Makes

by Michael Roberts, UHERO, May 3, 2016

UHERO’s Energy Planning and Policy Group has been writing about how variable pricing of electricity, both wholesale and retail, can lower the cost of intermittent renewables. Get the rates right, and facilitate easy open-access to the grid for both buyers and sellers, and amazing things can happen. The idea is that variable rates will encourage households and businesses to shift electricity demand toward intermittent supply, and facilitate creative, low-cost storage of power, all of which would enable cheaper, faster growth of renewables.

Hawaiian Electric Industries (HEI) seems to be moving in this direction. With the right incentives they might move quicker. Unfortunately, the utility has little incentive to implement variable pricing, except to please the Public Utilities Commission (PUC), since these adjustments might do for free what otherwise requires investment in batteries, new power plants and other grid upgrades. Under current regulations HEI grows its profits by maximizing investment, regardless of whether or not those investments are cost effective.

But here I’d like to focus on another rate that can make a big difference in the cost of renewable energy: the interest rate used to finance capital investment. It’s a good time to write about this little detail as the PUC, Consumer Advocate, legislators and others pour over HEI’s latest, more comprehensive revision of the Power Supply Improvement Plan, or PSIP. While there’s lots to study and think about here—all 1200 pages of it—the interest rate assumptions strike me as, well, high. And I wonder if these could be a key factor underlying some differences between HEI’s plan and our own Matthias Fripp’s plan. The plan also includes off-shore wind, which at a cost of about $4/Watt, may be an economic part of the portfolio—it will be good to incorporate this possibility into Fripp’s planning model.

Table 1. Hawaiian Electric Industries assumed cost of capital in the PSIP (p. J-4)

Here’s the crux: interest rates have been trending down for the last 35 years, and sit near all time lows today. And there’s little hint in market data that they’re likely to go up much soon. Yet, in the midst of these low rates, HEI’s new PSIP uses rates that were typical for utilities some 20 years ago.

HEI’s assumed cost of capital is comprised of 57% equity, for which they claim a cost of 11%, which exceeds rates that many public utility commissions complained about as early as 2004, when market interest rates were much higher than they are today. Expectations for future rates of return on equities are smaller today than they were ten or twenty years ago, and utilities tend to have lower-than-average rates of return because they are considered safe, since returns are all-but-guaranteed by the government. Rates for debt also appear roughly 20 years old. Today, typical rates on corporate “a” bonds, a conservative rating for utility investments, are less than 3 percent on average, and barely over 4% for long-term issues. HEI assumes 7% for long-term debt, which is assumed to comprise 39% of capital costs. The return rate for equity is a policy decision, but it stands to reason that rates ought to follow market rates, which have come down 3-4 percent since 10% was typical.

Clearly, higher overall interest rates would imply higher overall generation costs and higher rates for customers. But the rate also influences the cost-effectiveness of different generation mixes. For wind and solar, nearly all costs are for up-front capital. Conversely, for traditional power generation (oil, coal, natural gas and biofuels), fuel and operation costs generally comprise a larger share of cost than generating equipment. Higher rates therefore favor traditional generation.

Another more subtle consideration is that solar and wind investments have lower risk premiums than traditional fuel-based generation. The reason is that solar and wind pay a higher dividend if fuel prices spike, which is just the opposite of traditional fuel-based generation. This means solar and wind can do more to reduce risk from the larger investment portfolios of typical equity shareholders, and should therefore have a somewhat lower cost of capital.

The upshot of all this is that the high rates used in the PSIP artificially make natural gas and biofuels more attractive from a cost perspective than solar or wind, and generally cause the projected path of customer rates to be higher than they need to be. Two or three percentage points can make a really big difference, as any homeowner with a mortgage can tell you. You can also get a sense of the magnitudes by playing with our solar calculator (now mostly obsolete due to the end of net metering).

We shouldn’t blame HEI for doing what they can to negotiate rates up, for the rate on equity, and the share of capital they finance with equity, is their main channel for growing profits. HEI has a legal obligation to its shareholders to seek to maximize profits, which the new PSIP does skillfully. It’s even better for them if higher rates causes capital investments better-suited to HEI (like developing a new traditional power plant, or retrofitting an old one) to be more attractive than those best suited to a third-party provider. And making the rate for debt similarly high may help to obscure the fact that the equity rate is so high. The problem with cost-of-capital rates falling much less than market interest rates is not unique to Hawaii, although the PSIP rates still appear higher than typical.

As I’ve argued earlier, regulatory incentives could be changed such that HEI would have an incentive to find the most inexpensive and cost-appropriate capital possible and implement variable rates. This could also help HEI align its profit-oriented goals with the state’s affordable, renewable energy goals. The trick is to divorce their profits from the size of their own capital investments, and instead link profits to improvements in overall cost efficiency of the system, including distributed energy. Other states are also flirting with different incentives for utilities. Finally, build renewable energy goals directly into the cost structure by taxing fossil fuels and/or subsidizing renewables, regardless of source. This approach is one option for a “new business model” that many vaguely refer to.

Other models could work too. I gather that many see these high rates and conclude that a government municipality or cooperative, which would have considerably lower capital costs, as the answer. But it’s important to keep in mind that these alternative structures have incentive problems too. Another option would be to replace HEI with an Independent Service Operator, or ISO. I’m still learning about ISOs, but think the model could hold a lot of promise for Hawaii. I’ll have more on ISOs in another post.

Today’s low interest rates, combined with remarkable technological advance in renewable energy, creates what could be an amazing opportunity for Hawaii. It’s conceivable to me that we could transition toward 100% renewable faster than many currently believe. Maybe not in Dinah Washington’s 24 little hours, but soon enough. But to do it, and do it cost effectively, means getting the rates right.

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UHERO: The Conversation: Michael Roberts on What a Difference a Rate Makes.