Holding Distribution Utilities Liable for Outage Costs: An Economic Look

Tim Brennan

Professor, Public Policy and EconomicsUniversity of Maryland, Baltimore County

Senior Fellow, Resources for the Future

brennan@umbc.edu

National Association of State Utility Consumer Advocates

Baltimore, MDNov. 12, 2012

Introduction

• To say the least, outages are a considerable problemo DC area “derecho”o NJ/NY Sandy

• Predicted to grow with climate changeo Higher watero More frequent intense storms: “100 year” every

year or two

• Most outages involve distributiono Transmission much rarer, if bigger: August

2003 N.E. blackout

• Within the purview of state utility commissions

11/12/12NASUCA: Outage Liability 2

The incentive issue

• What can (distribution) utilities control?

• Pre-storm mitigationo Tree trimmingo Burying lines?

• Post-storm restoration

• How to get them to do it? Look to other goods and serviceso Medical careo Consumer products

• Hold them liable for damages?

• Let a rule do the work of PSC oversight?

11/12/12NASUCA: Outage Liability 3

The economic view of liability rules• Incentives, not punishment

o How to get business to take the “right” amount of care

• What is the “right” amount?o The added expected benefit from being more careful

just equals the cost of added care (MB = MC to economics junkies)

o If the added benefit exceeds the cost of being more careful, should be more careful: Obvious

o If the added costs exceed the benefits of being more careful, don’t: May be more plausible in a bit than it is now

• What’s the benefit? The avoided expected outage costo Reducing the probability of an outageo Reducing the severity or cost if an outage occurs

11/12/12NASUCA: Outage Liability 4

Getting utilities (or anyone) to do that• They already bear the cost of care

o Will qualify this, as so do customers

• Want them to reap the benefits of being careful

• If more careful, become better off by the expected damages avoided

• To put it in reverse: If less careful, bear the added expected costs of being less careful

• How to do this: Have them bear the damages of a failure

• Get incentive to reduce likelihood, severity, and to restore

11/12/12NASUCA: Outage Liability 5

Takeaway #1: Why do we need added incentive?• In normal markets, ideally consumers could

shop around to get suppliers to be careful, avoid failure, design better products

• To some extent, they do: Car air bags

• But may be difficult, even with competitiono Evaluate safety, performance claims pre purchaseo Hold to contract after purchase

• Use liability rules when markets don’t work

• And markets don’t work, by definition, with regulated monopoly utilities

11/12/12NASUCA: Outage Liability 6

Takeaway #2: Who actually pays• If markets work, consumers pay

o Added safety, reliability comes at a costo Competition sets added reliability price equal to that

casto People decide if the added benefit is worth the cost

• How would this work with utilities?

• Under rate regulation, the costs of added reliability induced by a liability rule get added to the rates

• It’s the ratepayers that end up paying, NOT the utilities! But that’s OK

• The issue is to design a rule that would get distribution utilities to provide just so much reliability as customers are willing to pay for!

11/12/12NASUCA: Outage Liability 7

Basic rule #1: Strict liability• Hold the utility responsible for all outage costs,

period

• Regulator doesn’t have to decide when utility failed to take appropriate care

• The utility invests in care to reduce exposure, but will typically still be exposed to some outage costs

• Prohibitively expensive to make chance of outage = 0

• Ratepayers thus exposed to two costs:o 1. Cost of care—like the marketo 2. Cost of expected outages that weren’t worth preventing

• The second of these is having to buy “outage loss insurance” from the utility, whether wanted or not

11/12/12NASUCA: Outage Liability 8

Problem with strict liability• Do consumers want to buy insurance from the

utility?o Expected residual outage costs built into rates

• People pay whether they’ve taken action to limit costso Empty, not reload freezer when storm appears to be comingo Having gasoline, water; maybe buying generator

• Another way to put it: Moral hazardo If people know damages will be covered, why mitigate

them?o But ratepayers will pay, since the costs of damage given

moral hazard will be put into the rates

• Also, what limits utility spending if passed through?o Get more care than ratepayers willing to pay foro End up having to justify spending—NASUCA role!

11/12/12NASUCA: Outage Liability 9

All suggest alternative rule: Negligence• Hold the utility liable for damages only if it

fails to take “due care”

• In principle, that’s the amount customers would choose to pay for

• If so, in principle utility takes that amount of care to avoid liability

• Cost of that care passed on in rates, but no “insurance”

• Cost of damages that do take place borne by customers when they happen

• This gives people that incentive to take some actions to reduce exposure: No moral hazard

11/12/12NASUCA: Outage Liability 10

Problems with negligence• What is due care?

• “MB = MC” principle clear; determination somewhere between difficult and impossible

• Damages of an outageo Complicated, down-and-up function of timeo “Willingness to pay” to avoid an outage? “Lexus”

reliability?o And how does this relate to care to get “MB = MC”

level?o Set rule assuming no moral hazard to get care righto Marginal effect: If home destroyed, outage cost zero

• Circumstance dependent: Get the political, legal controversy one wants to avoid via a rule

11/12/12NASUCA: Outage Liability 11

How they do it in the UK

• OFGEM set in 2004 a penalty relative to a benchmark of £48/MWh

• “Gates” and trigger payments

11/12/12NASUCA: Outage Liability 12

Problems with liability in regulatory context• Profit regulation inhibits cost minimizing

incentiveso Already mentioned in connection with strict liability

• Can regulator commit to impose damages?o Bankruptcy threat on other sideo Rate increases cover expected costs, not actual

• Maybe the big one—distributional effectso Unlike standard product liability, damages paid to class,

not individual based on her losso Benefits of avoided outages likely correlated with incomeo Low for those who acted to reduce costs (bought

generators)o Costs of increased reliability, restoration correlated with

electricity use, probably not as tied to incomeo “Median voter rule”? Rather than overall efficient

avoidance?

11/12/12NASUCA: Outage Liability 13

Reminders and questions• Liability rules could get distribution utilities to

mitigate outages and restore power more quickly

• But can’t enact thinking that these will stick stockholders, utility executives with the costs

• How much reliability will customers pay for?

• Watch out for “moral hazard”

• But wouldn’t a negligence rule just leave us with the finger-pointing morass we have now?

• What are the distributional consequences? Should wealthy get better service at higher rates?

• Would state management do any better? Snow removal?

11/12/12NASUCA: Outage Liability 14