Energy Transitions in Regulated Markets

Regulated U.S. electricity markets have transitioned from coal to natural gas more slowly than restructured markets. This contrasts with the predictions from canonical models of regulation that regulated utilities would over-invest in new capital because they are allowed a fair rate of return on capital. In addition, observers have alleged that regulated utilities are operating coal plants even when this is inefficient because they are subject to a “used and useful” standard the only allows them a return on power plants that they use sufficiently. The paper develops and estimates a dynamic model of energy transitions in regulated electricity markets that can explain these stylized facts. In the model of the authors, regulators reimburse utilities for the use of productive assets, while aiming to keep electric rates low by limiting returns on capital when prices to electricity consumers are high. In the short-run, utilities make hourly dispatch decisions to maximize profits given incentives set up by the regulatory structure. This regulatory structure provides two opposite incentives: utilities will overuse expensive coal plants to meet the used and useful standard but this overuse will be constrained to the extent that it results in high electricity prices. In the long-run, utilities decide which plants to retire and in which new technologies to invest. The authors show that regulation slowed the energy transition from coal to natural gas, and that it may have important consequences for the transition to renewable electricity generation.