Holding Distribution Utilities Liable for Outage Costs: An Economic Look

1. 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

2. Introduction NASUCA: Outage Liability • To say the least, outages are a considerable problem • DC area “derecho” • NJ/NY Sandy • Predicted to grow with climate change • Higher water • More frequent intense storms: “100 year” every year or two • Most outages involve distribution • Transmission much rarer, if bigger: August 2003 N.E. blackout • Within the purview of state utility commissions

3. The incentive issue NASUCA: Outage Liability • What can (distribution) utilities control? • Pre-storm mitigation • Tree trimming • Burying lines? • Post-storm restoration • How to get them to do it? Look to other goods and services • Medical care • Consumer products • Hold them liable for damages? • Let a rule do the work of PSC oversight?

4. The economic view of liability rules NASUCA: Outage Liability • Incentives, not punishment • How to get business to take the “right” amount of care • What is the “right” amount? • The added expected benefit from being more careful just equals the cost of added care (MB = MC to economics junkies) • If the added benefit exceeds the cost of being more careful, should be more careful: Obvious • 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 cost • Reducing the probability of an outage • Reducing the severity or cost if an outage occurs

5. Getting utilities (or anyone) to do that NASUCA: Outage Liability • They already bear the cost of care • 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

6. Takeaway #1: Why do we need added incentive? NASUCA: Outage Liability • 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 competition • Evaluate safety, performance claims pre purchase • Hold to contract after purchase • Use liability rules when markets don’t work • And markets don’t work, by definition, with regulated monopoly utilities

7. Takeaway #2: Who actually pays NASUCA: Outage Liability • If markets work, consumers pay • Added safety, reliability comes at a cost • Competition sets added reliability price equal to that cast • 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!

8. Basic rule #1: Strict liability NASUCA: Outage 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: • 1. Cost of care—like the market • 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

9. Problem with strict liability NASUCA: Outage Liability • Do consumers want to buy insurance from the utility? • Expected residual outage costs built into rates • People pay whether they’ve taken action to limit costs • Empty, not reload freezer when storm appears to be coming • Having gasoline, water; maybe buying generator • Another way to put it: Moral hazard • If people know damages will be covered, why mitigate them? • 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? • Get more care than ratepayers willing to pay for • End up having to justify spending—NASUCA role!

10. All suggest alternative rule: Negligence NASUCA: Outage Liability 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. Problems with negligence NASUCA: Outage Liability • What is due care? • “MB = MC” principle clear; determination somewhere between difficult and impossible • Damages of an outage • Complicated, down-and-up function of time • “Willingness to pay” to avoid an outage? “Lexus” reliability? • And how does this relate to care to get “MB = MC” level? • Set rule assuming no moral hazard to get care right • Marginal effect: If home destroyed, outage cost zero • Circumstance dependent: Get the political, legal controversy one wants to avoid via a rule

12. How they do it in the UK NASUCA: Outage Liability OFGEM set in 2004 a penalty relative to a benchmark of £48/MWh “Gates” and trigger payments

13. Problems with liability in regulatory context NASUCA: Outage Liability • Profit regulation inhibits cost minimizing incentives • Already mentioned in connection with strict liability • Can regulator commit to impose damages? • Bankruptcy threat on other side • Rate increases cover expected costs, not actual • Maybe the big one—distributional effects • Unlike standard product liability, damages paid to class, not individual based on her loss • Benefits of avoided outages likely correlated with income • Low for those who acted to reduce costs (bought generators) • Costs of increased reliability, restoration correlated with electricity use, probably not as tied to income • “Median voter rule”? Rather than overall efficient avoidance?

14. Reminders and questions NASUCA: Outage Liability 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?