Totex Ratemaking Could Help Keep Rates Affordable Through the Clean Energy Transition
What is totex? The robotic superhero from Hollywood’s next sci-fi blockbuster? A new brand of house paint? Or the hottest new trend sweeping the US regulatory scene?
The answer is none of these — at least, not yet. But totex (or, more precisely, totex ratemaking) is gaining traction overseas, and new RMI research indicates that it would also be feasible in the United States. So, it could be coming to a utility regulatory proceeding near you soon.
Let’s back up. What is totex ratemaking, and why should you care?
Totex ratemaking is a regulatory innovation that could help keep utility rates affordable through the clean energy transition. It is part of the UK’s performance-based regulatory framework RIIO and has also been adopted in Italy — but so far no US state has seriously considered it. Read on to find out why.
Affordability Is a Pressing Concern Today
Keeping utility rates affordable through the coming clean energy transition will be a major challenge. To limit global warming to 1.5°C — as climate scientists say we must if we are to avoid the worst consequences of climate change — the electric system must rapidly decarbonize while also accommodating the growing electrification of vehicles, buildings, and other end uses. In the United States, this could mean replacing much of the existing fossil infrastructure while greatly expanding clean capacity (Exhibit 1). Upgrading the grid to incorporate technological advances, ensure resilience, and replace aging distribution infrastructure will add spending needs to the mix.
If costs are not carefully managed through the clean energy transition, customer bills could rise dramatically. This could create particular hardship for low-income households, many of which already struggle to pay for vital services (Exhibit 2).
Totex Ratemaking Could Help Keep Rates Affordable
To keep costs down through the coming investment boom, utility spending must be cost effective. However, traditional cost-of-service regulation (COSR) creates a perverse incentive known as capex bias. Capex bias encourages utilities to pursue capital-intensive projects (such as power plants and grid infrastructure) over other alternatives (for example, energy efficiency and grid flexibility) — even if those alternatives could save customers money.
Totex ratemaking addresses capex bias by changing how regulators set the amount of money that investor-owned utilities are allowed to collect from customers. Under COSR, utilities are allowed to earn a return for their shareholders on capital expenditures (capex) but virtually nothing on operating expenses (opex). This means utilities can grow their profits by substituting capex for opex.
In contrast, under totex ratemaking, capex and opex are pooled to form total expenditures (totex), and then totex is divided into “fast money” and “slow money” according to a predetermined capitalization rate (Exhibit 3). Slow money is treated like capex under COSR (earning a return for shareholders), whereas fast money is treated like opex. Because the same capitalization rate is applied equally to capex and opex, the utility cannot increase investor profits by spending dollars on capex rather than opex.
To realize its full potential, totex ratemaking should be paired with other regulatory mechanisms that encourage cost containment. For example, the RIIO framework features a multiyear rate plan with a revenue cap, a totex incentive mechanism (TIM), and other strategies to incentivize efficient spending. Thus, under RIIO, totex ratemaking removes utilities’ financial incentive to pursue uneconomical capital projects, while other strategies encourage utilities to select the most cost-effective solutions overall.
Totex Ratemaking Has Not Yet Been Adopted by Any US State
Totex ratemaking is a more comprehensive strategy for addressing capex bias than anything adopted by US regulators to date. However, regulatory discussions about totex ratemaking in the United States have not progressed very far.
A key reason seems to be the perception that totex ratemaking could conflict with US accounting standards — potentially making a utility look like a riskier investment and driving up its cost of capital. The main focus of concern has been the part of US Generally Accepted Accounting Principles (GAAP) that is codified as ASC 980.
The core function of ASC 980 is to allow utilities’ public financial statements to reflect the regulatory assets and liabilities used by regulators to set rates. Regulatory assets track revenues that the utility will be permitted to recoup in the future, whereas regulatory liabilities track obligations to customers. These tools play an important role in US ratemaking; for example, regulatory assets are often used to recover storm costs, fuel costs, and retired plant balances over time.
Given the potential benefits of totex ratemaking, we wanted to know if adopting it in the United States would be feasible. To find out, we interviewed utility accounting experts, credit analysts, equity analysts, and other industry stakeholders. Our research and findings are detailed in a new report and summarized in brief below.
Key Finding #1: Totex Ratemaking Is Compatible with US Accounting Standards
Our first major conclusion is that totex ratemaking is broadly compatible with US accounting standards — including ASC 980. We therefore do not expect totex ratemaking to threaten utilities’ ability to continue reporting regulatory assets and liabilities on their financial statements.
The caveat is that if totex ratemaking were implemented as part of a broader reform package that substantially decoupled the utility’s revenues from its own costs, a utility might lose the ability to apply ASC 980. However, this possibility is less about totex ratemaking than the overall regulatory framework.
Key Finding #2: If There Is an Accounting Conflict, the Consequences Should Be Manageable
We do not believe totex ratemaking will undermine utilities’ use of regulatory assets and liabilities for public reporting purposes. However, even if this did occur, the consequences should be manageable.
The experts we interviewed did not expect that losing the ability to apply ASC 980 would adversely impact utilities’ credit ratings, valuations, or access to low-cost capital. While some regulators who fear such outcomes could implement unnecessary regulatory changes as safeguards, we think it is more likely that any misplaced concerns will dissipate as the evidence-gathering process proceeds.
Should US States Consider Totex Ratemaking?
Whether totex ratemaking should be adopted in the United States is ultimately a question for state regulators and local stakeholders. However, we need innovative strategies to keep utility rates affordable in coming years — and totex ratemaking represents one promising solution. To date, totex ratemaking has been viewed as unworkable in the US context, but based on our research we see no reason why states interested in exploring it should not move forward.
And to any Hollywood producers reading this, we encourage you to make a sci-fi thriller starring Totex. We can’t say whether a robot superhero with a laserlike focus on utility regulatory reform would break box office records — but we would watch it.