In the face of enormous capital needs, the fundamental principle of energy sector regulation is more important than ever

Ray Gifford is a managing partner and Matt Larson is a partner in the Denver office of Wilkinson Barker Knauer.

Energy policy van — those who most want to see the traditional public service sector disintegrated have a problem. The “regulatory compact” that is variously derided as nonexistent at worst, or pernicious at best, is reaffirming its durability as a fundamental principle of public service regulation. The regulatory compact may be an unwelcome guest in a world of zero marginal costs and distributed resources, but its viability as a measurable, fundamental principle will not fade.

What is a regulatory arrangement? For our purposes, it is sufficient to define it as an implicit (or imagined) agreement between a utility and its regulators: in exchange for profit regulation and an exclusive service area, the utility agrees to prudently invest sufficient capital to serve all demand in that area. On the utility side, it receives assurance that its prudent long-term capital investment will be repaid; on the customer/regulator side, it agrees to return its upfront capital investment to build and maintain the network, but also may limit profits and, in part, exercise management over the utility’s decisions.

But like all real and imagined deals, the pact can be broken and suffers from that evergreen human impulse—opportunism. Once a utility has sunk its capital, political convenience or technological change can make it easier for regulators or policymakers to back out of the deal. By the same token, incentives for a utility to hedge on the deal are certainly there. The deal must exist and be treated in balance: regulators and customers must honor the agreement so that the utility’s capital investment can continue; the utility cannot hedge on the margin.

No less than Warren Buffett has emerged as a leading voice on the need for a regulatory agreement. While Buffett has pointed to Jay-Z as “a guy you can learn from” the Oracle of Omaha himself points the way to the need for a regulatory framework. In this year’s installment of his legendary and always eagerly anticipated letter to investors, Buffett—talking, of course, about his book—notices the challenges to Berkshire Hathaway’s sizable investments in utilities posed by the uncapped liability risk associated with wildfires. Citing not only the losses at Berkshire’s utility PacifiCorp but also the wildfire liability risks faced by Pacific Gas and Electric and Hawaiian Electric, Buffett raises the specter of states that will implicitly undo the regulatory framework: “The established but satisfactory recovery arrangement has been broken in several states, and investors are beginning to fear that such breaks could spread.” Finally, Buffett warns that a public energy model may be the only viable solution if investors like Berkshire refuse to invest capital in an investment that offers limited returns but uncapped liabilities.

Warren Buffett and Berkshire Hathaway will be okay in the end. The world’s most famous investor didn’t become one by throwing good money after bad. But his warning should be heeded.

The United States is experiencing a staggering increase in electricity demand. Policymakers are demanding an energy transition, albeit in different directions and at different paces. The amount of capital that must be invested in the U.S. electric grid is not only substantial, it is enormous. And these capital needs are not driven only by states pushing for a rapid energy transition. The demand forecasts facing all utilities predict significant resource requirements to keep up with electrification, data centers, industrial, and overall rising consumer demand. Whether motivated by “drill, baby, drill!” or “decarbonize now!”, the U.S. utility industry needs mountains of capital to keep up with demand. Meanwhile, analysts note weakening of credit indicators for utilities — a problematic trend when the same entities are key to developing the grid of the future and national and state energy priorities, no matter what those priorities are.

Some commentators have called for “utility reform” or “regulatory reform” to combat so-calledforce field of boredom.” After doing some research, “boredom” is “the state of being tedious,” and tedious means “too long, slow, or boring.” Honestly, I’m not sure that’s the problem. It’s about the need for stability to accelerate investment and accelerate the energy transition at a time of growing load, which is taking us further away from Atlantic and back to Warren Buffett and the original form of regulatory rules: the pact.

The basic wisdom reflected in the regulatory pact is as old as the network industries themselves. Railroads, the original network industry that emerged in the 19th century, required massive capital investments to grow. But railroads shared the same economic imperatives of all network industries: the need for massive upfront capital to build the network and then relatively low marginal costs to deliver the product. Moreover, competition in these network industries played out on a knife-edge between being good for consumers and bad for everyone.

The regulatory compact is a necessary principle that legislators and regulators must consider as a necessary tool for attracting and retaining capital in the sector. Moreover, the principle is agnostic to one’s underlying political preferences. If you believe that the utility sector needs to decarbonize rapidly and invest in clean energy and transmission at scale, then you need a huge amount of capital to make those investments. If you believe that the utility sector needs to electrify transportation and heating rapidly, then you need a huge amount of capital to make those investments. If you believe that nuclear is the only viable long-term answer to a decarbonized energy sector, then you need a huge amount of capital to make that happen. Regardless of the preferred version of the energy future, it is a capital-intensive version, and capital needs are only exacerbated by the wave of demand and load growth that is underway across the country.

To be clear, the regulatory pact as an open-ended rule may be too much of a good thing. It cannot go so far as to protect every maladjustment of capital, nor should it. Performance-based regulation, done well (and this is easier said than done), may alleviate some of the incentive problems embodied in the original design of the pact. Nevertheless, proportionally, the regulatory pact is a necessary rule to induce investors to invest capital in long-lived assets, and we need it now more than ever.