Capitalizing the Cloud: The Regulatory Challenges

Editors Introduction

The last time the Editors of the ERQ published an Editors Introduction was a year ago when we published a study1 prepared by two law firms, one in Canada and one in the United States that examined the regulatory challenges that were preventing the timely introduction of electricity storage technology into the electricity grid.

This study2 deals with a different technology known as cloud computing. A second difference is that this technology can be employed by both electric and gas utilities. The study is timely. Both Alberta3 and Ontario4 have proceedings underway trying to improve the regulatory process for introducing new technology.

The first step is to understand what cloud computing is. Over the last decade a new digital technology with Internet-based application software hosted by third party providers has been replacing standard computer facilities operated by electricity and gas utilities.

There is a reason why this new technology is operated by third parties. It is large and expensive and it requires significant complex maintenance. However, it turns out it is more efficient than stand alone facilities. The cost reductions are reported to be in the order of 40 per cent.

The cost reduction is just one of the advantages. An important feature of this new technology is that it offers greater security and protection from cyber security threats. The importance of this feature will only increase over time.

The regulatory challenge cloud computing faces is unique. Utilities earn a rate of return on their current investment in stand alone facilities. If they lease services as they do in the case of cloud computing they lose that return. They do not own the asset. The cost recovery is usually limited to recovering the lease payments as operating costs. This creates a regulatory disincentive to moving to new more efficient technology.

This study examines more than the costs and benefits of the new technology. It also carefully examines the range of potential regulatory solutions and considers the different measures adopted by regulatory agencies in Ontario5 and Québec, as well as those in New York6, Pennsylvania7, and Illinois8.

The recent attention by both Canadian and American regulators to this issue was prompted by a November 2016 resolution the National Association of Utility Regulatory Commissioners (NARUC) that represents state public service commissioners in the United States. In that resolution NARUC asked utility regulators to consider the following9:

“whether cloud computing and on-premise solutions should receive similar regulatory accounting treatment, in that both would be eligible to earn a rate of return and would be paid for out of a utility’s capital budget”; and whether “existing regulatory accounting rules may be interpreted, if appropriate, to allow for utilities to capitalize cloud-based software”.

In the preamble to this resolution, NARUC noted:

“WHEREAS, Under current guidelines, a utility may classify investments in legacy hardware and supporting on-premise software as a capital expense, on which it can receive a rate of return; however, if a utility invests in cloud-based technologies, it typically treats the investment as an operating expense, on which it does not receive a rate of return; and

“WHEREAS, The disparity in accounting treatments between these two software approaches creates a regulatory incentive for utilities to invest in on-premise software solutions and creates unintended financial hurdles that hinder utilities from realizing the benefits that so many other industries are experiencing with cloud-based software;”

As noted in the quotation above, concerns over shareholder incentives, and specifically the loss of shareholder earnings associated with traditional capital investments, were a key factor in the adoption of the resolution.

The authors of the study also did a good job of the canvassing Canadian utilities to determine their position on this issue. To summarize, the study found as follows10:

Among the utility stakeholders consulted, there was near unanimous consensus that Canadian utilities should be allowed to defer cloud costs and earn a regulated return (consisting of a debt and equity return) similar to on-premise IT investments, which are part of utilities’ capital budgets as opposed to OM&A. There was a strong desire to “level the playing field” between cloud and on-premise IT investments. Stakeholders stated that if the regulatory accounting treatment continues to treat cloud investments differently from on-premise IT investments, then it will slow the adoption of cloud in the utility context. In particular, as the costs of cloud adoption continue to increase due to larger and larger systems being transitioned to the cloud, the current OM&A regulatory accounting approach will increasingly serve as a barrier with unintended consequences.

Stakeholders noted that, since applications hosted in the cloud versus in on-premise equipment can serve roughly the same business purpose, the regulatory accounting treatment should treat these two delivery approaches in a similar way. Interviewees argued that the costs for the cloud solution simply have a different profile; they become ongoing costs instead of a one-time cost. In order to make the best decisions for ratepayers, the accounting treatment should not be a factor in management’s decision-making. Stakeholders often noted that, for cloud services, current regulatory treatments have evolved slower than the technology itself.

This study was too large to incorporate in the ERQ in the usual fashion. Accordingly, we provide this link to the report:
https://www.energyregulationquarterly.ca/wp-content/uploads/2020/04/CEA_CGA_-Capitalizing-the-Cloud-Report-EN_04.23.20.pdf

Hopefully this summary will point readers in the right direction.

For many years energy regulators faced the question of what assets are “used in useful”, the basic test for determining what assets should be in rate base.11 But as the Ontario Energy Board pointed out 10 years ago, regulators have always had some flexibility.12

The problem today is that we live in a world of rapid technological change. It is increasingly clear that the regulatory process has not made the necessary adjustments to accommodate new technology on a timely basis.

This study is an important first step in addressing the transition to new complex and expensive computing facilities which are often beyond the competence of individual utilities in terms of both capital and technical resources. It is also important to remember that this transition may make the network assets necessary for mission-critical functions more secure in a world of cyber security threats.

 

  1. Paul Kraske et al, “Electricity Storage in North America” (2019) 7:1 Energy Regulation Q 55, online (pdf): <www.energyregulationquarterly.ca/wp-content/uploads/2019/03/ERQ_Volume-7_Issue_1_2019.pdf>.
  2. KPMG, “Capitalizing the Cloud” (March 2020), online (pdf): Energy Regulation Quarterly  <www.energyregulationquarterly.ca/wp-content/uploads/2020/04/CEA_CGA_-Capitalizing-the-Cloud-Report-EN_04.23.20.pdf>.
  3. Market Surveillance Administrator, “Distribution System Inquiry Proceeding 24116 Submission” (17 July 2019), online (pdf): AUC <www2.auc.ab.ca/Proceeding24116/ProceedingDocuments/24116_x005F_X0160_MSADSIModuleOneSubmission_0172.pdf>.
  4. Ontario Energy Board, Letter, “Utility Remuneration and Responding to Distributed Energy Resources Consultation Initiation and Notice of Cost Awards Process Board File Numbers: EB-2018-0287 and EB-2018-0288” (15 March 2019), online (pdf): <www.oeb.ca/sites/default/files/OEB-Ltr-Remuneration-DER-20190315.pdf>.
  5. Ibid.
  6. New York State Department of Public Service, “Staff White Paper on Ratemaking and Utility Business Models” (28 July 2015) at 42, online (pdf): <documents.dps.ny.gov/public/MatterManagement/CaseMaster.aspx?MatterCaseNo=14-m-0101>.
  7. Administrative Law Judge Katrina L. Dunderdale, “R-2018-3000124 et al PA PUC et al v Duquesne Light Company RD” (18 October 2018) at 30, online (pdf): Pennsylvania Public Utility Commission <www.puc.state.pa.us/pcdocs/1590205.pdf>.
  8. Bureau of Public Utilities, “Staff Report to the Commission Regulatory Accounting Treatment for Cloud-Based Computing Systems” (17 June 2019) at 1, online (pdf) : Illinois Commerce Commission <icc.illinois.gov/docket/P2017-0855/documents/288004>.
  9. National Association of Utility Regulatory Commissioners, “Resolution Encouraging State Utility Commissions to Consider Improving the Regulatory Treatment of Cloud Computing Arrangements” (16 November 2016), online (pdf): <pubs.naruc.org/pub.cfm?id=2E54C6FF-FEE9-5368-21AB-638C00554476>.
  10. KPMG, supra note 2 at 25.
  11. British Columbia Hydro v West Coast Transmission, [1981] 2 FC 646, 36 NR 33; Alberta Power Ltd. v Alberta Public Utilities Board (1990), 66 DLR (4th) 286, 72 Alta LR (2d) 129.
  12. Ontario Energy Board, “The Regulatory Treatment of Infrastructure Investment in Connection with Rate Regulated Distributors and Transmitters in Ontario” (15 January 2010), online (pdf): <www.oeb.ca/oeb/_Documents/EB-2009-0152/Board_Report_Infrastructure_Investment_20100115.pdf>.

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