TODAY’S STUDY: HOW UTILITIES CAN MAKE IT IN A NEW ENERGY WORLD

New Regulatory Models

Sonia Aggarwal and Eddie Burgess, March 2014 (Energy Innovation/America’s Power Plan/Utility of the Future Center – Arizona State University)

Introduction: Changes in the Power Sector

Are We Reaching Tipping Points?

In recent months, a steady stream of commentaries has suggested that the U.S. electric power industry is facing new pressures that may require a fundamental reexamination of the traditional utility business model and the regulatory compact that supports it. Some examples include the following:

Fereidoon Sioshansi, “Why the time has arrived to rethink the electric business model,” Electricity Journal, August-September 2012.

Peter Kind, “Disruptive Challenges: Financial Implications and Strategic Responses to a Changing Retail Electric Business,” prepared for the Edison Electric Institute, January 2013.

Ahmad Faruqui, “Surviving Sub-one-percent Growth,” Electricity Policy, June 2013.

John Slocum, “Threat from behind the meter,” Public Utilities Fortnightly, July 2013. “America’s Power Plan,” Electricity Journal, September 2013. “Why the U.S. power grid’s days are numbered,” Bloomberg Businessweek, August 2013. “Lights Flicker for Utilities,” Wall Street Journal, December 2013.

Many observers have emphasized the role of potentially “disruptive” technologies such as solar photovoltaics (PV), automated demand-response, and other distributed energy resources. Other trends identified include flattening commodity (kWh) sales, evolving wholesale markets, and new environmental regulations requiring plant retrofits or retirements. The Western U.S. has witnessed some of these trends first hand. For instance, cost reductions in solar PV technology have allowed both Arizona and California to eliminate the upfront incentives for new rooftop installations. In Colorado, wind and utility scale PV Purchased Power Agreement (PPA) prices have also declined to the point where they are lower than the average system cost to supply energy. Meanwhile, PacifiCorp and the California Independent System Operator are in the process of establishing an Energy Imbalance Market between their respective balancing areas that could transform how energy imbalances are settled in the West.

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While these developments have potential to bring significant benefits to electricity customers, they are at odds with the traditional utility business model. More specifically, these developments could have the effect of reducing utility electricity sales growth or limiting opportunities for future capital investments. Given the unique role and ability of utilities to deliver modern electricity services to customers, it is important to think about the long-term financial health of these institutions. This confluence of factors raises challenging questions for state regulators: First, what is the significance and urgency of the trends being described and their possible negative impact on utilities? Second, how will utilities adapt to these changes under the current regulatory framework? Third, what potential changes to regulatory frameworks are warranted in response? In other words, these tipping points cause us to ask: Are there modifications -- or more fundamental changes -- to traditional cost-of-service regulation that would be beneficial for achieving 21st century goals for the power sector?

This report intends to begin addressing these questions by providing a snapshot of novel regulatory approaches in the U.S. and abroad. Our goal is two-fold:

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-To place the discussion of threats to the regulated utility business in context by identifying counterbalancing business opportunities —which some utilities are already realizing.

-To introduce the concept of performance-based ratemaking (Section 2) -- one alternative to traditional cost of service regulation -- by providing real world examples that demonstrate modifications to traditional regulation that orient them more toward performance.

This report does not intend to provide a comprehensive survey of modern regulatory practices. Previous efforts have sufficiently documented how traditional cost-of-service regulation (COSR) has evolved in the U.S. Instead we aim to provide snapshots of a few thought-provoking case studies (Section 3) and draw conclusions from these examples in the form of “principles” for regulators and utilities to consider (Section 4). Finally, we provide a perspective on the prospects for performance-based ratemaking (Section 5) and offer some recommendations for next steps (Section 6).

In addition to the discussion, case studies, principles, and recommendations presented, we also provide a comprehensive annotated bibliography of the current literature on performance-based ratemaking and related topics (see Appendix A). Furthermore, in recognition of the growing interest in distributed generation (DG) and its impact on the utility sector as a whole, we offer some insights into the recent impacts of DG on utility earnings (Appendix B). Finally we summarize initiatives related to extreme weather events, such as Hurricane Sandy, that pose new challenges to utilities and regulators in decisions regarding prudent cost recovery (Appendix C).

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Finding Solutions: Goals for the Power Sector

To determine whether modifications to the regulatory framework are needed to achieve society’s modern goals for the power sector, it is first necessary to have a clear idea of what those goals are. Some possible goals are listed in the table below:

Most regulators are quite familiar with these goals, as well as the tradeoffs among them. Indeed, balancing tradeoffs among competing objectives is usually at the core of the most challenging regulatory decisions. However, these performance goals are not always made explicit at the beginning of the traditional cost-of-service ratemaking process. Tools such as Integrated Resource Planning have made strides towards a more forward-looking regulatory process. Yet, despite incremental improvements to ratemaking over the years, traditional cost-of-service regulation in the U.S. can be seen as a backward-looking exercise in many cases – that is, rates are predominately based on incurred costs of utility assets and utility operations. As one recent report observed, U.S. regulatory regimes typically focus on the central question: “Did we pay the correct amount for what we got?” In contrast, other regulatory regimes have emerged (e.g. performance-based ratemaking) that place performance objectives at the forefront, thereby changing the focal question to: “How do we pay for what we want?” In other words, the regulatory regime becomes predicated more on value provided by serving electric customers ("value for money") rather than simply the cost of providing service.

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One Potential Solution: Performance-based Ratemaking

Performance-based ratemaking (PBR) starts with the outcomes that matter to customers, utilities, regulators, and other power sector industry participants. As noted above, these goals might include objectives such as minimizing costs, maximizing reliability, maximizing environmental performance, and enhancing the value of customer service. It aims to align the goals of customers, regulators, and utilities. In performance-based ratemaking, the utility is rewarded based on its achievement of specific performance targets, providing an opportunity to earn a higher return if the company is able to perform on the objectives identified. This contrasts with traditional ratemaking where utility rates are based mainly on incurred costs, which may motivate utilities to overinvest in fixed assets, and may not provide adequate incentives for productivity improvements. Well-designed performance-based ratemaking includes both incentives for over-performance and penalties for underperformance (see Figure A). This system of paying for performance broadens the scope of options utilities can call on to run their business. It can offer investment and business model flexibility to the utilities by decoupling profits from sales, and thus may be able to offset some of the concerns that utilities have raised about revenue erosion from flattening electricity demand and customer-owned generation.

Under some PBR designs, the utility might also be given a multi-year period to try to meet these objectives and must create a business plan for doing so. This performance period provides sufficient lag time to allow the utility time to improve its performance, providing a greater long-term incentive for lowering costs. Performance-based ratemaking encourages utilities to achieve desired goals by granting them some more freedom to innovate and drive efficiency, but in return for that increased opportunity for upside, the utility takes on some of the risk that the customers would otherwise bear under traditional regulation. Essentially, performance-based ratemaking is focused on delivering value, rather than accounting for costs.

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Exploring the potential for performance-based ratemaking begins with engaging important parties to understand system goals (see Figure B). System goals may fall into several categories—for example: cost, reliability, environmental performance. Important customer service outcomes may be measured at the retail level—for example: equity, innovative services, accurate billing. And system outcomes may be measured at the wholesale level—for example: system-wide least cost, reliability resource diversity, open access. It is important to engage a range of parties from the beginning including customers, the Commission, the utility, the grid operator, third-party energy companies, and state policymakers.

Once goals and outcomes are defined in plain terms, the next step is to develop quantitative metrics against which performance on those goals and outcomes can be measured. For each outcome, Commissioners can work with interested parties to determine the appropriate metric, as well as the level above which the utility should receive a reward and below which they should pay a penalty. See Figure C for a visualization of how performance-based ratemaking works. It is worth noting that the utility industry is already driven by standards, and in some cases these standards are tied to financial penalties. Examples might include alternative compliance payments for not meeting renewable portfolio standards, or penalties for violating NERC reliability standards; performance-based ratemaking goes one more step to develop additional standards and makes the reward and penalty structure a central feature of the ratemaking process.

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Clear methodologies for calculating performance (and the counter-factual) should be developed and made available before any performance program begins. The time horizon for performance must be sufficiently long so as to give the utility time to reorient its business around hitting important targets. At the same time, the program should build in opportunities for refinement as players gain real world experience with the performance measures. It is important to strike the right balance between long-term certainty and fine-tuning based on experience. One idea for doing so is to start small: ensure that changes respect investments already made, and that changes affect a relatively small volume of resources (i.e. less than statewide). If the program works well, expand it to larger and larger volumes with improved characteristics based on experience.

Of course, performance-based ratemaking is just one possible tool for achieving system goals, and should not be considered a panacea. Commissions have a long history of making smart trade-offs between worthy goals that are sometimes in competition with one another. Performance-based ratemaking underscores the importance of those choices, and provides a framework within which Commissioners can develop an integrated strategy for those trade-offs in a more transparent and flexible way. Careful attention must be paid to avoid some of the potential drawbacks of performance-based ratemaking, which include the potential for gaming the system if metrics are not chosen properly and measurements are not made and reported carefully. Performance-based ratemaking may require a larger administrative lift up front for both the state PUC and the utility, but the potential payoff is substantial.

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Note that performance-based ratemaking can work in a traditional vertically integrated utility model, or in a more competitive, or restructured system with many third-party service providers. For the former, the Commission sets clear performance targets and the utility works to meet them. For the latter, the utility acts as a market-maker, and uses its powers to buy or build to achieve the clearly-defined objectives as efficiently as possible. To meet the objectives and get suitably rewarded, the utility must be a very efficient buyer of services. In the more competitive case, performance-based ratemaking will only apply to services for which the distribution utility is responsible—but that is a non-trivial suite of responsibilities, including system reliability, local service delivery, and grid stability.

Fortunately, there is a wealth of experience from which to learn. Performance-based ratemaking is not a new concept. Regulators across America have been experimenting with performance-based ratemaking in the energy sector for almost as long as the sector has existed. Much thought and effort has been put into the subject, particularly in the 1990s when a large body of literature was developed on the theory and practice of performance-based ratemaking (see Appendix A.1 for some sample references from this body of literature). The following section describes elements of performance-based ratemaking in action, and extracts principles based on a broad range of experience…

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A Path to Performance-based Ratemaking?

The examples described in this paper illustrate that elements of performance-based regulatory approaches are already used today in many U.S. states and abroad. However, none of the approaches highlighted here are widespread or universal. Moreover, the mechanisms for incentivizing performance frequently appear to be established in an ad hoc or piecemeal fashion, rather than through a more holistic process (with the exception of the UK RIIO example).

As changes in technologies, markets, and economic conditions continue to present challenges to traditional ratemaking, decision-makers in some states may be compelled to transition from their current regulatory framework to one that is more performance-oriented rather than cost-oriented. If such a transition becomes desirable, it may be useful to consider what the end-result should look like and, perhaps more importantly, what the right path is for making the transition. Even if there is agreement that such a transition is beneficial, there will undoubtedly be different opinions regarding the speed and scale of any transition to a performance-based approach.

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States could choose to pursue more holistic changes, such as those undertaken in the UK. These undertakings are more thorough, but also require significant time investment by regulatory staff and other stakeholders. Additionally, the governor’s veto in the Illinois case demonstrates that landmark shifts in regulatory models can often have pitfalls and political implications.

Alternatively, if state policy-makers are not prepared for a whole-cloth change to a new regulatory model, they might consider a more incremental approach that builds a “portfolio” of different performance-based earnings mechanisms over time. New opportunities for utility earnings, such as those illustrated by Xcel’s REC sales or NSTAR’s EE Performance Incentive, could be added incrementally until most utility decisions and investments are oriented towards performance outcomes, rather than commodity sales growth or investment in physical assets. Performance-based earnings could be added either by:

a) Broadening the scope by introducing new performance incentives, or

b) Enlarging the scale by increasing the fraction of utility earnings derived from existing performance incentives (rather than simply cost of service).

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Regardless of the approach (incremental versus holistic), the end result is likely to be similar – a regulatory model that rewards utility employees and shareholders for delivering the outcomes that customers and society value. This “value based” approach contrasts with the traditional cost of service model, which usually incentivizes growth in asset base and sales volumes. Such incentives are increasingly at odds with the industry trends discussed in the introduction to this paper, and performance-based ratemaking provides a solution for utilities and regulators facing the challenges and opportunities in a 21st century power system.

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Recommendations for the State-Provincial Steering Committee and the Committee on Regional Electric Power Cooperation

Recommendations: This initial exploration has revealed some promising attributes of a performance-based approach to regulation that may warrant further consideration by stakeholders in the Western U.S. However, as stated earlier, performance-based ratemaking is not a panacea and requires a thoughtful approach. Accordingly, we recommend that SPSC and CREPC consider the following next steps for developing performance-based tools to adapt to trends unfolding in the industry today.

Possible next steps for SPSC and CREPC:

Develop a handbook for regulators interested in understanding how PBR might be implemented.

Conduct a survey of stakeholders throughout the West to find out what outcomes matter to them.

Develop an inventory of existing and desired regional performance indicators.

Use the “Principles for Designing Performance-based Ratemaking” in this paper as a starting point for developing future work.

Additionally, there are steps that could be taken outside of the SPSC and CREPC forum that both commissioners and utilities could consider. Possible next steps for commissioners and utilities:

Commissioners: Open a proceeding on performance measures.

Utilities: Convene customers and other stakeholders to identify important performance outcomes; bring proposals to your Commission.

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Concluding Thoughts

Commissioners and utilities in the United States today have a choice between paying for value in the electricity system, or paying for capital investment. These outcomes are neither mutually exclusive, nor are they substitutable. Well-designed performance-based ratemaking, drawing from experience to follow the principles outlined here, has the potential to drive important societal outcomes, as well as to create new business opportunities for innovative utilities and third-party players alike, while retaining low costs, high reliability, environmental performance, and customer service.

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