TODAY’S STUDY: A Plan To Help Utilities Perform Better
State Performance-Based Regulation Using Multiyear Rate Plans for U.S. Electric Utilities
Mark Newton Lowry, Matt Makos, and Jeff Deason, July 2017 (Grid Modernization Consortium/Lawrence Berkeley National Laboratory/U.S. Department of Energy)
Berkeley Lab published a report in 2016 that discussed two approaches to performance-based regulation (PBR) of electric utilities: multiyear rate plans (MRPs) and performance incentive mechanisms (PIMs).1 The authors described these approaches at a high level and in the context of growing levels of demandside management (DSM), distributed generation and other distributed energy resources (DERs).
This report presents a more in-depth analysis of the multiyear rate plan approach to PBR for electric utilities, applicable to both vertically integrated and restructured states. The report is aimed primarily at state utility regulators and stakeholders in the state regulatory process. The approach also provides ideas on how to streamline oversight of public power utilities and rural electric cooperatives by their governing boards.
We discuss the rationale for MRPs and their usefulness under modern business conditions. We then explain critical plan design issues and challenges and present results from numerical research that considers the extra incentive power achieved by MRPs with different plan provisions. Next, the report presents several case studies of utilities that have operated under formal MRPs or, for various reasons, have stayed out of rate cases for more than a decade. In these studies we consider the effect of MRPs and rate case frequency on utility cost, reliability and other performance dimensions. Appendices present further information on MRP plan design and some details of the technical work.
What Are MRPs?
MRPs are a comprehensive approach to PBR designed to strengthen general incentives for good utility performance. Two key provisions of MRPs strengthen cost containment incentives and streamline regulation:
1. A rate case moratorium reduces the frequency of rate cases, typically to once every four or five years.
2. An attrition relief mechanism (ARM) escalates rates or revenue between rate cases to address cost pressures such as inflation and growth in number of customers independently of the utility’s own cost.
Loosening the link between its own cost and revenue gives a utility an operating environment more like that which competitive markets experience.
Most MRPs feature a performance metric system that includes some PIMs. These PIMs provide awards or penalties, or both, for performance in targeted areas. PIMs are most commonly used in MRPs to strengthen incentives for utilities to maintain or improve reliability and customer service quality. Some plans also include earnings sharing mechanisms, efficiency carryover mechanisms and marketing flexibility.
Provisions are often added to plans to strengthen utility incentives for DSM. For example, utility expenditures on DSM programs are usually tracked, and PIMs can be added to reward utilities for successful DSM programs. Revenue decoupling can mitigate a utility’s incentive to boost retail sales and reduce risks of revenue losses from rate designs that encourage DSM.
How Prevalent Is This Approach?
MRPs were first widely used in the United States in the 1980s to regulate railroads and telecommunications carriers, industries beset by rising competition. Early adopters of MRPs in the U.S. electric utility industry included California and several northeastern states. Use of MRPs has recently grown among vertically integrated electric utilities in diverse states that include Arizona, Georgia and Washington. Greater use of MRPs for power distributors has been slowed by their requests for accelerated system modernization, which complicate plan design. MRPs are much more common for electric utilities in Canada and countries overseas. The impetus for adopting MRPs in these countries has often come from policymakers rather than utilities.
What Is the Rationale for These Plans?
America’s investor-owned electric utility industry was largely built under cost of service regulation (COSR). This regulatory system traditionally adjusted rates that compensate utilities for costs of capital, labor and materials only in general rate cases. The scope of costs eligible for tracker treatment, which expedites cost recovery, has gradually enlarged and sometimes includes capital costs as well as energy expenditures.
The efficacy of COSR varies with external business conditions. When conditions favor utilities (e.g., are conducive to realizing at least the target rate of return), rate cases are infrequent. Performance incentives are then strong and the cost of regulation is quite reasonable. When conditions are less favorable, rate cases are more frequent and more costs are tracked. Performance incentives can then be weak and regulatory cost can be high. These attributes of COSR are worrisome because business conditions today are often less favorable to utilities than in the past.
MRPs are a different approach to regulation that is especially appealing when the alternative is frequent rate cases or expansive cost trackers. The regulatory process is streamlined and better utility performance can be encouraged due to stronger performance incentives and increased operating flexibility. Benefits of better performance can be shared with customers. Recent advances in MRPs such as efficiency carryover mechanisms and statistical benchmarking can “turbocharge” their incentive power and ensure benefits for customers.
What Are Some Disadvantages of MRPs?
MRPs are complex, and their adoption can involve extensive change to the regulatory system. It can be challenging to design plans that strengthen incentives without undue risk and share benefits fairly between utilities and their customers. Some kinds of business conditions (e.g., brisk inflation and declining average use) have proven easier to address using MRPs than others (e.g., capital spending surges). MRPs can invite strategic behavior and controversies over plan design.
This report discusses six case studies of utilities operating under MRPs:
1. Central Maine Power operated under a sequence of MRPs from 1996 to 2013. The plans afforded the company unusual marketing flexibility which it used to develop special contracts with large-volume customers. These contracts helped the company retain their contributions to fixed costs of the system, for the benefit of all customers.
2. California has the nation’s longest history with MRPs for retail services of electric utilities. The Public Utilities Commission has limited rate case frequency and staggered plan terms to avoid simultaneous rate cases. Plan provisions have provided strong incentives for utilities to embrace DSM.
3. New York has regulated electric utilities using MRPs since the 1990s. The state’s Reforming the Energy Vision proceeding has considered how rate plans should evolve to regulate the “utility of the future.”
4. MidAmerican Energy operated under a rate freeze in Iowa from 1997 to 2013. This freeze extended to charges for energy procured as well as for capital, labor and materials.
5. Ontario, Canada, has used MRPs to regulate the dozens of power distributors since the late 1990s. Capital spending surges have posed special plan design challenges. Innovations in Ontario regulation also include incentive-compatible menus and extensive use of benchmarking.
6. Great Britain also has a long history with MRP regulation. The current “RIIO” approach to regulation of energy utilities there has attracted the attention of many North American regulators.
Impact on Cost Performance
This report also addresses the impact of MRPs (and, more generally, rate case frequency) on utility cost performance using two analytical tools: incentive power analysis and empirical research on utility productivity trends. An Incentive Power Model uses numerical analysis to assess the incentive impact of alternative stylized regulatory systems. For North American case studies, we compared productivity trends of utilities operating under MRPs to U.S. norms. We also considered productivity trends of utilities that operated under unusually frequent and infrequent rate cases.
Both lines of research suggest that the frequency of rate cases can materially affect utility cost performance. For example, the multifactor productivity (MFP) growth of the electric, gas and sanitary sector of the U.S. economy was materially slower than that of the economy as a whole from 1974 to 1985, when rate cases were frequent due in part to adverse business conditions, than in the early postwar period, when favorable business conditions encouraged less frequent rate cases. We also found that the MFP growth of utilities that operated for many years without rate cases, due to MRPs or other circumstances, was significantly more rapid than the full sample norm. Cumulative cost savings of 3 percent to 10 percent after 10 years appear achievable under MRPs.
The case studies and incentive power and productivity research presented in this report have important implications. First, utility performance and regulatory cost should be on the radar screen of U.S. regulators, consumer groups and utility managers. Our research shows that key business conditions facing utilities today are less favorable than in the decades before 1973 when COSR worked well and was becoming a tradition. Today’s conditions encourage more frequent rate cases and more expansive cost trackers. MRPs can produce material improvements in utility performance which can slow growth in customer bills and bolster utility earnings.
Notwithstanding the potential benefits of MRPs, they are still not used in most American states. COSR is well established and there are many accomplished practitioners. It can be difficult to design MRPs that generate strong utility performance incentives without undue risk, and that share benefits of better performance fairly with customers. MRPs invite strategic behavior and controversies over plan design. Continuing innovation of COSR will occur, and this will slow diffusion of MRPs.
However, MRPs are also evolving and remedies to problems encountered in early plans have been developed. MRPs are well suited for addressing conditions expected in coming years, such as rising input price inflation and DER penetration and increased need for marketing flexibility. For these and other reasons, we foresee expanded use of MRPs in U.S. electric utility regulation in coming years.