Can performance-based ratemaking save utilities?

Time for utilities to ask: “How do we pay for what we want?”

Performance-based ratemaking is an emerging solution for utilities’ growing need to respond to new ways customers are getting and using electricity.

There is increasing interest ​in performance-based ratemaking among those thinking about the future of utilities.​ T​hough not new, performance-based ratemaking ​might be re​designed to meet new challenges.

Traditional cost of service regulation is “balancing tradeoffs among competing objectives,” explain Sonia Aggarwal and Eddie Burgess in New Regulatory Models. But cost of service regulation is backward-looking: Rates are mostly based on the incurred costs of a utility’s assets and operations. “Did we pay the correct amount for what we got?” it asks.

Instead, performance-based ratemaking asks, “How do we pay for what we want?”

How does performance-based ratemaking work?

Performance-based ratemaking addresses concerns about the erosion of utility revenues from disruptive technologies like distributed solar and demand-side energy efficiencies. But it also adds revenue opportunities.

“The tweak,” explained former utility exec and Environmental Defense Fund Attorney John Finnigan, “is when a utility’s performance metrics are higher, it is allowed a higher rate of return.”

Proposed performance-based ratemaking plans are aimed at “minimizing costs, maximizing reliability, maximizing environmental performance, and enhancing the value of customer service,” Aggarwal and Burgess say. Performance-based ratemaking’s focus on “delivering value, rather than accounting for costs…aligns the goals of customers, regulators, and utilities.”

Cost of service regulation rates “may motivate utilities to overinvest in fixed assets, and may not provide adequate incentives for productivity improvements,” they explain.  With performance-based ratemaking, there are “incentives for over-performance and penalties for underperformance.” And performance objectives and incentives are clear.

The theory and practice of performance-based ratemaking was thoroughly developed in the 1990s but targets and incentives have developed “in an ad hoc or piecemeal fashion.”

Now, flattening demand, new wholesale markets, new emissions regulations, and the increasingly competitive cost and availability of wind and solar are pushing the power system to​ward reconsidering them​.

“The threat is not immediate,” Aggarwal and Burgess document from recent Wall Street earnings calls and S&P and Fitch public comments. In the short term, legislative and regulatory proceedings will likely “make any corrections necessary to help stabilize utilities” through lost fixed cost recovery mechanisms, decoupling, or revenue per customer mechanisms. In the longer term, though, falling sales and growth prospects could discourage capital investment.

How can utilities move to performance-based ratemaking?

The first step to implementation is defining goals and metrics. Much of that was done in the UK’s Revenue using Incentives to deliver Innovation and Outputs (RIIO), which has been successfully implemented, Finnigan said. And last year’s UTILITY 2.0; Piloting the Future for Maryland’s Electric Utilities and their Customers, done by the UN Foundation for Maryland’s governor, also laid groundwork.

For implementation by vertically integrated IOUs, “the commission sets clear performance targets and the utility works to meet them,” Aggarwal and Burgess say.  In competitive or restructured markets with competing third-party service providers, “the utility acts as a market-maker, and uses its powers to buy or build to achieve the clearly-defined objectives.”

A multi-year trial period would allow utilities to accommodate risks now carried by ratepayers in return for the new opportunities, Aggarwal and Burgess observe. It would also allow utilities and regulators to work toward long-term certainty while adjusting in response to market experience.

A trial period ​would also allow utilities to ​see the ​value of less frequent rate cases. “Instead of being tied to the annual effort of a rate case, a utility can see in performance-based ratemaking long stretches between rate cases and gradual predictable rate increases tied to performance,” former Duke exec and Rocky Mountain Institute principal Owen Smith said.

The biggest challenge, both Smith and Finnigan agreed, is that performance-based ratemaking cannot be instituted under many states’ regulatory frameworks. And legislating change is likely to be difficult for two reasons, Smith explained.

First, it is hard to give legislators’ certainty about how ​constituents’ utility bills will be affected​. ​Performance-based ratemaking​ might increase bills faster or slower than ​cost of service regulation, depending on the utility’s performance.

Second, performance-based ratemaking’s forward looking estimate of what stakeholders want prevents it from showing value in the familiar “installed, in-service, used and useful” cost of service regulation​ value terms, Smith said.

States could instead pursue an incremental approach “that builds performance-based ratemaking earnings mechanisms over time,” Aggarwal and Burgess suggest, like Xcel’s REC sales or NSTAR’s EE Performance Incentives. Metrics could then be broadened either through increasing performance incentives or increasing utilities’ returns on existing performance incentives.

Is performance-based ratemaking the answer to utilities’ search for a new business model?

If utilities see the opportunity, if services are priced fairly and in a way the utility can get the total revenues it needs, if the objectives and incentives are fair, if there are rewards as well as punishments, Smith said.

Performance-based ratemaking could also ​change the traditional generation mix and end resistance to distributed generation and energy efficiency if utilities get “a clear signal” those are things stakeholders agree on, Smith added.

By allowing commissioners and utilities to pay for value instead of capital investment, well-designed performance-based ratemaking could “drive important societal outcomes, as well as create new business opportunities for innovative utilities and third-party players,” Aggarwal and Burgess conclude, “while retaining low costs, high reliability, environmental performance, and customer service.”