The following is a contributed article by Mark Newton Lowry, president of Pacific Economics Group Research.
Performance-based regulation (PBR) is a popular alternative to traditional cost of service regulation (COSR) of energy utilities. Widespread in Canada, Great Britain, and other countries around the world, there is growing interest in PBR in the United States.
Misconceptions about PBR abound, however, and may keep America's regulatory community from making sound decisions about its proper role. This article considers some of these myths and provides counternarratives.
Myth: PBR is an approach to utility ratemaking that features performance metrics.
Reality: There are four well-established approaches to PBR.
- Multiyear rate plans (MRPs) reduce the frequency of rate cases by escalating revenue using attrition relief mechanisms (ARMs) that are not linked to the utility's actual cost growth during the plan. This can strengthen utility cost containment incentives and free regulatory resources for better uses.
- Performance metric systems use metrics to shed light on performance areas that regulators are concerned about. Performance can be measured by comparing utility values for these metrics to target values (aka benchmarks). Some metrics are used in targeted performance incentive mechanisms (PIMs) that link earnings to measured performance.
- A third PBR approach is to weaken the link between the revenue of a utility and the use of its system. This reduces the "throughput incentive" that prompts utilities to resist demand-side management and distributed generation. Revenue decoupling mechanisms are used in many American states for this purpose. These adjust rates automatically to help a utility's actual revenue track its allowed revenue.
- A fourth approach to PBR is targeted inducements to use inputs that utilities tend to underuse. The inducements include pilot programs and trackers for and capitalization of the cost of these inputs. In Great Britain, utilities must capitalize a share of total expenditures (totex), in contrast to the North American approach where all capital expenditures (capex) and a small share of opex are capitalized
PBR in practice commonly combines these approaches. For example, revenue decoupling is often paired with a PIM that rewards good DSM performance. An MRP may include revenue decoupling, a tracker for DSM expenses, pilot programs and a performance metric system with several PIMs. Regulators in Great Britain and New York, who make imaginative use of PIMs, are longtime MRP practitioners.
Myth: Utilities are the driving force behind PBR
Reality: Utilities are advocating alternatives to COSR today because it is not ideal for them under current business conditions. Especially under historical test years and rate designs with high usage charges, revenue growth does not keep pace with cost growth. But PBR is not the only form of alternative regulation (Altreg) that can accelerate revenue growth. The other options include extra cost trackers, cost of service formula rates, forward test years and high fixed charges. PBR can involve material risk, tight operating budgets and an unaccustomed spotlight on performance issues. Many utilities prefer combinations of the other Altreg options to PBR.
Other parties to regulation, meanwhile, also have concerns about COSR. Under today's business conditions, COSR can yield weak cost containment incentives and high regulatory cost. Incentives to contain fossil fuel use are especially weak. Reflecting this reality PBR has, in many jurisdictions, been championed by legislators, regulators, environmental groups, and/or vendors of underused inputs. Energy utilities in British Columbia, Michigan, and Quebec have resisted PBR while utilities in Alberta and Australia have taken their regulator to court to contest unfavorable PBR decisions.
Myth: The attrition relief mechanisms of MRPs involve indexes based on controversial research.
Reality: Indexed ARMs (e.g., revenue cap indexes) that are designed using research on industry cost trends can automatically compensate utilities for major cost pressures, such as inflation and customer growth, without weakening their performance incentives. Allowed revenue growth can be linked to results of benchmarking studies. Indexed ARMs were first used on a large scale in railroad and telecommunications ratemaking and are widely used today by the Federal Energy Regulatory Commission in oil pipeline ratemaking. In the regulation of retail energy utility services, indexed ARMs are popular in Canada but in the United States are at present widely used only in Hawaii and Massachusetts.
Controversy over methods for choosing the X factor in an indexed ARM formula has arisen in several recent proceedings. However, the ARMs in approved MRPs can also be designed using cost forecasts or a mix of methods. In California, for example, a hybrid approach is sometimes used that indexes opex revenue while capex is assumed in each year of the plan to equal its (carefully-examined) value for the test year or an average of the utility's recent historical capex. A tracker/freeze approach to ARM design has been used in some states (e.g., Arizona and Louisiana) which combines a rate freeze with trackers for some rapidly growing costs.
Myth: PBR tends to favor utilities.
Reality: Utilities have built-in advantages in all established ratemaking approaches. Under COSR, for instance, regulators usually have the evidence to disallow only a small fraction of a utility's cost in each rate case. COSR with historical test years is valued by some parties to regulation for its tendency to undercompensate utilities under modern business conditions. However, this commonly leads to more frequent rate cases and/or pressure on regulators to add cost trackers.
Commission staff and consumer advocates can "retool" to become effective PBR practitioners. The battle over the X factors in indexed ARMs is illustrative. Utilities have rarely won X factor debates in Canada. The Massachusetts regulator has recently dismissed any and all X factor arguments that consumer groups venture but Hawaii's regulator has dismissed any and all utility arguments. Regulators have rejected many PBR proposals by utilities over the years.
Skepticism is warranted when considering new approaches to regulation, but the perfect should not be the enemy of the good. PBR is imperfect and a work in progress but so are the alternatives.
Under modern business conditions, COSR can produce weak cost containment incentives, frequent rate cases, and a particular indifference to the costs of using fossil fuels. Amongst the Altreg options, the PBR options are designed to improve utility performance, and some can also improve the efficiency of regulation.
Progress has occurred gradually, but this is also true of other areas of ratemaking such as rate design and managed bulk power markets. Lessons learned from accumulating PBR experience can make future PBR better. The diverse approaches to PBR that have now been established make it easier to find PBR reforms that make sense for particular jurisdictions.