The following is a guest post written by Ron Lehr and Michael O'Boyle. Lehr is the former chairman of the Colorado Public Utility Commission and a contributor to America’s Power Plan. Michael O’Boyle is a Policy Analyst at research firm Energy Innovation.
In the past, consistent load growth meant steady capital expenditures and stable returns on equity for utility shareholders. But today, the trends traditionally driving consistent load growth are being disrupted by rooftop solar, energy efficiency, and changing consumer preferences.
Like any other company, a utility’s stock value depends on ability to consistently increase returns. In cost-of-service regulation, new value is created through new capital investments, but these investments are subject to increasing competition from demand-side resources. Furthermore, no clear links exist between many utility investments and desired electricity system outcomes – affordable, safe, reliable, clean power that responds to consumer preferences and encourages innovation. Without these links, more regulatory risks must be factored into utility cost of capital.
So how can utilities find new sources of revenue to supplement shrinking growth prospects? One answer is performance-based regulation. In Utility Dive’s 2015 State of the Electric Utility Survey, 56% of utility executives indicated they prefer performance-based regulation to traditional cost-of-service regulation. Rewarding performance aligns the utility business model with the inevitable shift toward a more distributed, efficient, clean electricity system.
Performance-based ratemaking adds alternative sources of revenue to an otherwise stagnant business model subject to flat or shrinking demand for electricity service, and links shareholder value to customer value by financially rewarding utilities for achieving the outcomes customers want from electricity service.
This provides new opportunity for utilities to increase returns and reduce risks if they provide the outcomes customers want, creating a win-win for customers and shareholders.
Utility Dive’s survey tells us roughly half of utility executives recognize traditional cost-of-service regulation might not be the best long-term option to sustain and increase shareholder value. This division of opinion may be the product of differing business models; some areas might be growing while others see flat or declining load growth, increasing pressure for regulatory reform.
Other differences likely reflect varied ownership structures – for example, what drives a municipal utility differs from investor-owned utilities. Whatever the reasons, a significant portion of utility leadership considers cost-of-service regulation less attractive for long-term growth than performance-based alternatives.
How can utilities move forward?
Given these insights, why have we only seen a few examples of open dockets or regulatory actions to promote performance-based regulation? Utility responses to distributed generation, for example, have centered on fairness and cross subsidy claims rather than the need for regulatory reforms addressing fundamental utility financial incentives.
Without speculating on the causes of such a discrepancy, it’s clear utilities and their shareholders should be promoting performance-based regulation. As Steve Kihm and Elizabeth Graffy stated in a 2014 Electricity Journal article, “Firms that are facing shocks to their viability must not only adapt to them but embrace them as inspiration to find a new winning trajectory.”
Utilities can provide significant leadership to stay ahead of value-destroying regulation as competitive forces take their toll. First, they can convene stakeholders to clarify which performance outcomes best suit them as universal service providers with unparalleled customer access and public trust. Second, by actively engaging stakeholders and regulators, utilities can focus on the real challenges to their business models and how to address them. Third, utilities are in the best position to help stakeholders understand the financial implications of both business as usual and incentive regulations, and to reach agreement about what incentives are effective for them. No other entity is in as good a position to accomplish these tasks.
Electricity stakeholders should likewise seize every opportunity for constructive dialogue, identify positive outcomes they seek from the system of utilities and regulation, work constructively to link those outcomes with appropriate metrics and measurements, and then support incentives (and often symmetrical penalties) driving utility financial incentives toward those outcomes.
Perfection should not be the enemy of the good – even imperfect performance-based ratemaking can reach better outcomes than the status quo for customers, emerging technologies, the environment, and utility shareholders.
Change is already happening
Forward-thinking utilities are already moving in this direction and productively engaging regulators and stakeholders. In a letter to the Minnesota PUC, Xcel Energy affirmed their need to shift the state’s regulatory framework to align business financial health with innovation, grid modernization, integration of distributed resources, and public policy goals. Xcel’s letter listed performance-based regulation as one path to facilitate this transition. The letter was the product of e21, a yearlong stakeholder engagement process called facilitating compromise and agreement among utilities, environmental advocates, academics, and other stakeholders. e21 shows how open, proactive engagement can produce outcomes that increase value for utilities, customers, and other stakeholders.
As detailed in Energy Innovation's California Policy Report Series, similar opportunities for performance-based regulation exist in California as regulators, utilities, and stakeholders weigh in on policies to meet Governor Brown’s ambitious carbon goals for 2030 and beyond. Current regulations and market forces are already pressuring utilities in California: The state’s “loading order” expresses a statutory preference for distributed energy resources such as efficiency, demand response, and rooftop solar over centralized resources, the energy efficiency incentive program presents utilities with high regulatory risk and costs, and excess power and curtailments threaten the economics of solar deployment, all while load growth in the Golden State is far from certain. In order to align utility incentives with carbon reductions and customer preferences, California’s utilities would be wise to follow Xcel’s lead.
The need for, and financial implications of, creating new utility sources of revenue requires more analysis, both in timing and scale. Simply measuring and reporting utility performance along well-established reliability, affordability, and environmental standards, as well as renewable energy and efficiency standards, may be sufficient to improve performance as a starting point. A recent handbook on Performance Incentive Regulation by Synapse Energy Economics provides guidance on how to measure performance, and expands on other practical implementation issues.
The United Kingdom’s RIIO model is providing concrete examples of how to calibrate financial incentives and performance. Under RIIO, utility returns on investment can range between 2% for poorest performance to 12% for highest performance. How this wide range affects utility performance will inform future calibration of these incentives in other jurisdictions.
Lingering questions on performance-based incentives
Other lingering questions around performance-based ratemaking will require more thinking and experimentation. Are regulators and stakeholders ready, willing, and able to take on new responsibilities? What do regulators know about business planning, anyway? What incentives exist for intermediaries in current regulation to give up the known fights for a future with more settlements and fewer contested cases? Are utilities the best potential leaders here? (See regulator-driven reforms in New York and the U.K.) Answers to these questions should emerge in open, inclusive, and constructive dialogues.
Performance-based regulation should provide a greater value for shareholders and customers – and the first to benefit from these new business models will be forward-thinking utilities who pioneer the process.