performance-based regulation

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PERFORMANCE-BASED REGULATIONSONIA AGGARWALNATIONAL GOVERNORS’ ASSOCIATIONJULY 28 , 2015

2WWW.AMERICASPOWERPLAN.COM

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1.WHY

2.HOW

3.EXAMPLES

4.NEXT STEPS

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THE POWER SECTOR HAS EVOLVEDOld Goals: Meet growing demand Build new infrastructure Build to deliver universal service Affordability, reliability, safety

Old Options: Centralized power plants Transmission lines Distribution system

COST OF SERVICE REGULATION

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THE POWER SECTOR HAS EVOLVEDOld Goals: Meet growing demand Build new infrastructure Build to deliver universal service Affordability, reliability, safety

Old Options: Centralized power plants Transmission lines Distribution system

New Goals: Build Maintain Reliability Resilience Clean power Customer satisfaction Affordability, safetyNew Options: All the old stuff, plus: Innovative distributed energy

resources (EE, DR, PV, EVs, etc.) Advanced IT

COST OF SERVICE REGULATION PERFORMANCE-BASED REGULATION

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COST OF SERVICE REGULATION Utilities spend prudently to maintain and operate the

power system Utilities recover capital expenses plus a rate of return Operational expenses are recovered at no risk to the

utility

This incents capital investments and sales volume A great structure for 20th century goals

(meet growing demand, build new infrastructure, build universal service)

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NEW GOALS FOR THE POWER SYSTEM

Resilient

Affordable, Safe

Clean

Customer-oriented

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ALIGN FINANCIAL INCENTIVES OF:

UtilitiesCustomers

Independent Power Producers

3rd party service providers

$Resilient

Affordable, Safe

Clean

WITH THESE GOALS:

PERFORMANCE-BASED REGULATION CAN ALIGN FINANCIAL INCENTIVES

Customer-oriented

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PERFORMANCE-BASED REGULATION

Works (for the residual monopoly) in both vertically-

integrated & restructured

markets!

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From: “Did we pay the right amount for what we got?”

To: “Are we paying (the right amount) for what we want?”

Utility and Regulatory Models for the Modern Era

by Ron Lehr

PBR changes the central question…

PERFORMANCE-BASED REGULATION

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1.WHY

2.HOW

3.EXAMPLES

4.NEXT STEPS

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COST OF SERVICE REGULATION, SIMPLIFIED

Revenue = Operating Costs + (Capital Costs) *

ROR…As utility investment increases

Revenue increases…

(Rate of Return)

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Revenue = Operating Costs + (Capital Costs) *

ROR

ELEMENTS OF COST OF SERVICE EQUATION

Often recovered at no risk to the utility Reviewed by regulators for

prudence and public interest

Greatest opportunity for affecting overall shareholder value creation

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Regulators

Set quantitative performance goalsEstablish reward & penalty structure

Utilities

Meet goalsReceive rewards and/or penalties

Reliable service Customer satisfaction Equity Innovative third-party

services

System-wide least cost

Resource diversity Effective facilitation

of open access Reliability Innovation

Retail Level, e.g.:

Wholesale Level, e.g.:

OutcomesPolicymakers

Establish policy prioritiesWork with regulators

POLICY SOLUTIONPERFORMANCE-BASED REGULATION Already

a standards driven industry

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Revenue = Operating Costs + (Capital Costs) *

ROR

PERFORMANCE-BASED REGULATION, SIMPLIFIED

± Performance …As utility investment increasesperformance improves

Closer to the cost of capital

Revenue increases…

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MOVING FROM COST OF SERVICE TO PERFORMANCE-BASED REGULATION

Opex (including

depreciation & taxes)

Opex (including

depreciation & taxes)

ROR ROR

Reve

nue

Incentives available for

value-creating activities*

ILLUSTRATIVE

Traditional Modelvalue derived from all investment activities

Performance Value Model

value derived from both investments and

performance

*Overall costs may actually decrease; but potential returns to shareholders should grow commensurate with the additional risk shifted to utilities

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1. Return on Equity (ROE) Adjustments: Basis point adjustments applying to the whole ratebase

e.g. IL, UK Incentive ROE for projects that meet performance criteria

e.g. CA: nuclear performance

DELIVERING THE INCENTIVETWO METHODS

* Shares may change over time

2. “Direct incentives” Shared savings / shared profits*

e.g. CO: Xcel off-system sales Shareholder incentive mechanisms

e.g. CA: efficiency performance

PREFERRED

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1. Work with stakeholders to clearly define goals and outcomes in quantitative terms.

2. Include incentives for exceptional performance and penalties for missing the standard.

PRINCIPLES FOR DESIGNING PERFORMANCE-BASED REGULATION

3. Use a transparent and consistent methodology for measuring performance. Define it clearly at the outset of the program.

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PRINCIPLES FOR DESIGNING PERFORMANCE-BASED REGULATION4. Shift an appropriate amount of performance risk to the utility in exchange for longer-term regulatory certainty and the opportunity to earn incentive compensation. Reward entrepreneurialism.

5. Establish a long enough time horizon for the utility and third-parties to make investment decisions with certainty, and to innovate to meet performance targets.

PLANNING TIME HORIZONMONTHS YEARS DECADES

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PRINCIPLES FOR DESIGNING PERFORMANCE-BASED REGULATION6. Consider revenue sharing to align utility performance with customer benefits.

7. Build on the existing framework, but look for holistic solutions that go far enough to truly align incentives and simplify the regulatory process.

8. Consider provisions for mid-course correction—any changes should be announced well in advance of implementation to minimize uncertainty.

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1.WHY

2.HOW

3.EXAMPLES

4.NEXT STEPS

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EXAMPLE 1 OF 2: FIRST STEPS

O.38% of total utility revenue at stake Penalty-only structure Three primary output categories tied to revenue, more being tracked:

1. Reliability2. Reduction of system uncertainty3. Affordability

Performance targets set for 10 years, assessed annually, with increasing stakes

Incentive delivery: ROE adjustments to all cap expenditures

Illinois

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EXAMPLE 2 OF 2: GOING (A LOT) FURTHER

3% of total utility revenue at stake Penalties and rewards offered Six primary output categories tied to revenue:

1) customer satisfaction, 2) reliability and availability, 3) safe network services, 4) connection terms, 5) environmental impact, 6) social obligations

Eight years to adapt and perform, opportunity to review at year 4

Incentive delivery: ROE adjustments applied to all capital and operational expenditures

United Kingdom

“Utility investors agree RIIO is a paradigm of success.”

Julien Dumoulin-Smith, UBS

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1.WHY

2.HOW

3.EXAMPLES

4.NEXT STEPS

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NEXT STEPS TO CONSIDER1. Agree on top goals for the state’s power sector. What value

can utilities deliver to citizens and customers?

2. Identify appropriate quantitative performance metrics under each goal. Work with the Commission to establish a transparent methodology for calculating performance on each metric.

3. Begin to measure and track performance. Support pilots.

4. Grow the share of utility revenue tied to performance once the metrics and methodologies are well understood.

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THANK YOU

@USPOWERPLAN@ENERGYINNOVLLC

WWW.AMERICASPOWERPLAN.COMWWW.ENERGYINNOVATION.ORG