2015 CAMPUT Energy Regulation Course

Regulatory Reform and Performance-Based RegulationWillie Grieve, QC, Chair, Alberta Utilities CommissionTuesday, June 23, 2015

Introduction

• Alternative economic regulation of prices approach

• Most utility legislation mandates a form of cost of service regulation - rate base rate of return (RBROR)

• Concerns about cost of service incentives, effectiveness of traditional regulatory tools and regulatory burden have led to examinations of new approaches to economic regulation.

• Legislative provisions have been added in some jurisdictions to encourage incentives for greater efficiency.

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Regulatory tools of RBROR

• Forward-looking test year of costs and demand with reasonableness assessment

• After the fact prudence reviews for assets in rate base and potential disallowances

• Cost oversight and potential disallowances of past costs for forecast purposes

• Establish service quality levels and standards (penalties)

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Incentive features of RBROR

• Preference to invest in capital assets (rate base) to improve earnings (higher rate base means greater earnings)

• Few incentives to minimize operating, maintenance and administration costs (reduced costs means lower rates)

• Incentives to forecast high costs and low demand growth

• Few regulatory tools to examine prudency of expenses or capital costs and overcome perverse incentives (the capital-expense mix)

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Historical environment

• Pure utility

• Vertically integrated utilities

• Scale and scope economies

• Simple corporate structure

• Limited geographic reach

• Limited technological change

• No affiliates

• No or limited competition

• Full visibility for regulators

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Industry changes

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• Holding companies

• Broad geographic reach with utilities spread across the country

• Dis-integration into generation, distribution, transmission, retailo Loss of economies of scale and scope

• Creation of affiliates – both regulated and unregulated

• Technological change o new alternative energy sourceso self-generation

• Portions may no longer be monopolies

• Transmission still largely monopoly

• Distribution monopoly

• ISOs

New tools added for RBROR

• ‘Mini’ rate bases (cost allocations)

• Transfer prices from affiliates

• Pass through costs and prices

o deferral and reserve accounts

• Codes of Conduct

o for competitiono for affiliate pricing to protect customers

• RBROR incentives remain and may be exacerbated by changes

• Regulatory burden increases

• Regulatory focus moves away from most important issues

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Need for new regulatory approaches

• Increasingly large amounts of paper filed with little or no effect on ability to control costs

• Need to address the perverse incentives created by cost of service regulation

o traditional incentiveso new incentives caused by industry evolution

• Need to improve efficiency incentives and efficiency of regulation while not losing the purpose of regulating

• Some forms of incentive regulation have been adopted and adapted in many jurisdictions for this purpose

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How do competitive markets create incentives?

• Firms make trade-offs between price and quality to respond to customers

• Firms are largely price takers, not price setters

o Firms cannot influence price and so focus on efficiencyo Price largely set by marginal cost of most efficient competitor so focus is on reducing cost

• Firms must continually improve to match or better competition, instead of exerting effort in influencing regulators

• Firms must cope/adapt to externalities and shocks (as do their competitors)

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Incentive approaches

• RBROR time lags (rate freeze)

o Company remains in control of timing of next rate caseo All RBROR incentives remain in place but are muted until application

• Forward test years

o Incentives for greater static efficiency after rates set (but not too much)o Incentives to forecast high costs and low demand in test periodso Dynamic efficiency incentives manifested in regulatory strategy

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Incentive approaches• Earnings bands

o Allow greater earnings before regulatory action (similar incentives to forward test years)

• Benchmark or yardstick

o Bases rates on rates of peer or similar utilitieso Almost impossible to find peers because of history and unique

local issues of companieso Sometimes used as a reference point for size of X factors in

PBR (Ontario)

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Incentive approaches• Social contract

o Very flexibleo Most often used for political needs like infrastructure development, job creation or

quality improvemento Can be used to emulate market outcomes through PBR elements

• Price regulation

o Formula-based (FBR) or performance-based (PBR)o Time-limited so perverse cost-based incentives still arise

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Basics of PBR

• Start with Phase II cost of service prices

• Focus on changes in prices (not costs) over time and on quality of service

• Set plan to continue to provide opportunity to earn fair rate of return during the PBR period

• Eliminate reviews of costs during PBR period so as not to distort incentives

• Reduce regulatory burden -- eliminate old regulatory filings (some new filings)

• Allow for price adjustments for significant unexpected events

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Closer to competitive incentives• Utilities move from being price setters to price takers

• Price changes external to the individual utility’s cost changes

Set by formula (I – X)Inflation factor: IProductivity offset: X

• Shift from bottom up pricing to incentives

•Utility must re-focus on managing costs

•Less opportunity to flow through actual costs

•Rate cases to influence price reduced

•Reduced regulatory effort

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What we want to achieve

• Companies focused on management of operations rather than management of regulation

• Regulation focused on prices and quality

• Maintain quality of service

• Reduction in regulatory burden

• Rate of change in price increases less than expected under cost of service regulation

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Alberta PBR principles (Bulletin 2010-20)

1. A PBR plan should, to the greatest extent possible, create the same efficiency incentives as those experienced in a competitive market while maintaining service quality.

2. A PBR plan must provide the company with a reasonable opportunity to recover its prudently incurred costs including a fair rate of return.

3. A PBR plan should be easy to understand, implement and administer and should reduce the regulatory burden over time.

4. A PBR plan should recognize the unique circumstances of each regulated company that are relevant to a PBR design.

5. Customers and the regulated companies should share the benefits of a PBR plan.

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Calculation of PBR rates

Annual formula adjustment with factors such as

I: InflationX: Productivity Stretch factorExogenous adjustment(s)Flow-throughEarnings sharing (if any)Service quality adjustmentsOther

 

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How are rates calculated? (cont.)

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• Results in something like:

Rt = Rt-1* (1+(I-X)) – E – S +/- Z

• Where:

Rt = Current year’s rate for each class

Rt-1 = Prior year’s rate for each class

I = Inflation Factor

X = Productivity Factor =1.2

E = Customer portion of Earnings Sharing

S = Service quality penalties, if any

Z = Exogenous Adjustment

Prior year rates

• Two distinct issues

• First year “going-in” or “base rates”

o Sets the rates upon which the formula is based o Usually accept most recent COS application be it historical or prospectiveo Rate established is independent of PBR formula

• Ongoing, subsequent years

o Prior year’s rates adjusted by formulao New cost of service case to re-base

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I (Inflation)

• Compensates for inflation increases

• Common measure is CPI. However CPI is a consumer basket of goods not utility costs

o for example, watermelon prices unrelated to transformer prices

• CPI is what is known as an output measure

• Based on outputs not inputs (i.e., based on changes in retail prices not the costs of production inputs)

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Output versus input price indices

• Output measures likely include productivity improvements

o A $600 1990 computer vs. a $600 2010 computer has productivity improvements reflected in the price

o 1990 versus 2010 liter of gas is the same, so price comparison is pure inflation

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Output versus input price indices

• To address embedded productivity, industry-specific indices related solely to inputs were developed

• The I and X variables are often interlinked and/or require trade-off

• If I is based on an output measure such as CPI, then need to adjust X to “back out” productivity gains already in the output measure

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Illustration: different measures of I

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Illustration of different indices

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Illustration of different measures: geography

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Source: Enmax Power Corporation FBR Application Proceeding 12 Exhibit 18 page 13

X (productivity factor)

• Productivity is the rate of growth of outputs less the rate of growth of inputs

o calculated as a percentage

• Under PBR, utilities compete against an external (industry-wide) historical productivity measure

• This is a proxy for competitive market price pressures

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Total Factor Productivity• Total Factor Productivity study is a technique which measures all inputs

and outputs to derive a single measure suitable for comparison

• Range from economy-wide down to industry specific

• Geographic dispersion

• May not be a factor for steel or transformers, but may be for labour

• Usually disaggregate inputs to

o Labouro Capitalo Other (materials, rents, services etc.)

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Productivity variability

• Annual fluctuations suggest longer time series is required

• Fuel cost hike in airlines shows as decrease in productivity in one year when long term trend is productivity increase

• Different time measures, different numbers

• 25 years: Canada: -0.04% (a decline) versus US: 0.91%

• Canada-wide productivity growth for 2000-2004 averaged 0.8% per year

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Illustration of TFP variability

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Stretch factor

• A percentage amount added to X factor

• Designed to capture gains in excess of industry average productivity growth

• Firms under COS assumed to be less efficient than competitive firms

• Evidence that productivity improvements greater during initial PBR term

• Stretch factor usually eliminated after the first PBR term

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Exogenous adjustments• Defined as:

o Unplanned, unexpected or unforecastedo Uncontrollable change in costs or revenueso Independent of I, X or other factors in formulao Not included in the base rateo Material financial impact on utility

• Can include in rates if the above criteria are met

• In some cases the impact is transitory and is a one time adjustment only

• If carries on, may or may not be subject to the I-X adjustment

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Exogenous adjustments (continued)• Utility incented to pass through any negative shocks such as increases

in costs, decreases in revenues

• Allowed exogenous adjustments to reduce risk for both utilities and customers

• However, only the utility can take concrete steps to mitigate through:

o Planningo Contingency planso Other

1. For example, disaster planning, insurance versus self insurance, etc.

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Exogenous adjustments (continued)

• Materiality

• Determine whether you can add different “sub-material” items to get a material adjustment

• Alberta Enmax case, chose ≈1% of revenue as materiality threshold

• Deal with as situations arise

• Difficult to catalogue a list of events that are truly exogenous events

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Exogenous adjustments (continued)

• Three types:

1. Flow through 2. Exogenous 3. Off ramps

• No clear demarcation between the three. All three allow actual costs to be included in rates

• One of only two classes of items in PBR where actual costs impact rate changes (the other is capital adjustment if included)

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Flow through

• Usually agreed at outset of plan

• Uncontrollable normal course of business charges such as ISO charges to distribution entities

• Regular flow-throughs,

• e.g., monthly ISO charges or gas cost adjustments

• Not captured in I or X; in other words independent of these factors

• Item should affect the industry solely and not economy in general

• e.g., general tax increase captured in I so does not apply

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Off-ramps

• Pre-determined, significant issues

• Returns beyond specified thresholds

• Consistent service standard breaches

• If triggered, PBR arrangement either terminated or wholly re-opened

• Usually something that raises questions as to whether the structure should be revisited

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Earnings sharing mechanism

• Often in initial PBR terms because of uncertainty about new mechanism

• Some early PBRs resulted in very large earnings

• Parties concerned with over/under earning and perceptions

• Retains vestiges and incentives of RBROR regulation

o What goes into the net income calculationo What are allowable expenses

• Mutes incentives

• Why should there be any additional sharing at all?

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Capital

• Depreciation embedded in going-in rates and in TFP studies

• Factors Influencing Depreciation

o Growth: new additions increase depreciation o Replacement costs different from original cost changes depreciationo Replacing $10 1960’s transformer with $100 2010 transformero Depreciation decreases when asset fully depreciatedo Depreciation rate changes

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Capital (cont.)

• If depreciation increases are greater than rates (I-X) and growth, then shortfall arises

o therefore, some plans include adjustments if capital-related expenses exceed certain thresholds

• There is no a priori conclusion as to whether capital additions require an adjustment factor.

• Including a capital adjustment factor can have negative effects on incentives

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Quality of service

• PBR creates incentives to cut costs and therefore service quality may be at risk

• Need to ensure that companies maintain quality

• Penalties for specific and general failure to maintain service quality

• Asset monitoring as a tool for quality monitoring

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Review/renewal process

Review and renewal alternatives include:

•Full RBROR rebasing

o Reduces incentives as gains clawed backo Increased regulatory costo Keep details for prudence determination

•Adjust parameters such as I and X

o Generally the X or stretch factor

•Adjusts formula on a go-forward basis

o Past is pasto Leaves incentives intact

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Term • Length of time between reviews involves trade-offs

o Longer timeframe - more incentiveo Longer term adds certainty to regulatory treatmento Longer term provides incentive to invest long term – dynamic efficiency

• Shorter term reduces risk, mutes positive incentives and exacerbates perverse incentives

• Indefinite term appears to maximize incentives

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Conclusion

Questions?

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