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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.
2
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)
3
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)
4
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
5
Industry changes
6
• 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
7
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
8
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)
9
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
10
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)
11
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
12
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
13
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
14
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
15
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.
16
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
17
How are rates calculated? (cont.)
18
• 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
19
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)
20
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
21
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
22
Illustration: different measures of I
23
Illustration of different indices
24
Illustration of different measures: geography
25
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
26
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.)
27
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
28
Illustration of TFP variability
29
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
30
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
31
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.
32
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
33
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)
34
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
35
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
36
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?
37
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
38
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
39
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
40
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
41
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
42
Conclusion
Questions?
43