Electric Utilities: Get Over the Fear of this Four-Letter Acronym
Utility management and regulators have endured a long and colorful relationship with monopoly regulation. Much of that time was spent by experts on both sides honing their skills at a single principal regulatory approach: cost of service-based regulation. However, times are “a changing,” and some stakeholders in the electric industry believe the regulatory models also need to change. Utility leaders have long considered performance-based rate regulation (PBRR) to be the equivalent of a dirty word. This sentiment might be worth another look because more extreme outcomes are possible for the future of electric utility regulation.
The fear of PBRR may simply be that it takes utility rate experts and regulators who have spent their careers practicing the art of cost of service regulation (COS) out of their comfort zones. COS involves an often long, formal administrative case designed to establish a reasonable rate that permits the utility to collect revenues to cover its fixed and variable costs and an opportunity to earn a fair profit. Historically, COS has helped to achieve rate setting objectives including efficient capital investment and stable revenues for utilities, efficient use of energy by customers and rates most stakeholders believed to be equitable. COS works well when economic conditions and capital investment are stable, and sales and customer numbers are growing at a predictable rate.
Today, grid modernization is requiring substantial capital investment by utilities while economic conditions and distributed energy resource (DER) competition are leading to relatively flat or negative utility sales growth. Faced with the prospect of potentially more customer attrition due to community aggregators and self-generation, regulators, other stakeholders and even utility leaders may be questioning whether the continued use of COS and even the current utility business model are appropriate. For example, under COS, utilities earn a return on invested capital, so investing in GT&D normally would be pursued for company growth and financial stability. However, without an increase in sales, such as when growth is absent, rates rise. PBRR offers an option that may benefit all or most stakeholders.
Utility management and regulators have endured a long and colorful relationship with monopoly regulation. Much of that time was spent by experts on both sides honing their skills at a single principal regulatory approach: cost of service-based regulation. However, times are “a changing,” and some stakeholders in the electric industry believe the regulatory models also need to change. Utility leaders have long considered performance-based rate regulation (PBRR) to be the equivalent of a dirty word. This sentiment might be worth another look because more extreme outcomes are possible for the future of electric utility regulation.
The fear of PBRR may simply be that it takes utility rate experts and regulators who have spent their careers practicing the art of cost of service regulation (COS) out of their comfort zones. COS involves an often long, formal administrative case designed to establish a reasonable rate that permits the utility to collect revenues to cover its fixed and variable costs and an opportunity to earn a fair profit. Historically, COS has helped to achieve rate setting objectives including efficient capital investment and stable revenues for utilities, efficient use of energy by customers and rates most stakeholders believed to be equitable. COS works well when economic conditions and capital investment are stable, and sales and customer numbers are growing at a predictable rate.
Today, grid modernization is requiring substantial capital investment by utilities while economic conditions and distributed energy resource (DER) competition are leading to relatively flat or negative utility sales growth. Faced with the prospect of potentially more customer attrition due to community aggregators and self-generation, regulators, other stakeholders and even utility leaders may be questioning whether the continued use of COS and even the current utility business model are appropriate. For example, under COS, utilities earn a return on invested capital, so investing in GT&D normally would be pursued for company growth and financial stability. However, without an increase in sales, such as when growth is absent, rates rise. PBRR offers an option that may benefit all or most stakeholders.
As the name implies, performance based rates are designed to reward utilities based on the achievement of specific goals and are less dependent on or entirely disconnected from capital investment and sales volume. The goals may be related to increasing energy efficiency, capital cost avoidance, some form of shared savings or capitalization of program costs. Performance based rates can be designed around an almost limitless range of business, environmental and social goals. Measurement of success should be straightforward and less dependent on utility company growth. Some stakeholders point to Great Britain’s RIIO model as a helpful example of a long-term performance based rate design.
Will changes more fundamental than PBRR be needed as the electric sector continues to evolve? Some stakeholders argue that the utility business model as well as the regulatory model we are discussing here may need to change. There’s a broadly shared sentiment that capturing new load growth opportunities such as EVs and further electrification may save the traditional COS and business models. Some argue such electric sales growth opportunities are not developing quickly enough and may not be sufficient. They believe utilities will need other opportunities for new investment to remain financially viable and maintain reasonable rates. Those opportunities might include direct investment in DERs, financing of third-party energy systems and more flexibility in the ownership and sale of energy services. New rate designs also may be necessary to allow greater recovery of costs by utilities using fixed charges and mechanisms for recovery of lost fixed charges from departing customers.
