Q&A on Performance-Based Regulation with Energy Innovation's Sonia Aggarwal
Post date: March 30, 2016
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In Minnesota, GPI convenes a stakeholder effort called the e21 Initiative that recommends, in part, shifting toward a more performance-based regulatory approach to determine how electric utilities in the state are compensated.

Recently, the Minnesota Public Utilities Commission discussed performance-based regulation (commonly referred to as PBR) with expert Sonia Aggarwal, Director of Strategy at Energy Innovation. Ms. Aggarwal and the commissioners had an interesting discussion (see summary here) that raised key issues about how a PBR approach would work and its implications.

I followed up with Ms. Aggarwal (who presented to e21 in 2015) to talk more about PBR and pose some questions that are central to understanding this alternative to traditional regulation. What follows is our conversation:

 

Christensen: To begin, can you give the ‘elevator speech’ for what PBR is and how it works? 

Aggarwal: Performance-based regulation asks: what value do we want out of our utility system, and what are we willing to pay for it?  It’s a different way of structuring utility regulation designed to align a utility’s financial success with its ability to deliver what customers and society want.

 

Christensen: There is a lot of interest in moving to a more performance-based approach to utility regulation, not just in Minnesota, but in New York and other parts of the US. What would you say are the main motivations for looking to alternative regulatory models at this time, and to PBR in particular?

Aggarwal: Traditional regulation was quite effective when we were trying to build out the power grid to meet growing demand for electricity and provide universal access to electricity.  Now, we are in a period of flat or even declining electricity demand, and the old utility value engine is running out of gas.  Costs have plummeted for new technologies, offering new opportunities for utilities to optimize energy use.  At the same time, third parties are taking advantage of those new technologies to offer products and services directly to customers—effectively competing with utility business and eroding sales. 

This is all happening amidst a growing imperative to clean up emissions from the power system – for reasons of national security, economic stability, public health, and climate change.  Utilities are important institutions intended to serve the public interest cost-effectively.  And a new regulatory approach—like PBR—can help keep utilities financially healthy as they deliver customer and societal value during this time of transition.

 

Christensen: In your presentation to the Commission, you explained that PBR could help enable achievement of new goals for our energy system, such as resiliency and clean energy, and to enable new options such as innovative distributed energy resources (efficiency, demand response, photovoltaics, electric vehicles, etc.) and advanced IT.  Can you talk about how PBR enables these shifts versus traditional cost of service regulation?

Aggarwal: Traditional cost of service regulation pays the utility a uniform rate of return on all prudently incurred capital investments.  This can create a bias toward centralized, capital-intensive projects, as well as a bias toward direct ownership of all grid infrastructure. 

Moving to a model that pays the utility based on whether it achieves quantitatively defined outcomes (like system resilience, affordability, or environmental performance) can make it profitable for them to pursue optimal grid solutions to meet those outcomes.  Under this model, utility shareholders may be just as happy with operational fixes that avoid capital costs, payments to customers for providing distributed grid services directly, or procurement of grid services from third parties.  Done well, this can have knock-on benefits too: customers can access more choices, and the system can be more cost-effective overall.

 

Christensen: In a PBR framework, where does the money come from to pay utilities for meeting performance objectives? To some, this approach can sound like you’re potentially adding on to what utilities already earn.

Aggarwal: Peter Bradford, a famous regulator, pointed out that all regulation is incentive regulation.  It just depends on what you want to incent.  Traditional regulation pays the utility a uniform rate of return—above the utility’s cost of equity—on all capital investments.  In simplified terms, it essentially incents capital investment, without regard to the type or quality of capital investment.

Of course, if the administratively-set rate of return was exactly equal to the utility’s cost of equity, the utility would be completely indifferent about whether to make an investment or not, and the system would stagnate.  There would be no incentive to maintain the system for customers.  So we don’t want that either. 

This is where the art of performance-based regulation comes in.  PBR can take advantage of the difference between the rate of return utilities earn and the cost of their activities.  After all, this gap is what drives value for utility shareholders at the end of the day.  Under PBR, utilities can earn a greater return if they cost-effectively deliver outcomes that customers and society want, or a lower return if they fail to deliver those outcomes—even in cases where the total system costs stay the same or even decrease.  This may seem like a nuanced point, but a focus on performance can streamline business activities and investments by better simulating competition—focusing management on achieving the outcomes to drive higher returns for shareholders.  PBR breaks the link between undifferentiated capital investment and shareholder value, instead connecting shareholder value to what customers and society want—a safe, affordable, resilient, and clean grid.

If customers and regulators need more cost-effectiveness assurances, though, some regions have implemented a cap on total revenue over time—adjusted for inflation and a productivity improvement factor.

 

Christensen: When some people learn about PBR, they’re concerned that it isn’t cost-based anymore. How would you describe the role of accounting for cost under PBR vs. traditional regulation?

Aggarwal: As long as a monopoly utility owns and maintains infrastructure, costs will continue to form the basis for revenue recovery.  This is not going away.  The idea of PBR is to ensure the basics are covered via a rate of return, but then also adjust earnings based on performance targets.  Then, it is important to give the utility some more freedom to make business decisions about how to meet those performance objectives.

 

Christensen: Another key issue is making sure that all customers are getting value from the regulatory framework and that there are robust protections for customers. Can you talk about how a PBR approach can be structured to make sure customers are protected and receiving benefits?

Aggarwal: First, a caveat: PBR is predicated on the idea that there is value in customers remaining connected to the system, taking advantage of a diverse portfolio of grid resources and drawing electricity services as needed.  That value is likely to remain unless or until distributed power for all customers is as cheap, safe, reliable, and clean as being connected to the grid system.

If you acknowledge the value of an interconnected system, PBR can actually protect customers more than the traditional regulatory approach.  PBR starts with the question of what customers want out of the electricity system, and pays the utility a fair price to deliver it.  So PBR is an improvement over the traditional model where captive utility customers are never really asked that question.  The central purpose of PBR is to tie utility incentives (positive or negative) to customer value.  PBR is designed to give customers more value for their money.

 

Christensen: What advice would you give states that are interested in pursuing PBR? What are some of the most important considerations in designing a PBR approach?

Aggarwal: To pursue PBR, policymakers and stakeholders must first agree on top goals for the power sector, answering the question: what value do we want utilities to deliver to citizens and customers?  Many regions have landed on some combination of affordability, resilience, and environmental performance.  Then, regulators can begin to identify appropriate quantitative performance metrics associated with each goal.  Establishing a transparent methodology for calculating performance against each metric will be important at this stage.  After those pieces are defined, utilities and their regulators can begin to measure performance.  Looking at performance over time, regulators and stakeholders can confirm whether performance on the chosen metrics is tied directly to achieving the goals agreed upon at the outset of the program.  If so, they can set targets for long-term improvement and begin to grow the share of utility revenue tied to performance.

Of course, the real-world utility regulatory business is messier than this makes it sound, but following these steps can move states and their utilities toward a system better equipped to handle the industrial transformation facing the electric utility industry.

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If you’re interested in learning more about PBR in detail, please see this presentation and paper by Ms. Aggarwal.