Emerging Lessons on Performance-based Regulation from the United Kingdom

A version of this article was published on Greentech Media on October 6, 2017

 

Many U.S. states are considering moving from cost of service regulation for utilities toward a regulatory structure that incents efficient fleet turnover, incorporates clean energy and other cost-effective technologies, and stimulates smarter build-or-buy decisions.  These conversations are motivated by aging infrastructure, new customer energy use patterns, innovative competition from third-party service providers, the need for flexibility to accommodate carbon-free variable generation, a recognition of utilities’ unique role in the electric system, and a commensurate desire to ensure they remain financially viable.

Performance-based regulation (PBR) has emerged as a promising potential solution to these challenges for many public utility commissions (PUCs).  Some, like Ohio, Minnesota, and Missouri, have initiated informal discussions or official workshop series on the topic. Others, like Pennsylvania and Michigan, have commissioned or directly conducted research.  And still more, like Rhode Island, Illinois, and New York, have already taken concrete steps in this direction.

The need to improve utility incentives is reaching consensus, and the potential for performance-based regulation to meet the task is widely discussed. But regulators interested in PBR are searching for real-life examples where it has worked well.  Luckily, the United Kingdom began moving in this direction a few years ago.  Though the U.K. is different in its public policy priorities and regulatory capacity and philosophy than many U.S. states, RIIO already provides U.S.-relevant lessons from their experience.

RIIO – performance-based regulation at work

First, some context: the U.K.’s Office of Gas and Electricity Markets (Ofgem) regulates 14 electric companies and four gas companies, akin to a public utility commission in the U.S.  More than 25 years ago, the U.K. market was restructured by splitting generation and distribution businesses, creating a centralized generation market, and decoupling distribution utility revenues from sales.  In 2010, after a year of gathering stakeholder comments, Ofgem made another set of major changes. These reforms were designed to keep costs low for customers, seeking “better value for money,” and encouraging innovation among remaining monopoly utilities in gas distribution, electricity transmission, and electricity distribution.  Ofgem’s changes “sought to put consumers at the heart of network companies’ plans for the future and encourage longer-term thinking, greater innovation and more efficient delivery.”

The new regulatory structure comprised a multi-year rate plan with a revenue cap plus performance incentives.  The program, affectionately called RIIO (Revenue set to deliver strong Incentives, Innovation, and Outputs; or Revenue = Incentives + Innovation + Outputs), went into effect just over four years ago, and contains several important design features:

  • RIIO extends the time between financial reviews to eight years, with a review after four (the first part of this four-year review is happening now, and inspired this update).
  • RIIO combines utility capital expenditures and operational expenditures into one capped bucket of allowable revenue (a “revenue cap”), and enables a rate of return on the whole (a structure they call “totex” to indicate both capex and opex). This design intends to do two things:
    • First, the revenue cap provides financial incentives for utilities to spend prudently, as they have an opportunity to keep (at least some of) whatever costs they save as profit.
    • Second, the totex reduces the capital bias that can arise from traditional cost of service regulation (which allows a rate of return for capital expenditures but treats operational expenditures as a pass-through). When utilities can only make money from investments, they will systematically choose capital solutions over operational solutions that may be more cost effective—one of the key insights from RIIO for U.S. regulators.
  • RIIO highlights six important goals or “outcomes”, for which it defines quantitative metrics and sets specific targets. RIIO’s outcomes will likely sound quite familiar to U.S. regulators: safety, environment, customer satisfaction, connections, social obligations, and reliability/availability.
  • Beyond the financial incentives created by the revenue cap (discussed above), RIIO adds financial incentives and penalties for each of the outcome categories. These outcome-based performance incentives sum to about 200-250 basis points of incentives for excellent performance or a similar magnitude of penalties for poor performance.  This design feature is intended to motivate utilities to innovate to deliver what customers want out of the utility system.

 

  • RIIO tracks these outcomes and others via a standardized scorecard, making it easier for stakeholders to follow which goals utilities are meeting or exceeding, and where they may be falling short.
  • RIIO also held aside a pot of funding for innovative projects from R&D through pilots, to kick-start the intended shift in utility culture. In order to be eligible for these funds, utilities must agree to share lessons and ideas generated by the research.

Many of these elements of PBR are under discussion in states around the U.S., but RIIO combines all of them into one holistic change to utility regulation.

Lessons from across the pond

With that context, let’s dig in to the lessons from RIIO’s mid-term review.  Ofgem recently released an open letter that begins the discussion about lessons, based on preliminary evaluation work.

Most important, experience so far supports the notion that revenue caps with totex and carefully calibrated outcome-based performance incentives can drive innovation, stabilize or improve utility profitability, and focus utility attention on the outcomes customers most want.  For example, in the first performance year, many distribution utilities beat forecasts for customer bills, exceeded most of their performance targets, and achieved returns on equity averaging just over nine percent – 300 basis points more than their estimated six percent cost of equity.  Beyond performance numbers, anecdotal evidence also suggests that utilities have shifted their focus toward performance under RIIO.  There is no indication that Ofgem and the U.K. utilities will move away from this regulatory structure after testing it over the last four years.

Lesson for U.S. regulators: It’s worth exploring whether revenue caps, outcome-based performance incentives, and perhaps totex are right for your state.  Make sure the combined financial impact of performance incentives are carefully crafted and just large enough to capture utility management attention.

RIIO’s detailed design also provides important lessons for U.S. regulators looking to move toward rewarding utilities based on performance.  Most of the emerging lessons relate to the difficulty of getting long-term projections right, and the need for automatic calibration along the way.

First, setting the right revenue cap is very challenging in a world of growing uncertainties. For example, will efficiency flatten demand or will electrification kick-start demand growth?  External factors can cut both ways, but in the U.K., Ofgem notes that “forecasts for real price effects in setting allowances…appear in some instances to have resulted in gains for the companies.”  Thankfully, Ofgem designed the cap to share gains or losses between utilities and customers, but still, over the last few years, it is possible the utilities earned more than efficient business practices would have yielded alone under better-calibrated revenue caps.

Lesson for U.S. regulators: Pay attention to important normalization factors (for external factors like GDP, inflation, population changes, or electrification rates) and build in transparent off-ramps and correction factors (for external factors like storms) from the beginning.  Look for ways to share value fairly between utilities and customers.

Second, Ofgem’s mid-term review identified the eight-year length of the multi-year revenue cap as a key source of uncertainty.  Of course, the tension here is between setting targets too far into an uncertain future versus creating a long enough runway for utilities to innovate and deliver desired outcomes.  Ofgem points to rapidly changing technologies and competitive forces on the distribution side, urging a review of the length of the period “given the potential scale of future uncertainty facing network companies.”

Lesson for U.S. regulators: Create programs that last less than eight years, or suggest predefined points for review and adjustment within less than eight years.

Third, though some U.K. utilities are paying penalties for underperformance on outcomes, most are successfully earning incentives for performing well on outcomes.  This mix of penalty payments and incentive earnings is balanced, but it is worth noting that more utilities are performing (and earning) well than poorly on their outcomes.  This may indicate more ambitious performance targets could have been warranted to better share benefits between utilities and customers.

Lesson for U.S. regulators: Information asymmetry is likely to tilt in favor of looser targets for utilities.  It may be worth conducting independent studies of potential to assess whether proposed targets are sufficiently tight. It is less risky for customers to start with small financial incentives and work up, rather than over-incent utilities and then have to squeeze incentives down to the right level.

Fourth, even though Ofgem worked with utilities and stakeholders to define outcome metrics carefully at the program’s start, a couple instances of ambiguity still arose in the performance period.

Lesson for U.S. regulators: Invest the time up front, before a performance-based program begins, to define outcome-based performance measures clearly and quantitatively.

More lessons will arise as Ofgem continues its midterm review of RIIO, but we hope that these first, emerging lessons will be useful to U.S. regulators considering performance incentive program design questions today.