Incentive regulation for electric utilities

What is incentive regulation? In the past: ▫State regulatory commission overseeing a utility’s rate structure  Setting an allowed rate of return Currently seeking ways to promote EFFICENCY: ▫Incentive regulation  Condition financial rewards or penalties upon some determined measure of that utility’s performance

Road Map of this Presentation Presentation of an examination and assessment of the rationale for making incentive-oriented changes The principles that should be conducted when developing incentive regulation Practical problems of incentive regulation

Current Regulatory System and its Performance Typically: ▫Utilities sought to acquire sufficient generation and transmission to satisfy demand ▫Investor owned utilities: long term contracts ▫There was no competition ▫General belief: if utility compaines were allowed to set prices, they would set price to maximize profits ▫NOT GOOD FOR SOCIETY : (

Regulatory Procedures What do regulatory commissions do: ▫Set price and non price terms of retail electricity sales ▫Utility submits any changes they would like to make  RATE CASES  GENERAL:  What is fixed during a rate case is the formula/way the price will be set until the next proposed change

Regulatory Procedures Continued… Vague state mandates that give little insight on what the commission is supposed to do ▫Either:  Just, reasonable and non-discriminatory  Used and useful  Prudently incurred costs ▫More guidance in recent years  With regards to fuel adjustment and the treatment of costs of new generating facilities under construction

More regulatory procedures Currently? ▫Prices should reflect cost of service  TR = TC  Also, average revenue per unit of electricity sold equals the average cost of supplying it ▫In theory,  Commissions: set rates to cover operating and capital costs

Theory is great and all… BUT! ▫Regulators do continuously adjust prices to reflect all of the changes in cost  Only thing that changes rates: rate case process ▫Commissions are not bound to set rates that cover ALL costs incurred  That is, if they find some expenditures unnecessary

What else do commissions do? Terms and conditions of service ▫Line extension requirements ▫Billing procedures ▫Service quality attributes Issue certificates of convenience and necessity to allow new plan and equipment Supervise franchising and refranchising Approve mergers and acquisitions Sometimes: supply side planning and operating issues

The Regulatory Contract long term ‘regulatory contract’ between electricity customers, represented by the public utility commission and the utility With this: ▫Explicit and implicit obligations on both parts  Ex: utility takes on obligation to provide a reliable supply to all who demand it  Done at minimum cost  Regulatory does its part by covering the costs of the utility (prudent costs, mind you)

What if? Say, for example, the utility company does not meet its end of the contract ▫The commission can disallow recovery of their costs ▫Why threat of disallowance?  Incentive for the company to make efficient production decisions

Expectations Short Run: ▫Utility company is expected to: ▫Operate efficiently the plan and equipment ▫Least cost  Of fuel, labor, and other variable inputs  THIS IS A SHORT RUN PRUDENCE TEST  This test is very similar to the competitive market SR efficiency test

Expectations Cont Long Run ▫Utility company to:  Make efficient capital investment decisions  Plan, equipment etc procured at least cost ALSO INCLUDE: OPTIMAL QUATITIES AND TYES OF ASSESTS ACQUIRED

WHAT IS THE KEY HERE? WANT ▫EFFICIENCTY !!!!!!!!!!!!!! ▫MINIMUM COSTS!!!!!!!!!!!!

So why the contract? This type of incentive contract is supposed to simulate the outcomes of a competitive market The decisions in the long run to make investments in capacity so as to make a competitive return Consumers pay no more with the regulated firm…very similar to competition prices

Deficiencies of the contract Three basic reasons for a push towards incentive regulation ▫Regulators are not very good at distinguishing between efficient and inefficient behavior The requirement that prices cover virtually all costs incurred could turn regulation into something very close to a pure cost-plus contract ▫Average cost pricing leads to prices that do not properly track changes in short run supply and demand conditions

Incentive Regulation: Best 3 Objectives Price the electricity demanded by its customers at minimum cost in the SR and LR Consumers should pay no more on average than the minim cost of supplying the electricity demanded Prices should be sensitive to supply and demand conditions at every point in time to reflect MC of producing electricity

And, satisfying these constraints Prices must be high enough on average for the utility to be financially viable Regulators cannot fine utilities or make subsidy payments Must be incentives provided Regulators cannot sign binding contracts with the firms they regulate

Theories of Optimal Regimes Agency Theory ▫Principal/agent model  Principal – regulator  Agent-utility  Principal wants to design a way to compensate the agent and give the agent incentive to maximize what the principal wants the agent to do taking into account the amount it costs to compensate the agent

Agency Theory Continued Regulator (principal) ▫Has single, well defined objective  Maximize aggregate CW  Constraint: maintain the viability of the utility  And: regulator has less information than the utility  AKA asymmetric information

More on the agency theory Utility (agent) ▫The information that they give to the regulator comes from their accounting costs of providing the service  Reports are results of the firm’s past and present decisions on average  However, this is only accounting data  Other data and random events are not known to the regulator (principal)

So much agency theory… Maximize welfare (in dollar terms) subject to keeping the utility in business (financially viable) Welfare depends on : ▫Certain level of welfare can be observed from the firm’s decisions ▫Also depends on: decisions made by the utility’s management that is not known to the regulator, the cost function, and random events

Trade-offs that arise Linear pricing ▫If the customer’s payment was just price times consumption, the utility would have to set TR>TC in order for it to be rewarded  No way to do this without inefficiently discouraging consumption by setting P> unit C Nonlinear Pricing ▫Regulators to fine or subsidize utilities without too much distortion of price signals (what consumers base their consumption decisions on)  Ex two part tariff  F is fixed monthly charge, P is per kWh. As long as F is not very large, it will neither deter the consumer from the market nor affect their consumption decision  Thus in order to reward or punish the utility, the regulator can adjust F accordingly.

Incentive regulation insights 1.) partial separation of the compensation the utility receives from its accounting costs ▫Do not want cost plus 2.) need a careful definition of the commission’s objectives, its current information and nature of uncertainties 3.) incentive payments: ideally based on comprehensive measures o performance

Insights Continued 4.) want to induce the management to make efficient decisions 5.) want to anticipate the allowance of firms making profits ▫Want it such that the firm expects to recover its costs over time 6.) continuation of above… ▫May be such that: limit the rewards and penalties so it seems politically acceptable

Only two more insights… 7.) meshing with accounting principles ▫Most accounting principles have been around for years making more information available on real operating and capital costs ▫Difficulty when using incentives for investment decision making, since accounting methods are traditional 8.) These still will not produce perfect performance ▫Competition is inferior to regulation

Incentive Regulation in Practice The Sliding Scale ▫Ordinary, linear prices ▫Adjusted automatically when the ROR differs from it’s ‘fair’ target or target rate of investment ▫Done in order to provide incentive for efficiency since a price reduction is expected to leave the firm with some excess profits

The Sliding Scale Positive ▫Easy to explain ▫Easy to understand ▫Explicit incentives for cost minimization ▫Combines well with previous accounting methods and rate making principles Negative ▫Utility is rewarded for minimizing total accounting costs ▫Yields prices that are either too high or too low when economic conditions change

Partial Overall Cost Adjustment Mechanisms Incentives in this case are provided by having prices move up or down less than proportionately with changes in cost ▫Estimate how minimum costs change with input prices, output prices, and technological change ▫Primary problem: finding appropriate independent variables and determining their weights Leads to unreliable measures of relative performance

Indexed Rates and Institutionalized Regulatory Lag Believed that regulatory lag could provide some additional incentives to minimizing costs Introducing it into an equation/ similar method as partial overall cost adjustment ▫Base rates to set in regulatory cases and increased/decreased to reflect a general price index. (ex: CPI)  EX: CPI - X

Indexing continued… Problems ▫Many assumptions need to be held in order for this to work (this is reflected in the equation that I’m not showing you because the math was tedious and I didn’t want to bore you too much) ▫Broad indexing approaches are general  Do not reflect sensitivity to price changes of the utility’s inputs ▫Difficult to combine with previous accounting methods

Yardstick Approaches Fostering a competitive environment ▫Competing with other utility companies ▫Any particular utility is evaluated in terms of its performance relative to other firms  Comparable in the sense that these firms face the same production opportunities and demand functions ▫Each firm tries to beat the average to maximize profits

Yardstick Approaches are difficult Utility companies are so different from one another, thus making it hard to compare to one another ▫Current and past conditions

So…what is actually in practice Usually these approaches are applied to specific components of utility costs or performance ▫(Instead of applying these incentives to the firm as a whole) ▫Examples  Fuel cost indexing  Incentives for utilities to purchase fuel at minimum cost  Generating unit performance targets  Yardstick approach applied to generating units