Utility managers pay attention to Wall Street, and often reveal more about their top priorities in shareholder earnings calls than in regulatory proceedings. Naturally, as with any investor-owned company, managers of investor-owned utilities are obligated to maximize shareholder value. So how can regulators help to align shareholder value creation with the public interest?
Enter performance-based regulation (PBR) efforts taking shape across America in states like Minnesota, Illinois and New York, which could ensure utility regulation creates a cleaner and smarter electricity system.
Regulatory finance, distilled
When utility managers consider investments, they examine whether the allowed return on investment (r) is less or greater than the cost of the capital required (k). The return (r) is an accounting-based return for the firm, the cost (k) is a market-based return for its investors, and the difference between r and k is the engine driving stock price. Regulators can set r, but financial markets determine k.
Over time, these terms have been conflated; many observers inaccurately believe rate of return is the same as cost of capital. But these two terms are conceptually different, and are often different in numerical value as well. A new report, “You Get What You Pay For: Moving Toward Value in Utility Compensation,” describes how a performance-based approach can start paying utilities (and their shareholders) to deliver better value to customers and society.
Under the traditional cost-of-service regulatory model, all prudent capital investments earn the same rate of return, which empirical evidence shows is generally higher than the cost of capital. With returns exceeding the cost of capital, IOUs create investor value from every prudent capital investment, which motivates utility management to spend capital. (Conversely, if the return were equal to the cost of capital, utilities would have no incentive to invest in any project at all.)
Creating this kind of investment incentive worked when the primary social goal of utilities was to grow enough to provide universal service, with clear economies of scale. But given flat-lining demand for electricity, system build-out is no longer the primary objective. Having accomplished the first wave of the power sector goals, several states are considering realigning utility incentives with today’s customer and societal goals.
Using performance-based regulation to create value
Regulators can use the value engine (r-k) to align utilities’ financial motivations with delivering value to customers and society. If utilities have the opportunity to create shareholder value by investing in assets that improve performance, but can only recover basic costs if they invest in others, utilities will seek value-creating investments. This is not a new idea; in his classic 1970 text The Economics of Regulation, Alfred Kahn argued that utility value should closely track performance:
“The rate of return...must provide the incentives to private management that competition and profit-maximization are supposed to provide in the nonregulated private economy generally...permitting all regulated companies as a matter of course to earn rates of return in excess of the cost of capital does not supply the answer; there has to be some means of...identifying the companies that have been unusually enterprising or efficient and offering higher profits to them while denying them to others.”
Under performance-based regulation, utilities do not necessarily earn returns in excess of the cost of equity on all investments. Regulators can amplify (r-k) when utilities deliver value to customers and achieve public policy objectives, and shrink it when they fail to do so.
The latest developments in New York
In April 2014, New York announced six goals for its Reforming the Energy Vision proceeding -- the first steps toward aligning utility shareholder value with customer and societal goals:
- Enhanced customer knowledge and tools that will support effective management of the total energy bill
- Market animation and leverage of customer contributions
- System-wide efficiency
- Fuel and resource diversity
- System reliability and resiliency
- Reduction of carbon emissions
The proceeding was separated into two tracks, with Track One focused on developing distributed resource markets, and Track Two focused on reforming utility ratemaking practices. These six public policy goals form the basis for new ratemaking practices under Track Two, which seeks to “align utilities' financial interests with the objectives of reform.”
Public Service Commission (PSC) staff released the Track Two proposal in July, using three tools to align utility shareholder value with the original goals: earnings incentive mechanisms, measuring (but not monetizing) other performance metrics, and reforming the "clawback" mechanism.
Earnings incentive mechanisms supplement the rate of return with basis-point adjustments tied to performance, using the shareholder “value engine” to increase (r-k) as performance improves. The PSC staff recommends that peak reduction, energy efficiency, customer engagement and information access, affordability, and interconnection be measured and monetized as earnings incentive mechanisms.
Additional performance metrics will be measured but not monetized. Tracking these metrics encourages some management focus, offers an incremental step toward possible future monetization, and provides stakeholder transparency. Carbon emissions, despite being a main REV objective, are notably measured but unmonetized.
The PSC staff also proposes reforming the “clawback” mechanism whereby capital expenditures are adjusted in each rate case. Rather than punish utilities for revising capital expenses downward, the new clawback model would allow utilities to keep the difference between planned capital expenditures and cheaper third-party DER solutions.
Financial impacts of performance-based regulation
As states move toward performance-based regulation, it will be important for regulators to ensure that utilities remain in a favorable position to attract capital. Shareholders and utility managers need to see that the financial value engine can support adequate returns on investment as utilities deliver more value to customers and society.
A new utility compensation system need not be perfect to start; it only needs to improve upon the current one. For better or worse, current approaches set a relatively low bar. Today’s system determines utility compensation via rate cases, typically after utility investment decisions have been made, meaning investments are completely at risk until a rate-case order is issued. Under new compensation approaches, investment risks can be better managed, with more transparency -- and those risk calculations can guide utility investment toward assets valued by customers and society.
Concrete steps for policymakers to use the value engine to improve performance
Five steps can transform regulation into a forward-looking system creating customer and societal value.
- Engage stakeholders to consider which customer and societal values are most important for the regulated electric sector, driving toward quantitative metrics for performance in each category. (This Synapse handbook provides examples of quantifiable metrics for utility performance.)
- Improve estimates of the utility cost of equity to reflect the minimum markup on money received from shareholders. This value should set the lower bound for the return on equity allowed to utilities.
- Research the benefits in each of the value categories to estimate total benefits. This value should set an upper bound for the incentives offered to utilities that deliver these values.
- Consider the difference between the cost of equity and the current return on equity. This is the money motivating shareholders and utility management, and represents the existing or baseline incentive for performance against which future incentives should be measured.
- Consider alternative ways to deliver the performance portion of utility revenues, aside from adjustments to rate of return, keeping in mind that direct shareholder incentives (or, better yet, “shared savings” programs where some incentive goes to shareholders and some flows back to the customer) may provide the most direct connection to intended performance.
Utility executives and financial analysts need to see that the financial value engine can work to support adequate returns on investment as the electricity system, the regulatory model, and utility incentives evolve. If regulators follow these five steps, they can give utilities that assurance -- and put the power system on track to deliver more value to customers and society.
Sonia Aggarwal directs America’s Power Plan. Steve Kihm is a Chartered Financial Analyst who serves as chief economist at Seventhwave, a Wisconsin-based think tank. Ron Lehr is an attorney and consultant, and former chair of the Colorado Public Utility Commission.