Tariff design basics, Performance Based Rate Making

What are some Performance based ratemaking mechanisms?

PBR regulation is best conceptualized as a continuum, ranging from “soft” to “hard” mechanisms, rather than as a single type of regulatory regime. “Soft” mechanisms include relatively minor adaptations to the traditional COS framework, such as regulatory lags (where rates may be fixed for a period of time) and efficiency audits and reviews. In contrast, price caps and revenue caps (where prices or revenues adjust annually for inflation minus targeted productivity improvements) are “harder” forms of PBR. Performance standards and earnings sharing mechanisms, between customers and the regulated utility, lie in the middle of the continuum.

Soft

Medium

Hard

Regulatory lag or rate freeze
Performance standards
Earnings sharing mechanisms
Price cap or revenue cap
Outcomes-based PBR

Regulatory lag essentially allows for a delay in introducing new rates. The lag provides the utility a longer horizon to plan, operate and keep the benefits of the incentives provided in PBR.
Rate freeze means the utility’s rates are held constant during the PBR term. Such mechanisms give strong incentives to reduce or control operating costs. Rate freezes are also commonly used to protect consumers during the transition to a PBR regime. However, without inflation adjustments, lengthy terms can impose risks on the utility, particularly if substantial capital expenditure is required.
Performance standards – typically, the PBR framework necessitates a focus on the bottom line, which can lead utility management to pursue imprudent cost savings, thus negatively impacting reliability and service quality. To address these concerns, regulators usually impose a set of conditions and requirements designed to tie the allowed rate of return to reliability and service quality indicators
Earnings sharing mechanisms – where excess returns (or alternatively a shortfall in returns) is shared between the utility shareholders and customers. The specifics of the sharing mechanism may include symmetrical sharing (e.g., excess earnings are split 50/50 in the form of an extra return to shareholders, and a rate reduction to customers), or it may be asymmetrical (e.g., customers may not be responsible at all or for only a small share of a shortfall in earnings, yet they may benefit from excess earnings).
Price cap – the regulator approves a formula that determines how fast rates can increase. The regulator sets an initial price, and the rates are adjusted for each year, taking changes in inflation and productivity into account. A price cap provides incentives for cost efficiency and an increase in sales. These incentives arise because the tariff is fixed for the regulatory period and does not vary with changes in electricity sales within the term. Another advantage of a price cap is that it provides greater rate predictability for customers. A price cap regime is best suited for utilities in an environment with stable or increasing demand, as it provides incentives for them to operate cost-effectively while meeting the growing demand.
Revenue cap – regulates the maximum allowable revenue that a utility can earn. Under a revenue cap, the revenue requirement in a given year is established according to the previous year’s revenue requirement and adjusted based on a predetermined formula, which considers changes in inflation and productivity. Under a revenue cap, there is no incentive for utilities to maximize sales, but there is still an incentive to minimize overall costs, making it arguably more compatible with utilities that are facing substantial demand response programs or energy efficiency reductions in consumer demand. Revenue cap regimes provide more pricing flexibility and are preferable when costs do not vary significantly with sales volumes.
Outcomes-based PBR – the “next generation” of PBR is the so-called outcomes-based PBR approach, where the focus is on the outcomes rather than on the inputs to the revenue requirement. The utility under this approach is expected to achieve the outputs that are set during the PBR filing (or before the implementation of PBR), which can generally be grouped into categories such as reliability and availability, operational effectiveness, safety, public policy responsiveness, customer satisfaction, financial performance, and environmental impact, to name a few.

What are the components of a typical performance based formula? »

What are the general steps involved in implementing a performance based regime? |

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