Incentive Regulation: Can It Save Utilities?

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Utilities in the U.S. are caught in a quandary.  The traditional model for creating earnings growth for investors is built around increasing sales and growing capital investment.  Yet as we move forward into the 21st century, market forces and government/regulatory policies are constraining demand and encouraging alternatives to utility generation. Utilities fear a death spiral, where fewer and fewer customers are asked to pay more and more to support utility fixed costs.

Meanwhile, many in the industry believe that consumers are soon to awake from their century-long acceptance of monopoly utility services to demand options not dissimilar to phone and internet services[1].  Utilities in the United Kingdom (U.K.) are facing similar concerns, and over the last two years the U.K. regulator Ofgem (Office of Gas and Electricity Markets) has begun implementing a new incentive-based monopoly pricing mechanism designed to move their utilities into the new world[2].  Ofgem’s mechanism is worth studying as a possible future for U.S. utilities.

When the U.K. electric and gas utilities were restructured in the 1990s, the business was separated into four sectors – production (generation in the case of the electric business), transmission, distribution, and retail supply.  Transmission and distribution were defined as monopoly network companies subject to regulation.

But since the network companies no longer had generation resources or could make a margin selling supply to customers, the U.K. had to develop new methods of creating a profitable but fair revenue stream.  The U.K. decided on performance-based regulation (PBR) and has been implementing and refining this model since.

The latest methodology is called RIOO.  The name is taken from the equation Revenues = Incentives + Innovation + Outputs.  RIOO will set allowed prices for network companies for an 8-year period.  According to Ofgem, the regulation will encourage network companies to:

  • put stakeholders at the heart of decision making
  • invest efficiently to ensure continued safe and reliable service
  • innovate to reduce network costs for customers
  • play a full role in delivering a low-carbon economy and wider environmental objectives

The mechanism will allow the network companies to attain a specified rate of return based on performance as measured against criteria such as customer satisfaction, reliability and availability, safe network services, connection terms for new customers, environmental impact, and social obligations.  Note that return is not based on the amount of capital invested to achieve these criteria; that decision is left up to utility management.

So will we soon move to radically different regulatory models in the U.S. similar to those in the U.K.?  As most readers know, nothing moves fast in the utility industry. And the U.K. has been refining its model for over 20 years. But the U.K. experience provides some interesting ideas for states to consider as regulators and utility management try to figure out how to keep utilities viable as we move into a new energy world.


References:

[1] See for instance the Utility Customer of 2020 from PwC: https://assets.fiercemarkets.com/public/sites/energy/utility%20customer%202020.png

[2] See Ofgem’s site describing the regulatory mechanism here: https://www.ofgem.gov.uk/network-regulation-%E2%80%93-riio-model

Original Article on Enerdynamics

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