Building a Brighter Future by Changing Utility Incentives
How comprehensive performance-based regulation can improve outcomes for customers and society.
A century ago, traffic signals and radios were cutting-edge technologies, women had just won the right to vote, and the climate was still stable. A lot has changed since then.
But one thing that hasn’t changed much is how most investor-owned utilities are regulated. In the United States today, most of these utilities are subject to a traditional cost-of-service (COSR) model. Under this model, profits are tied to how much the utility spends rather than on the value it delivers, and some types of spending are more profitable to it than others. Unfortunately, this approach is poorly aligned with modern policy objectives.
For instance, traditional COSR creates a strong incentive for electric utilities to spend more than needed on grid infrastructure — but affordability is a growing concern today in light of load growth, the aging grid, and the need to ensure resilience in the face of increasingly severe weather. Traditional COSR also encourages utilities to prefer investing their own capital over utilizing third-party services and customer-owned solutions. However, the best solution today may not be a big utility-owned asset, but customer-owned batteries or a virtual power plant.
Performance-based regulation (PBR) can help address these challenges. PBR is not one tool but a whole toolkit, and one that can be applied in myriad ways. This flexibility means PBR can be tailored to local needs and priorities, but it can make it hard to know how to do so effectively.
In a new report, we offer guidance to regulators and stakeholders on implementing PBR. We begin by drawing a distinction between incremental and comprehensive PBR. Incremental PBR involves adopting piecemeal reforms to the traditional COSR framework, whereas comprehensive PBR fundamentally restructures the incentives regulated utilities face. This difference is illustrated below.
Incremental vs. Comprehensive PBR
We also propose a new Four Pillars Model to help guide the development of comprehensive PBR reforms. The four pillars consist of incentivizing cost efficiency, removing the throughput incentive, equalizing the incentives between capital expenditures and operating expenses, and incentivizing targeted outcomes. Together, these pillars address the key shortcomings of traditional COSR.
The Four Pillars of Comprehensive PBR
Though the Four Pillars Model helps clarify what comprehensive PBR is, translating it into real reforms will require moving beyond abstract principles. To assist regulators and stakeholders on this journey, the report also provides:
- An introduction to the PBR toolkit. We discuss a variety of PBR tools, including multiyear rate plans, revenue decoupling mechanisms, different capex-opex equalization strategies, and also metrics, scorecards, and performance incentive mechanisms (PIMs). We also explore a number of alternative ways to structure PIM financial incentives, ranging from simple lump-sum rewards for good performance to shared savings mechanisms, return on equity incentives, and more complex formulations.
- Suggestions for how to apply the Four Pillars Model to guide reform. We suggest a number of ways the Four Pillars model could be utilized by regulators and advocates, such as to assess the current regulatory framework and evaluate proposed PBR reforms for comprehensiveness. We also discuss how PBR fits into the broader regulatory context and highlight a number of potentially synergistic reforms.
- Tips for conducting the reform process. Even small regulatory changes can be complex to implement, and the prospect of restructuring an entire framework may seem intimidating. We propose some ways regulators can break down the process to be more manageable and yield better results.
- A case study. We discuss Hawaii’s current PBR framework as a real-world example of the four pillars in action.
Comprehensive PBR offers a solution to many of the undesirable outcomes of traditional COSR, and its impact is likely to be even greater when adopted in conjunction with other synergistic policies. We hope the addition of the Four Pillars Model to the regulatory toolbox will help public utility commissions bring the regulations of public utilities into better alignment with 21st-century policy goals.
