Regulatory Reform is a Game of Hopscotch, Not a Flying Leap

The changes underway in the electricity industry are well documented: Demand is flat or declining; renewable energy and storage technology costs are plummeting; utilities and third parties are offering customers new technologies and services; and the need to cut emissions is increasing. And there’s a growing recognition that adapting to these changes requires new regulatory approaches.

Why can’t our traditional approach to regulation tackle these new challenges? A key reason is that it was primarily designed to get utilities to build out the power grid and provide universal access to electricity — key public policy goals of the early 20^th century. The traditional cost-of-service model, which rewards utilities for increasing sales and capital-intensive solutions to grid needs, served those original goals admirably. But it stands as a barrier to achieving other outcomes that society now cares about. Public policy aims have shifted since the early 20^th century, and increasingly states want to focus on other goals such as system resilience, consumer empowerment, affordability and emissions reductions. This has resulted in a rethinking of how we compensate utilities for providing energy services.

As states consider moving to a regulatory model that compensates utilities not on their capital investments but rather on whether they achieve certain defined outcomes — the model known as performance-based regulation — it is important to make sure those outcomes directly benefit the public good. At RAP, we think that means things like better service quality, lower costs, more clean energy and reduced emissions.

All of this sounds like a no-brainer — connecting utility shareholder value to benefits for customers and society. In practice, challenges await states that go down this road, but several are taking steps in this direction. For starters, defining and agreeing on key outcomes can be tricky with a diverse and growing set of stakeholders, but defining priorities can help. The Minnesota and Hawaii public utilities commissions have recently done just that with orders that lay out processes for selecting and prioritizing performance goals and outcomes.

Once goals and outcomes have been chosen, the next steps are to design metrics to track whether utilities and the broader energy system are meeting them and to decide whether to pair those metrics with monetary incentives or penalties. Where the data on these metrics comes from, and whether it is verifiable by outside entities, are also important cornerstones to establish. Determining the best baseline from which to measure progress is also an important element, as are creating a fair way to motivate utilities and avoiding potential unintended consequences.

Implementing such significant changes is no small feat for regulators, but fortunately they are well suited to the task. They may have to start, however, by doing something uncomfortable: embracing imperfection. The nature of the challenge — with its technical complexities, imperfect information and constantly changing circumstances — means that getting everything exactly right the first time is unlikely. Instead, we should focus on moving in the right direction while regularly reevaluating our progress. Reforming regulation to meet the requirements of the future will necessarily be a process of continuous improvement.

Taking a hopscotch approach to regulatory reform, where each step validates the last and enables the next, also will make it easier for regulators to include and value the importance of benefits that have been hard to monetize traditionally. Several of these — such as greater customer empowerment, enhanced participation by distributed energy resources and reduced emissions — may in fact be central rationales behind states’ exploration of regulatory reform. By acknowledging that the assessment and achievement of these benefits will require adjustments over time, regulators can encourage utilities and stakeholders to actively engage in this iterative process. In practice, this means periodically revisiting both the goals and outcomes and the metrics and data used to assess whether they are being effectively achieved. This, in turn, will help identify opportunities for improving and strengthening the overall structure.

Although challenges lie ahead in reforming our traditional regulatory paradigm to meet the needs of the future, we needn’t fear that doing so requires a flying leap. Unlike Evel Knievel in his famed motorcycle jumps, we don’t need to clear the chasm all at once. We can use hopscotch to get there instead.

Brewing Up the Regulation of the Future

The regulatory system that governs U.S. electric utilities is 130 years old—while our power grid is rapidly modernizing. Utility regulators need a tool that can facilitate reform to keep pace with this change. One tool they are increasingly exploring: performance-based regulation, or PBR for short (no, it’s not a beer, it just sounds like one).

A variety of states are now eyeing the idea of tying revenues to utilities’ ability to meet performance goals, and RAP has been providing recommendations on how to put PBR ideas to work in various contexts. This blog is the first in a series that will examine best practices, design considerations, and specific applications. What goes into the 21^st-century brew that is PBR? Let’s learn more.

The Traditional Model

Most utility regulation in the United States today is cost-of-service (COS) regulation. This means that consumers pay utilities for the cost of providing electric service (e.g., for transmission, distribution and other utility infrastructure), plus a regulated return on their investment. The regulators’ job is to oversee this arrangement, ensuring that service is safe and reliable and that rates are fair. This approach incentivizes certain behaviors:  regulated utilities recognize they can maximize revenue and profits by building more generation, transmission, distribution, and other infrastructure, and by selling more electricity between rate cases. This works particularly well for a system with large, centralized power plants that required substantial capital investments.

But today, average residential customers are increasingly able to control their energy usage through efficiency upgrades and energy management tools, and even to become grid resources themselves through behind-the-meter solar or storage. This is a fundamental shift from the 20^th-century era of large, centrally operated generating plants. Consumers are seeking different energy options, and in much of the United States, electricity use is not growing – which would serve to keep rates down – as it did in the 20^th century.

Can the aging regulatory paradigm adapt to the changing nature of resources, delivery, and consumption of energy?  How can regulation help deliver what customers want today, and still keep utilities profitable and responsive in the face of these fundamental changes?

The Modern Approach

PBR is one route to accomplish this regulatory reform. Instead of solely evaluating utilities’ costs, PBR focuses on the outcomes that policy makers and stakeholders (regulators, utilities, consumers, advocates) establish, and then rewards utilities based on their performance. While traditional COS regulation looks at performance in terms of sales, revenue, rates, and often reliability, PBR addresses these concerns and additionally incentivizes goals like customer engagement and empowerment, environmental outcomes, and cost-effectiveness.

The good news for regulators looking to reform the current regulatory system – but unsure how to proceed – is that PBR can take a variety of forms and pursue different goals, from simply adding individual mechanisms to revising the whole regulatory paradigm.

Individual mechanisms, or performance incentive mechanisms (PIMs), act as an overlay on a traditional COS regulatory framework. PIMs set specific performance metrics to affect utility behavior in a way that furthers public interest priorities. They provide a bonus – or penalty – to strengthen performance in target areas. Many jurisdictions in the US have experience using PIMs for energy efficiency incentives.

At the other end of the spectrum, PBR can be designed to transform the whole regulatory system to focus on specific goals. The United Kingdom’s Revenues = Incentives + Innovation + Outputs (RIIO) approach focuses on six major outputs as a means to evolve the energy system of the future. These outputs are linked to incentives to advance the overall goal of a lower cost, more sustainable energy system. Similarly, New York’s Reforming the Energy Vision (REV) process is constructing a regulatory system that rewards distribution utilities for high levels of customer satisfaction, facilitates power sector transformation to cleaner and more distributed resources, and focuses increasingly on outcomes rather than inputs.

Like home brewers choosing from a range of recipes, utility regulators have a range of options for implementing PBR, and they can readily review mechanisms that worked (or didn’t work) elsewhere for lessons learned. Having considered “what” PBR is here, the next post in this series will introduce “how” PBR can be implemented, and examine design practices to ensure that performance incentive mechanisms are successful.