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Editor's note: In the recent guest editorial "Why we should switch to performance-based regulation," consultant Paul Alvarez made some compelling arguments for a change. I asked him to return to address the next logical question – how to design cost recovery risks and rewards in that brave new world. As you will read, he believes we need to standardize on some performance metrics, and hints that he will be back soon to give specific suggestions. I hope you'll use the Talk Back form at the bottom of the page to let Paul know if you think he's on the right path. -- Jesse Berst

 

By Paul Alvarez

 

In a previous contribution to Smart Grid News, I made the case for performance-based recovery of IOUs’ smart grid investments. I suggested incorporating both rewards (incentives) and risks (penalties) for shareholders.  My premise was that capital investment does not make a grid smart; the value comes from the manner in which utilities make use of new data and capabilities.  I argued that regulated utilities should NOT be rewarded simply for making smart grid investments.  Instead, they should be rewarded for maximizing smart grid value (by completing difficult organizational, operational, data utilization and customer-facing changes required). Similarly, I argued that customers should consider paying a premium for strong value creation, matched by appropriate discounts for poor value creation.

 

A discussion on performance-based cost recovery leads logically into a conversation about the relative size of shareholder rewards and risks. And to further discussions about how performance should be measured. Due to space constraints I’ll tackle the latter in a future article.  But the former -- designing rewards and risks -- is a difficult enough issue and merits its own conversation.

 

Let's be fair

It seems equitable that utilities be offered incentives for good performance of the same magnitude as the penalties for poor performance.  It also seems appropriate that incentives and penalties be set at levels relative to investment that do not discourage said investments. That is, penalties shouldn’t be too large, but large enough to ensure utilities make the post-deployment effort to maximize the value of the investments. Said another way, the incentives should be attainable with reasonable effort towards high-priority outcomes. 

 

With these cost recovery principles in mind, let’s look how forward-looking regulators are framing smart grid cost recovery.

Cost recovery risk/reward based primarily on economic performance

Regulators in some states are using cost recovery risk/reward to hold utilities

accountable for economic benefits.  In Ohio (Case 10-2326-GE-RDR) and Oklahoma (Cause PUD 201000029), regulators approved smart grid cost recovery at authorized rates of return. However, they specified a withholding to be fulfilled through the economic benefits the utility could realize from smart grid investments.

 

In Oklahoma, the OCC withheld the amount Oklahoma Gas and Electric estimated it would save in O&M spending in its smart grid business case -- $22 million from 2010 to 2013, relative to an overall smart grid capital investment projected to be $366 million.

 

In Ohio, the PUC withheld the amount of economic benefit an independent auditor (a team led by the author) estimated after a mid-deployment review.  These benefits included O&M reductions, increased revenue capture and other sources amounting to $36 million by 2014.  (Duke Energy projects a total investment of $1 billion in its five-state service area).

 

If my interpretation of these orders is accurate, utility shareholders were offered the opportunity for rewards as well as penalties. Rewards if economic benefits exceed the withheld amounts. Penalties if economic benefits are less than withheld amounts.  In addition, the risks and rewards appear to be of reasonable magnitude relative to investment size, and the rewards appear to be attainable with reasonable effort.

 

A more demanding approach that may stifle investment

Regulators in Maryland established a more demanding approach to smart grid cost recovery.  Smart grid investments by Maryland IOUs are categorized as regulatory assets until the IOUs can demonstrate their cost-effectiveness (Orders 83531 and 83532).  If the IOUs can do so to the Maryland PSC’s satisfaction, the assets will be allowed into the rate base and costs recovered at the authorized rate of return.  If not, the Commission could disallow some or even all smart grid investments from the rate base.  Most IOUs would argue that such an approach is sufficiently severe to discourage smart grid investment, though consumer advocates applaud the protection of customers’ economic interests.

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Talk Back to the Author

Current Comments (7)

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Performance Incentives & Innovation

Paul Greatly appreciate your writing on the subject of performance based ratemaking and the notion of financial incentives tied to performance. I would argue with or without smart grid type investment this approach makes sense. As a regulator I found traditional rate making to be largely about finding the lowest number but not the highest quality outcome. In the competitive markets price and quality go together and are inextricably linked to the consumer experience. Cost plus rates do not account for or measure qualitative performance. Instances where qualitative metrics are tracked is less common. In Vermont we had "Service Quality & Reliability Plans (SQRP), but these only meted out penalties for below par performance, no payments for superior outcomes. With grid modernization I see no other path, the key is symmetry of benefits and risk between ratepayers and shareholders. I do not see the capital markets making the billions of dollars necessary for grid modernization available under the current rubric. If all of the risk appears to rest with shareholders SG will be very difficult to underwrite. I agree strongly with your observation that the utilities must leverage the technology to enhance customer satisfaction, lower costs, etc. As I pointed out in my piece on the SG Inflection Point http://www.smartgridnews.com/artman/publish/Business_Policy_Regulation/Are-we-at-the-smart-grid-inflection-point-4380-page2.html there is a quid pro quo where utilities deliver superior value while regulators provide greater clarity through such mechanisms as a multi-year performance based plan. David O'Brien Bridge Energy Group

David O'Brien - 09/04/2012 - 06:55

A better way to do smart grid cost recovery?

Paul, I agree with much of what you propose. Yet, in many cases, moving in this direction may require additional statutory authorizations -- plural -- from state legislatures as the traditional economic based approaches may not give PSCs the latitude needed to do as you propose sans new authorities from legislative branches, and signed into law by governors. You allude to this probability in your reference to the new Illinois legislation. Each State's Commissioners can answer this question better than I, and my expectation is there will be diverse answers.

Michael E Ebert - 09/04/2012 - 11:36

Not Again

Oh brother, here we go again. Did you hear that SG has shown to reduce heart attacks and cure cancer? First, let me begin by saying that from the ratepayers’ point of view, PBCR makes no sense. Am I missing something or are you saying that we cannot expect reliable power or a well managed utility without a PBCR? As a raypayer, I guess that I should never have assumed that utilities were operating efficiently. This is what you are inferring in this article when you state that a PBCR model would incentivize utilities to actually start performing. I could spend the rest of the evening explaining why this is a bad idea. To date, I have not seen one SG project that has reduced base rates. Instead, base rates increase with the promise of some future cost reductions. Kind of sounds like Congress to me. Especially, when you start saying that the rate of increase has been slowed due to these investments. I don’t subscribe to this philosophy of paying in advance for future savings that cannot be quantified. While we are the subject of AMI, I predict that IOU's will never reach the participation level that they envisioned for TOU rates. Therefore, utilities will have no choice but to press the PSC to allow them to implement mandatory time-differentiated (TOU) rates. I don't see this sitting well with the ratepayer, but who cares? Today, we are building “fields of dreams” with the ratepayer on the hook.

Todd Sumner - 09/04/2012 - 17:05

PBCR

Todd: Thanks for comments, to your potential surprise I think we are on the same page. What I am suggesting is: 1. Customers are less likely to obtain the future cost reductions you cite without PBCR. 2. TOU rate participation will likely be lower as you cite without PBCR. 3. The ratepayer needn't be 'on the hook', as properly designed PBCR can protect their interests. You might want to read my first guest column on this subject at http://www.smartgridnews.com/artman/publish/Business_Policy_Regulation/Smart-grid-regulation-Why-we-should-switch-to-performance-based-regulation-5051.html

Paul Alvarez - 09/04/2012 - 19:01

Statutory Authorizations

Michael: I couldn't agree more with your comment that regulators are not always authorized to take the actions I am suggesting. I have also found that Commissioners and Staffs are generally buried by rate cases, generally under-resourced relative to their responsibility, and occasionally under seige by executive and legislative branches of their state governments. I am not suggesting that my approaches would be easy, only that they are important if benefits are to be maximized for customers.

Paul Alvarez - 09/04/2012 - 19:05

Rejoinder on Paul's comments:

Paul, Everything you've said in your reply to me is, unfortunately, so very true: most state PSCs, Commissioners, and staff are over-burdened, under-resourced, and whiplashed by various "stakeholders." And I agree 100% with your last sentence. The challenge in the environment you've well described, is that in general our politics (writ large) increasingly seeks only the easy and ducks the difficult but worth doing. -- Michael Senior Research Affiliate Volgenau School of Engineering George Mason University Thanks for your reply and your essay.

Michael E. Ebert, CISA, MPP - 09/05/2012 - 08:41

What Utilities Need to Focus On

Paul, I appreciate your response. However, I have a different vision for our IOU's. Public power (Cooperatives and municipalities) have different business models so I will exclude them from this discussion. As you know, IOU's are motivated to increase capital spending because this allows them to increase their profits using the same ROI (percentage) approved by their PSC. What IOU's are less likely to do is provide the necessary funding for Operations and Maintenance of their electric systems. Since most of these costs cannot be capitalized, IOU's tend to spend just enough on O&M to meet or slightly exceed the minimum reliability and power quality levels set by their respective PSC. Therefore, I agree that the present system is not benefitting the ratepayer. Is PBCR the answer? I cannot definitively say no, but I am skeptical. I could envision ENRON like activities where accounting is more important than results. I would hope that PBCR incentives would be well thought out before deciding to go down this road. This would require a good benchmark and the ability to measure (quantify) results. To be honest, I think that this could turn into a situation like your local cable company where they charge you more then they explain that we just added 10 channels to your package. Generally speaking, most people would have preferred the lower cost package without the enhanced channels. Also, my recommendation is that ratepayers should be responsible for their impact on their utility system. For instance, a customer that decides to purchase an all electric vehicle (BEV) would pay a higher base rate because of the advanced monitoring required to ensure power quality and reliability for the other ratepayers. Likewise, if a customer decided to add PV solar, they would pay a higher base rate because of their poor load factor. Unfortunately, underutilized assets should not be absorbed by the rate base. However, PV solar customers should benefit from reducing kW demand during system peak. However, PV solar does not help winter peaks (7:00-9:00 a.m.) and it only marginally helpful during summer peaks (4:00-6:00 p.m.)in Florida. I am not sure how these savings would be calculated, but PV solar customers should see some savings. In conclusion, IOU's have done little to increase ratepayer value... now shareholder value is a different subject.

Todd Sumner - 09/05/2012 - 17:34

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