A better way to do smart grid cost recovery (PUCs pay attention)


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 based primarily on reliability performance

The Illinois legislature’s Public Act 097-0616 contained significant provisions to encourage Illinois IOUs to make smart grid investments - up to $3.7 billion over 10 years.  (The opportunities offered were so significant that both Exelon and Ameren stock rose 5% in the two weeks following the Act’s effective date of Oct. 26, 2011, while IShares’ U.S. Utility Index was flat over the same period.)  Authorized rates of return on such investments were set at 600 basis points (6%) over the 30-year U.S. Treasury Bond rate (most recently 2.75%) subject to the achievement of specified performance metrics. 


When Illinois announced performance-based cost recovery and incentives, both Exelon and Ameren stock rose 5% in two weeks, compared to flat performance by the IShares U.S. Utility Index.


Missing any one of nine performance metrics -- most of which related to reliability -- will reduce rates of return by five basis points (0.05% each), updated annually. Cost recovery in Illinois is perhaps most notable for asymmetrical risk; shareholders were offered no rewards for strong performance.  On the other hand, customers were dismayed to find that cost recovery penalties are extremely small relative to investment size.  Customer concerns were compounded by the fact that no cost recovery risk was established for the attainment of potentially significant customer benefits (i.e., time-based rate participation/demand response, distribution grid efficiency, O&M expense reductions and customer/third party data access). 


As customers continue to question the value from massive investments, regulators will increasingly turn to cost recovery incentives and penalties to maximize smart grid value. But perhaps the most significant observation is the large variability in cost recovery approaches from state to state.  Since cost recovery drives utility behavior, it becomes increasingly important to standardize on a manageable number of critical smart grid outcomes, associated performance metrics and their application.  Continue to watch Smart Grid News for the latest developments in smart grid policy and regulation.            


Paul Alvarez is the President of the Wired Group, a distribution business consultancy with a focus on smart grid benefit quantification and performance measurement.  He has led teams that have completed comprehensive, independent evaluations of smart grid deployments for Xcel Energy (SmartGridCity) and the Ohio PUC (Duke Energy’s Ohio deployment). For smart grid reference work, links to benefit and performance measurement resources, and more visit www.wiredgroup.net.