As new energy technologies proliferate and eat into electricity sales, utilities and regulators are searching for a rate design that addresses growing load defection.

One currently popular response is tinkering with rate design in a way that could compromise these technologies’ value propositions, but utilities nationwide have experienced a backlash from customers intolerant of those rate changes.

A less common but better option for utilities is rate design that’s palatable to everyone, according to a new report, "Performance-Based Regulation in a High Distributed Energy Resources Future," from the Lawrence Berkeley National Laboratory (LBNL). The study promotes performance-based regulation as the key to a future grid with “a high reliance on energy efficiency, peak load management, distributed generation and storage.”

It is becoming more difficult to make the longstanding cost-of-service regulation work, LBNL Researcher Lisa Schwartz, the paper’s editor, told Utility Dive.

With cost-of-service regulation, a utility’s revenues come from investment backed by a guaranteed rate of return built into its rates, the paper explained. As a result, utilities do not get “the financial incentives to address evolving electric industry challenges such as changing customer demands for electricity services, growth of distributed energy resources, and changing federal and state policies.” ​

Creative rate alterations, from cost trackers to decoupling, are attempts to remedy this shortcoming. They have been so widely adopted that there is no longer “pure [cost-of-service regulation],” Schwartz said. But with the increasing penetration of innovative and disruptive technologies, even the altered models may no longer work.

A more comprehensive alternative that's beginning to emerge is performance-based regulation, which is based on strong performance incentives and a pre-set long-term rate escalation. Performance-based regulation aims to change how rates are set to streamline regulatory burdens and allow utilities more flexibility to innovate. When it works, the utility and its customers share benefits.

“There are two fundamental pieces for comprehensive performance based regulation,” Schwartz said. The first is incentives.

The add-ons to cost-of-service regulation led to a lot of thinking about incentives, she said. “Performance incentive mechanisms give utilities performance-based goals and the financial incentives to meet them so they won’t choose to cut service quality instead of costs.”

Less attention has been given to an equally important piece of the puzzle, the multi-year rate plan. “The idea is to provide a financial incentive for utilities between rate cases to cut costs and get efficient,” Schwartz said. “It is a real stay-out. The utility has no rate case for three, four, five, or even eight years.”

Performance-based regulation is not 'one-size-fits-all'

The LBNL paper is part of a set of U.S. Department of Energy-funded “deeper dives into the pros and cons on different issues to better inform discussions by regulators and policymakers,” Schwartz said. 

This paper is a “point-counterpoint discussion that demonstrates the elements of [performance-based regulation] design look different to investor-owned utilities trying to earn their target returns than to utility customers concerned about rates.”

Performance-based regulation is “not a one-size-fits-all construct,” the paper said. Several elements “can be applied in different ways and in different combinations.”

Most often, performance-based regulation includes the multi-year rate plan and performance-incentive mechanisms. The incentives reward the utility for performance, while the multi-year rates include an “attrition relief mechanism” as a key protection against the utility failing to perform and other unintended outcomes.

The attrition relief mechanism “automatically adjusts rates or revenues between rate cases to address cost pressures without closely tracking the utility’s own cost,” the paper explained. To do this, jurisdictions where multi-year rate plans are used have developed forecasts linked to “quantifiable cost drivers such as inflation and customer growth.”

Performance-based regulation is common in most of the English-speaking world outside the U.S., according to Pacific Economics Group Research President and paper co-author Mark Newton Lowry.

To be confident that utilities’ cost forecasts are reasonable, he said, many countries’ regulators employ their own economists and engineers to do independent “statistical benchmarking to protect customer interests.”

This fact-checking of utility projections “can result in very large disallowances, which is unheard of in the U.S. unless a nuclear plant stops producing or a natural gas pipeline explodes in an affluent neighborhood,” he said.

The pros and cons of multi-year rate plans

From the customers’ perspective, well-designed multi-year rate plans motivate utilities to test and support technological innovations favored by policymakers and the marketplace, such as distributed energy resources (DERs), the paper said. Utilities gain the flexibility to market new technologies, but customers remain protected from bearing a cost burden from any unsuccessful efforts. With less frequent rate cases, taxpayers and ratepayers are also relieved of regulatory costs.

The downside is the higher cost to regulators and consumer advocates for dealing with the greater complexity of setting rates and protections over a potentially much longer term. Some, such as those in jurisdictions where there is “an asymmetry of expertise” due to ratepayer-funded utility resources, may not be able to do the necessary benchmarking, Schwartz pointed out.

With a multi-year rate plan, “a utility’s revenue may exceed its costs for extended periods,” the paper found. If regulatory tools to contain that are introduced, “utility performance incentives may be weakened.”

Another challenge, especially to commissions and consumer advocates with limited staff and recourse to experts, is that a multi-year rate plan “is essentially a rate case moratorium and can almost seem like automatic rate increases,” Schwartz said.

The attrition relief mechanism is a way to impose an “offramp” for unintended outcomes but it depends on regulators and consumer advocates having the resources to effectively impose them, Schwartz said. “This is something every jurisdiction has to face."

From the utility’s perspective, a multi-year rate plan offers new access to revenue opportunities and the flexibility to pursue them. The utility could profit on some marketing efforts and lose on others because its earnings come from its overall performance.

A utility with a multi-year plan also does not have to allocate costs between products and deal with cross subsidy issues at regular rate cases, Lowry said. For utilities and regulators, those are complicated, controversial issues. “The less frequently it is necessary, the better.”

Benefits can include meeting competitive challenges, retaining large-load customers, and satisfying the complex, changing demands of its rate base, the paper found. “Improved performance can become a new profit center for a utility at a time when traditional opportunities for earnings growth are diminishing.”

The downside is increased risk with no guaranteed return. “Revenue may occasionally fall short of cost,” the report noted. And regulators may insist on programs designed in such a way that customers receive the most benefits, “leaving the utility at a disadvantage.”

The pros and cons of performance incentive mechanisms

From the customers’ perspective, regulators and stakeholders can use performance incentive mechanisms to guide utilities “to specific performance areas and the desired outcomes,” the paper reported. This can be done “incrementally and gradually” to reduce customer risk.

On the downside, designing performance incentive mechanisms can be “complex, contentious and resource intensive,” it added. A performance-based regulatory proceeding may therefore end up focusing on the easier performance areas like service quality, reliability, and demand-side management implementation, while potentially overlooking more difficult but equally important performance areas.

Well-designed performance incentive mechanisms have to balance financial rewards and penalties so they motivate the utility while avoiding unintended outcomes — and that “can sometimes be difficult to achieve,” the paper found.

From the utility’s perspective, it sees clearly what customers, regulators, and policymakers want from performance incentive mechanisms. The utility also knows what type of performance will increase its earnings.

On the downside, “targets can be unreasonable at the outset or ratcheted unfairly,” the paper noted. Tentatively designed performance incentive mechanisms can offer too little reward; those that only penalize underperformance instead of rewarding higher earnings are essentially "anti-competitive."

The right incentives, however, could help mitigate utility bias toward capital investments and against less capital-intensive but potentially more effective innovations like DERs or operational improvements, Schwartz said. They are also “critical to ensure the cost cutting doesn’t degrade things like service quality and safety.”

Performance-incentive mechanism programs can be and are often instituted without multi-year rate plans, the paper added.

Customer advocates like the simplicity, transparency, and reduced risk of that approach. However, without the increased flexibility of an multi-year rate plan, utilities may be reluctant to test the most innovative technologies.

Utilities can be comfortable with stand-alone performance incentive mechanisms when they can continue to get guaranteed returns for traditional capital investments, according to the paper, allowing them to avoid the complexities of a multi-year rate plan. It can be “relatively easy for the utility and stakeholders to agree on a set of revenue escalation provisions."

But the paper pointed out that multi-year rate plans allow utilities the flexibility to deal with competition from private sector DER providers by offering customers the products they are demanding. That flexibility also offers the opportunity to test new rates and new services.

Studies show utilities with multi-year rate plans do cut back on capital spending, Lowry said. “It is the best possible way to get good performance. Utilities that have done the most with DERs have all these features of performance-based regulation in place.”

A history of successful performance-based regulation

While cost-of-service regulation is the dominant model for electric utilities across the U.S., there is evidence that performance-based regulation has been and could be successful. 

Significant use of multi-year rate plans and performance incentive mechanisms in North America began in the 1980s. The methods have had the most acceptance where utilities were looking for marketing flexibility. They were effective at transitional moments for the railroad, oil pipeline, and telecom industries.

In the U.S. electric utility industry, California led with a 1980s Rate Case Plan that continues to limit general rate cases. Iowa, Maine, Massachusetts and New York have also used versions of a multi-year rate plan.

That approach helped Central Maine Power market to struggling paper mills and allowed MidAmerican Energy to weather a rate freeze. Vertically integrated utilities in Colorado, Florida, Georgia, Virginia, and Washington are now testing the concept.

“Statistical benchmarking studies by PEG Research have shown that vertically integrated electric utilities that have operated for long periods without rate cases often display superior cost management,” the paper said.

Performance-based regulation 'can work for any jurisdiction'

Properly designed performance-based regulation can “drive increased efficiency, cut costs, and provide consumer benefits and there is little disagreement on that between the authors,” Schwartz said. “But it is a big change. If there is disagreement, it is that consumer advocates are less confident that customers will actually benefit.”

But the trends are clear: Load is declining, DERs are proliferating, investments are being made in grid modernization, and it is not clear that cost-of-service regulation will get utilities to the kind of system that is needed, she said.

Each jurisdiction must establish its own goals and policies to implement performance-based regulation, she said. “Consumer preferences and competitive businesses have put the utility and the regulator in a different situation than they were a decade ago.”

In discussions that led to the paper, consumer advocate and co-author Tim Woolf of Synapse Energy Economics developed growing respect for the potential of performance-based regulation, if it includes both a properly designed mutli-year rate plan and appropriate performance incentive mechanisms, according to both Schwartz and Lowry.

“Performance-based regulation can work for any jurisdiction,” he explained. Comprehensive programs work where there is an inclination toward innovation and a willingness to see big regulatory change. “Where there is not that appetite, performance incentive mechanisms or revenue decoupling can be a starting place.”