Incentive Mechanisms NARUC Staff Subcommittee on Accounting and Finance Portland, Oregon September 8-12, 2013 Presented By Bill Steele Bill Steele and Associates.com

Presentation Outline  What are Incentive Mechanisms (IMs)?  What is the process of establishing an IM?  What are the features of an IM?  What are examples of IMs for the natural gas industry?  What are the major issues surrounding IMs?  How have IMs operated? 2

What Are Incentive Mechanisms  Incentive Mechanisms are viewed as a tool in addressing the problem in “Rate-of-Return Regulation” of weak financial incentives for cost control  IMs can be defined as a set of innovative regulatory approaches designed to provide utilities with incentives to achieve specified goals, or to meet specified standards or benchmarks, or to operate in a more efficient manner

What Are Incentive Mechanisms - continued  The goals of Incentive Mechanisms are three-fold:  To align customer and shareholder interests  To measure utility performance relative to a benchmark, and  To reduce the regulatory burden

Process of Implementing an IM  Reaching agreement that an IM should be implemented  Developing the general features or structure of an IM  Resolving the implementation issues (“the devil is in the details”)  Modifying or terminating the IM when supported by ex post information

Features of an Incentive Mechanism  Stated objective of the IM, compatible with guiding principles and assumptions  Specification of the benchmark  Accounting and reporting of actual costs under an IM  Sharing rule for differences in benchmark and actual costs  Dead band ” region (optional) 6

Examples of IMs for the Natural Gas Industry  Price caps for distribution service  Gas-procurement, cost-sharing incentives  Revenue sharing for capacity brokering, interruptible sales, off-system storage services, off-system sales  Sharing of storage benefits  Targeted DSM incentives  Profit or earnings sharing  Targeted service-quality incentives

Some Observations  A benchmark should be established in the case of gas cost incentive mechanisms that reward companies based on performance relative to an external benchmark of market gas cost.  The benchmark should be used in conjunction with the current PGA/deferral process.  PGA rates, as price signals, should provide the most accurate estimate of expected gas costs and should be based on the Company's most accurate estimate of prospective gas costs, with deferral accounting and true- up of revenues collected to actual costs.  The sharing mechanism should be based on a comparison of actual gas costs to a benchmark. 8

Some Observations - continued  Total gas costs should be included in the benchmark, including fixed and variable transportation costs, fixed and variable commodity costs, and fixed and variable storage costs.  Transportation and storage components of the benchmark should be updated, as FERC regulated rates change.  The inclusion of total gas costs in the benchmark (1) avoids problems such as how to handle bundled supply resources and gaming of transportation/commodity costs or fixed/variable costs, and (2) provides a potential opportunity to reward or penalize a utility for long term transportation capacity decisions.  Incentive mechanisms should be simple to understand and apply, avoiding complex calculations which could lead to disputes or gaming. entivePolicy.aspx

What Different Groups Want From Incentive Mechanisms  Utilities: greater profit opportunities, compensation for increased market risk  Consumers: lower prices, no deterioration of service, more stable prices  Regulators: “ win-win ”

Issues Concerning Incentive Mechanisms  Rewards too small to elicit change in utility behavior  Windfall gains to the utility (e.g., “free riding”)  Weighing dollar benefits to consumers compared with dollar benefits to the utility (e.g., a dollar to consumers is worth more, from a societal perspective) than a dollar to the utility)  Measuring actual benefits to consumers  Decline in reliability/quality of service  Effect on regulatory-administrative costs 11

Preliminary Findings on Incentive Mechanisms  Setting a benchmark has been the most controversial, as well as difficult, aspect of Incentive Mechanisms  Careful attention should be paid to establishing an appropriate benchmark  Common for constant tweaking of the Incentive Mechanisms over time– Incentive Mechanisms should be seen as part of an evolutionary process where everyone learns from past problems 12

Undesirable Outcomes of Incentive Mechanisms from Different Perspectives  Utilities: greater profit opportunities as compensation for increased market risk not materializing  Consumers: prices not decreasing or exhibiting more stability; lower quality of service  Regulators: more resources devoted to plans than expected; failure to achieve a “ win-win ” scenario

Concluding Remarks  Setting a benchmark has been the most controversial, as well as difficult, aspect of IMs  Careful attention should be paid to establishing an appropriate benchmark  IMs should be evaluated periodically (e.g., three years) to determine success or failure  IMs should not replace the commission's ability to review the prudence of utility management actions in general rate proceeding or other proceedings  Try to keep it simple 14