Regulation & Incentives

Regulation & Incentives
Center for Energy Studies Regulation & Incentives Michigan State University, Institute of Public Utilities, Annual Regulatory Studies Program David E. Dismukes, Ph.D. Center for Energy Studies Louisiana State University August 12, 2014

Table of Contents 1.0 Theory of the Firm 2.0
Profit Maximization & Regulated Firms 3.0 Incentives & Regulatory Lag 4.0 Asymmetric Information 5.0 Incentives, Regulation & Performance 6.0 Tracker Mechanisms 7.0 Conclusions © LSU Center for Energy Studies

Section 1: Theory of the Firm
Center for Energy Studies Section 1: Theory of the Firm © LSU Center for Energy Studies

Coase addressed and provided a framework for understanding:
Center for Energy Studies Theory of the Firm Theory of the Firm First codified by Ronald Coase in is work entitled The Theory of the Firm. Purpose was to explain and provide a theoretical construct for primary economic unit of business/industry (“the firm”). Coase addressed and provided a framework for understanding: Why do firms exist? How are they organized? How do they behave? How do they interact with market and other market participants? Ronald Coase

Center for Energy Studies
Theory of the Firm Why Do Firms Exist? Coase posited that firms arise when the transactions costs of utilizing the market are too high given informational costs (or, when the cost of “internalizing” an activity is lower than seeking that activity in the market). Relaxes an important competitive market assumption (the presence of perfect information) but introduces another one (constant returns to scale industry). A constant returns to scale firm internalizes activities up to the point, at the margin, where costs equals benefits. Firm size in various industries can be explained by the information/transactions costs in the market place. The higher the transactions costs in any given industry, the likely the larger the firms. Wide range of literature opened up in the 1960s to critically examine, challenge, and/or expand upon this basic idea and the role of information and transactions costs on firm organization. (i.e., Baumol, Williamson) © LSU Center for Energy Studies

Theory of the Firm Profit Maximization One of the single largest contributions from Coase’s work is the conclusion that firms are “profit maximizing.” This is fundamental tenet underlying modern microeconomic theory. Incentives for competitive firms in competitive markets is to reduce costs and maximize profits relative to prices given to them by competitive marketplace. The firm’s goal is to maximize profit (Profit = Total Revenue minus Total Cost). According to the cost-benefit principle, a firm should increase output as long as marginal benefit exceeds the marginal cost: This means the profit-maximizing quantity can be found where marginal benefit equals marginal cost. © LSU Center for Energy Studies 6

Theory of the Firm Analytics of a Firm’s Profit Maximization Decision In the example below, there are no “excess” or “economic” profits since prices are equal to marginal costs for this particular (marginal) firm. © LSU Center for Energy Studies 7

If P<ATC, the firm is making a loss:
Center for Energy Studies Theory of the Firm Can Excess Profits Arise? Compare the price in the market to the firm’s total cost per unit (average total cost) If P> ATC, the firm is making an “economic profit.” Note – economic profits is not the same as “profits” or a rate of return on capital invested. Firms do receive “profits,” or a return on investment – they do not receive “economic profits” which are returns beyond what regulators would think of as a “fair rate of return.” If P<ATC, the firm is making a loss: If P>AVC, the firm will stay open in the short-run, but will eventually stop producing. If P<AVC, the firm will shut-down in the short-run. © LSU Center for Energy Studies 8

Theory of the Firm Analytics of Firm Making “Economic Profits” Excess profits since average costs (and marginal costs) are well below the going market price. In this example, the marginal firm is very efficient relative to the going market price. Economic profits are “bid away” over time as potential firms (entrepreneurs) see excess profit opportunities and enter the market until, at the market, no more “economic profits” are left. © LSU Center for Energy Studies 9

Marginal firm in this example is losing money in the short run.
Center for Energy Studies Theory of the Firm Analytics of Firm Making Economic Losses Marginal firm in this example is losing money in the short run. The shut-down point is the lowest value of AVC, if price falls below this point the firm will immediately shut-down and stop producing in the short-run © LSU Center for Energy Studies

Theory of the Firm The Market Equilibrium Returns Consumer Surplus: difference between the price consumers are willing to pay (MB) and the market price. Producer Surplus: difference between the market price and the cost of production (MC) Total Surplus in a market gives a measure of efficiency: where, at the margin, costs equals benefits (MB = MC). © LSU Center for Energy Studies

Theory of the Firm Summary: Incentives & Competitive Firms So, in summary, profits incent competitive firms to employ factors of production, invest resources, take risks, and produce costs and services. Higher prices, holding costs constant, leads to more profits. However, firms in competitive markets have no control over prices – so, lower costs, holding prices constant, results in higher profits. Competitive firms expand total profits by reducing costs and increasing output. The incentive to maximize profits, through cost efficiency, is the competitive market discipline that keeps prices low. This is one important outcome the regulatory process seeks to emulate. © LSU Center for Energy Studies

Section 2: Profits & Regulated Firms
Center for Energy Studies Section 2: Profits & Regulated Firms © LSU Center for Energy Studies

Regulated Firms Incentives and Regulated Firms Are incentives for regulated firms the same as those for competitive firms? Yes… regulated firms are profit maximizing – hence their requests for allowed rates of return. The role of profits for a regulated firm, however, differs since it is not a constant-cost firm like one underlying the Coasian theory of the firm. © LSU Center for Energy Studies

How are Prices and Output Determined in Perfectly Competitive Markets Regulated Firms In competitive markets, prices are set where marginal costs equals the marginal willingness to pay (demand). Thus, prices are set at costs, where costs reflect the cost of providing goods and services to the market. © LSU Center for Energy Studies

How are Prices and Output Determined in Perfectly Competitive Markets Regulated Firms “Natural” monopolies, however, do arise in certain high sunk cost infrastructure industries. These industries have declining costs throughout their entire range of relevant production, making the most efficient outcome one where there is a single, not multiple firms (a contradiction to the traditional competitive market). © LSU Center for Energy Studies

Monopoly Characteristics of a monopoly
Center for Energy Studies Monopoly Characteristics Monopoly Regulated Firms Characteristics of a monopoly One firm selling a product which has no close substitutes Monopoly supply is the same as industry supply There are significant barriers to entry for new firms Barriers to entry: legal or technical conditions that make it impossible or prohibitively costly for a new firm to enter a given market. Costs: declining costs throughout relevant range of production can lead to “natural monopoly” conditions. © LSU Center for Energy Studies

Monopoly profits or “rents.”
Center for Energy Studies What Would Happen if We Didn’t Regulate? Regulated Firms The unregulated profit maximizing solution for a monopolist is to price at a point on the demand curve where marginal revenue equals marginal costs. This raises price, and restricts output: MONOPOLISTS ARE STILL PROFIT MAXIMIZING, they just do so in a way different than competitive firms. Price Monopoly profits or “rents.” A monopolist makes profits by restricting output and raising price – this is an important distinction from competitive firms. Pm S = MC PC D Quantity Qm MR © LSU Center for Energy Studies

The Natural Monopoly Problem: Setting Prices at Optimal Levels Regulated Firms If we were to set prices equal to marginal costs in a declining cost industry, a firm would be unable to earn a return of and on its investments. This would result in a loss, other things being equal. Note, the socially optimal level is “unattainable.” Have to seek a “second-best” solution. © LSU Center for Energy Studies

Comparison of Various Monopoly/Regulated Pricing Outcomes Regulated Firms The “fair-return” price is set at average total costs (average cost pricing). This results in lower prices and higher output than the monopoly profit maximizing level, but one not as good as the socially optimal price. © LSU Center for Energy Studies

Monopoly A natural question arises from the regulatory process:
Center for Energy Studies What are the Incentives for Regulated Firms Monopoly Regulated Firms A natural question arises from the regulatory process: If regulation eliminates “economic profits” then what motivates utilities to reduce costs and to be efficient? The answer rest with a concept referred to as “regulatory lag” which is thought to incent firms to reduce costs and to increase efficiencies between rate cases. © LSU Center for Energy Studies

Section 3: Incentives & Regulatory Lag
Center for Energy Studies Section 3: Incentives & Regulatory Lag © LSU Center for Energy Studies

Regulatory lag can have a number of definitions:
Center for Energy Studies Definition: Regulatory Lag Regulatory lag can have a number of definitions: Can be defined as the period of time between when a utility’s rates go into effect, and its next rate case. May also be represented as the period between when a utility investment is made and the time it enters into rates. Can also be interpreted as the time in which a utility’s achieved rate of return (meaningfully) differs from its allowed rate of return. © LSU Center for Energy Studies

Typically, utilities control the duration between rate cases.
Regulatory Lag Center for Energy Studies Who Controls Regulatory Lag? Typically, utilities control the duration between rate cases. In most states, utilities have the statutory ability to request a change in rates. While state utility commissions and other stakeholders can, in theory, request a utility be “brought in” for a rate case, this rarely happens. Ronald Braeutigam and James Cook, surveyed state utility rate cases during the period 1948 to 1978 and found that over 350 of the 363 surveyed rate cases (96 percent) were brought by a regulated utility, with the smaller number attributable to regulators or consumer groups. © LSU Center for Energy Studies

Regulatory Lag Center for Energy Studies Control of Regulatory Lag and Risk Relationships Under Traditional Regulation Timing of rate case rests with utility – gives utility the ability to shift the risk of regulation and regulatory lag away from itself and onto ratepayers. Utility has “option value” creating a price floor to buttress value. This price floor allows shareholders to retain benefits created by regulatory lag, as well as the option to defend against challenges to those benefits through the timing of a rate case. Joskow (1973) reached similar conclusions noting that utility commissions tend to defend against rate increases, but are less aggressive in pursuing rate decreases when rates are stable or decreasing in real terms. Source: Graeme Guthrie. (2006) “Regulating Infrastructure: The Impact on Risk and Investment.” Journal of Economic Literature. 44 (December): Paul L. Joskow. (1973) “Pricing Decisions of Regulated Firms: A Behavioral Approach.” The Bell Journal of Economics and Management Science. 4 (Spring): © LSU Center for Energy Studies

Regulatory Lag Center for Energy Studies Is Regulatory Lag Inherently “Unfair” or “Confiscatory”? The premise that regulatory lag is somehow unfair is simply antithetical to 40 years of utility regulation research and practice. Regulatory lag is long recognized as imposing discipline on utility operational and investment decisions. Regulatory lag prevents utility regulation from devolving into a “cost-plus” regulatory approach that simply passes through costs on a dollar for dollar basis to ratepayers, and can lead to cost and investment inefficiencies. The cost-plus regulatory approach also shifts a considerable amount of performance-related risk away from utilities and onto ratepayers and leads to inefficient outcomes, which was recognized as early as the 1960s and has come to be known as the “Averch-Johnson” or “A-J” effect. © LSU Center for Energy Studies

Regulatory Lag Center for Energy Studies What is the Averch-Johnson Effect? Harvey Averch and Leland Johnson and published in the American Economic Review in 1962, posited that rate of return regulation creates an incentive for regulated utilities to overcapitalize, resulting in an inefficient utilization of resources and higher than optimal rates. This finding, however, was premised upon a model with a number of assumptions, one of which presumed there was no regulatory lag and that rates were set on a period-to-period basis: in other words, rates were set on a “cost-plus” regulatory approach. Source: H. Averch and L. Johnson. (1962) “Behavior of the Firm under Regulatory Constraint.” American Economic Review. 52: © LSU Center for Energy Studies

Regulatory Lag Center for Energy Studies Follow-Up A-J Research Soon after its publication, Averch’s and Johnson’s article was met with a flurry of scholarly research attempting to empirically verify the A-J effect, as well as examining the conditions under which the effect would, and would not, be sustained. Rejoinders to the research noted that two characteristics of the regulatory process tended to temper the likelihood and prevalence of the A-J effect: the possibility of disallowances through the prudence review process and the positive efficiency incentives created by regulatory lag. In fact, a series of articles published soon afterwards noted that regulatory lag typically creates incentives for utilities to seek efficiency opportunities between rate cases since the gains (profits) from those investments inure to shareholders instead of ratepayers. © LSU Center for Energy Studies

Regulatory Lag Center for Energy Studies First Articles Identifying the Benefits of Regulatory Lag William Baumol and Alan Klevorik (1971) was the first of what was to become a series of articles showing that regulatory lag actually diminished incentives to avoid overcapitalization, since the earnings gained by avoiding these inefficient actions passed directly to shareholders. Soon after, Klevorik, writing separately from Baumol, built upon this model by explaining how multi-year year regulatory lags, coupled with demand and cost uncertainty, created strong incentives for efficiency to maintain profitability. One of his additional findings at the time, however, was that these incentives might also discourage regulated firms from investing in research and development. Source: William J. Baumol and Alan K. Klevorik. (1970). “Input Choices and Rate-of-Return Regulation: An Overview of the Discussion.” The Bell Journal of Economics and Management Science. 1 (Autumn): © LSU Center for Energy Studies

Regulatory Lag Center for Energy Studies Other Works: The Role of Regulatory Lag and Innovation Elizabeth Bailey, who also served as an economic researcher at Bell Laboratories, addressed this issue, as well as other issues associated with the incentives created by regulatory lag, during this active period of regulatory scholarship. Bailey found that regulatory lag helped to facilitate, not reduce, the incentives for a cost-reducing innovations. Bailey’s work built upon earlier work that she did with Roger Coleman in 1971 that further supported the conclusions of Baumol and Klevorick, that regulatory lag induces profit-maximizing firms to adopt minimum-cost production alternatives. Source: Elizabeth E. Bailey. (1974). “Innovation and Regulation.” Journal of Public Economics. 3: Elizabeth E. Bailey and Roger D. Coleman. (1971). “The Effect of Lagged Regulation in an Averch- Johnson Model.” Bell Journal of Economics and Management Sciences. 2 (Spring): © LSU Center for Energy Studies

Regulatory Lag Center for Energy Studies Alfred Kahn: The Economics of Regulation In his seminal work in utility economics and regulation, Alfred Kahn noted the following about regulatory lag: Freezing rates for the period of the lag imposes penalties for inefficiency, excessive conservatism, and wrong guesses, and offers rewards for their opposites; companies can for a time keep the higher profits they reap from a superior performance and have to suffer the losses from a poor one. Sound familiar? These are the same forces that discipline competitive markets. © LSU Center for Energy Studies

Regulatory Lag Center for Energy Studies Summary: Arguments Supporting Regulatory Lag (“Good Thing”) May impose discipline on utility operational and investment decisions: encourages efficiency. Prevents utility regulation from devolving into a “cost- plus” regulatory approach. Reduces incentives to avoid overcapitalization, since earnings gained by avoiding inefficient actions are passed directly to shareholders. © LSU Center for Energy Studies

Regulatory Lag Center for Energy Studies Summary: Arguments Against Regulatory Lag (“Bad Thing”) Utilities view regulatory lag as a problem because rates do not keep up with rising costs. Hinders infrastructure development / capital expenditures and investment in “non-revenue generating” system improvements (i.e., safety, reliability, resiliency). Theory of regulatory lag is “time-dated” – it may have held merit in a high growth/high productivity environment but holds less merit today with low energy demand growth and infrastructure replacement challenges. © LSU Center for Energy Studies

Regulatory Lag Center for Energy Studies Historic Utility Earnings Compared to Estimated Allowed ROE for Industry Overall Who’s right? Empirically, likely depends on time period, but more often than not, lag has benefited utilities. (Percent) Note: Estimated achieved return is calculated as Net Income divided by Proprietary Stock (less preferred stock). Source: Federal Energy Regulatory Commission; and Public Utilities Fortnightly. © LSU Center for Energy Studies

Section 4: Asymmetric Information
Center for Energy Studies Section 4: Asymmetric Information © LSU Center for Energy Studies

Asymmetric Information Expansion of the Literature, Emergence of Informational Economics Coase’s work led to a new body of literature, “informational economics,” that discuss the role of information, its costs, and how economic decisions (and incentives) are influenced. Early challenges to the literature began to incorporate real world structural considerations into the theory of the firm such as the differences of incentives between “managers” and “shareholders.” Early work question the asymmetric information between “managers” and “shareholders” in terms of profit maximization: for instance, do managers act in shareholders’ best interest? © LSU Center for Energy Studies

What do we mean by “asymmetric information?”
Center for Energy Studies Asymmetric Information Definition: Asymmetric Information What do we mean by “asymmetric information?” Definition: when one contracting party has a different set of relevant information relative to another contracting party. The difference in information held by the two parties can lead to differing incentives, and can lead to differing economic outcomes that are usually “not efficient.” Led to wide range of literature known as “moral hazard” which, consistent with above, is said to occur when one party can take a particular action that cannot be closely observed by another. © LSU Center for Energy Studies

Asymmetric Information Moral Hazard Moral hazard occurs in instances where an economic agent facing a certain degree of risk behaves differently when it is insulated from that risk than it would if the risk were not insured. Moral hazard is, in effect, the behavioral difference that results from the presence or introduction of insurance. Moral hazard results in a “market failure” or inefficiency because the agent receiving the insurance does not have to bear the full responsibility for its actions. Source: W. Nicholson. Intermediate Microeconomics and Its Applications. 5th Edition. (1990) Chicago: Dryden Press, 695. © LSU Center for Energy Studies

Banking: “too big to fail”
Center for Energy Studies Asymmetric Information Examples of Moral Hazard Moral hazard has significant implications across a wide range of industries that rely heavily on contracting and performance, particularly insurance and finance. Examples: Banking: “too big to fail” Insurance: Life insurance and risky behavior. Moral hazard arises when the presence of “insurance” causes a party to behave differently. This impacts behavior and “incentives.” Here, “insurance” can be almost anything that provides a certain guarantee that is not entirely tied to performance (or imperfectly set to performance). © LSU Center for Energy Studies

Bonbright, et.al. defines moral hazard as:
Center for Energy Studies Asymmetric Information Moral Hazard and Regulation Moral hazard has been recognized in regulatory theory and practice. In fact, incentive regulation is based upon a special case of a moral hazard called the “principal-agent” problem. Bonbright, et.al. defines moral hazard as: A moral hazard is involved when someone other than the purchaser pays for the purchase and hence the purchaser acts, unconstrained by ethics or other institutions, as if there is no resource cost on society from his or her purchases. In other words, moral hazard increases the risk of an event turning out favorably because there may be positive rewards or at least insufficient penalties for opportunistic behavior. Source: J. Bonbright, A. Danielsen, and D. Kamerschen. (1988) Principles of Public Utility Rates. Arlington, VA: Public Utility Reports, 138. © LSU Center for Energy Studies

Asymmetric Information Moral Hazard in Practice Not difficult to see how moral hazard can become a problem in any form of regulation including banking, insurance, environmental, and utilities. Regulated firms typically have more information about their operations and industry than regulators. Couple this with resource differentials, and the case for the presence of moral hazard becomes strong. What are moral hazard outcomes in utility regulation? Typically cost inefficiencies and overcapitalization (Gold plating/X-inefficiencies). Disallowances have historically been the “active” deterrent that regulators have used to address these moral hazard outcomes. © LSU Center for Energy Studies

Asymmetric Information
Center for Energy Studies What is Gold Plating? The “A-J Effect,” is commonly thought to create an incentive to over-capitalize, also referred to as “gold- plating.” “Gold-plating” is usually related to capital expenditures and can take a number of different forms from over-emphasis of capital, to the adoption of questionable technologies, to excess capital expenditures. Differs from “X-inefficiencies” which tend to be associated with operating expenditures, not a factor considered in the A-J literature, but one recognized in the practice of regulation. © LSU Center for Energy Studies

Center for Energy Studies Prudence as a Active Deterrent to Gold Plating While the older literature has shown that “regulatory lag” creates a “passive” disincentive towards gold-plating, more “relatively” recent developments in the literature of shown that regulatory disallowances can serve as an “active” disincentive towards over-capitalization. The prudence standard has existed for a long time in state public utility regulation. The first recorded use of the prudence standard was exercised by the Massachusetts Public Service Commission in The concept was used to ensure that only prudently incurred capital expenditures would be allowed in rate base. Source: National Regulatory Research Institute, The Prudent Investment Test in the 1980s (Columbus, Ohio: National Research Regulatory Institute, 1985), p. 2. © LSU Center for Energy Studies

Center for Energy Studies Definition of Prudence The definition of a prudent investment was expressed by U.S. Supreme Court Justice Louis Brandeis in 1923: The term prudent investment is not used in a critical sense. There should not be excluded from the finding of the [rate] base, investments which, under ordinary circumstances, would be deemed reasonable. The term is applied for the purpose of excluding what might be found to be dishonest or obviously wasteful or imprudent expenditures. Every investment may be assumed to have been made in the exercise of reasonable judgment unless the contrary is shown. Source: Separate, concurring opinion of Justice Brandeis, Missouri ex rel. Southwestern Bell Telephone Company v. Missouri Public Service Commission, 262 US 276, PUR1923C 193 (1923). . © LSU Center for Energy Studies

Historically, prudence disallowances were rare until late 1970s.
Asymmetric Information Center for Energy Studies Regulatory Disallowance – Historical Perspective Historically, prudence disallowances were rare until late 1970s. According to a 2005 study, between 1981 and there were more than $19 billion of prudence-related rate recovery disallowances associated with new power plant construction projects. More than 95 percent of disallowances were related to nuclear power plant delays and cost overruns. Since early 1990s, prudence disallowances are again the exception, and not the norm. © LSU Center for Energy Studies

How did regulation respond/adapt to this experience?
Center for Energy Studies Asymmetric Information Prudence Effectiveness Some could question the effectiveness of the use of the prudence standard in addressing all of the uneconomic investment costs of the 1970s-1980s. The presence of a substantial level of stranded costs suggests that the process was not very effective; particularly if a comparison to market costs is used as the standard (which is challengeable). How did regulation respond/adapt to this experience? (a) introduction of competition. (b) alternative forms of regulation. © LSU Center for Energy Studies

Section 5: Incentives, Regulation & Performance
Center for Energy Studies Section 5: Incentives, Regulation & Performance © LSU Center for Energy Studies

Incentives & Performance Moving to Differing Regulatory Paradigms The less than satisfactory outcome with the disallowance experiences of the 1980s highlighted the asymmetric information problem for both regulators and regulated companies. While the introduction of competition was the preferred solution to the disallowance experience, some states did begin the process of exploring alternative forms of regulation (either independently or through the restructuring process itself). There was a significant development of regulatory theory during the prudence period (late 1970s-1980s) exploring alternative forms of regulation. Theoretic basis was the recognition of moral hazard in the regulatory process. © LSU Center for Energy Studies

While optimal costs are difficult to observe, profits are not.
Center for Energy Studies Incentives & Performance Consideration of Alternative Regulation The purpose of alternative regulation was to improve utility performance through the use of incentives. Moral hazard notes that often, the informational asymmetry between regulators and regulated companies, prevents traditional regulation from forcing the most optimal outcome. While optimal costs are difficult to observe, profits are not. Regulated firms are profit maximizing: thus, tying regulatory outcomes to observable output-based information (profits) was seen as preferable to unobservable input-based information (costs). Movement to alternative regulation presumes that these unobservable efficiency opportunities actually exist and the benefits of changing regulation are greater than the costs. © LSU Center for Energy Studies

Incentives & Performance How Do Regulators Affect this Change? Starts with a certain policy leap of faith: regulators have to be willing to allow prices (or revenues) become “decoupled” with traditional (utility-specific) measures of costs. Alternative forms of regulation inherent recognize that there are (a) information asymmetries and (b) there may be certain risks for utilities in pushing themselves to achieve certain efficiency improvements. Alternative regulation moves the traditional regulatory process away from governing inputs to defining acceptable outputs. The process is not unbridled since regulators often build in a hedge that sets boundaries on the program (so, this should not be interpreted as “deregulation”). © LSU Center for Energy Studies

Incentives & Performance Similarities Between Traditional and “Alternative” Regulation Note that all forms of “alternative regulation” incorporate an important component of “traditional regulation:” regulatory lag. Recall that regulatory lag can create incentives for efficiency since utilities can keep a portion of those increased efficiency- induced returns, but: only a portion is allowed to be kept since the process does still govern returns. Efficiencies are not constant – they exhibit diminishing returns and can become difficult (and uncertain) to attain over time. Utilities may have to take certain risks to achieve efficiencies that requires (i) more pricing flexibility and/or (ii) higher incremental returns depending upon the action/utility. © LSU Center for Energy Studies

Incentives & Performance Institutionalizing Regulatory Lag Alternative regulation effectively “institutionalizes” regulatory lag in a type of contract. Alternative regulation recognizes the presence of a certain degree of moral hazard and defines the terms and conditions under which the gains from efficiency will be kept by the utility, or shared with its ratepayers. Alternative regulation reduces the risk that efficiency gains will get “scooped” in the regulatory process, and rewards utilities for enhanced (not normal or sub-normal) behavior – it also penalizes utilities for sub-par performance. Alternative regulation, therefore, institutionalizes performance since only through performance can profits increase. © LSU Center for Energy Studies

What is alternative regulation?
Center for Energy Studies Incentives & Performance Definition: Alternative Regulation What is alternative regulation? No universally-recognized definition and often means differing things to different individuals. May also have a legal/statutory definition that trumps a textbook definition. Generally, an approach that allows for increased earnings (beyond a traditional allowed rate of return) if certain performance-based criteria are met. Premised upon the theory that dynamic efficiency gains will become greater than what may appear in short run as monopoly profits (i.e., earnings above “normal” rate of return). © LSU Center for Energy Studies

Common forms of alternative regulation:
Center for Energy Studies Incentives & Performance Forms of Alternative Regulation & Components Common forms of alternative regulation: (a) Fixed price/fixed revenue approach. (b) Variable price/variable revenue approach. Both forms will usually have the following components: (a) Incents efficiencies through increased earnings. (b) A fixed term or duration (c) Start with an initial rate case. © LSU Center for Energy Studies

Incentives & Performance Fixed Price/Fixed Revenue Prices or revenues are fixed for a set period of time (three to five years – or “stay-out” period ) after an initial rate case review. Utility allowed to retain a certain share (or large share) of excess earnings that arise from efficiencies arising during the “stay-out” period. Rates are recalibrated and program effectiveness is reviewed at the end of the stay-out period. Examples include post-merger rate freezes, retail restructuring rate freezes. Inherent assumption in these (fixed) mechanisms is that there are enough accumulated inefficiencies that can be garnered over time that will self-fund the efficiency improvements. © LSU Center for Energy Studies

Incentives & Performance How Does Earning Sharing Work? This hypothetical example defines a sharing range above the allowed rate of return and fixed sharing percentage between shareholders and ratepayers over a five year period. ROE Earnings in excess of allowed ROE are shared on 75/25 percent basis to some capped (threshold) level. ROET ROEA Time/Period 1 2 3 4 5 © LSU Center for Energy Studies

Incentives & Performance How Does Earning Sharing Work? This hypothetical example defines various sharing ranges above the allowed rate of return, with increasing sharing percentages between shareholders and ratepayers over a five year period. ROE 25/75 sharing range. 50/50 sharing range. ROE1 75/25 sharing range. ROEA Time/Period 1 2 3 4 5 © LSU Center for Energy Studies

Incentives & Performance Why is Timing/”Stay Out” Period Important? Commonly set in three to five year range, although some are set for much longer periods that can include up to one decade. Length is often part of the regulatory bargain between utilities and regulators and likely determinant on other program components (like earnings sharing bands). Determination of stay-out period itself is one subject to a certain degree of moral hazard since the utility will have a better understanding of its short and long run efficiency improvement opportunities. Does not eliminate opportunism since utilities often have statutory (constitutional?) provisions allowing them to “break” the contract. © LSU Center for Energy Studies

Incentives & Performance Why is Timing/”Stay Out” Period Important? Argument for long stay-out periods: longer periods give utilities the opportunity for making longer-run investments that will yield efficiency gains (and returns) over a period of time. Longer stay out periods help to create opportunity to attain the full return from the investments. Arguments for short stay-out periods: allowing long periods of time can result in a significant disconnect between rates and costs without recalibration and can lead to utilities earning the same monopoly returns regulation is intended to eliminate. © LSU Center for Energy Studies

Incentives & Performance Variable Rates/Variable Revenue Approaches These approaches allow rates/revenue to grow based upon a pre- determined formula; utilities share in excess earnings. Not the same as “formula-based rates.” While this can also be thought of as an alternative form of regulation, it is simply cost- based regulation that can be exceptionally weak in encouraging efficiency (by itself). Usually cost-plus regulation or inflation plus costs regulation. Price cap or performance-based regulation (“PBR”) allow rates/revenues to grow for inflation less productivity offset. Presumption is that utility is already reasonably efficient at what it does but could improve to above-average or best practices with additional incentives in the form of pricing flexibility. © LSU Center for Energy Studies

Incentives & Performance Revenue Caps A revenue cap restricts the rate of growth in average revenues (revenues divided by output); accounting for inflation, growth in productivity and output, and various exogenous factors. Where pi is the price of service i, qi is the quantity demanded at price pi, Q is an aggregate index of outputs, and p0 is the maximum average price allowed based upon price-cap formula. © LSU Center for Energy Studies

∆𝑷𝑰≤∆𝑷−𝑿±𝒁 Center for Energy Studies
Incentives & Performance Price Caps Designed to limit the ability of utilities to earn more than normal profit, while incentivizing the utility to attempt to reduce input costs and invest in productivity improvements. Price caps typically take the following form: ∆𝑷𝑰≤∆𝑷−𝑿±𝒁 Where: ∆𝑷𝑰 = the rate of change in the price index of regulated prices ∆𝑷 = a measure of price inflation X = total factor productivity, or an index of expected efficiency gains Z = a factor capturing other relevant variables © LSU Center for Energy Studies

Incentives & Performance Revenue Cap/Price Caps Challenges Implementation of revenue and price caps can be contentious since the analytics of the formula has to be estimated. Issues on “bundling” services and good for a revenue cap. Issues on measuring inflation and productivity. “Average” vs “best practices.” Accumulated inefficiencies for underperforming utilities. The entire formula has to be taken into context with the program duration (stay-out period) and earnings sharing. Note – price inflation and productivity offsets can be negotiated against duration and earnings share – more guaranteed up front benefits can be offset with less “back-end” earnings upside or longer durations. © LSU Center for Energy Studies

Section 6: Tracker Mechanisms
Center for Energy Studies Tracker Mechanisms Section 6: Tracker Mechanisms © LSU Center for Energy Studies

Tracker Mechanisms Definition of Tracker Mechanisms Mechanisms that remove cost and/or revenue recovery from base rates to a separate rider or tariff. Can be for the collection of new costs not included in base rates or true-ups of revenues or expense items from levels that differ from the test year. Recovery typically periodic and more frequent than rate cases. While mechanisms can include surcharges and credits they should not be automatically considered “symmetrical.” Mechanisms originally developed with fuel-cost recovery, but have expanded to a variety of other sales, capital and expense-related changes. © LSU Center for Energy Studies

Tracker Mechanism Examples Center for Energy Studies Tracker Mechanisms Tracker Mechanism Recovery Type Purpose Asset Replacement Riders Capital Replace aging or inferior assets. Inflation Riders Expense Inflate costs to match general inflation or other measure. Asset Development Riders Facilitate preferenced assets like baseload generation, smart meters. Energy Efficiency Riders Recover energy efficiency expenses as incurred. Renewable Energy Riders Recovery renewable energy development costs, rebates, and/or PPAs. Environmental Cost Riders Capital/Expense Recovery of capital investment or air emission credits. Weather Normalization Clauses Revenue Recovery of changes in sales due to weather. Revenue Decoupling Recovery of changes in sales due to other factors. © LSU Center for Energy Studies

Center for Energy Studies Rationale Driver
Commonly Cited Rationales for Trackers Center for Energy Studies Tracker Mechanisms Rationale Driver Volatile and unknown cost changes. Recent increases in commodity costs and inflation. Remove disincentives to purse public policy goals. Energy efficiency, renewables, fuel diversity. Required by “Wall Street.” Capital crisis/recession. Required to ensure recovery of revenue requirement. Changes in UPC, climate change, other “exogenous factors.” Reduce rate cases. Increase in recent number of rate cases. © LSU Center for Energy Studies

Tracker Mechanisms Tracker Expansion While some of these mechanisms are somewhat older in implementation (e.g., WNA, revenue decoupling), others are relatively new (asset development, inflation riders), and others are being modified and expanded (energy efficiency, renewables, environmental cost). Another recent theme in tracker proposals is the “multiple proposal” approach being pursued by utilities in various regulatory filings (numerous as opposed to individual tracker proposals). Increased adoption by some state commissions has led some utilities to refer to these mechanisms as the “new traditional regulation” or “new chapter” in utility regulation. © LSU Center for Energy Studies

Tracker Shortcomings Center for Energy Studies Tracker Mechanisms Practice/Theory Traditional Approach Tracker Approach Cost recovery and regulatory lag under “regulatory compact.” Utilities have traditionally been tasked with proposing projects, developing projects, and incurring the cost to develop projects. Afterwards, the utility must prove that the investment is used and useful and developed a reasonable cost. Utilities would incur costs for projects often no defined ex ante, and recover the costs of these projects, as they are incurred, in rates. Afterwards, regulators and other parties would be required to show that the investments were not needed and the costs were unreasonable. Asymmetric information in utility regulation and performance-based regulation. Regulated firms know their cost structures better than regulators. Thus, best policy is to use regulatory lag, or incentive regulation (benchmarking) to drive utilities to efficient outcomes. Presumes that regulators can easily determine the reasonableness of all capital investments and their costs within a matter of months and can comfortably adjust rates accordingly. © LSU Center for Energy Studies

Risk Shifting Center for Energy Studies Tracker Mechanisms Risk Type Risk Shifting Perceptions Potential Consequence Regulatory Risk Ratepayers have higher burden to prove investments are imprudent rather than utilities proving that they are prudent. Takes away, or significantly reduces the power of a regulatory disallowance that is long recognized as a powerful regulatory tool in minimizing cost and expense inefficiencies and offsetting potential “A-J” or “X-inefficient” outcomes. Performance Risk Ratepayers have higher burden to prove that tracker objectives were not met on sometimes illusive (qualitative) cost and investment decisions. Effectively paying for a service before it has been rendered. Sales Risk Ratepayers will make utilities whole for any change in sales regardless of reason (economy, price, weather). Decoupling revenues from sales is likely to lead to a decoupling of costs from revenues in a regulated cost-based industry. © LSU Center for Energy Studies

Conclusions Perspectives of Regulatory Effectiveness (NREL Report) Source: Comnes, G. A., S. Stoft, N. Greene and L.J. Hill; Performance-Based Ratemaking for Electric Utilities: Review of Plans and Analysis of Economic and Resource Planning Issues; November 1995; Lawrence Berkeley National Laboratory. NA=not applicable FCC= Federal Communications Commission LEC = local exchange companies. © LSU Center for Energy Studies

Conclusions Conclusions Incentives matter and the economics of regulation, like other fields in economics, have attempted to understand those incentives and the interaction that informational asymmetry and other market failures play in effective regulation. Movement away from traditional regulation is a policy call based upon a regulator’s belief that other forms of regulation will be more effective. Measurement, benchmarking and analysis is the first step in this process since effectiveness is relative. © LSU Center for Energy Studies

Conclusions Conclusions Interesting time for the consideration of alternative gas/electric regulation given other policy agendas (reliability, resiliency, replacement) and their corresponding ratemaking mechanisms (trackers). (Most) trackers are the antithesis to PBR since they are not tied to performance, are periodic, and cost-plus based. PBR should be thought of as a substitute, not compliment to tracker-based regulation and may be an alternative for “tracker-fatigued” commissions. Do utilities want PBR and rewards for efficiency or do they want insulate themselves from cost-recovery risk? While PBR/incentive regulation “decouples” rates and costs, it “recouples” performance not found in tracker-based approaches. Was thought to be a very effective form of regulation in telecommunications and the concurrent advances in technology. © LSU Center for Energy Studies

Conclusions Conclusions Interesting time for the consideration of alternative gas/electric regulation given other policy agendas (reliability, resiliency, replacement) and their corresponding ratemaking mechanisms (trackers). (Most) trackers are the antithesis to PBR since they are not tied to performance, are periodic, and cost-plus based. PBR should be thought of as a substitute, not compliment to tracker-based regulation and may be an alternative for “tracker-fatigued” commissions. © LSU Center for Energy Studies

Conclusions Conclusions Do utilities want PBR and rewards for efficiency or do they want insulate themselves from cost-recovery risk? Utilities in today’s environment may not be supportive of performance based approaches since it requires them to bear performance risk of their investments. Utilities may not preference PBRs since they are uncertain about the likely performance effectiveness of these reliability, resiliency, and replacement investments. If this is the case, it raises new set of issues related to cost-recovery, prudence, and performance. While PBR/incentive regulation “decouples” rates and costs, it “recouples” performance not found in tracker-based approaches. Was thought to be a very effective form of regulation in telecommunications and the concurrent advances in technology. © LSU Center for Energy Studies

Regulation & Incentives

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