What Is Performance-Based Regulation (PBR)?
Performance-Based Regulation (PBR) is a regulatory framework to better match regulated utilities' financial interests and activities with public interest objectives and customer benefits.
The framework incentivizes utilities to attain well-defined outcomes rather than just rewarding capital expenditure, which is today's major source of utility revenue and profits.
PBRs calculate utility revenue or shareholder earnings for some businesses based on specified performance criteria and other non-investment considerations.
Non-investment concerns, such as providing low-cost services and responding to government demands, can be especially essential for state-owned utility enterprises (SOEs).
The regulation can consist of revenue adjustment mechanisms such as decoupling and performance incentives (PIMs).
PBR has the potential to alter how utilities, consumers, and third-party providers create, distribute, and utilize energy.
Types of Performance-Based Regulation
There are two types of Performance-Based Regulation:
Award-Penalty Mechanism
An APM is intended to improve performance incentives in certain areas, which is why it is also referred to as a targeted performance reward.
A key performance indicator, a performance assessment that compares the utility's value for the indicator to a benchmark value, and a method for changing utility prices to reflect the performance appraisal are the basic components of such arrangements.
APMs commonly target the following performance categories.
- Reliability
- Other aspects of customer service
- Management of demand
- Cost
Multiyear Rate Plans
In a multi-year rate plan, the regulatory authority sets the prices the utility can charge for its services for some time (usually 3 to 5 years).
The utility's revenue is then determined by how well it performs against the targets set by the regulatory authority.
Additionally, an MRP minimizes the frequency of rate cases by increasing revenue through attrition relief mechanisms (ARMs) unrelated to the utility's real cost rise throughout the plan period.
This can boost utility cost-cutting incentives while also freeing up regulatory resources for greater purposes.
Importance of Performance-Based Regulation
There are several reasons why PBR is deemed important.
1. First, PBR has the potential to create a more efficient and effective energy sector. It can help utilities make better use of resources while also providing improved services to customers by aligning utility interests with public objectives.
It can incentivize utilities to focus on efficiency and innovation rather than relying on traditional investment models.
2. Second, PBR can help to create a more resilient energy sector. Utilities may adapt to changing conditions and meet customer needs more flexibly by incentivizing utilities to focus on outcomes rather than inputs.
Additionally, PBR can help utilities respond more effectively to natural disasters and other disruptions.
3. Third, it can help to create a more sustainable energy sector. PBR can help utilities make decisions in the best interest of both customers and the environment by incentivizing utilities to focus on long-term outcomes.
PBR can help utilities reduce their reliance on fossil fuels and move towards a more sustainable energy mix.
4. Fourth, PBR can help to create a more competitive energy sector. PBR can help utilities compete more effectively with other energy providers by incentivizing utilities to focus on cost-effective solutions.
In particular, PBR can help utilities attract new customers and retain existing customers in the face of competition.
5. Finally, PBR can create a more transparent and accountable energy sector by requiring utilities to report on their performance.
It can also ensure that utilities provide value for money and that customers get the service they expect.
Performance-Based Regulation vs Traditional Regulation
Performance-based regulation is different from traditional regulation in several ways.
Goals
Traditional regulations concern the dependability, cost, and appropriateness of highly centralized power supply systems. Through fair charges and strict regulatory control, consumers are safeguarded against monopolistic power.
On the other hand, PBR concentrates on common regulatory goals and particular outcomes established by policymakers, utilities, and stakeholders. Customers obtain dependable services. Opportunities for customer and third-party value generation and innovation are made possible.
Incentives for Utilities
For traditional regulation, revenues are calculated to match costs approved by regulators and recovered via rates, which are frequently based on per-unit energy use. The utility is incentivized to boost consumption to raise income.
While in PBR, revenue is generated via several charges and programs. Incentives are created, presented, and assessed. More comprehensive rates are intended to assist the adoption of dependable services and technologies. Incentives for utility revenues are connected with policy results rather than increasing consumption.
Earnings
In traditional regulations, regulators assess the sustainable cost of service spending with the amount of money that the utility spends on capital projects, predominantly driving profitability.
In PBR, utilities maximize overall expenditures (capital and operational), and regulators reward measurable results. Earnings are still regulated, but they can be increased based on how well the utility performs rather than particular targets.
Time Scale
Traditional regulations have a short-term emphasis on cost reduction combined with a traditional long-term capital planning strategy.
PBR has a balanced emphasis on short-term cost reduction/near-term grid reliability investments and long-term investment in future grid architecture, performance improvement, and achievement of public policy goals.
Implementing Performance-Based Regulation
To effectively implement PBR, the basic framework outlined below may assist policymakers and utilities in designing and implementing reforms tailored to their requirements and circumstances.
Setting Up Specific and Clear Goals
The goals should be based on the policymaker's objectives, considering the needs of different stakeholders.
It is important to ensure that the goals are achievable, measurable, and time-bound. If the goal is not clearly defined, the metrics, incentives, and outputs will be apparent, leading to an effective mechanism.
Establishing an Authoritative Body
When analyzing PBR, stakeholders must evaluate the particular conditions of the jurisdiction, such as legal, institutional, utility, and financial market issues. In many states, the utility regulator is uniquely positioned and has the legislative ability to intervene in support of PBR goals.
However, who has the right to determine what PBR means for the state must be apparent. This involves demonstrably responding to utility incentives, such as valued results.
Incentives that link utility income and cost recovery to successful performance encourage utilities to invest in a broader range of initiatives and technologies than they may consider under current cost-of-service regulation.
When properly implemented, PBR may supplement traditional rate and cost management with innovation in energy services and technology and enhanced performance.
Defining Performance
To implement PBR, lawmakers, regulators, and stakeholders must collaborate to define, prioritize, and incentivize desired performance. Performance targets may be jurisdiction-specific.
Another crucial factor to consider is the level of reward. For PBR to be effective, incentives must be big enough to have the desired influence on utility behavior while remaining limited to safeguard consumers.
Stakeholder Engagement
Stakeholder participation is critical to the success of PBR. Regulatory processes should include stakeholders in the essential components of PBR plans, such as defining performance objectives and rewards.
Utilities may strive to set feasible objectives, but a regulatory agency or other stakeholders may advocate for seemingly unattainable targets.
Engaging in a collaborative approach, guided by broad policy objectives, is more likely to result in a set of targets and incentives that encourage success and create meaningful outcomes.
Identifying Measurable Metrics and Incentives
In general, performance objectives and indicators should be built around the most critical, forward-looking assumptions influencing the planned utility investment business case.
Although metric categories should be consistent across all utilities in a jurisdiction, actual objectives may change amongst utilities due to variances in customer base, system condition, or other variables.
Optimizing Between Capital and Operating Expenses
A PBR framework's purpose is to place operational costs equally with capital investments, especially where non-capital spending might provide a better answer.
Under a PBR framework that rewards utilities for more than just capital investment, utilities consider a more extensive range of viable solutions, recognizing that those based on operational expenditures also present revenue prospects.
Incentives and prices might also be changed regularly based on assessing utility performance and service quality measures.
Aligning Benefits and Rewards
To achieve the most significant degree of practicality and feasibility, aligning consumer receipt of benefits through timely payment of rewards and incentives (or implementing penalties if negative repercussions occur) is recommended.
The link between incentive and performance is easier to measure when incentives and punishments are administered close to utility performance. A tight relationship can lessen regulators' likelihood of over- or under-reward utilities for consumer satisfaction.
Focusing on Learning
Solid management practice is to learn from experience and alter PBRs to address operational insights. Because factors beyond the control of utilities influence certain results, utilities may be hesitant to adopt a pure outcome aim or metric.
Consider a rolling multi-year average rather than a single annual aim or statistic to solve this. The range of utility performance and patterns in a rolling average become apparent over time.
Establishing Complementary Policies
PBR should be one of many policies or regulations guiding utility behavior.
Performance plans and other business processes provide additional input to help utilities understand how they should modify their operations to satisfy various stakeholders' objectives.
Complementary policies, regulations, and statutes can guide performance-based regulation in several ways:
- Defining key terms
- Outlining processes for stakeholder engagement
- Creating independent review boards
- Delineating how often performance plans should be updated
Ensuring that complementary policies, regulations, and statutes are in place can help to create a comprehensive regulatory regime that provides clarity and certainty for all parties.
Evaluating and Verifying
An independent entity should review monitoring data to ensure accuracy and completeness.
A well-functioning PBR system requires periodic review and evaluation to make necessary adjustments.
Performance goals, indicators, and metrics may need to be updated as circumstances change or new technologies become available.
Performance-Based Regulation in Action
Performance-based regulation has been implemented in utilities around the world. The longest-running major PBR initiatives are in Illinois, New York, and Massachusetts.
Illinois
PIMs and a formula rate were established by the state's Energy Infrastructure Upgrading Act in 2011, allowing Commonwealth Edison (ComEd) and Ameren to invest billions of dollars in grid modernization.
They added penalty-only incentives for failing to enhance reliability on top of current cost-of-service regulation (COSR).
The law contained a $2.6 billion investment package producing record reliability.
New York
Reforming the Energy Vision (REV) processes in New York have done more than any other state to alter the utility business model.
REV enabled utilities to use a rate of return for non-infrastructure investments in non-wires solutions and an earnings adjustment mechanism (EAM) for energy efficiency investments.
Massachusetts
The 2017 Eversource rate case in Massachusetts established a five-year MRP plan with yearly fines of around $50 million for failing to achieve current safety and reliability criteria.
The Massachusetts Department of Public Utilities (DPU)-approved plan did not incorporate new criteria or PIMs for attaining state policy goals, which drew criticism from climate policy supporters.
Eversource is collaborating with DPU to provide new metrics on which PIMs may be built.
Challenges in the Implementation of PBR
Performance-based regulation has its challenges. Here are a few factors to consider when implementing PBR:
- Political support: PBR can be controversial and may be opposed by utility companies, ratepayers, or other stakeholders. It is essential to build political support for PBR before it is implemented.
- Regulatory capture: There is a risk that PBR may be "captured" by the utility companies it is meant to regulate. This can happen if the goals and metrics need to be carefully designed or the regulatory body overseeing PBR is independent.
- Resource constraints: PBR can require significant resources to implement, including staff time, data collection and analysis, and stakeholder engagement.
- Complexity: PBR can be complex and require specialized knowledge and skills to implement successfully.
- Legal challenges: PBR may face legal challenges if it is incompatible with existing laws or regulations.
The Future of the Utility Sector
The utility sector is undergoing a period of transformation. New technologies, such as distributed generation and storage, are changing how electricity is produced and consumed.
The rise of renewable energy is also having an impact on the utility sector. These changes are challenges for traditional utilities, typically designed to operate in a centralized, fossil fuel-powered system.
As the utility sector evolves, so must the regulations governing it. Performance-based regulation is one way to meet the challenges of the future utility sector.
When properly designed and implemented, PBR can help promote efficiency, service quality, and long-term investment in infrastructure.
PBR can also help create a more adaptive and flexible utility sector, which is better able to respond to future challenges.
Bottom Line
Performance-based regulation is a tool that can be used to promote efficiency, quality of service, and long-term investment in infrastructure. When properly designed and implemented, PBR can help to create a more efficient and effective utility sector.
There are two main types of performance-based regulation: award-penalty mechanisms and multiyear rate plans.
An APM is a targeted performance reward since it aims to enhance performance incentives in certain areas.
The fundamental elements of such arrangements are performance evaluation that contrasts the utility's value for the indicator with a benchmark value and a way for altering utility charges to reflect the performance appraisal.
Multiyear rate plans allow utilities to earn higher returns when they outperform their targets and lower returns in years when they do not.
Performance-based regulation is not without its challenges, and it is essential to consider them when implementing PBR.
Despite the challenges, performance-based regulation can be a valuable tool for promoting efficiency, quality of service, and long-term investment in infrastructure. When properly designed and implemented, it can help to create a more efficient and effective utility sector.
FAQs
1. What is Performance-Based Regulation (PBR)?
PBR is a regulation that ties a utility's earnings to its performance. Under it, utilities can earn higher returns in years when they outperform their targets and lower returns in years when they do not.
2. What are the benefits of PBR?
The benefits of PBR include promoting efficiency, service quality, and long-term infrastructure investment. It can also help create a more adaptive and flexible utility sector, which can better respond to future challenges.
3. What are the challenges of PBR?
The challenges of PBR include the potential for increased complexity and legal challenges. Additionally, it may not be compatible with existing laws or regulations.
4. How can PBR be implemented?
It can be implemented by setting specific and clear goals, establishing an authoritative body, defining performance, and stakeholder engagement, identifying measurable metrics and incentives, optimizing capital and operating expenses, aligning benefits and rewards, and focusing on learning.
5. What are the two main types of PBR?
The two main types of PBR are award-penalty mechanisms and multiyear rate plans.
