X Marks the Spot: How U.K. Utilities Have Fared Under Performance-Based Ratemaking
Returns for U.K. RECs have proven resilient, despite price cuts, efficiency targets, and the windfall profit tax.
The introduction of performance-based ratemaking (PBR) in the United Kingdom and elsewhere sparked a dramatic change in how distribution utilities were run and regulated. Performance-based ratemaking was imposed concurrent with the divestiture of the regional electricity distribution companies (RECs) in the United Kingdom. Instead of the traditional cost-of-service methodology, in which utility revenues were directly linked to actual costs, the form of PBR adopted in the UK allowed for rates to increase by inflation minus an efficiency, or X, factor. This X factor was set periodically by the regulator in conjunction with expert studies on the level of efficiencies that were achievable and on the relative efficiencies of similarly situated firms. The result has been to allow those firms which were able to beat the X factor in terms of efficiency gains to retain some of the savings until the next distribution price review, absent windfall profits taxes or other occurrences.
Performance-based ratemaking in the United Kingdom is now entering its third "generation," or regulatory period. Due to the sharpened incentives of PBR relative to cost-of-service regulation, the UK has seen a substantial improvement in electricity distribution productivity. Whereas electricity distribution sector productivity in the United States has languished at 1.2 percent per annum, and few jurisdictions have exceeded productivity gains of 2 percent per year, the UK has seen annual gains of 3.5 percent. The price cap form of PBR, incorporating an X factor, is being adopted in an increasing number of regions, from the Netherlands to Canada. United Kingdom experience suggests that companies that adapt well to the regime can continue to make robust profits in the face of seemingly high initial round price cuts. However, those companies that are not prepared can face challenging times.