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Dealing with Asymmetric Risk

Improving performance through graduated conditional ROE incentives.

Fortnightly Magazine - May 2009

electricity distributors to the OEB’s authority, the OEB instituted a process to structure a suitable regulatory framework. These LDCs represented a highly diverse collection, ranging in size from several hundred to hundreds of thousands of customers. Some stakeholders, including utilities, held that initial levels of efficiency varied significantly, due primarily to overcapitalized rate bases. 15 Some participants pointed to the YCs being implemented in the U.K., Europe, and Australia and argued that Ontario should adopt such models. 16 Due to the government’s tight deadline (which envisioned the market opening in November 2000, although subsequently this was delayed to May 2002), these critical issues could not be analyzed and addressed within the time permitted. 17

The OEB’s stakeholder task force on implementation issues noted the dilemma involved in moving to a PBR. 18 While it was clear that the utility would face notably greater incentives to eliminate the significant embedded inefficiencies likely accumulated under cost of service, the regulator couldn’t easily quantify the potential level of inefficiency.

[T]he move towards a PBR regulatory system is in part motivated by the belief that, in general, PBR regulation allows for more efficient and effective regulation than rate of return regulation. It follows that the essence of the rationale for moving from rate base-rate of return (RB-ROR) regulation to any other form of Performance Based Regulation (PBR) is to remove embedded, non-quantifiable inefficiencies… It seems difficult to conceive that any party that supports the adoption of PBR could deny that the differences in incentives under the alternate regimes affect efficiency… [T]here is a significant amount of inefficiency embedded in the existing cost structure of the regulated companies. If there were no significant embedded inefficiencies, there would be no justification for incurring the regulatory and other transitional costs and risks that are involved in moving from RB-ROR regulation to a PBR mechanism.

Taking into consideration the extremely short period allowed by the government to establish the PBR, the task force went on to say:

…the adoption of the PBR mechanism would not be necessary if it were not for the practical reality that the amount of embedded inefficiency cannot be quantified with an acceptable level of confidence or precision… In these circumstances… the setting of appropriate productivity factors is that much more difficult, and the risk, therefore, of “getting it wrong” that much higher. In short: historical productivity gains … underestimate the expected, and reasonable, productivity gains that should be realized under Performance Based Regulation; achievable productivity gains cannot be accurately estimated because the amount of embedded inefficiency cannot be determined; and the appropriate productivity offset cannot be quantified with a reasonable level of confidence and precision.

The intent of moving to PBR is to set an offset that reflects the gains that can be reasonably expected… The incentive to improve productivity comes both from the danger of under earning and the opportunity to earn an above-normal return—the carrot and the stick.

The task force noted that a PF that better balanced the interests of ratepayers with shareholders could be structured if the utility’s interest in achieving