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Dealing with Asymmetric Risk

Improving performance through graduated conditional ROE incentives.

Fortnightly Magazine - May 2009

upper tier options over the entire decade from 1988 to 1997. As a group, they had averaged 2 percent TFP growth (option D) during the higher incented 1994 to 1997 period.

Furthermore, during the mid 1990s, the Norwegian regulator, NVE, had begun work to examine and potentially establish a PBR for its several hundred electric distribution utilities. This research involved two sets of information: first, a times-series analysis to examine long-run productivity potential, and second, a cross-section benchmarking to determine each LDC’s relative efficiency. In the former instance, NVE found that the most efficient firms had a growth in productivity of 1.5 to 2 percent. In the latter instance, NVE found that among the roughly 80 percent of firms found to be off the efficiency frontier, many were found to be 30, 40 percent (or more) less efficient than the best. The regulator, NVE, instituted a two-part PF: a long-run element equal to 1.5 and a relative inefficiency factor that ranged from zero to 3 depending on the individual LDC’s efficiency. This meant that the PF imposed by NVE for its first term PBR ranged from 1.5 to 4.5 over the 1997 to 2002 period. 21

Third-Generation PBR

In 2008, the OEB commenced a proceeding to examine choices for its “third-generation PBR” for electric distributors. Board staff issued a discussion document that covered a wide range of design issues. Among these issues, board staff broached the question of implementing a PF-ROE menu as developed in the first-generation PBR process. 22

Stakeholders seemed to be fairly consistent in their view that the repeated changes to government policy toward electric distributors and in the regulatory oversight by the OEB had wreaked havoc among the LDCs’ operations and investments. Indeed, the authors commented on this unfortunate development in 2005:

Electric distribution utilities have undergone significant regulatory reforms over the past decade including changes in: governance and ownership, regulatory oversight, horizontal and vertical integration, and retail market competition. Yet, we question if the costs associated with these restructurings are yielding sufficient benefits? In Ontario, decision makers embarked upon new policies in an information void, relying upon anecdotal or ideological beliefs. Critical empirical research was either ignored or never undertaken. Almost immediately, political implications of “unforseen” consequences ( e.g., distribution rates would rise as municipals were privatized) drove politicians to shift positions: even the “independent” status of the regulator would not forestall overt interference. Government policy and regulatory missteps, inconsistencies, and contradictions have left the distribution sector worse than before restructuring, burdened with sizeable and largely unnecessary costs, but without correcting the one notable deficiency among some distributors, excessive allocative inefficiency. 23

For example, the provincial government had voided its own legislated mandate to recapitalize the MEUs with market-based capital costs, had forced utility mergers when no savings where apparent, and ultimately overturned the newly implemented PBR plan put in place by the “independent” regulator. Subsequently, the OEB adopted a “second-term” PBR with a macro price index. Furthermore, the OEB did not have, or could not use, LDC capital data specified and collected during (and after)