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Dealing with Asymmetric Risk

Improving performance through graduated conditional ROE incentives.

Fortnightly Magazine - May 2009

improvements.

Sharing Benefits

The menu can be structured to meet sharing goals between ratepayers and shareholders. In Figure 3, the split between customers and ratepayers is about 60 to 40 percent. How was the stakeholder sharing split for menu increments derived? As indicated, if the LDC selects an incremental PF of 0.2, it’s allowed ROE increases by 100-basis points. Assuming total costs per customer, the share of capital in costs, the share of equity in capital, and the time path of the LDC’s operational savings, the savings to the ratepayer and increased earnings to shareholders can be calculated. Assuming that in a three-year incentive regulation (IR) the LDC would need two years to reach full incremental ROE, a 57-percent share for customers and 43-percent share to shareholders was calculated. Ratepayers likely would experience long-term benefits as well.

Indeed, the issue of self-directed choice would seem to be very appealing. On the one hand, it would allow the regulator to explore the feasible set of PF much more assiduously than could be done through a multi-generation IR framework that could take a decade to fill out. On the other hand, it permits the regulator to recognize the existence of diversity among the LDCs and to embed this reality into the PF options.

From the customer stakeholders’ perspective, the menu also would appear appealing. Such a structure mitigates the inherent tendency for risk-averse regulators in an asymmetric environment to impose downwardly biased productivity factors. Instead, the selection risk would be transferred to the party best informed to assess the options and with the greatest alignment of information, action and reward. LDCs would be incented to more aggressively review productivity improvements and undertake those that it could manage. Within the plan’s term (and presumably after the term), ratepayers most likely would experience greater reductions in rates than would have happened otherwise. Shareholders would experience concomitant increases in ROE and earnings.

 

Endnotes

1. Cronin, F.J., et al. , 1999, Productivity and Price Performance for Electric Distributors in Ontario ,” Ontario Energy Board Staff Report .

2. For a discussion of peer-based, endogenously determined PBR, see “ The Road Not Taken ,” By Francis J. Cronin and Stephen A. Motluk, Public Utilities Fortnightly, March 2004.

3. Both the British regulator, Ofgem, and the Dutch regulator, Dte, have imposed what some participants viewed as relatively sizeable efficiency improvements without any empirical basis for these dynamics/periods. In the case of Dte, some LDCs had X factors of 9-percent per year imposed.

4. Shleifer, A., “A Theory of Yardstick Competition,” The Rand Journal of Economics , Vol. 16, No. 3, Autumn 1985, pp.319-327.

5. See F. J. Cronin and S. Motluk, “Yardstick Competition in Service Quality Regulation” (in process).

6. Ibid, p.323.

7. Although artificially-created competitions still may be possible by employing out-of-jurisdiction comparisons.

8. See Report Of the OEB, PBR Implementation Task Force , May 1999, p. 70 - 71 .

9. See Report Of the OEB, PBR Implementation Task Force , May 1999 .

10. In its 1990 order establishing price caps for the LECs,

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