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Dealing with Asymmetric Risk

Improving performance through graduated conditional ROE incentives.

Fortnightly Magazine - May 2009

the first-generation implementation process, and so opted for an O&M-based efficiency comparison (that ignored capital usage, reliability, or capitalization policies). Because of these shortcomings, the OEB used a literature-reviewed X factor.

While lacking critical data on LDC capital, stakeholders put forward evidence that these governance vagaries substantially reduced LDC productivity over the decade since 1997. Indeed, subsequent research, which included both O&M and monetized values of capital similar to that employed in the OEB’s first generation, found a widespread negative rate of productivity growth over the 2000 to 2006 period.

Based on this information, data and research from the first-generation PBR, and subsequent work using this data examining efficiency and utility performance, a menu proposal was developed to address the OEB staff request (see Figure 3) . Due to the legacy implications of ambiguous and contradictory government and regulatory direction, two options were presented that fell below the lowest option in Figure 1. The new menu provides a baseline ROE of 8.5 percent and PF of 0.8 with an ROE of 8.5, i.e., option A. Option B also provides a below-market rate of return of 9.5; it would require a PF of 1.0. Option C is nearly identical to Option A in the 2000 menu. The ceiling ROE is now 12.5 percent with a PF of 1.6.

Following the first-generation process, research examined some of the issues raised by stakeholders but not initially examined due to time pressures: first, the status of efficient versus inefficient LDCs; second, the relationship between third-party financing and allocative inefficiency; and third, productivity potential including the performance of frontier (most efficient) versus interior (less efficient) LDCs. 24 Looking at the period 1988 to 1997, a TFP framework similar to that used in first-generation PBR was used: one output, four input, fixed weight calculation of TFP. It was found that the LDCs that were judged to be most efficient, after examining both technical and allocative efficiency, at the start of the period had consistently higher subsequent growth in TFP than did less efficient LDCs. This was true over both the 1988 to 1993 and the 1993 to 1997 periods. Over the full 10-year period, the average annual growth in TFP for these frontier firms is about 1.6 percent.

That is, during the earlier decade the most efficient firms had been able to improve TFP by 1.6 percent. On this basis, the recommendation for the menu was that a ceiling be set for PF at 1.6 percent for the three-year term of the next PBR. Increments of 0.2 in the PF would be associated with 100-basis point increments in the allowed ROE. This would set the baseline TFP at .8; slightly below the ten-year growth among Ontario LDCs in the first generation. 25

Furthermore, it was noted that before starting its second-term PBR, NVE raised the upper range of its PF from the 4.5 set in the first term. Presumably, the institutional and operating changes implemented by the regulator were not done in such a way as to render the LDCs unable to continue expectations of on-going productivity

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