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Dealing with Asymmetric Risk

Improving performance through graduated conditional ROE incentives.

Fortnightly Magazine - May 2009

“above normal” returns could be leveraged by providing the firm a choice in the PF under which it would operate. This would mitigate the likely downward bias in exogenously imposed PFs.

Another way to mitigate the bias would be to establish a productivity offset that better balances the interests of shareholders and ratepayers… Imposing this risk on the company would be more acceptable if the company is given a choice in adopting an aggressive productivity target.

Given the varying circumstances facing LDCs, the uncertainty regarding initial efficiency, and a desire to maximize cost savings for rate payers, OEB staff and consultants designed a response to the task force analysis and recommendation. In the 2000 Draft Rate Handbook ,19 they proposed a PF–ROE menu (see Figure 2) . Distributors could choose a combination of productivity growth and ROE: Higher productivity growth would permit higher returns. The menu offered combinations from 1.25 percent productivity growth and 10-percent ROE up to 2.5 percent productivity and 15-percent ROE.

Due to the varying circumstances facing utilities and differences across utilities in their potential for efficiency gains, the plan allows utilities to select the particular productivity factor from a set of six that it believes best reflects the combination of circumstances, opportunities, risks and rewards facing the utility… Note that the default value for Option A is a productivity factor of 1.25 which is about 25 basis points above the distributors’ average from 1988 to 1997. This means that, on average, ratepayers of distributors in the default option would experience a decline of 1.25 percent in real rates after which the distributor then has the opportunity for higher ROE above the target market-based rate of return. Associated with the 1.25 percent productivity factor is a ceiling of 10 percent on a distributor’s ROE. Utilities selecting Option A whose actual productivity change falls below the target ( i.e., 1.25 percent) would experience ROE below the target ROE ( i.e., the market-based rate of return).

How realistic are the elements of the menu? Recall that over the 10-year period from 1988 to 1997, Ontario LDCs had a growth in total factor productivity (TFP) of approximately one percent. Substantial variation existed. While the government’s schedule allowed only a few months for specification, collection, and analyses of LDC data, a substantial effort was made to profile a large number of LDC’s cost and productivity performance. The associated research found that across the 48 distributors, representing the vast majority of electricity customers, half of the distributors had productivity exceeding the average, with many of these also exceeding 2.0 and even 2.5 percent. Many of the utilities with above-average TFP growth were also utilities found to have total costs per customer around or below the mean. Finally, this research found that growth of TFP was about 2 percent during the earlier, de facto PBR from 1994 to 1997.20

Clearly, the PF choices offered in the menu represented performance levels that had been observed over the preceding decade by these same utilities. Individually, a number of utilities had operated at the

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