(November 2009)Regulators are in the unenviable position of determining an allowance for ROE that’s fair to consumers and investors in a volatile economy. The cases that stand out this year...
Regulatory Reform in Ontario
Successes, shortcomings and unfinished business.
In the past several months, Francis Cronin and Stephen Motluck have published three, largely critical articles in Fortnightly on the regulation of the electricity distribution industry in Ontario. In “ Dealing with Asymmetric Risk ” (May 2009), the authors criticized the performance-based regulation (PBR) plan established for the industry in 2008 and proposed an alternate mechanism that they claimed would “minimize data requirements and allow firms to reveal productivity potential.” 1 This was followed by the two-part “ Ontario’s Failed Experiment – Part 1 and Part 2 ” (July 2009 and August 2009), which argues that service quality has declined in Ontario because of the PBR framework.
Although regulatory reform in Ontario is a work in progress, there is no basis for concluding that current reform efforts are a “failure.” Indeed, the PBR plan approved in 2008 is almost universally seen as a significant step forward, which will provide a foundation for sustainable incentive regulation in the future. The prior authors’ evidence on service reliability is also far more ambiguous than they indicate. It is certain, however, that if there has in fact been a decline in service quality in Ontario over the last decade, it can’t be due to the influence of PBR.
The current experience in Ontario can be understood only by first considering its earlier PBR initiatives. Of particular importance is the “third generation incentive regulation mechanism” (3rdGenIRM) approved for electricity distributors in 2008.
PBR in Ontario
Ontario first implemented comprehensive PBR ( i.e., PBR that applies to overall regulated rates, which therefore reflects both capital and operating costs) in 2000 for electricity distributors. The PBR proceedings produced a “Rate Handbook,” which presented the recommendations of OEB staff and its advisors on a preferred PBR plan. 2
The Rate Handbook recommended a PBR plan where each distributor’s rates were adjusted by an inflation measure minus an X factor. Distributors also were allowed to select their X factor using a menu approach that included six alternative X factor and allowed return on equity (ROE) combinations, with higher values for X associated with higher-allowed ROE levels and vice versa. Companies then would be allowed to select the X factor- ROE combination that most appealed to their risk-incentive preferences.
In January 2000, however, the OEB rejected this approach as too complex for a first-generation PBR plan. It also didn’t believe there was a well-developed analytical foundation supporting the specific menu of X factor and ROE combinations. Instead of this menu approach, the OEB opted for a more conventional PBR plan where the inflation minus X formula used a single X factor. This indexing mechanism then was used to adjust the rates of all