Future Ratemaking for Distribution Service

Performance Based Ratemaking (PBR) is emerging as a key element of the restructuring of the electric utility industry. While competition will determine the prices of unbundled generation, PBR will likely become the primary rate setting mechanism for re-regulated distribution service.

This will happen because PBR is a simpler, lower cost means of regulation, and can be more effective in promoting efficient utility operations. PBR can be more effective because it eliminates micro command and control by regulators and allows utilities the incentives, freedom, and creativity to manage their operations within specified rate constraints.

For PBR to be effective, however, the setting of the PBR formula must be done carefully and uniquely for each utility. If the formula is not given the numerical structure appropriate for a specific utility, it will not constrain rate growth sufficiently or will damage the financial position of the utility.

The typical price cap formula implies that the annual growth rate of electricity distribution charges should increase with the rate of distribution cost inflation less the rate of growth of distribution total factor productivity, plus adjustments for quality of service, plus the rate of growth of other costs outside the control of the distribution company such as customer growth, disaster recovery, etc.

Effective use of the PBR formula requires the unique setting of values for each of these measures appropriate for each utility. Of special significance is the determination of the so-called "productivity offset". In theory, the productivity offset is intended to be a reasonable measure of industry total factor productivity growth and a target for individual distribution company total factor productivity growth. It provides incentives for the utility company to adopt new technologies and reduce costs to meet the target and, to beat the target to the benefit of shareholders and ratepayers. If the productivity offset is too high, the price cap will fail to cover the utility’s service costs. If it is too low, then the company will earn extra-ordinary profits at the expense of ratepayers.

An implicit assumption of the theory is that utilities all operate efficiently, and the productivity offset is a measure of shifts in the "efficiency frontier". If this were true, a single productivity offset applied to all utilities might conceivably work. However, the practical reality is that all utilities do not operate on the efficiency frontier some are more efficient than others. Therefore, what the productivity offset term should measure, in application, is a target gain in efficiency plus the shift in the efficiency frontier.

The offset should, therefore, be higher for less efficient utilities and lower for more efficient utilities. To set an appropriate value for the productivity offset requires estimation of both the rate at which the "efficiency frontier" will be shifting and how close the utility’s operations are to the efficiency frontier. Unfortunately, most empirical studies that have been performed to estimate the productivity offset have not made the distinction between shifts in the efficiency frontier and movement toward the efficiency frontier. The studies have simply thrown together the data of efficient and inefficient utilities and pretended that all productivity change was because of shifts in the efficiency frontier. This methodology yields average productivity offsets that are too large to be applied to PBR’s for really efficient utilities and too small for really inefficient utilities.

ESC’s Performance Based Ratemaking Services

ESC designs and implements PBR price cap formulas with the aim of equitably aligning the interests of both shareholders and utility customers so that the formulas will endure in achieving efficiency and service quality. The PBR formulas are complete and explicit in defining the terms for all distribution rate adjustments.

ESC implements each term with values unique to each utility. The distribution cost inflation term is developed from local measures of labor, materials, and services and capital costs.

The productivity offset is rigorously developed by estimating the industry efficiency frontier and its movement due to technical progress and the unique position of the utility from the frontier. The various quality of service adjustment terms for such measures as: frequency of outages, average outage minutes, emergency response time, time to answer calls, time to fill service requests, etc. are all developed from utility-specific data. Similarly, the exogenous factor adjustments are defined around potential local area cost-influencing events.