2015 CAMPUT Energy Regulation Course

1. 2015 CAMPUT Energy Regulation Course • Regulatory Reform and • Performance-Based Regulation • Willie Grieve, QC, Chair, Alberta Utilities Commission • Tuesday, June 23, 2015

2. Introduction • Alternative economic regulation of prices approach • Most utility legislation mandates a form of cost of service regulation - rate base rate of return (RBROR) • Concerns about cost of service incentives, effectiveness of traditional regulatory tools and regulatory burden have led to examinations of new approaches to economic regulation. • Legislative provisions have been added in some jurisdictions to encourage incentives for greater efficiency.

3. Regulatory tools of RBROR • Forward-looking test year of costs and demand with reasonableness assessment • After the fact prudence reviews for assets in rate base and potential disallowances • Cost oversight and potential disallowances of past costs for forecast purposes • Establish service quality levels and standards (penalties)

4. Incentive features of RBROR • Preference to invest in capital assets (rate base) to improve earnings (higher rate base means greater earnings) • Few incentives to minimize operating, maintenance and administration costs (reduced costs means lower rates) • Incentives to forecast high costs and low demand growth • Few regulatory tools to examine prudency of expenses or capital costs and overcome perverse incentives (the capital-expense mix)

5. Historical environment • Pure utility • Vertically integrated utilities • Scale and scope economies • Simple corporate structure • Limited geographic reach • Limited technological change • No affiliates • No or limited competition • Full visibility for regulators

6. Industry changes • Holding companies • Broad geographic reach with utilities spread across the country • Dis-integration into generation, distribution, transmission, retail • Loss of economies of scale and scope • Creation of affiliates – both regulated and unregulated • Technological change • new alternative energy sources • self-generation • Portions may no longer be monopolies • Transmission still largely monopoly • Distribution monopoly • ISOs

7. New tools added for RBROR • ‘Mini’ rate bases (cost allocations) • Transfer prices from affiliates • Pass through costs and prices • deferral and reserve accounts • Codes of Conduct • for competition • for affiliate pricing to protect customers • RBROR incentives remain and may be exacerbated by changes • Regulatory burden increases • Regulatory focus moves away from most important issues

8. Need for new regulatory approaches • Increasingly large amounts of paper filed with little or no effect on ability to control costs • Need to address the perverse incentives created by cost of service regulation • traditional incentives • new incentives caused by industry evolution • Need to improve efficiency incentives and efficiency of regulation while not losing the purpose of regulating • Some forms of incentive regulation have been adopted and adapted in many jurisdictions for this purpose

9. How do competitive markets create incentives? • Firms make trade-offs between price and quality to respond to customers • Firms are largely price takers, not price setters • Firms cannot influence price and so focus on efficiency • Price largely set by marginal cost of most efficient competitor so focus is on reducing cost • Firms must continually improve to match or better competition, instead of exerting effort in influencing regulators • Firms must cope/adapt to externalities and shocks (as do their competitors)

10. Incentive approaches • RBROR time lags (rate freeze) • Company remains in control of timing of next rate case • All RBROR incentives remain in place but are muted until application • Forward test years • Incentives for greater static efficiency after rates set (but not too much) • Incentives to forecast high costs and low demand in test periods • Dynamic efficiency incentives manifested in regulatory strategy

11. Incentive approaches • Earnings bands • Allow greater earnings before regulatory action (similar incentives to forward test years) • Benchmark or yardstick • Bases rates on rates of peer or similar utilities • Almost impossible to find peers because of history and unique local issues of companies • Sometimes used as a reference point for size of X factors in PBR (Ontario)

12. Incentive approaches • Social contract • Very flexible • Most often used for political needs like infrastructure development, job creation or quality improvement • Can be used to emulate market outcomes through PBR elements • Price regulation • Formula-based (FBR) or performance-based (PBR) • Time-limited so perverse cost-based incentives still arise

13. Basics of PBR • Start with Phase II cost of service prices • Focus on changes in prices (not costs) over time and on quality of service • Set plan to continue to provide opportunity to earn fair rate of return during the PBR period • Eliminate reviews of costs during PBR period so as not to distort incentives • Reduce regulatory burden -- eliminate old regulatory filings (some new filings) • Allow for price adjustments for significant unexpected events

14. Closer to competitive incentives • Utilities move from being price setters to price takers • Price changes external to the individual utility’s cost changes • Set by formula (I – X) Inflation factor: I Productivity offset: X • Shift from bottom up pricing to incentives • Utility must re-focus on managing costs • Less opportunity to flow through actual costs • Rate cases to influence price reduced • Reduced regulatory effort

15. What we want to achieve • Companies focused on management of operations rather than management of regulation • Regulation focused on prices and quality • Maintain quality of service • Reduction in regulatory burden • Rate of change in price increases less than expected under cost of service regulation

16. Alberta PBR principles (Bulletin 2010-20) • A PBR plan should, to the greatest extent possible, create the same efficiency incentives as those experienced in a competitive market while maintaining service quality. • A PBR plan must provide the company with a reasonable opportunity to recover its prudently incurred costs including a fair rate of return. • A PBR plan should be easy to understand, implement and administer and should reduce the regulatory burden over time. • A PBR plan should recognize the unique circumstances of each regulated company that are relevant to a PBR design. • Customers and the regulated companies should share the benefits of a PBR plan.

17. Calculation of PBR rates Annual formula adjustment with factors such as • I: Inflation • X: Productivity • Stretch factor • Exogenous adjustment(s) • Flow-through • Earnings sharing (if any) • Service quality adjustments • Other

18. How are rates calculated? (cont.) • Results in something like: Rt = Rt-1* (1+(I-X)) – E – S +/- Z • Where: Rt = Current year’s rate for each class Rt-1 = Prior year’s rate for each class I = Inflation Factor X = Productivity Factor =1.2 E = Customer portion of Earnings Sharing S = Service quality penalties, if any Z = Exogenous Adjustment

19. Prior year rates • Two distinct issues • First year “going-in” or “base rates” • Sets the rates upon which the formula is based • Usually accept most recent COS application be it historical or prospective • Rate established is independent of PBR formula • Ongoing, subsequent years • Prior year’s rates adjusted by formula • New cost of service case to re-base

20. I (Inflation) • Compensates for inflation increases • Common measure is CPI. However CPI is a consumer basket of goods not utility costs • for example, watermelon prices unrelated to transformer prices • CPI is what is known as an output measure • Based on outputs not inputs (i.e., based on changes in retail prices not the costs of production inputs)

21. Output versus input price indices • Output measures likely include productivity improvements • A $600 1990 computer vs. a $600 2010 computer has productivity improvements reflected in the price • 1990 versus 2010 liter of gas is the same, so price comparison is pure inflation

22. Output versus input price indices • To address embedded productivity, industry-specific indices related solely to inputs were developed • The I and X variables are often interlinked and/or require trade-off • If I is based on an output measure such as CPI, then need to adjust X to “back out” productivity gains already in the output measure

23. Illustration: different measures of I

24. Illustration of different indices

25. Illustration of different measures: geography • Source: Enmax Power Corporation FBR Application Proceeding 12 Exhibit 18 page 13

26. X (productivity factor) • Productivity is the rate of growth of outputs less the rate of growth of inputs • calculated as a percentage • Under PBR, utilities compete against an external (industry-wide) historical productivity measure • This is a proxy for competitive market price pressures

27. Total Factor Productivity • Total Factor Productivity study is a technique which measures all inputs and outputs to derive a single measure suitable for comparison • Range from economy-wide down to industry specific • Geographic dispersion • May not be a factor for steel or transformers, but may be for labour • Usually disaggregate inputs to • Labour • Capital • Other (materials, rents, services etc.)

28. Productivity variability • Annual fluctuations suggest longer time series is required • Fuel cost hike in airlines shows as decrease in productivity in one year when long term trend is productivity increase • Different time measures, different numbers • 25 years: Canada: -0.04% (a decline) versus US: 0.91% • Canada-wide productivity growth for 2000-2004 averaged 0.8% per year

29. Illustration of TFP variability

30. Stretch factor • A percentage amount added to X factor • Designed to capture gains in excess of industry average productivity growth • Firms under COS assumed to be less efficient than competitive firms • Evidence that productivity improvements greater during initial PBR term • Stretch factor usually eliminated after the first PBR term

31. Exogenous adjustments • Defined as: • Unplanned, unexpected or unforecasted • Uncontrollable change in costs or revenues • Independent of I, X or other factors in formula • Not included in the base rate • Material financial impact on utility • Can include in rates if the above criteria are met • In some cases the impact is transitory and is a one time adjustment only • If carries on, may or may not be subject to the I-X adjustment

32. Exogenous adjustments (continued) • Utility incented to pass through any negative shocks such as increases in costs, decreases in revenues • Allowed exogenous adjustments to reduce risk for both utilities and customers • However, only the utility can take concrete steps to mitigate through: • Planning • Contingency plans • Other • For example, disaster planning, insurance versus self insurance, etc.

33. Exogenous adjustments (continued) • Materiality • Determine whether you can add different “sub-material” items to get a material adjustment • Alberta Enmax case, chose ≈1% of revenue as materiality threshold • Deal with as situations arise • Difficult to catalogue a list of events that are truly exogenous events

34. Exogenous adjustments (continued) • Three types: • Flow through • Exogenous • Off ramps • No clear demarcation between the three. All three allow actual costs to be included in rates • One of only two classes of items in PBR where actual costs impact rate changes (the other is capital adjustment if included)

35. Flow through • Usually agreed at outset of plan • Uncontrollable normal course of business charges such as ISO charges to distribution entities • Regular flow-throughs, • e.g., monthly ISO charges or gas cost adjustments • Not captured in I or X; in other words independent of these factors • Item should affect the industry solely and not economy in general • e.g., general tax increase captured in I so does not apply

36. Off-ramps • Pre-determined, significant issues • Returns beyond specified thresholds • Consistent service standard breaches • If triggered, PBR arrangement either terminated or wholly re-opened • Usually something that raises questions as to whether the structure should be revisited

37. Earnings sharing mechanism • Often in initial PBR terms because of uncertainty about new mechanism • Some early PBRs resulted in very large earnings • Parties concerned with over/under earning and perceptions • Retains vestiges and incentives of RBROR regulation • What goes into the net income calculation • What are allowable expenses • Mutes incentives • Why should there be any additional sharing at all?

38. Capital • Depreciation embedded in going-in rates and in TFP studies • Factors Influencing Depreciation • Growth: new additions increase depreciation • Replacement costs different from original cost changes depreciation • Replacing $10 1960’s transformer with $100 2010 transformer • Depreciation decreases when asset fully depreciated • Depreciation rate changes

39. Capital (cont.) • If depreciation increases are greater than rates (I-X) and growth, then shortfall arises • therefore, some plans include adjustments if capital-related expenses exceed certain thresholds • There is no a priori conclusion as to whether capital additions require an adjustment factor. • Including a capital adjustment factor can have negative effects on incentives

40. Quality of service • PBR creates incentives to cut costs and therefore service quality may be at risk • Need to ensure that companies maintain quality • Penalties for specific and general failure to maintain service quality • Asset monitoring as a tool for quality monitoring

41. Review/renewal process Review and renewal alternatives include: • Full RBROR rebasing • Reduces incentives as gains clawed back • Increased regulatory cost • Keep details for prudence determination • Adjust parameters such as I and X • Generally the X or stretch factor • Adjusts formula on a go-forward basis • Past is past • Leaves incentives intact

42. Term • Length of time between reviews involves trade-offs • Longer timeframe - more incentive • Longer term adds certainty to regulatory treatment • Longer term provides incentive to invest long term – dynamic efficiency • Shorter term reduces risk, mutes positive incentives and exacerbates perverse incentives • Indefinite term appears to maximize incentives

43. Conclusion • Questions?