The U.S. power sector has evolved drastically. New goals for resilient, clean, affordable, and safe electricity has transitioned the sector away from cost of service regulation and toward performance-based regulation (PBR). PBR changes the central question from "did we pay the right amount for what we got?" to instead, "Are we paying the right amount for what we want?". With PBR, rather than revenue increasing as utility investment increases, revenue increases as performance improves. There are a handful of ways to design PBR well, many of which are embodied in examples from utilities in Illinois and the UK.

1. 1
PERFORMANCE-
BASED
REGULATION
SONIA AGGARWAL
NATIONAL GOVERNORS’ ASSOCIATION
JULY 28, 2015

2. 2WWW.AMERICASPOWERPLAN.COM

3. 3
1.WHY
2.HOW
3.EXAMPLES
4.NEXT STEPS

4. 4
THE POWER SECTOR HAS EVOLVED
Old Goals:
 Meet growing demand
 Build new infrastructure
 Build to deliver universal service
 Affordability, reliability, safety
Old Options:
 Centralized power plants
 Transmission lines
 Distribution system
COST OF SERVICE REGULATION

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THE POWER SECTOR HAS EVOLVED
Old Goals:
 Meet growing demand
 Build new infrastructure
 Build to deliver universal service
 Affordability, reliability, safety
Old Options:
 Centralized power plants
 Transmission lines
 Distribution system
New Goals:
 Build  Maintain
 Reliability  Resilience
 Clean power
 Customer satisfaction
 Affordability, safety
New Options:
 All the old stuff, plus:
 Innovative distributed energy
resources (EE, DR, PV, EVs, etc.)
 Advanced IT
COST OF SERVICE REGULATION PERFORMANCE-BASED REGULATION

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COST OF SERVICE REGULATION
 Utilities spend prudently to maintain and operate the
power system
 Utilities recover capital expenses plus a rate of return
 Operational expenses are recovered at no risk to the
utility
 This incents capital investments and sales volume
 A great structure for 20th century goals
(meet growing demand, build new infrastructure, build
universal service)

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NEW GOALS FOR THE POWER SYSTEM
Resilient
Affordable, Safe
Clean
Customer-oriented

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ALIGN FINANCIAL INCENTIVES OF:
Utilities
Customers
Independent Power Producers
3rd party service providers
$
Resilient
Affordable, Safe
Clean
WITH THESE GOALS:
PERFORMANCE-BASED REGULATION CAN
ALIGN FINANCIAL INCENTIVES
Customer-oriented

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PERFORMANCE-BASED REGULATION
Works (for the residual
monopoly) in both
vertically-integrated &
restructured markets!

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From: “Did we pay the right amount for
what we got?”
To: “Are we paying (the right amount)
for what we want?”
Utility and
Regulatory
Models for the
Modern Era
by Ron Lehr
PBR changes the central question…
PERFORMANCE-BASED REGULATION

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1.WHY
2.HOW
3.EXAMPLES
4.NEXT STEPS

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COST OF SERVICE REGULATION, SIMPLIFIED
Revenue = Operating Costs +
(Capital Costs) * ROR
…As utility
investment
increases
Revenue
increases…
(Rate of Return)

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Revenue = Operating Costs +
(Capital Costs) * ROR
ELEMENTS OF COST OF SERVICE EQUATION
Often recovered at
no risk to the utility
Reviewed by regulators for
prudence and public interest
Greatest opportunity
for affecting overall
shareholder value
creation

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Regulators
Set quantitative
performance
goals
Establish reward
& penalty
structure
Utilities
Meet goals
Receive rewards
and/or penalties
 Reliable service
 Customer satisfaction
 Equity
 Innovative third-party
services
 System-wide least cost
 Resource diversity
 Effective facilitation of
open access
 Reliability
 Innovation
Retail Level, e.g.:
Wholesale Level, e.g.:
OutcomesPolicymakers
Establish policy
priorities
Work with
regulators
POLICY SOLUTION
PERFORMANCE-BASED REGULATION Already a
standards
driven
industry

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Revenue = Operating Costs +
(Capital Costs) * ROR
PERFORMANCE-BASED REGULATION,
SIMPLIFIED
± Performance
…As utility
investment
increases
performance
improves
Closer to the
cost of capital
Revenue
increases…

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MOVING FROM COST OF SERVICE TO
PERFORMANCE-BASED REGULATION
Opex
(including
depreciation
& taxes)
Opex
(including
depreciation
& taxes)
ROR ROR
Revenue
Incentives available
for value-creating
activities*
ILLUSTRATIVE
Traditional Model
value derived from all
investment activities
Performance Value Model
value derived from both
investments and performance
*Overall costs may actually
decrease; but potential returns
to shareholders should grow
commensurate with the
additional risk shifted to utilities

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1. Return on Equity (ROE) Adjustments:
 Basis point adjustments applying to the whole ratebase
 e.g. IL, UK
 Incentive ROE for projects that meet performance criteria
 e.g. CA: nuclear performance
DELIVERING THE INCENTIVE
TWO METHODS
* Shares may change over time
2. “Direct incentives”
 Shared savings / shared profits*
 e.g. CO: Xcel off-system sales
 Shareholder incentive mechanisms
 e.g. CA: efficiency performance
PREFERRED

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1. Work with stakeholders to
clearly define goals and
outcomes in quantitative
terms.
2. Include incentives for
exceptional performance and
penalties for missing the
standard.
PRINCIPLES FOR DESIGNING
PERFORMANCE-BASED REGULATION
3. Use a transparent and consistent
methodology for measuring
performance. Define it clearly at the
outset of the program.

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PRINCIPLES FOR DESIGNING
PERFORMANCE-BASED REGULATION
4. Shift an appropriate amount of performance risk to the utility in
exchange for longer-term regulatory certainty and the opportunity to earn
incentive compensation. Reward entrepreneurialism.
5. Establish a long enough time horizon for the utility and third-parties to
make investment decisions with certainty, and to innovate to meet
performance targets.
PLANNING TIME HORIZON
MONTHS YEARS DECADES

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PRINCIPLES FOR DESIGNING
PERFORMANCE-BASED REGULATION
6. Consider revenue sharing to align utility performance with customer
benefits.
7. Build on the existing framework, but look for holistic solutions that go
far enough to truly align incentives and simplify the regulatory process.
8. Consider provisions for mid-course correction—any changes should be
announced well in advance of implementation to minimize uncertainty.

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1.WHY
2.HOW
3.EXAMPLES
4.NEXT STEPS

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EXAMPLE 1 OF 2: FIRST STEPS
 O.38% of total utility revenue at stake
 Penalty-only structure
 Three primary output categories tied to revenue, more being tracked:
1. Reliability
2. Reduction of system uncertainty
3. Affordability
 Performance targets set for 10 years, assessed annually, with
increasing stakes
 Incentive delivery: ROE adjustments to all cap expenditures
Illinois

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EXAMPLE 2 OF 2:
GOING (A LOT) FURTHER
 3% of total utility revenue at stake
 Penalties and rewards offered
 Six primary output categories tied to revenue:
1) customer satisfaction, 2) reliability and availability, 3) safe
network services, 4) connection terms, 5) environmental
impact, 6) social obligations
 Eight years to adapt and perform, opportunity to review
at year 4
 Incentive delivery: ROE adjustments applied to all capital
and operational expenditures
United Kingdom
“Utility investors agree
RIIO is a paradigm of
success.”
Julien Dumoulin-Smith, UBS

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1.WHY
2.HOW
3.EXAMPLES
4.NEXT STEPS

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NEXT STEPS TO CONSIDER
1. Agree on top goals for the state’s power sector. What value can
utilities deliver to citizens and customers?
2. Identify appropriate quantitative performance metrics under
each goal. Work with the Commission to establish a transparent
methodology for calculating performance on each metric.
3. Begin to measure and track performance. Support pilots.
4. Grow the share of utility revenue tied to performance once the
metrics and methodologies are well understood.

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THANK YOU
@USPOWERPLAN
@ENERGYINNOVLLC
WWW.AMERICASPOWERPLAN.COM
WWW.ENERGYINNOVATION.ORG