by Tanya Bodell, Energyzt
Facing flat demand growth and other challenges to expected returns, electric utilities are searching for ways to maintain shareholder value through innovative, performance-based ratemaking. With low gas prices and a growing need for reliability, competitive wholesale markets also are seeking ways to incentivize performance. These two disparate corners of the industry are converging onto performance pay principles and regulatory incentives developed by French economist Jean Tirole.
Gaming the System
Jean Tirole might not be known directly by most in the U.S. electricity industry, but his award-winning theories on natural monopolies, oligopolies and regulatory incentives increasingly are serving as the economic underpinnings of the power sector. In October 2014, Tirole won the Nobel Memorial Prize in Economics. His work, developed in conjunction with Jean-Jacques Laffont in the 1980s, included the idea of using industry-specific incentive contracts to regulate oligopolies in markets where perfect competition, and therefore Adam Smith’s invisible hand of economic efficiency, could not. Such performance contracts increasingly are being adopted in the power sector.
North American Electric Reliability Corp. (NERC) has established 16 performance-based metrics to assess and promote transmission system reliability. These metrics support system stability, system frequency, system voltage, contingency management, restoration coordination, transmission adequacy and resource adequacy. In accordance with the Energy Policy Act of 2005 and FERC Order Nos. 672 and 795, NERC also has the authority to assess penalties, sanctions and require remedial actions on entities responsible for reliability (i.e., balancing authorities, reliability coordinators and transmission operators). To date, penalties have ranged from tens of thousands to hundreds of thousands of dollars per event, reaching up to seven figures for multiple violations.
In response to the past few years when electric generators were not available when needed, despite prior capacity market commitments, independent system operators on the East Coast are proposing incentive programs to ensure reliability. PJM has added a new product to its capacity market structure in addition to the traditional base capacity. Capacity performance would be a premium capacity product requiring a showing of fuel security, operational performance assurance, availability, flexibility and diversity. New England also is proposing to implement “pay-for-performance” incentives in its forward capacity market to motivate supply resources to invest to ensure availability by rewarding performance and penalizing underperforming resources. FERC is examining both proposals closely, accepting parts and sending other aspects back for modification. Performance incentives in the marketplace continue to evolve.
Although seemingly wedded to cost-of-service ratemaking, parts of the U.S. are beginning to implement performance incentives in rates. As international power markets restructured to allow for privatization, most governments adopted performance-based ratemaking mechanisms over cost-of-service regulation. Multiyear rate plans set an initial rate or projected rate over time and place a defined moratorium on rate changes to allow the utility to reap the benefit of innovation and cost improvements that occur in the interim, often subject to defined performance measures. This approach pioneered by Australia, Germany, the Netherlands and New Zealand continues to evolve. The push for performance in the U.S. is becoming a means for utilities to engage in innovative ratemaking to recoup revenues that are flat or shrinking due to limited demand growth prospects
Setting the Stage
Competitive markets create their own incentives for performance in the form of profits and losses. The traditional electric utility industry, however, tends to be monopolistic, requiring regulatory contracts to balance competing interests. Interestingly, both competitive wholesale electricity markets in the U.S. and traditional, regulated retail utilities are moving toward performance pay principles, each for different reasons.
Establishing the theory behind performance incentives is worthy of a Nobel Prize. Take the time to work through the details, however, and reap your own rewards.
Tanya Bodell is the Executive Director of Energyzt, a global collaboration of energy experts who create value for investors in energy through actionable insights. Visit www.energyzt.com. She can be reached at: email@example.com or 617-416-0651.
“What we have been trying to do is to get regulation which is light enough in order to let innovation happen and to promote investment by the incumbents.”-Jean Tirole