Current Issues

Driving Efficiency in Ontario’s Electricity Distribution Sector with Incentive Based Regulation

Multi-year Distribution Rate Setting Plan 2007 – 2010

In early 2006, the Ontario Energy Board (OEB) announced its intention to establish a multi-year electricity distribution rate-setting plan for the years 2007 to 2010.
The OEB recognises the need to reduce simultaneous annual rate setting for all distribution utilities and the idea that allowing rates to be set for multi-year periods will increase regulatory efficiency.

Among other things, the plan will help lay the foundation for what is being called a 3rd Generation Incentive Mechanism. The plan also provides for greater regulatory certainty for electricity utilities, and is meant to help drive efficiency improvements in the province’s distribution sector.

Incentive Regulatory Mechanisms or incentive based regulation (also commonly known as Performance Based Regulation, or PBR) is a regulatory methodology to encourage utility management to be efficient in the running of their business.

The PBR methodology puts a cap on the utility’s revenues or prices, in order to persuade management to produce and deliver electricity cost-effectively and in many instances incentives are tied to service quality improvement. The two common forms of PBR are price caps or revenue caps.

The OEB’s four-year exercise, and the subsequent changes that will occur in setting distribution rates in the future, will have an enormous impact on the electricity distribution sector and how it does business in moving forward. It will be an evolutionary process – an approach that refines the mechanisms as they are developed and implemented.

A staggered approach to re-base distributor’s revenue requirements is being adopted, which will see approximately a third of distributors re-based in each of 2008, 2009 and 2010. Re-basing is essentially a comprehensive review of all utility costs.

Realising that the transition to a performance-based regime will be a complex process, and that a number of rate-related studies need to be undertaken, the OEB is adopting a transitory methodology called the 2nd generation Incentive Regulatory Mechanism (IRM). 2nd generation IRM is a transitory methodology and not an end-state in itself. Consequently, the OEB has developed a multi-year rate-setting plan, which, according to the Board, is aimed at:

Providing greater regulatory certainty to distributors during the transitory period 2007 to 2010 when several rate-related studies are carried out;
To begin to drive efficiencies in the distribution sector; and,
To lay a foundation for a 3rd Generation Incentive Regulatory Mechanism.

The process will be complex and consist of a number of different elements or projects. Two key projects that have been pursued in 2006 are the Cost of Capital and 2nd Generation IRM.

The OEB’s Business Plan for 2006 – 2009 outlines the progression of fundamental long-term regulatory initiatives and ongoing core adjudicative work that is central to the effective operation of the energy sector. One of the key Strategic Business Objectives outlined in the Business Plan addresses the need for providing “sound economic regulation that balances the interests of consumers with the need for a financially viable energy sector” and, among other measures to achieve the objective, includes a commitment to the need for putting in place a multi-year incentive rate plan beginning with the 2007 rate year.

A Short History of Performance Based Regulation in Ontario

Performance based regulation (PBR) is not new to Ontario. The model stems from the concept adopted by the Ontario Energy Board at the time of restructuring of the province’s electricity industry. Initially introduced in Ontario as first generation PBR, the idea was to provide incentives to distributors to improve productivity while providing utilities with incentives to retain the gains from improved business efficiencies.

Under the former Ontario Hydro regime, electricity utilities operated on a ‘cost-of-service’ or ‘rate of return’ methodology model where rates were matched with expenditures. A PBR regime essentially separates the rates charged by distributors from the cost of providing that service. Improved efficiency and greater productivity within a distributor’s business became the key components for measurement and comparison.

Unfortunately, the Board’s initiation of PBR came to a sudden halt in 2002 when the Ontario government froze the distribution rates. Most investors were denied the opportunity to earn the allowed market based rate of return, even when they were putting in place aggressive efficiency measures.

Following the passage of Bill 4, the Ontario Energy Board Amendment Act, 2003, electricity distributors were again given an opportunity to earn a market-based rate of return. In determining the distribution rates for 2006 (the first such determination after the ‘rate freeze’ was lifted) the OEB adopted what was essentially a cost of service model in order to determine 2006 electricity distribution rates.

Overview of the Principles of Performance Based Regulation

Performance Based Regulation (PBR), also known as Incentive Based Regulation (IRM), was developed in response to the problems encountered with the application of the Rate of Return (ROR) methodology.

The traditional method used by regulators for determining rates that are just and reasonable has been based on a cost of service or, Rate of Return method. The ROR method allows utilities to recover their reasonable costs plus a return on the investment to the providers of capital, including debt and equity. The amount that the regulator considers to be prudently incurred to deliver electricity to consumers is recovered through a ‘revenue requirement,’ which is typically set for a test year. The revenue to be earned by a utility is equal to the distribution expenses, plus a fair return on the rate base. The ROR method guarantees utility investors a level of return on their investment that is considered by the regulatory to commensurate with their risk.

The Pros and Cons of the PBR Methodology

The PBR methodology is used to describe regulatory approaches that rely on financial incentives and disincentives to induce desired behaviour by a regulated entity. The desired behaviours, or outcomes, are generally:

Lower costs;
Improved service; and,
More rational allocation of risks and rewards.

Experience gained from other jurisdictions over the last 20 years supports the fact that well designed PBR mechanisms lead to efficiency improvements as well as service quality improvements.

A number of advantages to PBR methodology have been cited, including that it affords regulated entities the opportunity to earn greater returns for superior performance. In theory, incentive mechanism also goes hand-in-hand with a light handed approach to regulation which is preferred by distributors – unlike a Rate of Return approach, there should be less micro-management of utilities by the regulator under the PBR regulatory methodology. Because the PBR period runs for three to five years, the regulator does not have to follow a complex regulatory process to approve rates on an annual basis. Under PBR, much of the work is done in the initial stages, leaving the regulator to play a monitoring role that ensures that the methodology is indeed extracting the expected efficiency improvements.

Likewise, PBR methodology can also have its disadvantages. The approach is a forward looking method, leaving it open to a degree of uncertainty. In an environment of dynamic change and restructuring, it would be extremely difficult for the regulator to change some components during the set period. There is also the danger that the targets in the methodology are challenging to design and may benefit the utility or the consumer to the disadvantage of the other. Another argument that has been made is that in order to reduce costs, utilities may be tempted to cut down on maintenance, quality of supply and service, and investment in future capacity.

It is important to note however, that regulatory reforms that have taken place in many jurisdictions in the electricity distribution and transmission sectors have led to the development of a sound theoretical framework for PBR. PBR is an evolutionary process. A trial and error approach that refines the mechanisms as they are developed is key to implementing the methodology. Application of PBR mechanisms in a number of jurisdictions, including England, Wales, Argentina, Chile, Brazil, Peru, and New Zealand have led to improvements in labour productivity and service quality in electricity distribution.

EDA Policy Position on Incentive Based Regulation

Back in 2003, the EDA Board of Directors approved a list of Guiding Principles to establish parameters for discussing potential change to Ontario’s distribution sector. One of those principles reiterated the need for PBR by stating, “that any proposed model must promote Incentive Based Regulation as the primary tool, administered by the independent regulator, to drive efficiencies and appropriate levels of service improvements within the sector.”

The EDA Board has confirmed its adoption of Performance Based Regulation methodology for regulating the electricity distribution sector in moving forward. However, in the evolving regulatory climate in Ontario, the EDA is very concerned to ensure that any new regulatory mechanism that is created is working and effective. Accordingly, the EDA is also advocating for a timetable for the design and implementation of incentive regulatory mechanisms for electricity distributors that:

Provides sufficient time to assess whether the objectives of the designed regulatory mechanism have been achieved and are effective; and,
Provides sufficient time to continue to compare the effectiveness against the existing regulatory mechanism.

Initial Steps in the OEB’s Multi-Year Rate Setting Plan

Three key elements of the OEB’s Multi-Year Rate Setting Plan currently underway, include:

1. Cost Allocation – to determine the existence and extent of any cross-subsidization between current rate classes; examine the fixed/variable splits for various classes of distribution rates, focusing on monthly customer service charge outliers; and, to consider the merits of select rate classification change.

2. 2nd Generation Incentive Mechanism – to establish a simple, practical and mechanistic incentive rate adjustment mechanism for the plan period (until 2010).

3. Cost of Capital – To confirm the cost of capital to be used in adjusting annual revenue requirements for 2007 and beyond.

The Multi-Year Rate Setting Plan will have a significant impact on electricity distributors’ businesses. An overview of the impact of the OEB projects on utility businesses in areas such as revenue requirements, cost allocation, rates of returns, and incentives management is exhibited below.