The utility business model is evolving in response to a fundamental shift in our power system economics. Traditional utility models were built on the engine of inexorable electricity demand growth, which became less certain as America’s power system was built out and energy efficiency programs succeeded – electricity demand growth has been flat for 10 years, and it’s expected to stay that way.
Electrifying transportation and buildings promise to provide future growth for utilities, but just how much growth and when it will happen is uncertain. At the same time, customers are demanding more control over how they consume and produce their own energy, and energy economics have reached a critical cost crossover – renewable energy is now cheaper than many fossil power sources, even without counting health or climate benefits.
In response, utilities – and their regulators – are increasingly embracing a new revenue model that rewards performance against goals to meet evolving customer demands and avoid unwanted consequences: performance-based regulation (PBR).
PBR transforms the traditional utility revenue model where profit is driven by returns on capital investments (like power plants) or the volume of electricity sold into one where profit is driven by meeting goals to deliver an affordable, reliable, and clean power system.
Forward-looking utilities and policymakers are embracing this shift, and several leader states are showing when it comes to building a prosperous utility of the future, it pays to get out in front of the PBR trend.
Utilities Embrace Performance-Based Regulation
Integrating low-cost renewable generation and distributed energy resources (DERs) is an imperative for utilities and their regulators – and successfully reforming business models to make the most of this trend depends on getting the details right.
Thirteen states are now actively discussing or moving forward on PBR and are working on ways the utility business model can evolve to deliver and thrive on performance, according to state utility regulatory dockets accessed via Advanced Energy Economy’s PowerSuite.
For the most part, U.S. utilities are embracing this change. In Utility Dive’s 2018 State of the Electric Utility survey, more than three-quarters of respondents said they wanted PBR to form at least part of their model, and 32% preferred a predominantly PBR-based business model to govern their investment decisions.
Utility Dive reports 49% of utilities currently operate in a COS environment, while 32% operate in a hybrid COS-PBR environment, and just 4% operate in a predominantly PBR environment. However, 81% of utilities said they either already have or want a regulatory proceeding in their state to reform utility business and revenue models, and 73% expect to operate either in a hybrid COS-PBR or predominantly PBR-based environment within 10 years.
The tide’s changing for utility business models, and three states – Hawaii, Rhode Island, and Minnesota – lead the surge.
Hawaii – PBR to Help Achieve 100% Renewable Energy Goal
In April, Hawaii became the first state to legally require utilities separate revenue from capital expenditures, i.e. moving from a COS business model to a PBR environment. SB 2939, directing regulators to create a new utility business model, unanimously passed both houses of the Hawaiian state legislature and was signed into law by Governor David Ige. Hawaii’s primary utility, Hawaiian Electric, supports the new law and regulators have already opened a process to design and implement PBR.
By 2020, Hawaii will create PBR incentives that “directly tie an electric utility revenues to that utility’s achievement on performance metrics” through incentives and penalties to increase customer affordability, support grid reliability, and rapidly transition to renewable energy. Regulators will tackle the task in two phases: evaluating Hawaii’s existing regulations and identifying areas for improvement, then determining which PBR approaches work best for utilities and customers.
Hawaii’s PBR process is important for two reasons. First, the state has established a goal of 100% renewable energy by 2045, so determining how to quickly and reliably integrate variable renewables while keeping utilities profitable and customer costs low could provide lessons for other states. Second, Hawaii‘s energy prices are among the highest in America and renewables are already cheaper than fossil fuels, so lessons learned here can be applied to the challenge of retiring uneconomic generation across the U.S.
Rhode Island – Small State, Serious Action
Rhode Island is another epicenter of action on PBR. In March 2017, Governor Gina Raimondo directed state regulators and agencies to determine how utility regulations could help affordably and reliably reduce emissions 80% below 2005 levels by 2050.
The inter-agency team held technical meetings and solicited stakeholder engagement, producing their Power Sector Transformation Phase One report last Fall. The report outlined National Grid’s existing incentives and performance, summarizing that COS regulation discouraged the utility from seeking efficient solutions that don’t depend on large capital investment. It also recommended specific changes to the existing utility business model, including linking utility profits to performance through metrics and incentives to boost demand-side energy management and integrate DERs like renewables and energy storage.
Rhode Island’s experience shows value in getting ahead of the PBR trend. Shortly after the state report’s publication, National Grid filed a rate case proposing significantly different performance incentives than those recommended by the state’s report. Because the state’s process had already solicited a wide range of comments and generated buy-in its recommendations, Rhode Island regulators have existing stakeholder recommendations they can use to assess the utility’s proposal.
Minnesota – Land of 10,000 Stakeholders
Midwesterners are known for their friendly nature, so it shouldn’t be a surprise Minnesota has had the most success getting stakeholders spanning every element of the utility-customer spectrum to agree. The state’s e21 initiative launched in 2014 by convening utilities, environmentalists, consumers, cities, businesses, state officials, and regulators to determine how regulations could achieve state goals.
Through the structured “transformative scenario planning” process, e21 revealed that all power-sector stakeholders thought the existing business model and regulatory framework needed to change, even if they wanted change for different reasons. This set the table for change, and after a series of regular meetings, the group published consensus recommendations for future regulations prioritizing PBR. The recommendations guided several subsequent regulatory decisions, most notably approval of Xcel Energy’s 2016-2020 rate plan, which closely aligned with e21 recommendations.
Minnesota then proceeded through e21’s Phase Two, focused on determining how to best implement PBR, and began working with Xcel and stakeholders to develop PBR along two tracks: create performance metrics, and identifying where performance incentives could overcome consumer shortfalls in the existing utility regulatory model.
While Minnesota’s utility business model revisions may be taking more time than other states, they’re notable because of the degree that stakeholder agreement has improved outcomes and prevented disagreements.
What’s Next for Performance-Based Regulation?
The U.S. power sector has evolved, and PBR has emerged as a preferred option to maintain existing infrastructure and ensure a resilient grid based on clean and affordable energy that benefits customers, businesses, and utilities. Hawaii, Rhode Island, and Minnesota are making serious progress on PBR, and they’re not alone.
Illinois has had PBR on the books for years, and recently began the NextGrid utility of the future study to guide future regulation, help achieve its goal of more than 4 gigawatts’ new renewables, and capitalize on the billions it has already spent on grid modernization with several stakeholder groups.
Meanwhile, Ohio recently completed the third phase of its PowerForward review of utility regulation to incentivize grid modernization, and state regulators are considering several ideas raised in the PowerForward process.
Illinois and Ohio may be the next states to move on PBR, but they won’t be the last. Utilities and their regulators around the U.S. are increasingly looking forward to ensure customers get what they want from the electricity system.
By Sonia Aggarwal, Energy Innovation’s Vice President and Director of America’s Power Plan.