Regulatory Breakthrough? New York Ponders UK Approach to REV

on December 05, 2014 at 2:00 PM

Climate Protection - Photo Illustrations

On Tuesday, November 18, 2014, the Guarini Center at NYU Law convened a roundtable discussion on utility regulation in the United Kingdom, focusing on its new “RIIO” model. The event brought together American regulators, NGOs, utilities, and academics to exchange thoughts and ideas with presenters from the analogous spheres in Britain. A roundtable report will follow in the coming weeks. The Guarini Center gratefully acknowledges the Alfred P. Sloan Foundation for sponsoring this effort.

This post is adapted from the issue brief on RIIO that the Guarini Center prepared as a primer for the event. You can read the full issue brief here.

Background

This past April, the New York Public Service Commission (PSC) launched a proceeding called “Reforming the Energy Vision (REV)”[1] to overhaul the state’s electric industry. REV is a response to the economic, technological, and environmental pressures that presently confront the state’s energy systems. In addition to the traditional expectations that electric utilities provide reliable, affordable, and universal service, state regulators now seek to improve the industry’s performance across other dimensions: environment, resilience, and consumer engagement.[2]

To ensure that utilities evolve and perform in ways that further these policy priorities, the PSC has indicated that it will consider adopting performance-based regulation (PBR), under which utility profits depend on the achievement of targeted policy outcomes.[3] REV has identified a novel PBR variant employed by energy regulators in Great Britain—the RIIO (Revenue = Incentives + Innovation + Outputs) model[4]—as an exemplar of comprehensive output-based regulation that might secure New York State’s regulatory goals. RIIO’s emphasis on consumer value and integration of diverse policy objectives make it a potentially path-breaking regulatory innovation. As one of the first U.S. states to adopt incentive regulation for energy utilities and the first to enact performance incentives for service quality, New York may now be well positioned to introduce this type of integrated PBR in the U.S. context.

The U.K. pioneered incentive regulation for utilities in the 1980s, and has drawn upon its experience to develop RIIO, a more advanced version of such regulation. As early returns from RIIO’s early implementation become clearer, New York and other jurisdictions can draw upon lessons that this regime offers.

While RIIO has received considerable interest from U.S. observers as a standard to which “utility 2.0” reforms should potentially aspire,[5] accessible descriptions of RIIO’s mechanics have been scarce.[6] This post is intended to orient an American audience with the basic structures and mechanisms that govern utility regulation in the U.K. through RIIO.

What is RIIO?

The RIIO model for sustainable network regulation was introduced by British energy regulators in late 2010.[7] RIIO initially denoted “Revenue set to deliver strong Incentives, Innovation and Outputs,”[8] but has since been simplified to “Revenue = Incentives + Innovation + Outputs.” RIIO replaces a system called “RPI-X” regulation, in which regulators fix a utility’s allowed revenue for a five-year term and allow the prices to adjust for inflation and expected efficiency gains within that period.

British regulators used RPI-X to regulate newly privatized utilities in the telecommunications, gas, and water industries during the 1980s, and in the electric transmission and distribution sectors beginning in 1990. RPI-X was believed to be a more effective tool to motivate efficient utility performance than the traditional American convention known as cost-of-service regulation.[9]

A picture taken on February 3, 2012, sho

By the end of 20 years under RPI-X, however, Britain’s energy regulatory body, the Office of Gas and Electricity Markets (Ofgem), had concluded that the time had come to replace RPI-X with a new form of performance-based regulation (PBR). This new approach was needed in order to foster greater innovation and investment by the industry in light of new climate policy demands and aging infrastructure. Ofgem estimated that achieving the government’s environmental goals, while making needed network upgrades and keeping energy affordable and reliable, would necessitate £32 billion in utility investments by 2020—an amount roughly twice what the sector had invested in the previous 20 years.[10] Describing the shift away from RPI-X, Professor Aileen McHarg wrote that “the regulatory system appears to have reached a tipping point where measures to promote goals such as security of supply and decarbonization are no longer just add-ons, but central to the design of regulatory and market systems.”[11]

Unlike RPI-X, RIIO is not a price control system set unilaterally by the regulator; RIIO price controls are the product of negotiated settlements that result in regulatory contracts between Ofgem and regulated utilities.[12]

What sets RIIO apart?

Revenue cap | RIIO builds on RPI-X as an incentive-driven approach to delivering efficient performance. As before, the maximum rates a utility can charge in each year of the price control period are determined by dividing a revenue cap by forecasted annual demand. As it had under RPI-X, Ofgem estimates how much revenue would cover necessary expenditures over the subsequent period, based on estimates of efficient operation, and allows a fair return on the RAV. However, under RIIO, this base revenue, which comprises most of the revenue cap,is determined using forecasts of efficient total expenditures (totex) rather than distinguishing between operating (opex) and capital (capex) costs.[13] This approach balances the goals of reducing costs (both in the near term and over time) and increasing investment, which are often at odds.

Eight-year price control | While the five-year price control period of RPI-X was viewed as long relative to the U.S., where rate cases typically occur every three years, RIIO price controls will last eight years. This provides utilities with greater opportunity to retain cost savings without fear of imminent rate adjustment. A longer term also encourages utilities to make investments that have payback periods greater than five years, and thus better aligning investments with long-term network needs.

Performance incentives | RIIO base revenue is augmented with targeted financial incentives determined by the quality of performance or outputs delivered.[14] In contrast to RPI-X, in which ad hoc performance incentives were deployed to address issues as they arose, RIIO employs an integrated suite of performance incentives at the outset of the rate period to improve outputs along six dimensions of interest (customer satisfaction, safety, reliability, conditions for connection, environmental impact, and social obligations). These incentives reflect a paradigm shift to extend regulation beyond rates and revenues to include social and environmental performance. Depending on a utility’s performance in these areas, it may receive financial rewards or penalties that adjust its base revenue, making it probable that a utility’s actual revenue cap will be higher or lower than that allowance.[15] For example, in the first RIIO controls for electric transmission, Ofgem offered trans-mission operators the Environmental Discretionary Reward Scheme, which provides a share of a £4 million annual reward if they jointly facilitate the integration of low-carbon energy to Ofgem’s satisfaction.[16] RIIO has also introduced a mid-period review to ensure that targeted outputs remain appropriate over the full term.[17]

Innovation provisions | In addition to promoting innovation by establishing reward schemes and giving utilities more time to recover investments, RIIO introduces a profit-sharing arrangement to spread efficiency gains among consumers and utility shareholders and diffuse some of the downside risk associated with attempts at innovation.[18] Moreover, in case the incentive properties of RIIO fail to encourage sufficient innovation, Ofgem has provided a limited-time innovation stimulus package that it can deploy at its discretion outside of the basic revenue cap and performance incentive framework to reward innovations toward a more sustainable energy sector.[19]

Negotiated settlement/Business plan | The foundation of the RIIO regulatory contract is a utility-drafted business plan that is based on the elements summarized above and is informed by extensive consultation with environmental groups, consumer advocates, government officials, and third-party service providers.[20] The stakeholder engagement process allows utilities to determine the costs that they will need to incur to meet customer demands and pursue desired outcomes. Accordingly, utilities articulate in their business plans proposals for their base revenue, the various outcomes of interest that they intend to pursue, the metrics they will use to gauge achievement of those outcomes, and the methods they will employ to manage uncertainty over the eight-year price control period. Ofgem can “fast-track” approval of “well justified” business plans, while subjecting less satisfactory plans to greater scrutiny over a 30-month process.[21] This two-track approach, called “proportionate regulation,” is how Ofgem hopes to conserve administrative effort during implementation. Once approved, Ofgem incorporates the business plan provisions into proposed modifications to the utilities’ operating licenses, subject to utility consent.[22] However, utilities or directly affected third parties[23] can appeal these license amendments to the Competition & Markets Authority,[24] which is charged with promoting competition to benefit consumers.[25]

The first round of RIIO price controls for the U.K.’s electric transmission operators as well as gas transmission and distribution operators went into effect in April 2013. Early results of RIIO’s first year have begun trickling in, and will be used to inform RIIO price controls for electric distribution operators, which are scheduled to take effect in April 2015.

Whether New York or other jurisdictions ultimately import this sort of integrated PBR, and are able to deploy it successfully, will be something to keep an eye on in the coming months and years as regulators grapple with the difficult questions confronting the energy industry.

Benjamin Mandel is an Energy Law & Policy Fellow at the Frank J. Guarini Center on Environmental, Energy and Land Use Law at NYU Law School.

[1] DPS staff report and proposal, Case 14-M-0101: Proceeding on motion of the Commission in regard to Reforming the Energy Vision (N.Y. Pub. Serv. Comm’n Apr. 24, 2014)

[2] DPS staff straw proposal on Track One issues, Case 14-M-0101: Proceeding on motion of the Commission in regard to Reforming the Energy Vision (N.Y. Pub. Serv. Comm’n Aug. 22, 2014)

[3] DPS staff report and proposal (N.Y. Pub. Serv. Comm’n Apr. 24, 2014) at 46

[4] Office of Gas and Electricity Markets (U.K.) (Ofgem), RIIO: A new way to regulate energy networks. Final decision. (2010a)

[5] See, e.g., Sonia Aggarwal & Edward Burgess, Performance-based models to address utility challenges, 27 Electr. J. (2014); GE Digital Energy & Analysis Group, Results-based regulation (2013); and Ronald L. Lehr, New utility business models: Utility and regulatory models for the modern era, 26 Electr. J. (2013).

[6] Peter Fox-Penner, Dan Harris & Serena Hesmondhalgh, A trip to RIIO in your future?, 151 Pub. Util. Fort. (2013) provides a helpful, if technical, overview of RIIO mechanics.

[7] Ofgem (2010a)

[8] Id at 3

[9] See, e.g., Paul L. Joskow & Richard Schmalensee, Incentive regulation for electric utilities, 4 Yale J. on Regul. (1986) at 32 for a discussion of this “institutionalized regulatory lag”

[10] Ofgem (2010a) at 2

[11] Aileen McHarg, Evolution and revolution in British energy network regulation: From RPI-X to RIIO, in Energy Networks and the Law: Innovative Solutions in Changing Markets (Martha M. Roggenkamp, et al. eds., 2012) at 315

[12] Chris Watts, as quoted in Fox-Penner et al. (2013) at 64

[13] Id at 64

[14] See, e.g. proposed classifications of RIIO along the spectrum of incentive regulation or PBR in Lehr (2013) at 49 and Fox-Penner et al. (2013) at 61

[15] Cloda Jenkins, RIIO economics: Examining the economics underlying Ofgem’s new regulatory framework (2011). Available at http://www.rpieurope.org/publications/2011/Jenkins_RIIO%20Economics_FSR%20working%20paper_130611.pdf at 14

[16] Ofgem, Environmental Discretionary Reward Scheme:

guidance document (2013)

[17] Paul Whittaker, Personal communication (2014)

[18] McHarg (2012) at 327

[19] Ofgem (2010a) at 11

[20] Office of Gas and Electricity Markets (U.K.) (Ofgem), Handbook for implementing the RIIO model (2010c) at 14

[21] Fox-Penner et al. (2013) at 63

[22] Ofgem (2010c) at 11

[23] Particularly the statutorily appointed consumer advocate called Citizens Advice (http://www.citizensadvice.org.uk)

[24] Ofgem (2010c) at 19; see also Ofgem, A guide to price control modification references to the Competition Commission – Licensee and third party triggered references (2010d)

[25] https://www.gov.uk/government/organisations/competition-and-markets-authority