The cost of service model for setting regulated rates is fundamentally inconsistent with fostering innovation and creativity in regulated utilities, and the incentive regulation model is not much better.
We might like to think otherwise, but if we do we’re fooling ourselves.
That is not the end of the story, of course, but it does present the problem squarely. If regulators want to encourage utilities to be innovative, they have to find a way around this structural barrier.
In a competitive environment, two things drive thoughtful innovation (at least in theory).
First, companies are constantly under pressure – from their competitors and their customers and their shareholders – to increase revenues or drive down costs. If a competitor innovates, that can drive down their price, or improve their value proposition to the customer. In either case, other companies must also innovate to keep pace. You can’t let your competitor get a price advantage, or a value for money advantage, and keep it for long. Innovation is central to the notion of a competitive marketplace.
Second, innovation has to be thoughtful and disciplined. The competitive markets have built-in rewards and punishments for the success or failure of innovation initiatives. If innovation is done well, market share and therefore profits will increase. If it is done poorly, the incremental costs drive down profits.
It is important to understand that these are two different drivers. The first, the need to improve, is about whether to be innovative. The second, control of the execution, is about how well you innovate. The second assumes that you are implementing initiatives to improve your processes or products, and generates consequences based on the results of those initiatives. However, a risk-averse company could avoid those consequences, both good and bad, by refusing to innovate at all. The first driver prevents that. Failure to innovate is itself punished. In a truly competitive market, you can’t stand pat.
How do these things translate to the regulated world?
Obviously the most important thing to note is that the normal drivers of innovation are all profit-based. The cost of service model, on the other hand, treats profit as a fixed cost rather than as a variable reward. Because of the forward test year approach, profit can still vary, but only by the difference between forecast and actual revenues and costs. This is not about innovation. It is about forecast uncertainty: warmer or colder weather, changes in the economy, good or bad operational decisions, and even overly conservative forecasts.
In this environment, utilities can still propose innovative projects, but the reasons for doing so, and the consequences, are quite different from the competitive paradigm. A regulated entity does not propose such projects to increase profits, because they don’t get most of the benefit of that result. Those projects are suggested – and their costs included in cost of service – at least nominally because they are expected to produce future benefits for customers: costs will go down, reliability will go up, customer service will be more responsive, etc.
Sometimes in the background there are also utility executives seeking to “try something out”, in effect getting a new toy at the expense of the ratepayers. Even where this is not the case, cynical customers, shareholders, and regulators may suspect that it is.
With the profit drivers to innovation removed, utility innovation is on a weak foundation. Even choosing to innovate at all is essentially discouraged. There is no innovation imperative, as there is with competitive companies. Instead, it is left to utility executives – diverting their attention from their core function of operational excellence – to decide to take the risk.
Why would they? In a cost of service application, they will be criticised by stakeholders and often the regulator for taking unnecessary chances. Their proposed innovations will be stacked up against “best practices”, and will often be found to be wasteful, unnecessary or…(perish the thought) imprudent.
Further, after the fact they had better be shown to have been right. In the competitive sector, it is widely believed that if you haven’t failed, you haven’t taken enough risks. For the utility executive, failure in innovation will not get a gold star for trying. It will get accusations of imprudence, even disallowance of costs.
Even if the innovation is successful, the utility executive will often not get credit for delivering benefits to the ratepayers. We’ll take the benefits, for sure, but don’t expect a ticker tape parade. We – stakeholders and regulators alike – are quick to criticize utilities for what they do wrong, but our praise for what they do right is sometimes less enthusiastic than may be deserved.
Faced with these realities, most utility executives take a highly risk-averse approach to management. They don’t want to innovate, because the potential grief from trying out new-fangled ideas will usually outweigh any potential accolades for success. Instead, it is safer to follow the crowd, in effect choosing job security over creativity.
The regulator wants utilities to push for better outcomes for ratepayers. Forget it. The mantra is not continuous improvement, but rather “don’t make mistakes”. The system, and the attitudes of the players, encourage that approach. The result is not a surprise.
Now, incentive regulation is supposed to change all that.
At least in theory, IRM allows utilities to spend money on innovation, and reap the rewards in the form of increased profits. The concept is that IRM “decouples costs and rates”. If a utility spends money on innovation, that is essentially the shareholder’s money, but for at least a few years the benefits from that investment go back to the shareholder.
There are at least four problems with this.
First, IRM doesn’t really decouple costs and rates. IRM still forecasts costs, on a forward period basis. The difference is that cost of service uses a line by line budget, whereas traditional IRM uses a formula based on evidence of the relationship between costs and inflation. (That is, in fact, the reason why IRM still meets the fair return standard.) The combination of rebasing plus a formula is essentially a method of extending cost of service for multiple years.
What this means is that investments in innovation, if any, are usually built into the revenue requirement. The IRM structure encourages utilities to include innovation expenses in their rebasing budget, so that they have a set amount of ratepayer funds to spend annually on innovation for their full five years or more of IRM. The benefits of that spending during that same period are generally not (unless there is earnings-sharing) for account of the ratepayers, creating a mismatch between investment (from ratepayers) and benefits (to shareholder). For that reason, stakeholders often oppose innovation budgets. Utilities are therefore less likely to offer them, and more likely to give them up in negotiations. Everyone loses.
Second, the IRM period – five years, typically – can capture only innovations with very short paybacks. If the costs are paid by the shareholder, to avoid the mismatch noted above, the resulting payoffs should also be excluded from revenue requirement, but if we did that the maximum payback period would still be five years, until rebasing. Any payback period longer than that results in a mismatch in the other direction: investment of shareholder money, but benefits at some point accruing to the ratepayers.
Further, the fixed IRM period means that innovation in the later years is limited by the availability of almost no runway to get a payback. What utility would invest in innovative projects in year five, knowing that pretty well all of the benefits of that investment will be captured in year six rates, and flow to the ratepayers?
Third, these issues deal with innovation to reduce costs, but many innovations are about products, service quality, and customer experience. IRM has no good way to deal with those innovations. If these value for money investments are included in rates, there are no consequences for unwise innovations or poor implementation. Innovation just becomes a management plaything. If these investments are not included in rates, then the shareholder takes all the risk, but there is no mechanism for a payback to the shareholder on success.
So, IRM doesn’t deal with Guelph’s ZigBee chip, implemented to improve customers’ ability to manage their own energy use in the future. It ended up being shareholder money spent to benefit ratepayers, with no payback. That won’t foster innovation.
Similarly, IRM doesn’t deal with Festival’s electric car. If the ratepayers pay for it, it could end up being nothing more than an expensive toy. If the shareholder ends up paying for it, the payback (in better service to visitors and local residents alike who use electric cars) will go entirely to the customers.
Fourth, and finally, under IRM there remains no innovation imperative. In a competitive market, innovation is in most cases essential for success. Failure to innovate is punished. Under IRM, there is no downside to failure to innovate. Following the lead of others is currently the objectively optimal strategy.
If neither cost of service, nor incentive regulation, can in their current forms encourage innovation, what solutions are available to address this?
A system to encourage innovation must include at least three components:
• An innovation imperative, generating consequences for failure to innovate.
• A mechanism of reward and punishment driven by the success or failure of innovation initiatives.
• Because regulated utilities are largely immune to changes in market share, a mechanism to provide rewards to utilities who benefit customers by improving the “product”.
Are these things achievable? The simple answer is, “Probably not”, but let’s take a look.
Can you force utilities to be innovative? One way would be to make it a licence requirement, as was done with CDM targets. In theory, you could do that with innovation, but it would be messy. CDM can work as a requirement because there are clear and measurable metrics for determining whether the utility has achieved that requirement. Innovation is not so simple. Any assessment of whether the utility was innovative would necessarily be subjective. Further, at least some risk-averse managers would divert their energy to finding ways of looking innovative, without actually taking any risks (as some have already done with “customer engagement”). On the other side, utilities would be faced with cynical ratepayers second-guessing the alleged benefits from their innovation spending.
Worst of all, what is the regulator going to do when at least some utilities fail to achieve the innovation requirement? Terminate their licences? We have already seen the regulator’s inability to enforce this kind of licence condition with CDM. This clearly will not work.
What about making some of a utility’s profit dependent on being innovative? The first three problems would remain: subjective assessment of the results, some utilities seeking to game the requirement, and ratepayer cynicism.
There is, as well, a fourth problem with this approach. For many public sector utilities, their response to losing some of their profit level would be to accept the lower profit. In balancing the risk of action against the potential reward, the reward will usually be insufficient to justify the risk. Inaction, with the resulting lower profit, is still the wiser move.
One promising approach might be to have the electricity distributors, at least, “compete” against each other in the area of innovation. It is not clear how that would be structured, however, and in any case a concern could arise that utilities might be more effective co-operating rather than competing.
In theory, the benchmarking of costs that the regulator has already started in Ontario could generate an “innovation imperative” over time. As utilities start to see a downside in being found less efficient than their peers, they could start to turn to innovation as their way to improve relative efficiency, much as companies do in the private sector. Of course, this would only drive innovation in cost efficiency. On the other hand, who is to say that benchmarking of outcomes is not also possible in the future?
One thing to note about all of this is that, the closer you get to an innovation imperative, the less your regulatory model can be based on cost of service or IRM.
The second component of regulated innovation – consequences for success or failure – has attracted more analysis than the first. Not surprisingly, the emphasis has been on rewards for success.
Most well-known is the Efficiency Carryover Mechanism, a way of allowing the shareholder of a utility to benefit from cost efficiencies achieved during IRM for a period after the IRM term. This is largely directed at the problem of lower incentives late in the IRM term, but it can also be adapted to recognize cost efficiencies that have a longer payback.
ECMs do not have a very successful history, in part because risk-averse utilities try to maximize the upside and minimize the downside, and in part because skeptical stakeholders and regulators are unwilling to support additional profits for utilities without a guarantee that the ratepayers will benefit. No-one wants to take a chance, so the result is inaction.
In any case, the ECM still has the limitation that it is focused on cost reductions, and the easiest, most risk-averse way of achieving cost reductions is to focus not on innovation, but on operational excellence (“stick to your core competency”). As well, any ECM will always have a finite term, so by definition it will target a narrow band of innovation initiatives.
Are there other ways to generate consequences for innovative programs?
One recent suggestion that has some potential would invite Ontario electricity distributors to propose generic innovation initiatives. Those that are approved by the regulator would be funded by the shareholder, but then “belong” to that distributor (even if they are not technically protectable intellectual property, like a new, more advanced tree-trimming protocol), who could licence them to other distributors and charge fees for the use of their innovation. In a variation on this idea, distributors that develop a useful innovation could get approval from the regulator to make it mandatory for other distributors, thus ensuring an incremental revenue stream. A further variation would allow groups of utilities to work together to develop innovations, which could then be marketed to their peers.
Note that the success of this approach involves moving innovation from being a regulated activity to being an unregulated – competitive – activity. If it works, it works because it mimics innovation in the competitive markets. In fact, the end-state of this idea is likely innovation by unregulated affiliates, authorized by the regulator to licence their results to their own regulated affiliates, and to other regulated utilities.
Even if, when it comes to cost efficiencies, utilities can be driven to innovate, with consequences for success or failure, that still leaves the question of value for money innovation. As cynical as many ratepayers are about “better outcomes”, most customers would at least pay something for better customer service, or increased reliability, or improved emergency response. These are the areas, in fact, in which new technologies and creative staff can often deliver the most bang for the buck.
The problem is, you can measure a cost reduction. It is much more difficult to measure improved outcomes in a rigorous manner. It’s not impossible, but there is a real risk that the process of defining, and then monitoring and measuring, the impact on outcomes of value for money innovations would at least initially be complex and contentious.
In the competitive markets, the customers decide with their wallets which changes in products and services they value, and by how much. That “crowd-sourcing” of the value proposition, even if it is skewed in part by marketing, is not something that can easily be replicated in a monopoly environment. A lot of factors go into individual customer decisions; it is not susceptible to a formula.
You think conservation measurement and verification has become complicated and of questionable rigour? This would be in another league.
You may now be wondering when I am going to get to the answer. I’m not. There is no obvious answer. As long as utilities provide monopoly services, and in particular as long as regulators and ratepayers (and shareholders and boards of directors) punish utility managers for taking risks, innovation in the regulated energy sector will remain a challenging problem.
Innovation is one of the key strengths of the competitive markets. Without injecting a significant component of competition into the regulated energy sector – not easy to do – innovation will always be a tough sell.
– Jay Shepherd, January 9, 2015