advisory committee on innovation meeting 5... · 2018-11-22 · current incentives in oeb’s...

Advisory Committee on Innovation

Fifth Meeting: May 28, 2018

Venue: Royal York Hotel

For Committee’s use only

Not for further distribution

Agenda

2May 28, 2018

12:00 – 12:30pm Lunch (provided)

12:30 – 12:45 Introduction, Overview and Review of Agenda

12:45 – 1:30Member presentation

• Insights on Innovations

1:30 – 1:45 Roundtable discussion: Reflection on Discussions of May 22nd

1:45 – 2:30 Roundtable discussion: Remuneration

2:30 – 2:45 Break

2:45 – 4:55 Roundtable discussion: Remuneration (cont’d)

4:15 – 4:30 Reflection & next steps

4:30 pm Adjourn

Introduction, Overview and Review of Agenda… including Committee Roadmap

3May 28, 2018

Refresher from Last Meeting

Charge to the Advisory Committee

The Committee will focus on identifying actions that a regulator can take to support and enable cost effective innovation, grid modernization, and consumer choice to help inform regulatory policy development

Identified actions will be:

• within the OEB’s current authority and jurisdiction

• tested against the goals and objectives in the OEB’s Strategic Blueprint and the deliverables in the OEB’s LTEP Implementation Plan

May 28, 2018 4

Refresher/Adapted from from 1st Meeting

Identified Actions will Support Implementation of the OEB’s Blueprint

Transformation & Customer Value Innovation & Consumer ChoiceUtilities are delivering value to consumers in a changing environment

Utilities and other market participants are embracing innovation in their operations and the products they offer consumers

The regulatory framework incents utilities to focus on long-term value for money and least-cost solutions

Regional and utility system planning reflect the continuing evolution of the sector

Utility infrastructure is optimized during the shift to a low carbon economy

The regulatory framework incents and enables utilities to adopt innovative solutions

The design of network rates and commodity prices support the efficient use of infrastructure and enable greater customer choice and control

Our codes and rules reflect the needs of an evolving sector

May 28, 2018 5

Refresher/Adapted from from 1st Meeting

OEB’s Blueprint Goals & Objectives

Identified Actions will Support Achievement of OEB’s LTEP Implementation Plan

Way Forward for Regulation

• OEB will assess whether regulatory reforms are warranted to further enhance efficiency and innovation in the sector, including ways of setting revenues and rates for utilities so they can optimize their spending portfolio with consideration of choices, such as:

• new technology

• non-wires solutions

• operational measures to defer capital

• active system management and customer participation

• energy efficiency measures on distribution systems; and

• shared services with other distributors and shared distribution investments, where benefits extend beyond an individual distributor’s service territory

May 28, 2018 6

Outline for Today’s Discussion

• The Remuneration Challenge

• Opportunities for Improving Regulatory Approaches

1. Strengthening Incentives

a) Equalizing Incentives

b) Efficiency Incentives & Risk Sharing

c) Specific Incentives

2. Better addressing uncertainty

• Bringing it all together

• Potential Principles

May 28, 2018 7

The Remuneration Challenge

8May 28, 2018

Trends in Ontario

• What do the data tell us about electricity distributor

financial performance and spending levels that could

help to inform our assessment of what can be

improved?

• Staff looked at:

1. Financial performance

2. Total spending trends

3. Capital spending levels

May 28, 2018 9

1 – Financial Performance (Electricity Distribution)

May 28, 2018 10

Range of achieved

returns reported by

distributors 2011 – 2016.

• From 2014-6, 70% of

reporting distributors

achieved returns within

the +/-300 basis point

deadband of target ROE

* Deemed ROE is the OEB’s target return that

is built into the utility’s base rates

1 – Financial Performance (Electricity Distribution)

May 28, 2018 11

*Four rather than five years of plan term illustrated to support larger sample size over the study period.X= mean; line in middle of box shows median.

• Median

achieved

ROE

declines

over rate

plan term

2 – Total Spending Trends (Electricity Distribution)

May 28, 2018 12

Annual growth rate in sector

expenditures by category

OM&A 3.8%

Capital 7.5%

• Compound

annual growth

rate in

spending is

5.5% over the

last decade

3 - Capital spending levels (Electricity Distribution)

May 28, 2018 13

0.0

0.5

1.0

1.5

2.0

2.5

3.0

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

CA

P/D

EP

Year

Median Capital Spending to Depreciation Ratio by Calendar YearRRR Data from Distributors from 2006 through 2016; 2012 omitted

Median Capital Spending to Depreciation Ratio 25th and 75th Percentile

Change to OEB accounting policy

Meeting the Remuneration Challenge

• With evolution of the sector, OEB and utilities will face greater uncertainty regarding the evolution of network uses and efficient system costs. We need ways to align incentives and manage uncertainty for utilities to cost-effectively integrate new resources and take advantage of opportunities to reduce system costs and improve performance

Potential ways of meeting the remuneration challenge:

• Ensure the utility optimizes cost-saving tradeoffs between capital and operational expenditures

• Encourage the utility to seek cost-saving efficiencies and ensure appropriate sharing of risk

• Encourage and enable the utility to adopt innovative solutions

• Mitigate for uncertainty to facilitate planning and decision-making by ratepayers and utilities

All offer opportunities for improving regulatory approaches…

May 28, 2018 14

Opportunities for Improving Regulatory Approaches

15May 28, 2018

Objectives Underpinning OEB’s Renewed Regulatory Framework

As set out in the OEB’s Report1, in accordance with OEB statutory objectives

• Shift the focus from activities to outcomes and utility cost to value for customers

• Better align utility reliability and quality of service levels with customer preferences

• Advance continuous improvement and innovation in the sector

• Provide for a comprehensive approach to network investments to achieve optimum results

• Better align timing and pattern of expenditures with cost recovery

• Provide a sustainable, predictable, efficient and effectiveregulatory framework

16May 28, 2018

1 Ontario Energy Board. Report of the Board on Renewed Regulatory Framework for Electricity Distributors: A Performance-Based Approach. October 18, 2012. The OEB’s October 13, 2016 Handbook to Utility Rate Applications, outlines how the framework now applies to all regulated utilities.

Strengthening the Framework & Improving Regulatory Approaches

• Objectives continue to be appropriate; however, need

to strengthen framework to keep in step with

anticipated changes in the sector:

• Incent utilities to focus on long-term value for money

and least-cost solutions; and

• Incent and enable utilities to adopt innovative solutions

• Challenge is finding ways to address the issues,

mitigating risks without compromising objectives

May 28, 2018 17

Springboard for Discussions - MIT’s Approach to Meeting Remuneration Challenge1

• Equalizing incentives for the utility to optimize cost-saving tradeoffs between network investments and operational expenditures

• Creating strong efficiency incentives for the utility to seek cost-saving efficiency measures throughout plan and ensuring appropriate sharing of risk

• Considering specific incentives for longer-term innovation to accelerate investment in applied research & development and demonstration projects and learning about the capabilities of novel technologies and practices that may have higher risk or longer-term payback periods

• Recognizing uncertainty in a predictable and consistent way to facilitate planning and decision-making by ratepayers and utilities

May 28, 2018 18

1 Jenkins, Jesse D. and Ignacio J. Pérez-Arriaga. (2017). “Improved regulatory approaches for the remuneration of electricity distribution utilities with high penetrations of distributed energy resources.” The Energy Journal Vol. 38(1) (in press) [web link: http://energy.mit.edu/wp-content/uploads/2016/06/MITEI-JA-2015-001.pdf].

http://energy.mit.edu/wp-content/uploads/2016/06/MITEI-JA-2015-001.pdf

MIT Framework Combines Established Regulatory Methods1

• Equalized investment incentives for cost-saving efficiency efforts across both capital and operations spending (a pre-determined share of allowed total spend is capitalized)

• Use of engineering model2 to model anticipated evolution of network uses and forecast efficient costs

• Use of those forecasts to:

• set up profit-sharing incentives for cost saving efficiency efforts

• enable annual adjustments that reduce risk of uncertainty in the evolution of network use

May 28, 2018 19

1 Methods have been used in other jurisdictions including Spain, Sweden, or the United Kingdom2 Overview of the Reference Network Model is provided in the Appendix to this presentation

Refresher from Last Meeting

Why MIT Framework as Springboard?

• Attempts to bring together a number of regulatory innovations from a number of different jurisdictions

• Rules-based, formulaically forward-looking, and creates strong and equalized incentives, founded on sector-specific empirical analysis

• Some features implemented in various jurisdictions• Reference Network Modeling (Spain, Chile, Sweden)

• Totex approach (UK, New York planned)

• Performance contracts (UK)

• Efficiency & specific incentives (Australia, New Zealand, California, New York, Alberta, Ontario, etc)

• Uncertainty adjustments (many, including Ontario)

May 28, 2018 20

Addressing the Regulatory Challenges –Quick Comparison

OEB’s Renewed Regulatory Framework MIT’s Framework

Foundation for

Rate-Setting

• Based on 1-year utility forecasts of its

costs and volumes

• Allows choice of 3 rate-setting methods

to suit utility circumstance

• Based on multi-year utility forecast of the

evolution of its network uses, costs and

volumes

• Informed by regulator estimate of efficient

system expenditures

Equalization of

Incentives

• Allows return on capital • Capitalizes a pre-determined share of total

spend

Efficiency

Incentives

• Makes automatic adjustments for

expected efficiency & productivity gains

• Allows a utility to earn more if efficiency

better than expected

• Includes profit-sharing incentives to ensure

appropriate sharing of risk

• Allows utilities and ratepayers to share

achieved gains over longer-term (smooths

impacts)

Specific

Incentives

• Allows alternative cost recovery

mechanisms (2009) and funding for

non-wires alternatives through CDM

(2014)

• Propose “input-based” financial incentives,

whereby demonstration projects are

capitalized

Recognition of

Uncertainty

• Allows additional funding for capital

investment needs and for unforeseen

events

• Allows for prospective plan review in

extenuating circumstances

• Makes automatic adjustments to

accommodate uncertainty in the evolution

of network use and minimize forecast error

21May 28, 2018

Un

ce

rtain

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1. Strengthening Incentivesa) Equalizing Incentives

b) Efficiency Incentives & Risk Sharing

c) Specific Incentives

22May 28, 2018

Current Incentives in OEB’s Renewed Regulatory Framework

• Efficiency Incentives In Performance-based Ratemaking

• A financial incentive is built into indexed rate regulation plan formulas through the X-factor. When a utility “beats the X-factor bar” it is allowed to retain the achieved savings and/or share them with their customers. The approach creates a notional link between the utility’s performance and the prices it is allowed to charge its customers

• Specific Financial Incentives

• to help create more favorable conditions for timely and appropriate investment in electricity distribution and transmission infrastructure alternative cost recovery mechanisms are available

• to reward achievement of conservation and demand management results a shareholder incentive is available to electricity distributors (funded by the IESO) and gas distributors (funded by gas distribution rates)

• Reputational Incentives in Public Reporting of Utility Results

• Reputational incentives usually involve the measurement of company performance on delivery of services which is then published and made available in the public domain. Since 2005, the OEB has published annual Yearbooks of Electricity Distributors and Yearbooks of Natural Gas Distributors.

• Penalties Associated with Enforcement

• Potential financial penalties are associated with enforceable provisions. Where the OEB is satisfied that a person has contravened an enforceable provision in a Board code, the OEB may make an order requiring a person to pay an administrative penalty.

May 28, 2018 23

1 a) Equalizing Incentives

• The OEB uses a traditional return-on-rate base approach to regulation; i.e., only assets that are allowed into a utility’s rate base earn a rate-of-return. This can create a utility investment bias

• Alternative approach uses a total expenditure approach to mute the potential investment bias by capitalizing a predetermined share of total expenditures (i.e., capital and operating, “totex”)

• The share of totex capitalized is determined based on regulator's assessment of efficient expenditures and the utility

• In RIIO-ED1 Ofgem set totex capitalization rates between 68% and 80%; higher rate for high-performing distributors

May 28, 2018 24


Contrasting Return on Rate Base & Totex –Potential Impact on Utility

25

Under traditional return on rate base regulation, achievable returns change with a

change in expenditure mix. Under totex, achievable returns are more stable as

they are earned on the whole spending envelope

$0

$20

$40

$60

$80

$100

$120

Revenue Rqmt Achievable Rtn

$0

$20

$40

$60

$80

$100

$120

Revenue Rqmt Achievable Rtn

Traditional Return on Rate Base Totex

All CapEx All OpexExpenditure Mix

All CapEx All OpexExpenditure Mix

80% Capital20% Opex

20% Capital80% Opex

50% Capital50% Opex

80% Capital20% Opex

50% Capital50% Opex

20% Capital80% Opex

-40

-20

0

20

40

60

80

Contrasting traditional return on rate base and Totex: Revenue Requirement and Net

Income(at 74% cap. rate)

Difference in revenue requirement - Return on Rate Basevs Totex


Contrasting Return on Rate Base & Totex –Potential Impact on Customers

Choice in capitalization rate can lead

to rate impacts

• Moving away from traditional

approach, choice of capitalization

rate can drive rate impacts and

changes in net income

• firms that now capitalize less under

the traditional approach than would

be allowed under totex deemed rate

will see revenue requirement fall

• firms that now capitalize more will see

revenue requirement rise

• Deemed depreciation period for

capitalized totex can also drive

revenue requirement impact

Existing rate base at time of change to totex approach

would continue to earn WACC; only new spending would

be subject to the totex capitalization approach

26

High Cap. Rate Low Cap. Rate


2016 Capitalization Rates in Ontario –Electricity Distributors

May 28, 2018 27

0% 20% 40% 60% 80%

2016 Effective Capitalization Ratio (capital as % of total spend) by Distributor

Use of distributor-specific

or common capitalization

rate

Large range in effective

capitalization rates today

among Ontario electric

distributors (10% to 70%)

If Ontario were to adopt the

totex approach, distributor-

specific capitalization rates

could provide a smoother

transition for customers and

the rates they pay


For Discussion

Will equalizing incentives help to encourage

utilities to focus on long-term value for money

and least-cost solutions? Will it enable them to

adopt innovative solutions? Why?

How effective would either… Fo

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Adopting the ‘totex’ approach be?

May 28, 2018 28

Relatively moreRelatively less

What other actions can the OEB take to ensure a utility optimizes cost-saving tradeoffs between capital and operational expenditures? For example:• Expand the definition of “assets” that are allowed into a utility’s rate base

(such as capitalizing a service contract, or earning a return on an asset behind a customer’s meter)

1 b) Efficiency & Risk Sharing

The OEB’s current approach makes annual automatic adjustments, up front, for expected efficiency & productivity gains, and allows a utility to earn more if efficiency better than expected*

An alternative rules-based approach could include profit-sharing incentives for cost saving efficiency efforts

• Incentive scheme is set up, up front and automatic “performance-against-plan” adjustments are made after-the-fact annually

• Result is a performance contract with three key features:• Profit sharing factor varies with the difference between utility’s estimate

of expenditures and the regulator’s estimate

• An additional incentive is provided to reward alignment between the two estimates and to motivate utilities to avoid strategic behavior

• Annual incentive awarded is based on the distributor’s performance against its forecast

• Discussion of regulatory process is provided in Appendix

May 28, 2018 29

* The ability to earn more (or less) based on performance is provided uniformly to all distributors who have not otherwise obtained approval for a different earnings-sharing

mechanism (typically through Custom IR)


Performance Contract: Example

Date Ontario Energy Board 30

A distributor whose estimate

matches that of the regulator will

earn the greatest incentive payment

if its estimate is achieved

Incentive payment is lower if a utility

does not meet its forecast (either

over or under), regardless of the

level of spending predicted

Incentive payments are lower (and

can be penalties) for less efficient

utilities

1

2

3

-20.0

-15.0

-10.0

-5.0

-

5.0

10.0

85.0 90.0 95.0 100.0 105.0 110.0 115.0 120.0 125.0

Revenue Contracts in an Incentive Structure

100 120

Effi

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cen

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(%

)

Ratio (%) of utility’s expenditure estimate to regulator’s estimate

1

3

2

• Contract is founded on the extent to

which a utility’s estimate of

expenditures aligns with the

regulator’s estimate

Achieved cost performance as % of regulator’s estimate


Performance Contract: How it Works

Date Ontario Energy Board 31

• For a given expenditure level,

revenue is maximized when actual

costs match the forecast. Less

efficient utilities face penalties

• Incentive structure supports a range

of outcomes based on distributors’

performance to benchmark efficiency

• Strong incentives for genuine

estimates and performance against

plan

• The incentive to perform better than

expected is preserved: utility can still

increase final revenues by realizing

lower costs than anticipated (but

incentive from performance gains is

not greater than when actual cost

performance meets predicted costs)

-20.0

-15.0

-10.0

-5.0

-

5.0

10.0

85.0 90.0 95.0 100.0 105.0 110.0 115.0 120.0 125.0

Revenue Contracts in an Incentive Structure

90 100 110 120

Eff

icie

ncy In

ce

ntive

($)

Ratio (%) of utility’s expenditure

estimate to regulator’s estimate

Achieved cost performance as % of regulator’s estimate


For Discussion

Will strengthening efficiency incentives and

ensuring appropriate sharing of risk help to

incent utilities to focus on long-term value for

money and least-cost solutions? Will it enable

them to adopt innovative solutions? Why?

How effective would… Fo

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Adopting the ‘Performance Contracts’ approach?

May 28, 2018 32


This approach requires forecasting the evolution of network uses and estimate efficient system expenditures. What factors would be critical for success at adopting this approach in Ontario?

What other actions can the OEB take to encourage the utility to seek cost-saving efficiencies and ensure appropriate sharing of risk?

1 c) Specific Incentives

• The framework presented so far can be accompanied by appropriate incentives for a utility to maintain and improve quality of service, reduce losses, and meet other performance expectations

• Also, while a well-designed performance contract provides strong incentives for efficiency and will encourage a utility to pursue innovative approaches to investment and management, additional, explicit incentives for long-term innovation may be necessary

• For example, multiple and varied incentives are a feature in Ofgem’s RIIO Model

• targeted performance incentives; and

• innovation schemes

• Supplemental information on the development of specific incentives is provided in the Appendix

May 28, 2018 33


Targeted Performance Incentives under Ofgem’s RIIO Model

• Companies get rewards or penalties for over- or under-delivering on defined outputs and are allowed to keep a proportion of any savings they achieve over plan term, encouraging them to reduce their costs

• Annual adjustments made to revenues

• Specific incentives, that have a common structure, include:

• Interruptions Incentive Scheme

• Time to Connect Incentive

• Incentive on connections engagement

• Broad measure of customer service

• Losses discretionary reward scheme

• Total distribution revenues for 2016-2017 were £3,340 m; of which total incentive payments were 6.6%

May 28, 2018 34

Source: RIIO-ED1 Annual Report for 2016-2017. December 19, 2017.


Innovation Schemes under RIIO Model

• Ofgem provides backing to innovative projects which aim to help make the energy networks smarter, and accelerate the development of a low carbon energy sector and delivering financial benefits to consumers. The projects help develop crucial knowledge and expertise which is being shared across the industry

• Funding for innovation is provided by customers, as they are beneficiaries of innovation

• Specific incentives implemented in a time-limited package of innovation schemes consisting of:

• a Network Innovation Allowance for small projects directly related to the licensee’s network

• an annual Network Innovation Competition for research, development and demonstration of new technologies, operating and commercial arrangements; and

• an Innovation Roll-out Mechanism for the roll-out of a proven innovation into business as usual (1st window for this opened in May 2017)

November 15, 2018 Ontario Energy Board 35


More on Ofgem’s Network Innovation Competition and Allowance Schemes

May 28, 2018 36

Total distribution revenues for 2016-2017 were £3,340 m. The innovation

incentives represent 4.5% of this.


For Discussion

Are specific incentives needed to help to incent

utilities to focus on long-term value for money

and least-cost solutions? Will it enable them to

adopt innovative solutions? Why?

What outcomes / outputs need incentives?


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Developing targeted performance incentives be?

Establishing a ‘network innovation scheme’similar to the UK’s be?

May 28, 2018 37


What other actions can the OEB take to encourage and enable the utility to

adopt innovative solutions?

2. Better Addressing Uncertainty

38May 28, 2018

Recognizing Uncertainty

• OEB’s current approach allows additional funding for capital investment needs and for unforeseen events, and allows for prospective plan review in extenuating circumstances. Adjustments are determined on a case-by-case basis. In all other respects, the main elements of the regulatory contract are established strictly ex-ante.

• A more forward-looking approach uses automatic adjustments that are set up front and carry through the rate plan to reduce forecast risk for things outside of the utility’s control

• Utilities provide the regulator with forecasted network use

• The regulator carries out scenario analyses on identified network use drivers (e.g., load growth, DER connections) to determine “per unit” expenditure consequences of each driver

• Annual adjustments are made to bring utility revenues in line with actual network use (ex post)

May 28, 2018 39

For Discussion

Will more forward-looking automatic ‘uncertainty’

adjustments help to incent utilities to focus on

long-term value for money and least-cost

solutions? Will it enable them to adopt

innovative solutions? Why?


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Developing a means to estimate automatic adjustment factors to accommodate uncertainty in the evolution of network use and minimize forecast error be?

May 28, 2018 40


What other actions can the OEB take to help mitigate for uncertainty to facilitate planning and decision-making by ratepayers and utilities?

Bringing it all together

41May 28, 2018

Summary

Today’s discussion focused on four areas of opportunity for improving regulatory approaches

1 a) Equalizing investment incentives by changing the way revenues are set (i.e., the ‘totex’ approach) to help a utility optimize cost-saving tradeoffs between capital and operational expenditures

b) Strengthening efficiency incentives through a performance contract approach to reward a utility for cost-saving efficiencies, ensure appropriate sharing of risk and discourage strategic behavior

c) Consider specific incentives to reward desired outcomes, including encouraging and enabling a utility to adopt innovative solutions

2) Mitigating for uncertainty in rate-setting in a more forward-looking and mechanistic way that smooths risk effects due to uncertainty and forecasting to facilitate planning and decision-making by ratepayers and utilities

May 28, 2018 42

For Discussion

Would these approaches:

• incent utilities to focus on long-term value for money and least-cost solutions

• incent and enable utilities to adopt innovative solutions; and

• enhance efficiency and innovation in the sector?

Why? Why not?

What other actions can the OEB take to achieve these objectives?

May 28, 2018 43

Potential Principles

44May 28, 2018

Potential Principles for Remuneration

Building on the OEB’s Renewed Regulatory Framework:

• Outcomes and Value: Focus on outcomes and value to customers through competition and incentive regulation

• Utility and Customer Alignment: Utility reliability and service levels are aligned with customer preferences and an appropriate balance between costs and revenues within the system is maintained

• Continuous Improvement: Regulatory framework ensures continuous improvement and innovation in the sector while continuing to price the regulated services in an open, transparent, efficient and non-discriminatory way

• Comprehensive Approach: Provide for a comprehensive approach – ie, capital and OM&A -- to network investments to achieve optimum results

• Minimize Distortion: Ensure that timing and pattern of expenditures aligns with cost recovery and charges reflect costs and benefits in ways that minimize distortion

• Regulatory Effectiveness: Provide a predictable framework which supports efficient investment and allocates risk appropriately

Are there additional principles that the OEB should consider when developing utility remuneration policies?

May 28, 2018 45

Reflection & Next Steps

46May 28, 2018

advisory committee on innovation meeting 5... · 2018-11-22 · current incentives in oeb’s...

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