Time to revisit the benefits of performance-based regulation

by Edward L. Flippen
for Virginia Business
July 2007

Workers have to meet performance goals, so why not use the same idea to regulate public utilities? States have experimented for years with performance-based regulation plans, or “PBRs,” for utilities. The U.S. Nuclear Regulatory Agency defines PBRs as “[r]equired results or outcome performance rather than a prescriptive process, technique, or procedure.” PBRs include incentives and alternative forms of regulation, and generally link rewards to desired performance. For example, states as diverse as Florida, Illinois, Maine, Maryland, New York and Rhode Island have adopted price cap regulation, price indexing or earnings-sharing incentive plans. Still others such as California, Massachusetts, Michigan and New York have approved PBR plans tied to service quality, reliability or other benchmarks. Now Virginia has joined this group. State law has been amended to encourage electric utilities to develop new power plants while protecting Virginia’s environment.

Generally, PBRs are meant to augment the regulatory process. They provide utilities with financial incentives to manage costs, develop a more diverse resource mix, maintain or improve reliability, reward enhanced performance and discourage poor performance. PBRs focus on results rather than prescriptions. For example, last year the Virginia State Corporation Commission (SCC) approved the commonwealth’s first performance‑based regulation plan for a natural-gas utility. The plan provides an incentive for Virginia Natural Gas to construct a gas pipeline across the Hampton Roads channel to gain access to lower-cost natural gas from places as far north as Canada and as far west as the Rockies.

A 2005 presentation by the consulting firm of Pacific Economics Groups LLC to the Edison Electric Institute notes that there is mounting interest among U.S. utilities in alternative regulation, which is the overseas standard for electric, telephone and railroad utilities. Importantly, the energy problems experienced by California in the early years of this decade were largely unrelated to that state’s performance-based regulations. The collapse of Enron, the massive blackout of Aug. 14, 2003, and quadrupling of natural gas prices also were not tied to PBRs.

Today, however, the United States has largely settled into two camps with respect to electric utilities — regulated and deregulated jurisdictions. Recent crises have stalled the advance of deregulation. Without congressional action, the deregulation debate will continue indefinitely, with some parts of the country maintaining their deregulated structure (or hybrid regulated / deregulated systems), while other areas hold steadfast to traditional cost-of-service regulation. In the meantime, performance-based regulation has taken a back seat. Yet, PBRs offer the possibility of becoming the bridge that brings these two camps together and encourages behavior that benefits the public interest.

Early on, performance-based regulation plans were called incentive systems. They often pegged a utility’s allowed return on common equity to particular operating performance indicators. For example, the Federal Energy Regulatory Commission (FERC) tied return on equity for the Alaska gas pipeline to its ability to minimize cost overruns. In another example, FERC in 1982 implemented a three-year “performance incentive provision” for the wholesale operations of what is now Dominion Virginia Power, providing a sliding rate of return tied to the performance of the company’s generating units.

Until recently, Virginia had no performance or incentive form of regulation for electric utilities — only natural gas utilities. But until last year, no gas utility qualified for this form of regulation. This situation now has changed. The General Assembly and Gov. Timothy M. Kaine this year amended the Virginia Code to provide electric utilities with the same opportunities to operate under performance-based regulations as gas utilities. In addition, these amendments offer financial incentives for the construction of major generation projects and development of renewable energy programs.

Using performance-based regulation, Virginia now has the unique opportunity to create reliable sources of power for decades while encouraging the development of financially sound utilities and protecting the environment. Surely this is the time to move forward with a long-term infrastructure plan that accomplishes all of these goals. For as William Shakespeare noted, “Who seeks, and will not take when once ‘tis offer’d, Shall never find it more.” (from “Antony and Cleopatra” Act II, Scene VII).

Edward L. Flippen is a partner with McGuireWoods LLP and a lecturer at the Duke University and University of Virginia schools of law. Among the clients he represents are public utilities such as Dominion Resources Inc. and Virginia Natural Gas.