Is It Finally Time to Embrace Multiyear Rate Plans?

Traditional rate-of-return ratemaking has undergone harsh criticism at least since the early 1960s. Various stakeholders, consultants and academic economists have offered ways to improve, replace, or supplement it with mechanisms designed to overcome its widely-acknowledged infirmities, such as weak incentives for innovation, rigid prices between rate cases and high regulatory costs.

One such mechanism is provided by multiyear rate plans (MRPs). An MRP is a mechanism that sets base rates or revenues beyond a one-year period to account for attrition and other factors. It does this by applying a formula or index. Alternatively, it can provide detailed forecasts for allowable rate or revenue changes over the duration of the plan.

Rather than a utility filing a new general rate case when conditions change, an MRP may forecast what these conditions are and accordingly adjust rates within a single rate case. One common practice is to allow rates to automatically change for a specified post-test year period. An MRP, for example, may specify that base rates would increase by five percent in 2017, three percent in 2018 and two percent in 2019.

In recent years, more state utility regulators, including states such as Georgia, Minnesota and Washington, have either approved MRPs or have expressed interest in them. Other countries, such as Australia, Canada and Great Britain, have relied heavily on MRPs, often citing the deficiencies of traditional rate-of-return ratemaking, which is commonly referred to as U.S. regulation.

In the U.S., electric utilities are the major supporter of MRPs. In other countries, the government has been a major proponent. The utilities' main argument is that MRPs would improve the regulatory process and their financial condition, which suffers if there is a regulatory lag.

While utility customers may benefit from these outcomes, MRPs have other effects on utility customers, either positive or negative. From the perspective of the public interest, this precludes a prima facie case for regulators' support of MRPs. Regulators must then evaluate each MRP on a case-by-case basis.

Essential Features of a Good MRP

MRPs have attractive features that warrant serious attention by regulators. Their mechanism represents a potentially sound approach to ratemaking that can reduce regulatory costs and at the same time benefit both utilities and their customers.

MRPs are especially appealing in a dynamic world where utilities face rising average costs or attrition that naturally erodes a utility's earnings over time. This condition inevitably leads to utilities frequently filing rate cases.

MRPs should have three essential features to enhance customer benefits. One is that utilities have good incentives for cost efficiency. An automatic rate-adjustment component not linked to a utility's actual cost changes, for example, can motivate it to achieve higher cost efficiency. Where utilities use forecasts to address attrition, the effect on cost efficiency is much more dubious.

The second is that utilities are held accountable for their performance, whether for costs or other operational outcomes. Most existing MRPs contain separate performance metrics to guard against a utility's reliability or customer service declining during the course of an MRP.

A third, which is more contentious, is that at least for political purposes an MRP should have a safety net or set boundaries for outcomes. Earnings sharing is one prime example. The challenge for regulators is to prevent a utility's earnings from being extremely high or low while also providing the utility with good incentives to be cost-efficient.

Expected Outcomes from MRPs

What should regulators expect from MRPs in terms of a utility's performance? After all, from a public-interest perspective, the most salient feature of MRPs comes from improving a utility's performance, which goes far beyond its financial health.

The answer depends on the combination of an MRP's core features and add-ons and its execution. One critical factor is the calculation of revenues during the post-test year period. They can derive from forecasts of a utility's costs or indices based on some general or industry-specific price index.

MRPs have a distinct advantage over traditional ratemaking in alleviating the likelihood of a utility suffering financial difficulty. For example, MRPs allow for more rapid cost recovery and for greater certainty when it comes to a utility recovering its capital costs.

A financially stronger utility can benefit customers in the long run. For example, facilitating utility recovery of capital costs may reduce the cost of capital for new investments. And it may overcome a utility's hesitation to invest in socially beneficial projects.

Yet, the ultimate question for regulators comes down to how customers would benefit in totality from an MRP. That depends on whether the utility becomes more cost-efficient and whether customers receive some of those benefits. Those benefits might come through lower rates, without jeopardizing the utility's non-cost performance areas such as reliability and safety.

Fewer general rate cases under an MRP can benefit both utilities and regulators. For customers, with a longer duration between general rate cases, a utility should have more incentive to control its costs.

Fewer rate cases also drive down the regulatory costs for utilities and other stakeholders. Just as important, MRPs can also allow regulators to reallocate scarce staff resources from rate cases to other major activities, such as the investigation of utility resource plans. 

To the extent that the test-year concept under traditional ratemaking is incapable of setting rates for a multi-year period, an alternative way for utilities to recover costs becomes necessary. "Incapable" refers here to the inability of test-year costs and revenues to reasonably reflect conditions during the effective periods of new rates.

Piecemeal approaches such as revenue trackers and cost trackers for individual functions such as investment in new projects only partially address some of the problems under traditional ratemaking. For example, the lack of reasonable opportunity for a utility to earn its authorized rate of return.

MRPs could more effectively and comprehensively confront these problems, especially in a dynamic environment where regulators set rates based on the static test-year approach featured under traditional ratemaking.

The Forecasting Problem

The biggest challenge for regulators under an MRP is knowing whether a utility's forecasts over, say, a three- or five-year period are reasonably accurate. Poor forecasts can lead to extreme utility earnings, either on the high side or low side. However, information asymmetry would tend to favor utilities by allowing them to receive what might be perceived as excessive earnings. An example of information asymmetry is what economists call the market for lemons. In such a market, the party with the better information will leverage its favorable position to its advantage.

MRPs also require extra effort by a regulator's staff and other parties to evaluate multiyear forecasts. Additionally, they increase the complexity of rate cases. As a serious matter, when regulators are unableto determine whether a utility's revenue-requirement forecasts are unbiased and reflect prudent management, they should discount the ability of MRPs to benefit customers.

A positive public-interest outcome, not surprisingly, turns to the details of an MRP. Both structure and execution are crucial factors.

A number of things can go wrong, especially with bad forecasts, which would threaten the efficacy of MRPs. That might, at least partly, explain why MRPs are relatively uncommon in the U.S. for energy utilities.

The Ultimate Questions

In the end, regulators will need to address two broad questions in evaluating MRPs. First, in achieving a regulator's objectives, how do MRPs stack up with alternative ratemaking methods, including traditional ratemaking? Do MRPs, for example, enhance a utility's incentive to innovate and control its costs?

Second, probably most important, what ratemaking mechanism would be both fair to the utility and most beneficial to customers? How can an MRP produce a non-zero-sum outcome, where both the utility and its customers benefit? The key to advancing the public interest is to make someone better off without making anyone worse off. Regulators should give their full support to MRPs if they are able to accomplish that outcome.

The Final Word

As a last word of advice, utility regulators should take the initiative in proposing an MRP. This would enhance the chances that an MRP aligns with the public interest, rather than just with the narrow interests of individual stakeholders. Their efforts can produce dividends for utility customers and society at large.