Future Electric Utility Regulatory Incentives and ...

Future Electric Utility Regulation Advisory

Group Meeting

March27,2014

RegulatoryIncentivesandDisincentivesforUtilityInvestmentsinGridModernization

LegislativeEnergyHorizonInstituteTrainingOctober12,2017Washington,DC

SteveKihm,CFA– Seventhwave

2EnergyAnalysisandEnvironmentalImpactsDivision

Lisa Schwartz, Berkeley Lab, is the project manager andtechnical editor. U.S. Department of Energy provided funding.

https://emp.lbl.gov/publications/regulatory-incentives-and

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EnergyAnalysisandEnvironmentalImpactsDivision 3

AnalyticalTriumvirate

• Beecher:Traditionalregulation,ifproperlyapplied,canprovideincentivesforgridmodernization

• Lehr:Traditionalregulation,includingitslitigiousprocesses,isnotconducivetomakingatransitiontoamoderngrid

• Kihm:Incentivesvarybasedoncircumstances—tounderstandwhetherincentivesordisincentivesexistweneedtounderstandshareholdervalue



A Brief Summary ofCo-Author Perspectives


Janice Beecher, PhD

JanBeecher(institutionalperspective)

“Peoplecallforanewparadigm,[saying]thatthecurrentregulatorymodeldoesn’tfitwithmodernizationSoyouhearthatweneed‘incentiveregulation.’Butfrommyperspective,[regulation]isalwaysaboutincentives.Thedichotomybetweentraditionalandincentiveregulationisfalse.”




“Ataminimum,prudenceshouldbedefinedintermsofenforceablestandardsandgenerallyacceptedutilitypractices,bothofwhichcanbesubstantiallystrengthenedinlightoftechnologicaladvancesandopportunitiesaswellasdynamicsupplyanddemandconditions.”


“Thegrantingofanexclusivefranchisetoamonopolybythestatehasstringsattached.”


“Theregulatorycompactisnotsetinstone.Itisalivingandevolvingcharter.”


“Motivatingutilitiestowardevolvingsocialendsshouldnotautomaticallybeviewedasoutsideofthescopeoftheparadigmorbeyondthemodelandthemeansalreadyavailabletoeconomicregulators.”



“Meaningfulregulatoryreformdoesnotnecessarilyrequireparadigmaticchange.Withoutadoubt,whatmighthavebeenconsideredprudentevenadecadeagowouldnotbeconsideredprudenttoday,letaloneforautilityofthefuture.”




“Forgridmodernization,weneedanewprudenceratherthananewparadigm.”


“Toneglectthepowerofeconomicregulationtolimit,channel,andmoldthebehaviorofregulatedfirmsistoneglecttheverypurposeof‘regulationinthepublicinterest’...Inthehandsofcapableregulators,andguidedbyclearrequirements,thetraditionalmodelactuallyprovidesverypowerfulperformanceincentives.”



Ron Lehr, JD

RonLehr(formerChair,ColoradoPUC)

“Newinformationfromapplicationsofnewcommunicationstechnologiesenablesconsumerstobecomeenergyproducersandtotakemoreresponsibilityfortheirenergyuse.Buttraditionalregulationdoesn’tincentutilitiestosupportincreasedconsumersovereignty.”



“Return-on-equityincentivesencourageutilitiestoinvestincapitalprojects.Theylackequivalentincentivesforoperationsandcustomerengagement– operatingexpensesratherthancapitalexpenses.Onlyprovidingincentivestoinvestcapitalstandsinthewayofinnovation.”



“Avarietyoffactorsstandinthewayofcreatingwelltargetedandwellalignedutilityincentives,includinglitigatedprocesses,poorcommunications,relationshipsthatdonotbuildtrust,andlackofconsensusaboutoutcomes.”


“ Regulationcangetusthere,butitwillbealongroadifwejusttrytolitigateourwaythere.”


“Amongthesealternativesareregulatoryoptionsthatputrelativelylessregulatorytimeandeffortintoaddressingthequestion‘didwepaytherightamountforwhatwegot’andmoreregulatorytimeandeffortintoanticipatingthefuture,asking‘whatdowewant,andhowdowepayforthat’?”



Steve Kihm, CFA

Overview

• Canutilitiesraisecapitalforgridmodernization?Yes

• Doutilitymanagersseevalueforcurrentshareholdersingridmodernizationprojects?Maybe

• Shareholdervalue(stockprice)– risk,returnandscale

• Utilitymanagers,notthecapitalmarkets,decidewhetherinvestmentsshouldbemade


This is the relevant question.

Properframingoftheproblem


CreditSuisseDistributingCashtoShareholders


Cost of equity for S&P 500


Long-termROEabovecostofequity

Xcel EnergyBeyond 2019, we assume a system wide normalized 10% average allowed ROE and 0.5% average annual long-term usage growth. We assume a 7.5% cost of equity in our discounted cash flow valuation. This is lower than the 9% rate of return we expect investors will demand of a diversified equity portfolio. A 2.25% long-term inflation outlook underpins our capital cost assumptions. Our cost of capital assumption is 5.9%.




r k

Whomakesinvestmentdecisions?


Capitalallocationisaseniormanagementteam’smostfundamentalresponsibility...Theobjectiveofcapitalallocationistobuildlong-termvaluepershare.

Mauboussin,M.,etal.2016.CapitalAllocation:Evidence,AnalyticalMethods,andAssessmentGuidance.CreditSuisse.

EEIcommentingonlowerFERCROEsfortransmission


AsEEIexplains,“theseprojectsalsocarrythemostupfrontdevelopmenttime,longerconstructionschedules,andoverallrisk.”However,withoutasufficientROE,electricutilities arelikelytochoose short-term,morelocalprojects,insteadofriskier,morestrategicoptions.(Emphasisadded.)

Kuzika,L.S.2013,June17.EEIUrgesFERCtoReformitsROEMethodology.Energy&EnvironmentalLawAdviser.

EEIcommentingonlowerFERCROEsfortransmission


AsEEIexplains,“theseprojectsalsocarrythemostupfrontdevelopmenttime,longerconstructionschedules,andoverallrisk.”However,withoutasufficientROE,electricutilities arelikelytochoose short-term,morelocalprojects,insteadofriskier,morestrategicoptions.(Emphasisadded.)

Kuzika,L.S.2013,June17.EEIUrgesFERCtoReformitsROEMethodology.Energy&EnvironmentalLawAdviser.

This is not saying utilities couldn’t raise capital.It’s saying they won’t want to invest in transmission.

Returnonequity>costofequity


29

r k

EnergyAnalysisandEnvironmentalImpactsDivision

Whenrislessthank

actual dataresults when

r < k


Profitableinvestment,butbelowtheminimumacceptablelevel

31

Kihm, Barrett, & Bell, 2014, ACEEE Summer Study


Thevalueproposition


Thevalueproposition


How does the policy affect the utility’s systematic risk?

How does the policy affect the expected return on equity?

What are the scale differences betweenthe utility’s resource

options?




r k

Togetthefullpriceimpactyouwouldusesuchamodel


36

If both cars could be purchased for $15,000, which model would attractmore buyers?

BMW Series 7

Honda Civic


Honda Civic

BMW Series 7

37

Now which model would attractmore buyers?

$22,000

$97,000


TheValueLineInvestmentSurvey


2016 2017 2019-21

Highreturnsonequitydon’tattractmorecapital


Newinvestorsexpecttoearnaboutthesamereturnonallutilitystocks


Highreturnscreatevalueforpresent investors


For every dollar investedAlliant creates more valuefor present shareholders

Butdonotbenefitnewshareholders(pricing)


Stocks are priced so thatthose providing new capitalto either company expect toearn about the same return.

Incentiveexample


Can we provide an incentive to invest in the two-way flow project?

Here the project with the larger scalewill create more value per-share for investors.

Returnonequitycansometimesdrivetheresult


Now the project with the higher returnwill create more value per-share for investors.

Yes, if we set thereturn high enough.

Butnotalways


10.5% $14,000,000

Now the project with the lower returnwill create more value per-share for investors

(scale again dominates).

But not just any higher return will do the trick.

Don’tconfusetheshareholdergroups


10.5% $14,000,000

New shareholdersprovide all of this

capital

Present shareholderscapture the valuegain as a windfall

New shareholdersearn the cost of equity based on

what they paid for the stock

Thecurrentstockpriceimpoundsfuturevalue


Notethatanopportunitytoinvestinaprojectofferingmorethanthecostofcapitalgeneratesanimmediatecapitalgainforinvestors.Thisisawindfallgain,sinceitisrealizedexante.Myers,S.1972.TheApplicationofFinanceTheorytoPublicUtilityRateCases.TheBellJournalofEconomicsandManagementScience.

Incentivesforgridmodernization?


It’s all about the detailsThere are no general answers

Dothesepoliciescreateincentives?


• Differentratesofreturnandcostsofcapitalfordifferentutilityassets(itdependsonr,k,andI)

• De-riskingcertainresourcetypes(itdependsonr,k,andI)

• Providingratebasetreatmentforcertainexpenseitems(itdependsonr,k,andI)

• Formularates(itdependsonr,k,andI)• Pricecaps(itdependsonr,k,andI)• Earningssharingmechanisms(itdependsonr,k,andI)

Financialanalysis


Beware of statements such as

“Utilities have an incentive to...” or “Utilities have a disincentive to...”

Ask: Which utility?Ask: What’s the action in question?

Incentives/disincentives depend on circumstances


Why Many CorporateManagers Struggle With the Shareholder Value Concept

CreditSuisseCapitalAllocation


Capital allocation is a senior management team’s most fundamental responsibility. The problem is that many CEOs don’t know how to allocate capital effectively. The objective of capital allocation is to build long-term value per share.


“I happen to have atalent for allocatingcapital.”Warren Buffett

BuffettonwhyCEOsoftendon’tmaximizeshareholdervalue


This point can be important because the heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.

BuffettonwhyCEOsoftendon’tmaximizeshareholdervalue


Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch the point, it’s as if the final step for a highly-talented musician was not to perform at Carnegie Hall but, instead, to be named Chairman of the Federal Reserve.

CEOswhounderstandshareholdervaluearetheexception


Thorndike spent eight years working on the book and interviewed all the living CEOs he studied. The CEOs he ended up profiling were Tom Murphy of Capital Cities, Henry Singleton of Teledyne, Bill Anders of General Dynamics, John Malone of TCI, Katharine Graham of The Washington Post Co., Bill Stiritz of Ralston Purina, Dick Smith of General Cinema, and Warren Buffett of Berkshire Hathaway.

CEOswhounderstandshareholdervaluearetheexception


Managers don’t understand the counterintuitive concept of value maximization

MauboussinBuffettThorndicke

Managers do understand the concept, but they prefer to act in their own interest (agency theory)

Jensen-Meckling

Managers should not attempt to maximize shareholder value, but should consider all stakeholders (legal argument)

Stout

AgencyTheory


Agency theory: Agents (managers) will act in their own interests,which sometimes conflict with those of shareholders (principals).

LegalAnalysis


The notion that corporate law requiresdirectors, executives, and employeesto maximize shareholder value simplyisn’t true...The idea is a fable.

LegalAnalysis


This does not suggest that shareholder value is not important—it’s just not theonly thing that’s important.

Implications


Incentivesforotherutilitytypes

• Municipally-ownedutilities

• Cooperativeutilities

• Bcorporations


Possibleincentivesfornon-profitutilities

• Noshareholders,sothefocusmustshifttomanagers

• Incentivecompensationisasdesirableinthenonprofitsectorasinthefor-profitworld,but,unlikethelatter,whichbasesincentivepaymentsonorganizationalprofitability,nonprofitsneedtostructuretheirsystemsonotherperformancemeasures.(FrankA.Monti,CPA)

• Whatisessentialisthatthenonprofitclearlyspecify—inadvanceofimplementingtheplan—theperformancemeasuresagainstwhichindividualperformancewillbemeasured. (FrankA.Monti,CPA)

• Seehttp://www.massnonprofit.org/expert.php?artid=2869&catid=18


Questions?


Steve KihmPrincipal and Chief [email protected]

For information on Berkeley Lab’s Future ElectricUtility Regulation series please contact:

Lisa SchwartzDeputy Group Leader/Energy Efficiency Team LeaderElectricity Markets and Policy GroupLawrence Berkeley National [email protected] (office)510-926-1091 (cell)

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