22 Sep 2011

How do we know when a utility is efficient?

GS and I had another exchange of emails based on this post on utility performance, in which he said:
How nice would it be if the regulators published a metrics drive comparison of utilities? Then they could actually drive some efficiencies through things like ROE incentives for meeting prescribed benchmarks!
Well, we're getting closer to that goal, via benchmarking initiatives like the International Benchmarking Network for Water and Sanitation Utilities (IBNET), which -- unfortunately -- covers very few developed countries.

That said, we know what we need: better ways to measure and improve performance. To that end, I just uploaded a longer version of my post/idea on using insurance to improve performance at water utilities by creating virtual, or second-hand, competition among water utilities via the price they pay for insurance against service interruptions, etc.

"Creating Utility Competition Via Performance-focused Insurance" [link]

A monopolistic urban water supplier may succeed or fail in providing good service to its captive customers. Regulators can use benchmarks to rank performance and create virtual competition, but quantified outputs are imperfectly correlated with outcomes that matter to customers. Even worse, regulators face weak incentives to identify and target these outcomes. This paper suggests that insurance companies can supplement regulatory effort while improving outcomes, by providing policies based on difficult-to-measure factors such as water managers' effort and talent. Insurance will protect consumers from paying too much for water service or experiencing too many service interruptions.

It is DEFINITELY a draft, so please give me your comments and suggestions on how to improve the idea. I am also looking for earlier expressions of similar ideas, to make sure that I do not unintentionally re-invent the wheel.


Eric said...

Aren't most water utilities self insured so this insurance approach would have no real incentives?

David Zetland said...

@Eric -- good question. They would not be allowed to self-insurance b/c they have no incentive to get the price right if they can just raise rates if they make a "self insure" calc. mistake. I need to add that to the paper

DW said...

Unfortunately there are no regulators overseeing regional California water agencies like MWD and CWA, or the local water agencies. The energy utilities are overseen by the CPUC and the CEC, but the water agencies have escaped that kind of regulatory oversight. And I suspect many water agencies are self-insured.

If they had a regulatory oversight agency like the CPUC, the agency could decouple the water districts authorized revenues from their water sales, like the CPUC did for the energy utilities in 1981. Each district would get an approved authorized rate based
on their projected operating expenses, and if their water sales came in below that amount they would get a rate increase. If it came in above the approved amount, they would have to credit it back to their customers in their bills.

David Zetland said...

@DW -- I think they do that already.

DW said...

Not really. They are having to raise rates for two reasons, increased costs of imported water from MWD and lower usage by their customers. They have no reason to effectively promote conservation since when water usage goes down their revenues go down. Their revenues are directly tied to their water sales. Each agency sets their own rates. There is no statewide regulatory agency with jurisdiction over their rates like the CPUC has over the energy utilities rates.

David Zetland said...

@DW -- Yes -- and my point is that they just decide to raise their prices when people use less. Same as CPUC companies, who ALSO have no incentive to get people to use less b/c they just get paid THE SAME (not more).

GS said...

Just read your abstract – I think the concept is very intriguing. Apportioning real risk (of failing to invest in infrastructure replacement, water scarcity, water quality etc) to specific utilities would provide another pressure point to those utilities who choose a “riskier” path. But, since some utilities – by their location – must engage in “riskier” behavior (by this I do not mean riskier from a public health perspective), people choosing to live in those areas must accept the costs of those risks. Just as someone living in NYC may pay a higher car insurance premium, a utility operating in a water scarce area would be faced with higher premiums. Regionally, though, the costs should be the same except where utility philosophy is driving the difference.

So a certain portion of those costs must be borne by the ratepayers – and they should see benefits of that in lower operations and maintenance costs (a lower risk assessment should equal more efficiently run utility). One area that needs to be fleshed out is how the insurance premium relates to internal or external factors. A new utility, with no access to say historic surface water allocations, may have no choice but to pay a higher “water scarcity premium”. Those costs should be borne by consumers – who choose to live in the area. Conversely, an older utility that has failing infrastructure and chooses not to invest, should pay an “infrastructure premium”; that premium really should not be borne by the consumer.

A program of incentives for utilities managing risk and efficiency at a higher level should also result in rewards from the regulator. We often see disincentives from a regulatory perspective. A company that does not invest in its assets (and therefore has zero or even negative rate base) is provided an Operating Margin on top of expenses with very little analysis. Whereas a company investing in infrastructure must not only demonstrate that it is used and useful, but also must argue a very complicated and indeed arcane cost of capital case. Investing in regionally scaled infrastructure and renewable resources (eg recycled water) is often unrewarded.

Ultimately I believe that we need to move from prescriptive regulation to performance-based regulation...

The National Regulatory Research Institute is very active in modernizing regulation of utility monopolies (http://www.nrri.org/).

David Zetland said...

@GS -- although I agree about inside and outside factors, it's difficult to isolate them, and it's ALSO true that consumers eventually pay -- one way or the other. That's ok if they are seeing a reason for higher prices -- and they will increase pressure for change if those prices are for waste.

Also note that managers in water-scarce areas can lower their premia by managing "appropriately," such that premia equate on the risk/reward margin.

I agree with your observation on regulatory incentives. Their "state of the art" often reflects ideology, capture -- or past practices -- more than what's good for consumers.

GS said...

Yes, I would agree that the consumer always pays - the expectation would be that the costs align with the peoples' desire to live in a certain area (ie living in water scarce areas = higher cost - that's simply not true today!) and that people are not paying for the inefficiencies of the utility. That's harder to regulate - UNLESS the regulator established the goals, minimal acceptable levels and benchmarks against industry leaders. To do so, a regualtor must be forward looking. Unfortunately, many regulatory agencies are rearward focused - always trying to catch up to what the utility has been up to (which is why I think that rates set on a historic test year are folly). While the pendulum can swing too far the other way too, the concept of "insuring the risk" could cause the utility to employ a forward looking attitude. As long as the premium was a noticeable expense, and that the insurance program would not increase rates as a function of losses due to bad actors!

DW said...

Actually, the energy utilities have a huge incentive to help their customers with energy efficiency rebates and incentives. The CPUC adopted a policy that allows the investor owned utilities (IOUs) to retain 5% of the estimated value of the energy saved by their programs
and give it to their shareholders. That deal was worked out in the early 1990s, and has incentivized the IOUs into supporting more than $3 billion a year in energy efficiency programs over the last decade. This is the kind of thing you can do when you have a regulatory
overseer controlling rates. The water agencies are independent entities in each city or district, with nobody over them, so they do whatever their boards decide to do, and the whole business is fragmented beyond belief.

David Zetland said...

@DW -- the sad thing is that CPUC will NOT do the same thing for water -- at least as of a year ago, when I asked them in SF.

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