Performance-Based Regulation is an Underrated Tool for Utility Decarbonization
By 2023 DC Fellow Charles Harper
Performance-based regulation of utilities is often discussed for its cost-saving or reliability benefits. But PBR can also be a powerful, if under-considered, tool for state climate action.
Unfortunately, many electric companies have created roadblocks to the transition to clean energy technologies needed to avert the worst consequences of climate change. When the Edison Electric Institute announced its opposition to President Biden’s EPA rules to reduce power plant carbon pollution earlier this year, that was just the latest example in a long trend.
Why have so many utilities have posed challenges for the energy transition? The answer lies in their misaligned incentives.
How do you solve a problem like misaligned incentives?
The current regulatory model for monopoly utilities disincentivizes many actions that would cut climate pollution. The traditional “cost-of-service” model provides utilities a guaranteed financial return on investments made in physical infrastructure. This encourages overinvestment in some things (like distribution lines and utility-owned fossil fuel power plants) and discourages other solutions (like energy efficiency, customer-owned distributed solar or storage, or third-party clean energy). Overall, the cost-of-service model creates a powerful incentive for utilities to stick to the status quo energy mix and oppose climate action.
Utilities can be a powerful political opponent. Large electric companies are often the single-largest political donor and employer in many states. Transitioning to clean energy will be a slog as long as these powerful companies stand to profit from predatory delay.
But we are not stuck with the status quo. State legislatures and utility regulators can change the regulatory model — and in fact some already have. Many states are looking toward performance-based regulation (or PBR) to bring utility regulation into the 21st century.
PBR is a broad category that includes various methods of basing utility revenue not on how much money they spend, but on how well they perform on the metrics that matter to the public. That can include reliability performance, but PBR also provides an avenue to ensure utilities comply with public policy goals. That crucially must include climate and environmental performance.
Too often, utilities have set voluntary net-zero goals while still planning to rely on fossil fuel plants for decades, or even build new ones. When states have tried to pass climate policies, they have been a malign influence opposing ambition. Even in states with stringent climate policies on the books, utilities have opposed federal action.
Climate-focused PBR would realign utility’s incentives whole cloth, enabling more ambitious climate action. Powerful utilities would support further climate action because they would now stand to make more money from a faster transition. This change would cause a paradigm shift in the political economy of climate action.
How would climate-focused PBR work in practice?
Climate-focused PBR can take several forms, from performance incentive mechanisms that layer on top of traditional cost-of-service regulation, to a revenue formula that is directly based on how well a utility is achieving carbon pollution reduction targets.
If you want to know how this type of PBR would look in practice, there are already some real-life examples.
Hawaii, in its nation-leading effort to implement PBR, created a utility performance incentive that provides Hawaiian Electric Co. additional revenue if it deploys renewables faster than required by the state’s clean electricity standard. New York’s REV proceeding created an Earnings Adjustment Mechanism that gives regulated utilities a financial incentive to increase energy efficiency.
Other states have explored creating performance incentives or basing utility revenue on metrics including: deploying certain amounts of clean energy or distributed energy resources, hitting decarbonization targets, and timely interconnecting solar and storage.
PBR often requires authorizing legislation from a state legislature. But many state public utility commissions (or PUCs) have already gained authorization to implement PBR.
In these states, PUCs should pursue and finalize performance incentives for decarbonization. In places where Governors have set climate targets on their own, PUCs can use climate-focused PBR to ensure utilities are achieving these decarbonization targets.
Why now?
Earlier this year, the EPA proposed new emissions standards for carbon pollution from existing coal plants and some existing gas plants. States will now have two years to determine implementation plans. Integrating these carbon emissions requirements directly into utility regulation is a simple and powerful way that state governments can ensure compliance with federal regulations.
Many states also have their own 100% clean electricity standards. Creating direct incentives for achieving carbon pollution or clean energy targets, as Hawaii has implemented, will ensure utilities are on track to achieve these requirements and the interim targets along the way.
PBR will also ensure savings for customers. Cost-of-service regulation incentivizes utilities to gold-plate the transition. Clean energy is cheap, and PBR will ensure that utilities are truly taking the lowest-cost path toward zero emissions.
Utility opposition poses a major obstacle to clean energy, lower bills, and climate action. By changing utilities’ own incentives, we can build the clean energy utilities of the future — and create powerful new political allies in the process.
