After years of conspicuous success, the Performance-Based Rate (PBR) regime applied to much of Europe’s electricity distribution industry appears to be reaching the end of its useful life. First adopted in Great Britain in 1990, the PBR model requires regulators to set lower rates each year while allowing distributors to keep any value they generate by reducing their costs below the resulting revenues. Distributors thus have an economic incentive to improve their operations, which has led many formerly state-owned monopolies to become significantly more efficient, increased their margins and profits, and made them more reliable for consumers.

But the benefits of this policy are diminishing. Many European distributors can’t reduce their costs much more without reducing service levels. Moreover, if rates continue to drop, distributors won’t be able to finance the investments required to renew and upgrade their networks in the future. Nor will they have the means to promote a wider set of objectives by investing in new technologies, such as smart grids that distribute electricity generated with renewable sources and smart meters that discourage consumption at peak times.

We have identified three guiding principles for companies and regulators embarking on an effort to create a new regulatory regime: take into account the results achieved by companies in the past when setting the level of future rate reductions, design rewards in line with new objectives (such as environmental ones), and encourage new, efficient investments.

From cost plus to PBR

In the 1980s and 1990s, governments all around Europe sought to privatize previously state-controlled energy utilities—among them, electricity distributors. Distribution, involving the physical movement of electricity from the transmission grid to customers’ homes and businesses, is now separated in Europe from the supply or sale of energy, though many diversified utilities own both sorts of businesses. Suppliers pay regulated charges to transmission companies and distributors in order to use these monopoly networks to deliver energy to customers. In the United States, by contrast, distribution and supply are usually still integrated.

Regulators in Europe set out with a variety of postprivatization objectives, notably to ensure the reliability of service, to eliminate inefficiencies in the distribution system, and to protect consumers from the threat of excessive charges. Initially, governments favored a regulatory regime known as cost plus, which was also applied to other sensitive European industries, such as railways. This approach guarantees distributors a return that is sufficient to cover costs, plus an additional percentage constituting their profit margin. Under this system, distributors remain in business and consumers have an assured supply. The problem with the cost-plus model is that distributors can’t increase their profit margins by changing the way they do business, so they tend to avoid opportunities to improve their performance. Thus networks are often plagued by inefficiencies, whose costs are passed on to customers in the form of suboptimal services and unnecessarily high charges.

Countries started switching to PBR in the early 1990s. The regulator continues to guarantee the distributors’ returns, but an “efficiency kicker” lowers them annually. Rates, typically set every four years, are based on the distributors’ costs and updated annually by the so-called RPI-X formula. (X is the efficiency target for the duration of the regulatory period; after four years, the level of rates is reset and a new efficiency target introduced.) Distributors keep the difference between the rates they receive and their actual costs and therefore have an incentive to find new ways to make their operations more efficient and raise margins. At the same time, the price that customers pay falls.

Take the case of Great Britain, where distribution rates charged to local customers dropped by more than 30 percent in real terms from 1990 to 2005. The quality of supply improved, so that the average annual interruption time per customer fell by 39 percent. Meanwhile, the average EBITDA¹ margins of the distribution companies rose by 51 percent (Exhibit 1). Italy followed suit and enjoyed a similar success. Indeed, by 2007 a majority of the countries in Europe had implemented PBR systems and were reaping the benefits.

Diminishing returns

The PBR regime regulates two categories of returns: operational expenses and capital spending. Many distributors in Great Britain and Italy, however, have already cut most of the waste in their operations and have few realistic opportunities to reduce costs and achieve greater efficiencies. It won’t be long before distributors in other countries too reach best-practice operational-performance levels.

On the capital side of the equation as well, too, the dearth of new operating efficiencies is a problem because, historically, regulators assumed that such gains compensated distributors for low returns on capital investments. Specifically, the returns of the distributors and the rate of depreciation are based on the value of their regulatory asset base (RAB)—that is, the invested capital recognized by regulators. But in an effort to give distributors further incentives to run leaner networks, regulators often set the guaranteed rate of return on investments below the weighted average cost of capital (WACC), which most companies use to estimate their returns. In such cases, the present value of the guaranteed rate of return doesn’t cover an investment’s full cost (Exhibit 2). Companies can bridge that gap only by achieving higher operational efficiencies, which are becoming more and more elusive in many countries.

Distributors face two main challenges as a result of the current PBR capital-investment regime. First, without an increase in the guaranteed rate, most companies can’t afford to make the investments they need to meet the regulators’ quality standards, such as limits on interruptions to supply, for if they don’t renew assets such as old cables and transformers, prolonged outages will occur more often. As the many European assets built in the 1960s approach the end of their useful lives, maintaining current supply levels will be difficult.

Second, the low rate of return on capital expenses inhibits distributors from making the changes needed to realize Europe’s new environmental objectives—particularly to reduce emissions of carbon dioxide. One way to meet this goal might be for distributors to install smart-meter technology, which sends real-time price signals to consumers, who would thereby be alerted to the environmental (and financial) benefits of using electricity during off-peak times. The current PBR regulations, however, guarantee distributors an annual benefit based on the residual value of the capital invested in the existing mechanical meters—a clear disincentive to replacing them before the end of their useful lives. So if distributors were to switch to digital meters, the old ones would be written off from the capital invested and generate a loss.

Moreover, generation companies and their customers are keen to pursue distributed-generation options (such as wind, photovoltaic, and microcogeneration technologies) that are more environmentally efficient than the traditional ones. To support this effort, distributors need to invest in smart-grid technologies that manage power flows from many parts of the distribution network, devices such as sensors that monitor the supply of electricity in real time, and remotely activated switch gears that correctly balance the flows. The huge cost of these investments will be prohibitive given the insufficiency of the returns currently sanctioned by regulators.

Getting to the next regulatory paradigm

Without new regulatory regimes responding to the economic realities of today’s power markets, the momentum achieved over the last decade through PBR will falter. As regulators across Europe ponder the necessary changes—a process that typically involves reviews every four or five years—they urgently need to consider fresh ideas. Successful national regimes must naturally take into account specific local conditions. But our analysis and experience in various countries in Europe have helped us identify three guidelines that all regulators must keep in mind: they should overhaul the efficiency kicker by taking into account historical performance improvements when they set rate reductions, reward new investments to meet environmental objectives, and encourage efficient new capital spending on the network itself. By adhering to these guidelines, regulators will increase the chances of prolonging the PBR era’s win–win relationship between distributors and their customers.

Set a retrospective efficiency kicker

Regulators face a quandary. On the one hand, they must pressure distributors to go on reducing costs and increasing efficiency. On the other, they must avoid setting excessively aggressive efficiency targets that could jeopardize the distributors’ future profitability (and therefore ability to invest).

Before privatization, most utilities were state owned and largely sheltered from the competitive pressure that usually inspires cost cutting. Regulators could prod them to be more efficient only by periodically reducing the rates that end users paid. These cuts, which typically came at the beginning of a four-year regulatory period, were based on the distributors’ future cost-savings estimates.

Today, however, most European utilities have been privatized and face pressure from financial markets to improve their operational efficiency. Many of them have reached or are approaching best-practice cost levels, so further rate cuts based on estimates of added savings are no longer appropriate. When contemplating future rate reductions, regulators should therefore be sure to take into account the historical results already achieved by the distributors. This system ought to give them an incentive to achieve greater efficiencies—in other words, to reach the next practice level—while safeguarding their long-term financial viability.

The “profit sharing” mechanism created by the Italian regulator strikes such a balance by giving distributors that have already achieved current best practice a strong incentive to improve even more. The regulator calculates the difference between the costs embedded in a utility’s rates during the last year of a regulatory period and the utility’s actual costs in the same year. This margin, called “extra efficiencies,” is the additional cost reduction that the utility achieved on top of the target set by the regulator during the previous regulatory period. The rate reduction set for the subsequent one absorbs 50 percent of these extra-efficiencies in the first year and the remaining part gradually, over a certain number of years. Utilities have a strong incentive to improve their performance, since the lower their costs in a given year, the bigger their margins thereafter.

Reward efforts to achieve new objectives

Future regulatory models should give distributors incentives to invest in new distribution technologies, such as smart grids and smart meters, that will make it possible to distribute more electricity generated from renewable sources and encourage greater energy efficiency.

Today, power is usually generated at a central location (often a big coal plant or combined-cycle gas turbine) and transported by power grids to end users. In the future, users will probably get more and more power generated by many local sources (using technologies such as solar, wind, microcogeneration, and fuel cells) that are connected to the distribution network. Distributors will have to adopt smart-grid technologies that coordinate and balance the power flowing across the distribution grid, in a number of directions, from these local sources (Exhibit 3).

Regulators should also consider encouraging distributors to implement smart-meter technologies. Such digital meters can be read remotely, allow distributors to measure the use of power more accurately, and can send customers information about the cost of power throughout the day, so they can elect to use electricity when demand and prices are lower. Balancing demand in this way reduces the number of generators required to serve the network, thereby limiting energy consumption and its environmental impact.

Some regulators have already started to develop incentives that reward the adoption of these technologies. Italian distributors that invest in smart-grid projects, for example, receive a rate of return, for the first 12 months of the investment’s life, that is 2 percent higher than the regulated rate of return on investments that don’t support the new objectives. Other parts of the world provide inspiration as well, and companies themselves can always take the initiative. In the United States, for example, Duke Energy has proposed an energy efficiency regulatory scheme, called “Save a Watt,” that would allow the utility to earn a rate of return by implementing energy efficiency programs.

Encourage efficient investments

To ensure that the necessary investments improve the distribution network, regulators should increase the maximum returns allowed on capital expenses. Except in Norway and Great Britain, returns are now so low that new investments in the distribution system have become unattractive in Europe.

The new model should also provide incentives that encourage distributors to invest their capital where it is most needed and to find the most efficient means of doing so. A regulator will therefore have to bolster its analytical and managerial skills so that it knows which investments are most important for the network and the best way of encouraging distributors to make them. The GB regulator, for example, hired an external technical adviser to help it understand the investments its network required and to develop investment budgets for the next regulatory period. The Italian regulator used its analysis of the market to increase the return on investment in some equipment categories that are integral to the system’s future stability, such as high-voltage substations in areas that lack redundant lines or stations.

New regulatory models should also give companies clear incentives to use the most efficient contractors and materials. The GB regulator has already taken a step in this direction by introducing a novel way to calculate capital expenditure allowances during the next regulatory period. Its new approach makes explicit assumptions about the evolution of the unit cost of investment inputs such as manpower and materials. Another method, used by the Spanish regulator for new investments in gas transmission networks, establishes a standard price list (known as the standard unit cost) for the main items; the investment value recognized by the regulator is the actual cost minus 50 percent of the difference between the actual and standard cost. These devices force companies to invest wisely and build efficiently, for when regulators use standard costs to calculate the regulatory asset base, distributors rather than customers assume the risk of cost overruns on the actual investment. The regulated rate of return on new investments should, of course, reflect the additional risk borne by distributors.

The regulation of power distribution has produced clear benefits for consumers and power companies alike over the last few years. Nonetheless, the time has come for a hard look at regulatory systems based on the widely adopted PBR model. Further progress is still achievable. But the current model risks undermining PBR’s positive impact unless appropriate changes are adopted—a retrospective rather than prospective efficiency kicker and regulated returns that reflect the needs of network upgrades and meet the system’s new environmental objectives.