Setting Rates for Electricity Distributors: The Basics

March 2013

• The key recommendation of the Ontario Distribution Sector Review Panel was voluntary consolidation of 73 of the current electricity distributors into 8 to 12 larger regional distributors.
• One of the main concerns expressed in response to the recommendation for consolidation was that it would open the door for privatization, which in turn would drive up rates to electricity consumers.
• Given the regulatory framework for electricity distributors in Ontario, this concern is unfounded. At the core, the regulatory framework is not dependent on whether ownership is public or private, and it has a clear focus on consumer interests.

In December, the Ontario Distribution Sector Review Panel released its report, Renewing Ontario’s Electricity Distribution Sector: Putting the Consumer First. The Panel was established to assist the government in a comprehensive review of the province’s electricity sector including options for improving efficiencies. The Panel’s key recommendation was voluntary consolidation of 73 of the currently licensed local distribution companies into 8 to 12 larger regional electricity distributors; large enough to deliver efficiency improvements, to enhance services for customers, and to make it easier to obtain financing for maintaining and upgrading the distribution infrastructure.

Most of Ontario’s electricity distributors are owned by the provincial or municipal governments. One of the main concerns expressed in response to the recommendation for consolidation was that it would open the door for privatization, which in turn would drive up rates to electricity consumers.

Given the regulatory framework for electricity distributors in Ontario, this concern is unfounded.

With the exception of three utilities, the rates for all licensed electricity distributors are regulated by the Ontario Energy Board and by law, it is the responsibility of the OEB to set just and reasonable electricity distribution rates. The OEB is required to protect the interests of consumers with respect to prices and the adequacy, reliability and quality of electricity service. It does so while allowing for reasonable financial returns for the owners in order to support the maintenance of a financially viable electricity industry. The OEB must carry out these responsibilities regardless of whether the distributor is publicly or privately owned. As a point of interest, the two largest gas utilities in the province are regulated by the OEB and both are privately owned.

Setting Distribution Rates

So how does the OEB go about setting electricity distribution rates?

First, it is important to note that any changes to the rates of a regulated distributor must be approved by the OEB. The approval process is an annual event that begins with the distributor submitting a rates application to the OEB. The application contains the utility’s rate proposals for the upcoming year; so rate setting is a forward looking exercise. The OEB thoroughly reviews the proposed rates in a public process. The public nature of the review allows parties representing a wide range of interests, including those of the various types of electricity consumers, to actively participate in the process. The OEB has the final say on the rates that will be charged to consumers but in arriving at its decision, it takes into account the evidence and positions brought forward by both the company and interested parties.

Currently, the OEB operates a four-year rates cycle for electricity distributors. Although there can be exceptions under certain circumstances, the basic approach is that in the first year of the cycle, there is a detailed review of the distributor’s revenue requirement; the amount of money required to operate and maintain the distribution system and to cover capital expenses and infrastructure investments. The revenue requirement includes an amount for return on equity and so it too is subject to OEB approval. The review also involves allocating the distributor’s revenue requirement to its various customer rate groups and then designing rates to recover the allocated amounts. This whole initial process is referred to as a Cost of Service review.

The Cost of Service review is followed by three years of setting rates by what is called an Incentive Regulated Mechanism (IRM). This is a formulaic approach to setting rates whereby rates are adjusted by inflation less a productivity factor. The rates resulting from the Cost of Service review serve as the starting point going into the three-year period. Although the mechanism involves determining rates according to a formula, the distributor is still required to file an application with the OEB to get approval to make the rate changes.

The key idea behind the IRM is that it encourages a utility’s management to improve the efficiency and productivity of their distribution business by placing a price cap on its rate adjustments.

Managing Outcomes  

Distribution rate impacts are always a key issue to be addressed. Rate mitigation has been an OEB policy for quite some time.  The OEB recognizes that in some circumstances the rate setting process could result in customer bill increases which may be thought to cause hardships for some customers. Therefore, the OEB requires that distributors consider mitigation where total bill increases for any customer rate group exceeds 10%. (In a recent report examining changes to the regulatory framework for electricity distributors, the OEB indicated that distribution costs represent about 20-25% of the total electricity bill.) It is left to the distributors to propose and justify the type of mitigation mechanism to be used.

The OEB also has a trigger mechanism focused on a distributor’s annual return on equity during the term of the utility’s IRM. If a distributor performs outside of an annual return on equity dead band of +/- 300 basis points relative to the OEB-approved return on equity, then a regulatory review may be initiated. The idea behind the mechanism is to allow the OEB to take corrective action on a prospective basis if the IRM is not delivering the expected outcomes. This mechanism serves to protect customer interests as well as those of the distributors.

The OEB’s October 2012 report, Renewed Regulatory Framework for Electricity Distributors: A Performance-Based Approach, sets out modifications to the regulation of electricity distributors starting with the 2014 rate year.  The new framework does not alter the OEB’s responsibilities with respect to regulation, and many elements of the current approach are retained. As described by the OEB in its report, the renewed framework is “a comprehensive performance-based approach to regulation that is based on the achievement of outcomes that ensure that Ontario’s electricity system provides value for money for customers”.   

The Ontario Distribution Sector Review Panel made no recommendations on allowing more private players into the electricity distribution business.  However, it is the case that the OEB would regulate the rates of regional distributors along the same lines as it regulates the distributors now and in line with the changes and refinements being implemented as part of the renewed framework. At the core, the regulatory framework is not dependent on whether ownership is public or private, and it has a clear focus on consumer interests.

OEB Issues Report on Renewed Regulatory Framework for Electricity Distributors  Read more »

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