Regulatory Economics
Our regulatory economics consulting practice weds fundamental economic principles with a detailed understanding of the dynamics of evolving deregulated markets. London Economics International, LLC’s unique blend of commercial experience and academic credibility enables us to provide policy alternatives that are both practical and economically sound.
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Tariff and Rate Design
Cost of Capital
Cost Allocation
Performance-Based Ratemaking
Utility Management Audits
Public Policy and Sector Reforms
Electricity Market Design
Asset Valuation and Price Forecasting
Tariff and Rate Design
Our rate design practice is based on a strong understanding of regulatory finance principles and cost of service principles. It is further anchored by our ability to quantify current and achievable efficiency levels for regulated industries, and to convert the findings into efficiency targets mutually acceptable to both utilities and regulators. These abilities are supplemented by on-the-spot knowledge of how regulatory regimes in the US, Canada, UK, Australia, Latin America, and elsewhere have evolved. Our team has a successful track record developing tariff methodology and designing self-funding tariffs for clients around the world. We advise regulators and deliver workshop trainings on Performance-Based Rate design and on setting X-factors; our comprehensive model of comparative network efficiency, including hundreds of international utilities, helps to benchmark efficiency levels for particular regions.
Cost of Capital
LEI closely follows capital markets for all of its engagements, and has performed work specific to the regulatory cost of capital in a number of North American, Asian, and Middle Eastern countries. LEI regularly serves as a financial advisor to participants in the power sector across North America and internationally, including governments and regulators, and provides advice on issues ranging from cost of capital, target capital structures, and asset valuations. Typical issues include choice of an appropriate risk-free rate, referent market index, risk premium, deemed levels of debt and equity, and identification of continued areas of natural monopoly. Larger policy issues include the extent to which regulated businesses face increased risks due to climate change, and how this impacts the cost of capital.
LEI staff have completed capital structure reviews for utilities in Ontario, assessing the appropriateness of various cost of capital components, including equity thickness. Most recently, LEI was engaged by the OEB to act as their staff’s capital structure expert in respect of Ontario Power Generation’s (OPG) 2022–2026 Payment Amounts Application (EB-2020-0290). As part of its engagement, LEI provided analysis of evidence and support to OEB staff to prepare interrogatories; prepare an expert report following a detailed review of the analysis of the risk set out in the application; and provide an independent opinion on the risk faced by OPG. LEI responded to interrogatories with respect to its expert report to explain the analysis and findings in the report.
Cost Allocation
Cost allocation is a critical part of rate design. By deploying principles like functionalization, cost causation, and incentive compatibility, LEI is able to recommend billing determinants, identify customer classes, and allocate revenue requirements among those customer classes. Important issues include avoiding intra- and interclass subsidies, how often allocation should be reassessed, and the role of distributed energy resources in enabling customers to avoid paying for costs that they cause the utility to incur if rates are not properly designed. LEI has explored cost allocation across the value chain, including examining how long-distance high-voltage transmission should be paid for, how vertically integrated utility revenue requirements should be allocated, and the design of standby rates.
Performance-Based Ratemaking
Despite gains to consumers from the creation of competitive wholesale power and natural gas markets in the US, many jurisdictions continue to face high costs for electricity relative to nearby regions. These anomalies are forcing regulators to focus on the non-generation portions of customer bills. Increasingly, incentive-based ratemaking is seen as the next step in providing further reductions in delivered energy prices.
Historically, rates for monopoly network industries have been set using cost-plus rate of return regulation. This rate structure has tended to blunt incentives to improve efficiency, since few utilities were actually at risk on any portion of their investment. Incentive-based structures provide a mechanism for shareholders and consumers to share gains from efficiency improvements. Rates are set with reference to industry productivity growth targets. Companies that exceed these targets keep a portion of the profits; companies that fail to achieve them can lose money. Incentives are coupled with performance standards to guard against a deterioration in customer experience as utilities seek efficiency gains. Targets are reset periodically to ensure that incentives remain effective.
For companies facing a performance-based ratemaking (PBR) regime, or regulators exploring one, we help to quantify the potential revenue at risk and the compensating possibility for upside, examine issues such as performance standards, cost of capital, customer impact, and social protections, and provide support on regulatory filings.
Drawing on a wealth of international experience, LEI is able to provide comprehensive analysis and design of incentive-based regulation mechanisms. Using tools such as data envelopment analysis (DEA) or other appropriate techniques, we are able to normalize and compare utility productivity growth across companies throughout North America and in other jurisdictions. We advise state and Federal regulators on how such mechanisms can be designed; we work with companies required to file tariff proposals in response to regulatory incentive-based initiatives; and we incorporate knowledge of performance-based ratemaking (PBR) in our valuation of distribution companies for potential acquirers.
Utility Management Audits
LEI has experience conducting management prudency and performance audits of large integrated public utilities. The company has been engaged by public utility commissions of a number of states to perform such audits. The audits have included assessment of the prudency of fuel (oil, gas, coal, and nuclear fuel) and energy procurement processes; coal and nuclear inventory management; assessment of management oversight, organizational structure, and controls related to fuel and energy costs; examination of energy and capacity market offers; examination of power plant performance and outages; review of capital budgeting and expenditures; review of environmental controls; and audit of the mechanisms by which fuel, energy, capacity, and environmental costs are passed along to customers in rates and riders, including examination of the impacts of over- and under-recovery, and true-up mechanisms.
LEI performed a management and prudency audit of the fuel (gas, coal, and nuclear) and energy procurement activities of Entergy Mississippi. The LEI team:
The team also investigated the operations of a nuclear power plant, and the financial implications of the utility’s power purchase agreement for nuclear power.
- Assessed fuel, energy, and transportation contract terms for oil, gas, coal, and nuclear power
- Reviewed the prudency of coal and nuclear fuel procurement and inventory practices, which included an assessment of the methodology and accuracy of Entergy Mississippi’s coal consumption forecast
- Examined organization charts and interviewed executives to determine whether management, organization, and controls provided adequate oversight of the processes that impact customers’ fuel costs
- Investigated the process and evaluated outcomes for the company’s hourly MISO offers
- Assessed the performance of each of the generation units owned by Entergy Mississippi, in terms of capacity factors, availability, and forced outage rates
The team also investigated the operations of a nuclear power plant, and the financial implications of the utility’s power purchase agreement for nuclear power.
Public Policy and Sector Reforms
LEI has worked with policymakers and stakeholders around the world on a wide range of sector reforms. This includes helping to set up new regulators, establishing single buyers, designing renewable and net zero policies, examining the role of integrated transmission and distribution connected markets, creating business plans for new institutions, assessing subsidies and how to efficiently administer them and gradually reduce them, exploring lifeline tariffs for vulnerable customers, and a broad spectrum of market design and sector restructuring issues.
LEI brings to these exercises deep worldwide experience, enabling it to provide lessons from global case studies. Our approach is pragmatic, marrying theoretical principles to a practical understanding of political realities. LEI eschews a “one size fits all” mentality, focusing not just on best practice, but best fit given local conditions. Regardless of whether the question at hand involves a market, a commodity, or a regulated industry, our team is well positioned to provide timely and actionable advice.
Electricity Market Design
London Economics International is one of the world’s leading experts in power market design. The issues surrounding design of power markets are complex, with potentially costly implications for many stakeholders. Challenges range from the structure and timing of bidding in wholesale energy markets to the design of transmission tariffs and congestion charges to market power and trading in ancillary services. Having dealt with these questions repeatedly since the inception of wholesale power markets in the late 1980s in the UK, LEI is uniquely positioned to provide solutions informed with the knowledge of experience in other regions.
Our market design engagements in North America have taken place in, among other regions, California, New England, Texas, Alberta, and Ontario. We work both for the institutions responsible for establishing wholesale power markets and for the companies affected by them. The North American market is diverse, and trading arrangements for one region are not always appropriate in another. LEI is able to use its global expertise to recommend solutions based on international best consulting practice rather than just abstract economic theory.
The process of restructuring and creating electricity markets is complex. LEI has substantial experience in grappling with the challenges of unbundling, including estimation of stranded costs and benefits, approaches to retail competition, estimation of consumer benefits from restructuring, and examination of affiliate relationship codes. Clients include regulatory agencies, affected utilities, industrial groups, and consumer organizations. Our ability to apply economic principles in a sound and independent fashion enables us to present credible policy alternatives that clients can use to influence the course of restructuring.
The evolution of the electric power industry from a regulated monopoly to an unbundled set of interrelated production, supply, and distribution businesses has forced participants to examine what constitutes market power and how it can be constrained. Traditional tools, such as the Herfindahl-Hirschman Index (HHI), may not be easily applicable to electricity markets because of the difficulty in defining the market appropriately. To date, these questions have arisen mainly in generation markets; ultimately, they may also be of concern in creating competitive retail markets as well.
Our detailed knowledge of issues such as market definition, concentration ratios, and price tests has been frequently applied to regulatory filings before state commissions, the Federal Energy Regulatory Commission (FERC), and regulatory and market institutions worldwide. For example, we helped to draft Section 203 and Section 205 filings under the Federal Power Act associated with the acquisition of US generating capacity.
LEI has developed sophisticated models that move beyond simplistic concentration ratios to focus on the actual impact individual firms can have on market prices. We have also helped to develop contractual mechanisms to mitigate market power in jurisdictions where divestiture is unfeasible. In addition, we have created a wide range of policy position papers for a variety of clients that analyze market power in key markets, assess policy alternatives, and identify implications for return on investment.
- Analysis and authorship of pool rules
- Implications of auction theory and the role of iterative markets
- Institutional structure of ISOs and power exchanges
- Identification and amelioration of market power in generation
- Transmission tariff design, including congestion/capacity charges
- Role of generation capacity markets
- Calculation and recovery of stranded costs
- Design of transition contracts
- Economically rational approaches to provision of ancillary services
Asset Valuation and Price Forecasting
LEI provides valuation, price forecasting, and market analysis in a broad range of energy and infrastructure industries, including electricity generation, transmission, and distribution, natural gas networks, natural resources, water and wastewater treatment, mass transit, airports, and highways. By combining exhaustive sector-specific knowledge and a suite of proprietary quantitative modeling tools, LEI provides reliable, independent, substantial, and comprehensible valuation-related deliverables. LEI’s modeling approach has been refined over 25 years to incorporate state-of-the-art statistical and market dynamic examination techniques when analyzing competitive wholesale markets. Our strengths include being able to interpret incentive-based rates, quantify potential efficiency gains, relate revenue growth to population, weather, and local economic trends, and identify regulatory as well as technological risks.
LEI deploys economic fundamentals to determine appropriate, defensible ranges for value. We apply our economic valuation skills in conjunction with our understanding of the underlying industries to provide for realistic value assessments linked to genuine market conditions — our valuations are never “black box,” entirely hypothetical, or based on arcane accounting principles divorced from market realities. Thus, LEI valuations are often used to support various positions during dispute resolution, mergers and acquisitions, tax preparation, and stakeholder communication. Approaches include discounted cash flow analysis, examination of comparables, and discounted replacement cost, among others. Where appropriate, such as for development prospects, we can also deploy tools like real options models
London Economics International, LLC uses its proprietary models to forecast electricity and natural gas prices. For electricity markets, models of merit order dispatch and of bidding strategy enable LEI to provide a variety of energy and capacity price forecasting services. LEI has augmented its suite of models to provide insights on battery storage as well. Our natural gas pipeline models assess basis differentials and the cost of new pipelines to determine potential future delivered natural gas prices.
LEI’s extensive modeling experience in markets across North and South America, as well as overseas, enables us to respond quickly to the needs of our clients. We provide off-the-shelf forecasts of key North American markets, which can be customized to meet client needs. Furthermore, LEI can provide modeling for almost any wholesale produce market worldwide. Depending on the level of customization required, we generally provide basic price forecasts for key markets in 2–3 weeks. Our involvement is often more far-reaching: we work with clients from the initial bid stage through to final financing. This can entail assisting in board presentations, writing portions of the offering memorandum, and supporting the client in presentations to rating agencies.
- Assessment of impact of market design/pool rules on revenues
- Detailed modeling and regional price forecasts
- In-depth description of market rules, key players, trends, and institutions
- Risk registry, with attention to the role of new entrants, changing fuel prices, and regulatory uncertainty
- PPA, bilateral, and vesting contract design, with creative use of options value, locational/fuel arbitrage, and embedded incentives
- Quantification of transmission pricing impact on generators
- Liaison between developers, financial institutions, and power marketers
- Valuation of distribution franchises and distribution tariff analysis
- Economic valuation and risk assessment of transmission investments and associated transmission rights and derivative contracts