Promoting efficiency with neutral operationalcapital incentives under large uncertainty: A comparison of electricity distribution remuneration schemes

Abstract

Decarbonization of the energy sector involves the proliferation of decentralized renewable generation, and the electrification of energy uses, such as transportation, heating and cooling, and industrial processes that require renovation and new investment in electricity networks. In this context, the combination of traditional investment in grid infrastructure with smart grid solutions is required to minimize costs for consumers. Because electricity distribution is a regulated monopoly, the efficient combination of both solutions critically depends on the incentives embedded in remuneration schemes of distribution companies. Regulatory bodies increasingly emphasize the need for operationalcapital expenditure-neutral incentives, as a persistent bias toward capital-intensive investment in traditional grid reinforcement may hinder the deployment of smart grid flexibility-based alternatives. At the same time, in this context, growing uncertainty in future load growth requires adaptable network planning to put in value smart-grid flexibility solutions under the correct incentives given by distribution remuneration schemes.This paper formulates a methodology to quantitatively assess how different distribution remuneration schemes: cost of service, revenue cap, and total expenditure with a fixed capitalization rate, impact the investment decisions of a profit-maximizing distribution company.Our results show that the total expenditure with a fixed capitalization rate scheme, despite common belief among actual regulators, leads to cost misallocation, which, when combined with efficiency incentives, creates distortive investment signals. In contrast, the revenue cap scheme, if designed with a sufficiently high incentive rate, not only fosters efficiency but also mitigates the capital-intensive solutions advantage. Furthermore, once efficiency is properly incentivized, adaptable planning can deliver substantial savings and should be prioritized by regulators, following the shift from cost of service toward revenue cap with profit-sharing schemes.