[BETA] Fortnightly

In the alphabet soup of regulatory acronyms, performance-based ratemaking (PBR) may help shape events well into the next century. At present, PBR is being implemented, or considered by, public utility commissions (PUCs) in over 20 states. By 2000, PBR is likely to reach most of the 50 states as well as the Federal Energy Regulatory Commission. The pressures of a global economy have raised the stakes. State regulators as well as politicians are increasingly aware that major industrial sectors such as electricity, gas, and telecommunications can play a key role in creating (em or destroying (em competitive advantage. This concern over economic competitiveness is fueling the PBR experiment.

Proponents tout PBR as an evolutionary reform of traditional regulation for so-called "natural monopoly" industries such as electricity and gas distribution. PBR is also being promoted as a useful transitional step or "bridge" toward complete deregulation of electricity generation.

The basic premise of PBR is that traditional, cost-plus regulation does not teach utility managers to minimize costs but rather to strategically conceal their firm's true minimum cost curve. Why?

Because a set of "perverse incentives" encourages managers to inflate the firm's operation and maintenance expenses, "goldplate" or overinvest in capital, avoid optimal risk-taking, and otherwise operate inefficiently.

Though touted as a solution to this problem, PBR presents three paradoxes:

1) The PBR regulator seeks to encourage a utility to operate at minimum cost, but does not know the firm's true cost structure.

2) The best way to promote maximum cost savings is to give all the savings to the utility, but this defeats the goal of reducing the cost of service to customers and thereby enhancing their economic competitiveness.

3) Any effective PBR system must prevent utilities from cutting quality to achieve false "cost savings"; however, such mechanisms are expensive and difficult to implement, and changes in quality (em though easy to measure (em are difficult to value in the market.

The policy question is whether PBR will be a positive force for change or, as one critic has put it, simply "a luxury trip to nowhere, at ratepayer expense." A poorly designed PBR system will exacerbate, rather than eliminate, regulatory inefficiencies. It may also destroy, rather than help create, competitive trade advantage.

Designing a PBR System

To design a system of incentives that encourages utility managers to pursue savings both in the short and longer run, the PBR regulator should set a "baseline" revenue requirement that will permit adjustments for inflation, productivity, and other factors over time. Next, the regulator should provide utility managers with a package of incentives that encourages them to produce at a cost below this baseline. Any sharing of cost savings between ratepayers and shareholders must preserve the manager's incentive to pursue such savings. Finally, the regulator should include a "quality control" mechanism to ensure that the utility does not pursue cost savings at the expense of system reliability, safety, customer satisfaction, and other measures of quality.

In taking these three steps, the PBR regulator faces several potential pitfalls. First, the baseline revenue requirement must not be set too