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The ABCs of PBR

Fortnightly Magazine - July 15 1995

high or too low. Second, the sharing mechanism must encourage the utility to pursue the maximum achievable cost-effective cost savings rather than simply allowing the utility to reap the lion's share of the most easily achieved cost savings and then stop. Third, there must be a reasonable link between the penalty system for quality deterioration and the reward system established by the sharing mechanism. In this regard, the PBR system must not include any additional alleged "incentives" that, in reality, may have little or no relation to the utility's strategic behavior.

Setting a Baseline

Setting the baseline correctly is absolutely critical. The regulator faces the same problems of gamesmanship, incomplete information, and cost revelation as it does under rate-base regulation. Specifically, the utility will attempt to inflate the initial baseline, build in a generous escalation factor, and minimize any offsets such as "productivity factors."

Ratepayer advocates will have a tendency to do just the opposite: Understate the baseline, minimize escalation, and boost the productivity factor. To cope with this strategic gaming problem, the PBR regulator has three options: 1) use the same method used in rate-base regulation, 2) use a statistical benchmark model approach, or 3) apply some combination of the two methods.

There is nothing a priori to suggest that PBR will set a more bloated baseline than rate-base regulation. Nevertheless, statistical benchmark modeling can help the regulator reach a truer approximation of a firm's minimum cost curve.

The basic unit of measure in traditional rate-base regulation is the firm itself or, perhaps, a small cluster of firms operating within the regulatory jurisdiction. In contrast, statistical benchmark modeling examines the price and cost structure of a much wider sample of utilities. It then normalizes this data by adjusting for geography, weather, fuel mix, and other operating conditions and characteristics. A well-executed statistical benchmark modeling procedure can thus be used in a PBR proceeding both as an independent check on the traditional, firm-specific method of determining the baseline revenue requirement as well as a guidepost to the target ending point of the PBR experiment. If PBR works, this ending point should be the firm's true minimum average cost.

Choosing a Cost-Sharing Method

The major purpose of PBR is to encourage utilities to voluntarily undertake cost savings and then distribute a portion of those savings to ratepayers. If we assume that the profit-maximizing utility will pursue cost savings up to the point they no longer pay, then equilibrium in this PBR "market for cost savings" will occur at the intersection of supply (which reflects marginal cost) and demand (which reflects the utility's marginal revenue).

In a world of increasing costs, each additional increment of savings will be more expensive to achieve than the last. This means that the best cost-sharing mechanism will be "progressive" rather than "regressive." That is, the utility's share should increase, not decrease, with the amount of cost savings achieved.

In a world of perfect information, the supply curve for cost savings will be known, and this "progressive" mechanism will smoothly and continuously track up the supply curve. Maximum savings