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The ABCs of PBR

Fortnightly Magazine - July 15 1995

will be achieved along with maximum rate reductions for customers, thereby enhancing economic competitiveness.

The obvious problem, however, is that in a world of incomplete information, the precise savings cost curve is unknown. Therefore, a multi-tiered progressive mechanism may be a more practical compromise. The figure on the previous page illustrates the key differences between such a progressive sharing mechanism and an alternative regressive sharing mechanism in a world of either scarce or abundant cost savings.

Supply curve "A" represents a world in which cost savings are relatively scarce and expensive to achieve. Supply curve "B" represents a world in which cost savings are relatively abundant and inexpensive to achieve. (Note that both curves slope upward, reflecting the principle of increasing costs.)

The "ascending staircase" in green represents a multi-tiered progressive sharing mechanism in which the utility receives 25 percent of the first 100 basis points, 50 percent of the next 100 basis points, 75 percent of the next 100 basis points, and 100 percent thereafter. The solid portions of the staircase trace the utility's share of savings. Equilibrium in the abundant cost savings world occurs at point D. Maximum cost savings are achieved, and ratepayers receive a substantial portion of the savings.

In contrast, the "descending staircase" in gray represents a regressive sharing mechanism in which the utility receives 100 percent of the first 100 basis points, 75 percent of the next 100 basis points, 50 percent of the next 100 basis points, and 25 percent thereafter. With a regressive mechanism, equilibrium occurs at point C. Significantly less cost savings are achieved than with the progressive mechanism (em almost 200 basis points less.

Note, however, that the progressive sharing mechanism does not perform as well in the scarce cost savings world. Equilibrium is at point A, with 30 basis points of cost savings. The regressive sharing mechanism, on the other hand reaches equilibrium at point B, a savings of 70 basis points (em although the ratepayer receives none of these savings.

However, this scarce savings scenario belies the basic premise of PBR (em namely, that traditional rate-base regulation has bred a bloated, inefficient cost structure. Moreover, the regressive mechanism fails to meet PBR's goal of increasing economic competitiveness. As the figure shows, PBR's only benefit is a small reduction in technical inefficiency with no compensation to the ratepayer and a small reward to shareholders.

If PBR regulators believe that potential cost savings are small and potential rate reductions are negligible, there really is no point in embarking upon an admittedly speculative PBR experiment. On the other hand, if PBR regulators believe that utility cost structures are bloated, a regressive sharing mechanism is unambiguously undesirable and a progressive sharing mechanism will always be preferable.

Choosing a Quality Control Safeguard

The function of the quality control mechanism is to establish a clear link between any utility cost savings achieved under PBR incentives and the maintenance of various measures of utility performance. The potential problem is obvious: The utility may be tempted to achieve false cost savings by deferring necessary maintenance, reducing service personnel,