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The ABCs of PBR

Fortnightly Magazine - July 15 1995

or engaging in some other type of cost-cutting that reduces some measure of performance. The solution is to devise a system that directly links the sharing of cost savings to quality standards. In designing this third component of the PBR system, the regulator must:

Determine Parameters. The relevant quality parameters should include, but perhaps not be limited to, system reliability, customer service, and employee safety. Each of these parameters is regularly measured by utilities and therefore easy to monitor. For example, one common measure of system reliability in the electricity industry is the "average number of customer interruption minutes," while employee safety can be measured by the accident rate. Similarly, customer satisfaction is typically measured, albeit less precisely, through annual customer surveys for activities and areas such as field service and meter reading, local office, telephone center, service planning, and energy services.

While these various quality parameters may be easy to measure, they are difficult to value. For example, what is the dollar value of a 5-percent decrease in service reliability or customer satisfaction?

Set Thresholds. The PBR regulator may be tempted to simply peg quality at its existing level; but these levels may not, in fact, be optimal. For example, under traditional rate-base regulation, the utility may have padded its service force, or overbuilt its generation system. However, in cutting levels of target quality, the PBR regulator runs the risk of political criticism when levels of service or reliability fall.

Establish Penalties. In theory, the optimal penalty system is straightforward: Set the penalty high enough to outweigh gains from cutting service quality.

The easiest and toughest penalty would be to deny the utility its share of cost savings when a quality parameter is breached. Under such a rule, the quality threshold is inviolable. The danger here is that such a rule would discourage risk-taking on the part of utility managers and likely lead to a non-optimal "quality cushion" well above the quality threshold. A second, more flexible, approach is to assess the penalty as some fraction of the cost savings that increases as quality falls. Regardless of the method used, the most important rule is "do not impose small penalties for big violations and vice versa."

Implementing PBR

In the "one period and deregulate" framework, the PBR regulator sets a baseline, provides the utility with incentives to beat the baseline, and then deregulates the utility at the end of the period. Under this framework, utilities have two unambiguous incentives to minimize costs.

The first incentive is the potential savings available from the sharing mechanism. Utility managers can be expected to respond appropriately to a well-designed sharing mechanism. The second incentive is the competitive pressures of the market place: Utility managers can use the PBR period to "get into shape" for the rigors of competition waiting at the end of the experiment.

Under a recurring, multi-period framework, however, PBR may not provide the same incentives or results. Utility managers will weigh the benefits of achieving costs savings in any given period against the loss of utility savings and degrees of freedom in