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The ABCs of PBR

Fortnightly Magazine - July 15 1995

all future periods. Suppose that in the first regulatory period, utility managers undertake the appropriate actions and investments, and the utility eliminates all possible waste from its operations. The question is: What have utility managers given up?

If we assume that this new cost structure will serve as the initial baseline for the next period in the PBR cycle, the utility will have nowhere further to go to reduce its costs. It will also run a greater risk of being "low-balled" by the PUC (em that is, having its baseline set at a level where it could actually lose money. Perhaps most

importantly, in exchange for the cost savings achieved in the first period, the utility and its managers will forgo all the benefits associated with operating with a more inflated cost curve in future periods (em larger and more plush offices, high salaries, company cars, excessive staff, and so on.

The bottom line: PBR is unlikely to be a panacea for the ills of traditional rate-base regulation, particularly when applied in a multi-period model of continuing regulation. Moreover, PBR is clearly unlikely to reduce administrative costs significantly. The analytical problems associated with setting the baseline revenue requirement alone are formidable and resource intensive. They will require a type of proceeding similar to the general rate case format. Further, the information requirements for designing an appropriate sharing mechanism are demanding, as are the resource requirements for adequately valuing nonmarketed amenities such as customer service and employee safety. All in all, PBR is not an experiment to be undertaken lightly. t

Peter Navarro is a professor of economics and public policy at the Graduate School of Management, University of California-Irvine. Mr. Navarro offers a more indepth and technical treatment of PBR in "The Simple Analytics of Performance-based Ratemaking," an article that will appear in the winter issue of the Yale Journal on Regulation.

PBR in a Nutshell

The mechanics of implementing PBR are relatively straightforward.

First, avoid setting the baseline revenue requirement too high. Do not incorporate excessive escalators, indexing factors, or passthrough mechanisms. They can remove incentives in specific areas.

Second, choose a progressive rather than regressive sharing mechanism with as many tiers as practical. Forgo PBR if potential gains are small relative to risk.

Third, design a quality control mechanism that includes worker safety, system reliability, and customer service. Link the rewards from cutting costs to penalties for cutting quality.

California Scheming: PBR in Practice

In October of 1992, citing the need to "reduce the significant burden and regulatory inefficiency that arise from traditional regulatory oversight," San Diego Gas & Electric Co. (SDG&E) asked the California PUC for permission to convert to a PBR framework. That permission was granted on August 3, 1994, in Decision 94-08-023. Unfortunately, the CPUC adopted a precedent-setting PBR framework that appears to violate the basic principles of sound PBR.

First, the CPUC rejected statistical benchmark modeling and instead approved a baseline revenue requirement proposed by SDG&E that was arguably too high and based solely on firm-specific data.

Second, the CPUC endorsed the highly regressive sharing mechanism