[BETA] Fortnightly

For the past several decades, utility regulation at the state level dealt with secure local markets and truly captive customers. A regulatory compact flourished that offered reasonable prices to customers, while guaranteeing the monopolist the opportunity to earn a fair rate of return on prudently incurred investments. Cost-based, rate-of-return regulation provided a means to this end.

Unlike the past, the future portends unknowns for ratepayers, incumbent monopolists, competitors, and regulatory agencies. To accommodate that future, we believe a properly designed, incentive-based mechanism will prove superior to traditional rate-of-return regulation because it will allow the incumbent utility to compete with new market entrants on an even plain, while protecting the captive ratepayer and not interfering with competition.

Technology and Regulation

Whether engendered from product innovation (as in telecommunications) or process innovation (such as cost savings in the electricity industry), technological change lies at the heart of emerging competition and is the principle reason why changes in regulation are beginning to occur.

Technological developments in telecommunications have dropped the cost of market entry, forcing a reexamination of the natural monopoly argument. Digital and fiber-optic technologies allow the network to handle enormous quantities of voice, video, and information data. Coupled with the explosion of wireless technology and the potential of personal communications services, a dynamic industry has emerged with new and never-before-imagined services. And though not as spectacular, new technologies are beginning to emerge in the electric industry that are forcing regulators to rethink how they regulate. New generation technologies have lowered average generation costs and have enhanced the carrying capacity of transmission. These changes open doors for competitors of all types, undermining the assumptions of traditional regulation.

But rate-of-return regulation, through its inherent internal inconsistencies, fails to penalize inefficient producers or reward efficient ones. It does not create the incentives needed to lower costs or innovate (em two crucial

aspects of a technologically driven industry.1

The design of any incentive plan must take into account the dynamic movements of the regulated market relative to the current regulatory mechanism. Brown, Einhorn, and Vogelsang (1991) developed a set of criteria to evaluate any new regulatory structure.2 In no particular order, they suggest that any regulatory structure should, at a minimum:

1 Meet revenue requirements

2 Encourage cost minimization

3 Allow cost reductions to ben-

efit consumers

4 Maintain high service quality

5 Improve pricing efficiency

6 Ensure sustainability

7 Recognize fairness concerns

8 Streamline regulatory

workload

9 Use easily measured data.

In addition, we would add:

10 Promote innovation

11 Provide flexibility.

Regulators must assign a priority to each of these items when evaluating incentive-based regulatory structures. But cost-based, rate-of-return regulation does not meet requirements 2, 5, 6, 8, 10, or 11. We believe these criteria are vitally important. In our opinion, the imperfections of rate-of-return regulation are overcome in the alternative regulatory plan approved for Ameritech-Illinois.

Telecommunications (em

Lessons Learned

In October 1994, the Illinois Commerce Commission (ICC) enacted price-cap regulation for Ameritech-Illinois.3 Price-cap regulation focuses on constraining the company's prices, within a given degree of flexibility. Profits are allowed to fluctuate with the degree